Imagine an actively managed mutual fund that charges a management fee of just 0.05% or 0.10% if it performs in line or below its benchmark and only costs more if it beats its benchmark by 140 basis points.
Would that fee structure pique your interest as a financial advisor, maybe propel you to deposit assets into that fund, possibly from a passive ETF or index fund? Could this fee structure be the savior for actively managed funds that have lost approximately $1 trillion in asset flows to passive ETFs and index funds?
(Related on ThinkAdvisor: Asset Managers Struggle With Outflows, Fee Compression)
That’s what AllianceBernstein is hoping for with a handful of new actively managed funds known as the AB Performance Fee Series that it registered with the SEC. Five are equity funds – Large Cap Growth, U.S. Thematic, Core Opportunities, International Strategic Core and Emerging Markets Growth Portfolio – and one is a bond fund, the International Bond Portfolio.
(Related on ThinkAdvisor: AllianceBernstein Fires CEO Peter Kraus and Removes More Than Half Its Board)
If the funds fail to beat their benchmarks by sizable amounts — 140 basis points for all the equity funds except the Emerging Markets fund, where the hurdle rate is 175 basis points, and 70 basis points for the bond fund — investors pay only a small management fee. That fee is 0.05% for the equity funds and 0.10% for the bond portfolio.
The maximum fees, then, range between 0.05% and 1.05% for four of the equity funds, excluding Emerging Markets, whose management fees range between 0.05% and 1.45%. The management fee for the International Bond fund ranges between 0.10% and 0.70%. Dean Ungar, senior analyst at Moody’s Investors Service, says the new AllianceBernstein funds are “trying to give investors and advisors … reasons to buy their funds, and not mimic an index….The intention is to remain an active manager.”
Ungar, who spent nine years working in the wealth management research division at UBS, expects the new AllianceBernstein Performance Fee Portfolios will interest advisors. “Active management is under pressure … from outflows and fee pressures due to the passive revolution,” says Ungar, noting that is why Moody’s has a negative outlook for the industry. “The changes we’re seeing, if successful, can maybe stabilize the active management part of it.”
The AllianceBernstein Performance Fee Series of funds falls into the category called fulcrum funds, where the fulcrum (the pivot point) is the hurdle rate that compares to a benchmark, above which the fund collects a performance fee and below which it doesn’t, or some variation on that theme. AllianceBernstein bases its management fees on performance over a 12-month period; other funds base fees on performance over 36 months or 60 months, and their hurdle rates are not as high.
Laura Lutton, director of North American manager research at Morningstar, says such funds are “a creative answer to a complicated question: How are active funds going to remain competitive with passive options over the long term?
“Fees are on a lot of firms’ minds at this point and they’re considering many options to keep funds competitive as big distribution partners like broker-dealers are increasingly looking at cost and performance, and [Labor Department] regulatory changes make distributors increasingly fee conscious,” says Lutton. “Lower fees increase the odds of outperforming (and higher fees reduce those odds) as well as the staying power of firms.”
Performance-based fees are not new for mutual funds, according to Lutton. Fidelity, Putnam, Janus and Vanguard use them for certain funds, but the firms don’t seem to publicize them.
Vanguard, best known for its passive index funds and ETFs, uses performance-based fees for its actively managed equity funds managed by subadvisors, such as its Windsor Fund, Growth and Income and Capital Value.
(Related on ThinkAdvisor: Vanguard Announces Fifth Round of Fee Cuts Since December)
“If a fund outperforms [its benchmark] in a quarter, typically on a trailing 36-month basis or in some cases 60 months … it may earn an extra 50% of its base fee,” says Dan Newhall, who heads a team that oversees funds and managers.
The outperformance must be meaningful, roughly 1%, which will result in a 25% to 50% premium payment, depending on the contracts negotiated with the outside portfolio managers of the fund, according to Newhall.
He says such payments “align success with success and disappointment with disappointment for shareholders.”
An example of the latter can be found in the annual report for Vanguard’s Capital Value Fund, which trailed its benchmark and the average return of its peers. The fund returned 11.36% for the 12 months ended Sept. 30, 2016, compared with 16.38% for its benchmark and the 12.39% average return of its peers.
As a result, a negative performance adjustment deleted $1.956 million from the fund’s $2.203 million investment advisory fee, according to the Statement of Operations. The ratio of total expenses to average net assets in the 2016 fiscal year was half what it was in 2015, falling from 0.50% to 0.25%, according to the Financial Highlights section of the annual report.
Despite its reputation as an index fund behemoth, Vanguard runs about $350 billion in actively managed funds.
Its CEO, Bill McNabb, in an interview for the firm’s newsletter, spoke about the active vs. passive debate, noting it “shouldn’t be indexing versus active; it’s low cost versus high cost … We do think there’s a place for active – it needs to be low-cost active.”
Performance-based fees for actively managed funds may help them find their place.
— Related on ThinkAdvisor:
- How to Use Active Share to Find High-Performing Mutual Funds
- These 10 Actively Managed Funds Beat S&P 500 for 15 Years: Morningstar
- Think Longevity, Not Just Performance, When Buying Actively Managed Funds
- T. Rowe Price Launches Robo Platform With Only Actively Managed Funds