Some Funds Raise, Lower Fees Based on Performance

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."