Citing adviser frustration, TFS Fund backs away from performance-based fee

The ‘most aggressive mutual fund management fee known to man' was too ‘complicated' for advisers, according to a TFS exec

Feb 10, 2010 @ 10:04 am

By Jeff Benjamin

After nearly four years of linking its management fee directly to its investment performance, TFS Small Cap Fund (TFSSX) is raising the white flag and reverting to a more traditional static expense ratio.

“We love the idea of performance fees and it's right up our alley, but we've gotten some strong feedback from advisers that the fund's fee structure is too complicated and they don't like the unpredictable nature of the fees,” said Larry Eiben, chief operating officer of TFS Capital LLC.

The boutique asset management shop, with $1.1 billion under management in two hedge funds and two mutual funds, has already received advisory board approval and is currently gathering proxy votes on the proposed fee change.

If approved, the fund's total expense ratio, which currently adjusts on a fulcrum of 0.5% to 3% depending on how it performs relative to its benchmark, will lock in at 1.75%.

Mr. Eiben is expecting shareholders to support the change, which will likely take effect in March.

While the fund has grown to $22 million from $1.5 million when the fulcrum fee was introduced in March 2006, Mr. Eiben believes the unique fee structure has hindered inflows.

“We were surprised and disappointed by the reaction we got from advisers,” he said. “We had the most aggressive mutual fund management fee known to man, and it was not easy to set it up and get through the SEC.”

The fund's management fee was set up to earn just the basic administrative costs of 50 basis points unless the 12-month trailing performance beat the Russell 2000 Index by at least 2.5 percentage points.

“We wanted to be paid nothing if we couldn't beat that benchmark,” Mr. Eiben said. “In our eyes it's the right structure, because we felt our interests are aligned with our investors, and if we don't provide value we go out of business.”

Once the fund beats its bogey, the expense ratio starts at 1.75% and goes as high as 3% -- provided its 12-month trailing performance exceeds that of the index by 5 percentage points.

The fund's expense ratio is currently at the maximum level following its 65.4% gain last year.

The Russell 2000 Index gained 27.2% last year, meaning that the TFS fund had to do better than 29.7% to start earning a management fee, and better than 32.2% to earn the maximum fee.

The fund's performance ranked it in the third percentile of the small-cap blend category as defined by Morningstar Inc.

The category average last year was 31.8%.

The fund, which has a five-star rating from Morningstar, didn't do quite as well in 2008 when it declined by 38.4%, finishing in the 70th percentile of a category that averaged that had an average decline of 36.5%.

Investors in the fund were reimbursed management fees following 2008 when it failed to beat the Russell 2000, which declined by 33.8%.

It’s estimated that less than 10% of the more than $9 trillion in open end mutual funds is subject to fulcrum fees, according to Jonathan Kreider, fiduciary research analyst with Lipper Inc.

The use of fulcrum fees on mutual funds has been around for decades, but Mr. Kreider said there’s never been a general rush to add the fees or eliminate them based on things like market conditions or general marketing.

“The most critical comments we hear about fulcrum fees is that they might encourage the manager to take on more risk in an effort to generate those returns that lead to the higher fees,” he said. “But the fee ranges are usually pretty tame, and it’s nothing like you see in the hedge fund world.”

According to Mr. Kreider, most mutual fund fulcrum fees are set to move no more than 40 basis points in either direction.

A number of firms use fulcrum fees for some of their mutual funds. The list includes Fidelity Investments, The Vanguard Group Inc., RiverSource Investments, Janus Capital Inc., Putnam Investments and USAA Investment Management Co.

Unlike hedge fund performance fees that are typically added on top of asset-based fees and commonly take 20% or more of a portfolio’s gains, mutual fund fulcrum fees are more restrictive.

The Securities and Exchange Commission mandates that a mutual fund performance fee be set up as a fulcrum that increases or decreases based on portfolio performance. The fee must be based on the fund’s performance net of other fees.

According to a 2008 study of mutual fund fulcrum fees conducted by Lipper, those funds with incentive fees out-performed their Lipper categories, on average, over the prior 10-year period.

But the research also found that funds with fulcrum fees did take on slightly greater risk as measured by volatility of returns.

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