Is it time for performance linked fees in active mutual funds?

Published: March 11, 2023 at 6:00 am

We have repeatedly shown that most active mutual funds struggle to beat category benchmarks. This is not just a trend seen in large cap funds – Active Large Cap Mutual Funds vs Nifty 100 performance analysis.

Contrary to popular belief, the trend is also seen among mid cap funds as well – Only 3 out of 28 mid cap MFs consistently beat Nifty Midcap 150! While active small cap funds manage to beat the small cap index, they come up short compared to a mid cap index – Why investing in small cap mutual funds does not make sense!

Aggressive hybrid funds are also no exception! Why we badly need an aggressive hybrid index fund!

The biggest grouse against an active fund is its high fee is the same regardless of performance. A fund can go for years and years without beating the benchmark, but it would still earn the same high fee and even increase it!

While this model will not disappear anytime soon, small fund houses or new ones can consider adopting a performance-linked fee model for their active funds.

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How could this work? Suppose an active fund is launched with a fee of about 1.5% per year for the direct plan. This fee is deducted from the NAV since inception daily basis.

If, after a year of trading, the fund has beaten its benchmark (say by a margin of at least 0.25% after expenses) it can charge the same 1.5% next year as well. If the fund has fallen short, the next year’s TER is reduced by, say, half  to 0.75%

Please note: I am not saying all active funds should follow this way or that the regulator should impose this. I think such a performance liked free structure should be offered as a variant by at least some fund houses.

There can be other variants as well. For example, if after deducting 1.5% fees for one year, the performance after the fee is below the benchmark, a portion of the fee can be distributed back to the fund.

Or the fund can charge a fee equal to an index fund, say about 0.5% a year, and if the performance at the end of that period is above a certain threshold (hurdle rate), a portion of the gain goes to the AMC, just like a PMS. For example, “20% of Profit over 10% gains” is a typical clause in many PMSes. To prevent misuse, the high watermark principle can be used.

If a one-year time frame is too harsh to judge an active fund, it can be done over two or three years (not more!). I don’t claim to be an expert on this matter, but the essence of the idea is simple: no performance = no higher fee (higher relative to an index fund)

What are the advantages? A person who seeks to beat the market with an active fund will pay a fair price. They will not be overcharged when the fund is doing badly and will pay a reasonable fee for outperformance. This will prevent fund managers from sleeping at the wheel.

What are the disadvantages? It could lead to deviations from the benchmark, from the investment strategy and higher risks to earn more returns and, therefore, fees. Conviction bets may drop, giving rise to higher churn and momentum chasing. Meaning only funds with a small size can adopt this. So the risks may increase. The regulator may need to keep a closer eye on such funds.

It won’t be perfect (what is?), but at least an informed investor can take a reasonable bet with such funds and not pay extra when the fund does not deserve it.

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