Monday, April 5, 2010

The State of the Mutual fund industry

Got to play catch-up

assets robbed by index funds

fix: sliding fee scale.


I'm not a fan of actively-managed mutual funds. It's not because some managers aren't able to produce alpha, simply that most aren't able to. They either aren't equipped to or, more likely, they are much more comfortable mimicking their underlying index while making small changes around the sides. That way they place a small bet on "beating" their benchmark, while minimizing their downside. Do they deserve over a hundred basis points more per year for that kind of mediocrity? The overwhelming answer is no, and America has spoken by moving their money out of actively-managed mutual funds and into passive index funds.

I have an idea for a way to solve this problem plaguing the mutual fund industry to make it more competitive with the passive trend - sliding fee scale. I believe this idea will take out the egalitarianism in the industry and create a more performance-driven environment.
This idea, an example of which is outlined below, is characterized by two main properties: lower fees for underperformance in absolute returns and relative to the stated benchmark. As you can see the fees (which are a percentage of the assets under management) increase left-to-right and bottom-to top reflecting these properties. The plus-or-minus 2% band around the benchmark correlate with lower than average to average index fund fees, because what you are getting in actuality is the benchmark and that is all you should pay for.
The highest fees are for positively high absolute returns that significantly deviate from the benchmark index, which indicates a manager with superior portfolio skills and deserves the lion's share of rewards. The opposite is true for the least skilled, the mediocre, and the risk-takers, and multiple years of severe underperformance won't support their (often) large staffs resulting in their exit from the industry. This effect will "clean up" the industry, removing the complacent and ineffective fund managers while promoting those that have the skills necessary to be guardians of many Americans' nest eggs.