Many of us invest in mutual funds without asking ourselves how fund managers are compensated. Is compensation based on fund performance (i.e. does the fund manager have “skin in the game”), or are they paid a fixed amount regardless of performance? As investors should we care? I think we should. Let me explain why…
Fulcrum Fees
Most mutual fund managers are compensated with a flat fee each year. Only a small group of mutual fund managers are paid a bonus/penalized when their performance figures are strong/weak as compared to a benchmark portfolio. Under a “fulcrum fee” arrangement, the mutual fund manager’s compensation increases or decreases depending upon how the fund performs relative to an appropriate benchmark portfolio over a specified period of time.
Although fulcrum fees have many potential benefits, there are several criticisms. Critics argue that basing the fee on performance encourages managers to take more risks than they normally would take. The fees can force managers to take a narrow, short-term approach to their investment decisions because the manager does not want to be penalized for underperforming against the benchmark portfolio. Fulcrum fees can also potentially scare away qualified managers because they don’t want to suffer dramatic income swings.
I believe that the use of fulcrum fees for mutual funds outweighs any of the potential drawbacks. Fulcrum fees make the fund manager focus on delivering returns. Investors pay the fund manager more when they add value but less when they don’t. If a mutual fund doesn’t perform, you don’t add insult to injury by paying high management fees for the poor performance. Fulcrum fees make the manager more sensitive to how the fund is performing because their income is riding on it. A common complaint I hear is that mutual fund companies focus too much time on marketing and don’t spend enough time on investment research. With fulcrum fees, the fund manager will have an incentive to devote more time and attention to managing the assets of the fund as opposed to marketing and gathering new investors.
Dunham & Associates, a San Diego based investment firm that I highly recommend, has been using fulcrum fees in all of its funds since its inception in 1985. They strongly believe that the fees a client pays should be tied to the success of their investments, wherever possible. Currently, Dunham has 17 institutionally, sub-advised public mutual funds. The funds range from lower risk investments, such as corporate and government bonds, to high risk investments, such as small capital growth stocks. A complete list of their funds is available at www.dunham.com.
What type of mutual fund you should invest in for your retirement needs will vary depending on your unique situation. In addition to looking at the charges and expenses of investing in a particular mutual fund, you also need to look at several other important issues. Your risk tolerance will help determine the proper asset allocation of your investments. The amount of money you will need in retirement, when you anticipate retiring, and how long you expect to live are all important considerations. Inflation estimates should also be considered since the purchasing power of a dollar in the future may be much less than it is today. And last, but not least, tax consequences need to be factored into your decision.
If you are interested in learning more about fulcrum fees, need assistance in determining how to invest for retirement, or would like more information on Dunham & Associates, their investment strategy and their funds, please contact R. J. Kelly.
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Written by R. J. Kelly – March 2014