The last year has seen a steady and encouraging rise of alternative fee structures in mutual funds. In particular, a number of managers have adopted so-called fulcrum structures to their mutual funds. All of these funds charge a low or zero base fee, and then a performance fee for outperformance of their relevant benchmark. The idea is that customers only have to pay up for services that actually outperform benchmarks. Some providers that now offer these funds include AllianceBernstein, Fidelity, Allianz, and Fred Alger. The main criticism of the funds that is that they can skew incentives and push managers to take outsized risk in order to produce upside.
FINSUM: These funds are not without their imperfections, but they are a useful and thoughtful response by mutual fund managers who are realizing they need to do more to justify their raison d’etre versus ETFs. We think they are a good deal for investors because if the results aren’t good, you pay very little, if they are great, you pay for it. Compare that to an ETF, where you are never going to outperform, but will likely pay more than 10 bp.
The Wall Street Journal has published an interesting article giving advice to investors on how to assess, and when to dump, losing mutual funds. The article makes the point that investors should not automatically clear out their losing funds, just like they shouldn’t always buy winning ones. Funds have their own reasons for poor performance and those reasons can have a big impact on whether they should stay in a portfolio. Here are four questions to ask in assessing funds, “Does the fund have a good process in place?”, “Is the manager sticking to his or her own guns?”, “Is there a new manager, and do I trust him or her?”, “Is this negative performance coming in a segment of the market in which it is tough to beat index funds?”.
FINSUM: Good funds can have significant down periods, so it is important to have a methodology for deciding if and when to dump them.
The move towards passive management has been worthy of the term “flood”, with investors pouring funds into ETFs and out of mutual funds. Fees have been a major part of that shift, but performance has been too, as active management performance has been broadly weak over the last decade. However, there are some areas where mutual funds have significantly outperformed passives—international funds. Especially in emerging markets (e.g. India and Mexico), but also in developed ones like the UK and Italy, 10-year track records show significant outperformance for active managers. The opposite is true in US funds.
FINSUM: Sifting through market opportunities gets harder and harder (and finding alpha alongside it) as you move into less liquid markets. Accordingly, we think there is a lot of benefit to using actively managed funds for international stocks.
Over the last couple of years there has been a movement on the fringes of the active management space. That movement was towards funds that only charge investors full and/or rising fees if they outperform a given benchmark. If they underperform, their fees would fall back to ETF levels. Well, that idea has taken a big step recently as major fund provider AllianceBernstein has a handful of so-called “fulcrum funds”. The largest is the AB FlexFee Large Cap Growth Advisor Fund, with $106m under management. A top figure at AB put the goals most clearly, saying “The big impact of this will be if we can take money from passive, or money that would’ve gone there … That’s the ultimate goal here”.
FINSUM: Fulcrum funds make a lot of sense for active managers and clients. If the fund managers do their job and seriously outperform a benchmark, then higher fees make sense. If they don’t, then fees stay low.
One of the very interesting aspects—which is thoroughly underreported—is that despite the rise of ETFs, mutual funds have held a major portion of market share in the advisor allocation business. One of the trends which has emerged is that the growth of ETFs has not really cost mutual funds as much as one would expect. Rather, advisors have just started to use them in different ways. ETFs are seen as better for broad passive exposure, but when it comes to active management, mutual funds are seen as the superior choice. This helps explain why smart beta and other forms of active ETFs have been relatively unsuccessful.
FINSUM: It is not mutual funds that have suffered from the shift to ETFs, rather it has been variable annuities and individual stocks. This is a quite a positive development for the asset management industry, in our opinion.