The notion of “2-and-20” hedge fund fees often seem rapacious for cost-sensitive investors. But many people understand that aligning a fund manager’s compensation with his performance can be a powerful incentive to beat established benchmarks.

In the spirit of that concept, several mutual fund companies use a special kind of performance-based fee structure, known as fulcrum fees, to some degree in their funds. Dunham & Associates employs this structure in their entire suite of funds, while companies including Fidelity Investments, Janus Investments and Satruna Capital use them in some of their funds. 

We may now be witnessing a trickle-down of fulcrum fees into the exchange-traded fund segment. The just-launched AdvisorShares Focused Equity ETF (CWS) will deploy fulcrum fees, which in theory will help the firm attract assets through this seemingly investor-friendly expense approach.

How They Work

Fulcrum fees have some moving parts. A mid-range fee is established, and then that rate is adjusted upward or downward within a range, depending on whether the fund beat or lagged its benchmark. In the case of the AdvisorShares fund, the benchmark is the S&P 500.

The CWS fund’s stated expense ratio is 0.75 percent, but can range from 0.65 to 0.85 percent. The fund would charge the high end of that range if its returns exceed the S&P 500 by at least two percentage points, and fall on a sliding scale down to 0.65 percent if the performance lagged the benchmark by at least two percentage points.

Of course, this means the fund doesn’t need to deliver positive returns to charge the maximum fee—it only needs to fare slightly better than the S&P 500. According to the prospectus, “the investment strategy typically identifies large- and mid-capitalization stocks, although the Fund also may invest in certain small-capitalization or micro-capitalization stocks to a lesser extent and at certain times.”

AdvisorShares is banking on the strong reputation and track record of Eddy  Elfenbein, author of the popular website Crossing Wall Street since 2005. His approach, known as GARP (Growth at a Reasonable Price) investing, focuses on consistent growers that sport relatively low valuations. He also considers himself to be a buy-and hold investor, typically owning a stock for at least a year. His 20-stock annual model portfolio swaps out only five positions each year, avoiding the frenzied trading that many investors deploy to try to stay ahead of the market. “I wanted to show investors that you can beat the market with a ‘less is more’ approach,” he says.

Matching GARP and buy-and-hold investing approaches has clearly paid off. Over the past decade, Elfenbein’s model portfolio has returned 164 percent, well ahead of the S&P 500’s 102 percent gain in that time. (Both figures reflect total returns including dividends). His approach has beaten the S&P 500 in eight out of the past 10 years.

Why would he want to expose himself to an uncertain compensation structure? “It’s a way of saying I stand behind this approach 100 percent,” Elfenbein says. “I should share in pain or the gain of the fund.”