Are performance-based management fees conducive to mutual fund investment success? Not necessarily. Many funds with performance-based fees failed to outperform their respective benchmarks over the past five years. In the down markets, however, the data show that many funds with management-fee incentives avoided excessive losses, perhaps indicating that managers were not taking outsized risks in order to earn bonuses.

At first blush, over the past five years, it looks like funds with performance bonuses failed to live up to expectations. Over the past five years ending in March 2001, only 24% of all diversified stock funds beat their benchmarks and earned the performance bonus, according to Morningstar in Chicago.

Even though they failed to beat their benchmarks, the incentives may have motivated the managers to beat their peers. During the same five years, 60% (61 of 101) of diversified stock funds with performance-based management fees outperformed their peer-group averages, Morningstar says.

Fidelity Investments, which has the largest number of funds with performance-based fees, did fare much better. Over the past five years, only 15 of Fidelity Investments' 34 retail funds with performance-based fees (44%) outpaced their respective benchmarks, according to Fidelity Investments. While this 44% figure seems modest, it compares with 24% among the large-fund universe, and it occurred in a roaring bull market in which fund managers lagged their indexes by wider margins than in more normal times.

The 19 Fidelity funds that underperformed their benchmarks did so by an average of 1.46% annually. The difference is an amount similar to the average expense ratio of the funds. "It doesn't surprise me that many funds have underperformed their benchmarks," says Eric Kobren, publisher of Fidelity Insight, an independent Boston-based newsletter. "Prior to 2000, just a handful of stocks were responsible for the strong performance of the S&P 500. If the funds didn't hold those stocks as their largest holdings, they could have underperformed. It's how the funds performed against their peers that counts."

On average, the 19 Vanguard Funds with performance-based fees failed to beat their benchmarks in 2000, according to Dan Wiener, publisher of The Independent Advisor For Vanguard Investors in Watertown, Mass.

But there are two sides to the coin. Morningstar analyst Scott Cooley says performances fees, at best, keep a fund's performance steady. Typically, incentives are based on three years' performance versus an appropriate benchmark. As a result, fund managers don't have to shoot the lights out or try to jump on the hot stock of the week to beat their benchmarks. Managers' fees are cut if they underperform. So fund managers typically don't bet the ranch in an attempt to earn higher management fees.

"It [performance-based management fees] aligns the management company's incentives to those of the shareholders," Cooley says. "The goal is good performance. But the negative adjustments prevent a manager from taking on too much risk. If they try and hit a home run, they can hurt themselves."

The Fidelity Magellan Fund is an example of what can go wrong. Cooley says the fund had negative adjustments to its management fee through 1999 as a result of big losses due to a huge bet on the bond market in 1996 taken by former manager Jeff Vinik. "Bob Stansky, manager of the Magellan Fund, does not make big asset-allocation bets like the one that got the fund into trouble five years ago," Cooley says. He doesn't want to take major risks that can lead to negative adjustments to his management fees.

Meanwhile, Wiener says Vanguard sets such high benchmarks for its managers that it is difficult to earn the bonus. When the fund manager does well, the management company that subadvises the fund typically gets performance bonuses of 1 to 4 basis points from the tight-fisted Vanguard Group. Last year, the performance-based management fees ranged from minus 22 basis points for the Vanguard Global Asset Allocation Fund to about 4 basis points for Vanguard Explorer and Vanguard Growth & Income. Often, Wiener says, a fund may beat its benchmark or its peers by 50 basis points in total return and not get an increase in its management fee due to the high standards.

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