WITH THE STOCK

market behaving badly, do "pay-for-performance" mutual funds make good sense?

Various fund shops including Fidelity and Vanguard have had these funds for a while. In general, they reduce the management fee if the fund does badly and increase it if the fund bests its benchmark. Since management fees make up the bulk of a fund's operating expenses, this should have a real effect on what a mutual fund costs investors. But after at least three decades of existence, it's still an open question whether they're really a wiser deal.

Philosophically, it's an appealing idea. Investors who buy actively managed funds are paying managers for their expertise in picking stocks as opposed to passively following indexes. So why not attach the cost of that service to how well it's provided? Especially in times like these: Both the S&P 500 and Russell 2000 indexes are in the red so far this year.

"I like them in principle because investors should be willing to pay a bit extra for outsized returns, and a fund company should be willing to reduce its prices when they don't beat the benchmark," says Jeff Tjornehoj, a senior research analyst at fund tracker Lipper. "But it's not cut and dry whether they're always good for investors."

Jeffrey Dunham, founder of Dunham Funds, which runs all 10 of its mutual funds on a pay-for-performance basis, says the media create so much hype about fees that investors focus more on finding funds with low flat fees, rather than ones that will produce the best net returns after fees. "Is an investor better off paying a 0.3% fee for a 2% return, or a 2.5% fee for a 10% return?" Dunham asks. "The focus should be on whether the fees are reasonable in relation to what's delivered."

There aren't a lot of data showing how these funds stack up against traditional funds, which usually charge a flat management fee based on assets under management, or as Dunham says, "they're paid for attendance." But one study by professors at New York University and Fordham University, published in the Journal of Finance in 2003, concluded that these funds have lower expenses and "exhibit better stock selection ability than funds without incentive fees." But, "the investor should realize that residual risk is higher with these funds," and "risk is likely to increase at the very time that returns are poor."

* 10-Year Annualized as of 4/30/08.

Source: Lipper, U.S. stock funds; Standard & Poor's

An unscientific data sampling from Lipper shows large-cap stock funds with and without incentive fees returning about the same amount, nearly 10%, on an average annualized basis over the five years ended April 30. (The sampling pool was 88 incentive funds and 1,404 nonincentive funds.) But the pay-for-performance funds had a slightly lower

, on average, at 0.6% vs. 0.8%.

Pay-for-performance hasn't particularly caught on in the industry, with just over 200 such funds out there, according to Lipper. Vanguard, which has about $1.3 trillion in assets in U.S. mutual funds, stands out for having incentive fees on just about all of its actively managed stock funds. The fee structure varies by fund, since they're negotiated manager-by-manager. Generally, the manager gets a "base fee," which can then go up or down based on how well or badly the fund performs against its benchmark on a rolling three- or five-year basis.

"For managers to put their money where their mouth is further aligns their interests with our shareholders' interests," says Joe Brennan, a principal and head of portfolio review at Vanguard.

It's worth noting that the overall costs of mutual funds have been on the decline for the past two decades, according to the Investment Company Institute, a fund trade group. And, of course, there are plenty of good, low-cost mutual funds out there that don't do pay-for-performance. But for investors looking for another way to narrow their fund search, some of the better-performing pay-for-performance U.S. stock funds of the past decade are worth a try.

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