By Nir Kaissar
(Bloomberg Gadfly) --As investors lose faith in active managers, Fidelity Investments CEO Abby Johnson is trying to stem their flight to index funds. I doubt her plan will work.
Johnson, head of the money manager that built its name and fortune on traditional active management, wrote in the Financial Times last week that the growth in index funds “in part reflects investors’ desire for value and clarity around what they are paying for, and active managers have to respond.”
Here's the problem -- active managers fail to beat their benchmarks primarily because their fees are too high. If managers want to deliver more value to investors, the easiest way is to lower their fees.
Instead, Johnson proposes charging investors sliding fees based on performance, known as fulcrum fees. They work this way: The fund charges a base amount. If the manager beats the benchmark, that base fee goes up. But if the manager loses to the benchmark, it goes down. Johnson theorizes that fulcrum fees would address investors’ desire to bring costs down, make those costs more transparent and "align investment managers’ economics to their clients’ returns.”
Fulcrum fees, however, aren't likely to accomplish any of those things. For starters, funds that charge performance fees aren’t meaningfully cheaper than those that charge a flat fee. According to Morningstar data, there are 205 actively managed mutual fund share classes that charge a performance fee. Their average expense ratio is 1.11 percent. That’s just slightly lower than the 11,806 actively managed share classes that charge an average flat fee of 1.13 percent.
The performance-fee funds have also delivered less value to investors than the flat-fee funds. Morningstar calculates that performance-fee funds have generated an average alpha -- or risk-adjusted outperformance relative to the appropriate broad market index -- of 0.22 percent annually over the last 15 years through September. By comparison, active funds that charge a flat fee generated an average alpha of 0.29 percent.
It’s not even clear that fulcrum fees align managers' interests with those of investors. Johnson doesn’t provide details, but consider the fulcrum-fee funds that Alliance Bernstein recently rolled out. The AB FlexFee US Thematic Portfolio, for example, has a base expense ratio of 0.6 percent. Depending on the fund’s performance relative to the S&P 500, that fee can go as low as 0.1 percent or as high as 1.1 percent.
Investors, however, pay an expense ratio of just 0.04 percent for the Vanguard S&P 500 ETF. So no matter how badly the AB fund performs, investors in the fund will still pay more than twice as much as investors in the fund’s benchmark. That’s precisely the “heads we win, tails you lose” game that Johnson bemoans.
There are ways to make fulcrum fees fair for investors. The base fee, for example, should equal the cost of investing in the fund’s benchmark. And the same percentage of the profits that the manager collects for beating that benchmark should be refunded to investors if the manager loses to the benchmark.
Even so, fulcrum fees leave lots of opportunities for misalignment. They create incentives for managers to take more risk when they’re losing to the benchmark and less risk when they’re winning, regardless of whether those changes are best for investors. They magnify the uncertainty around managers’ compensation, which may interfere with their ability to make unemotional decisions. They also create an incentive for managers to pick easy-to-beat benchmarks in order to rack up fees.
Given those complications, a low, flat fee is more likely to provide the clarity and transparency that Johnson is after. That’s undoubtedly one reason why investors are flocking to Fidelity’s rival, Vanguard Group. Vanguard’s actively managed funds have an average expense ratio of 0.22 percent, while Fidelity’s funds charge an average of 1.01 percent.
Investors have woken up to the fact that low fees are the surest form of alpha. Fancy fee arrangements aren’t likely to dissuade them.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.