By Chuck Jaffe
Dow Jones Columnist

It's one thing to say you want to do the right thing, and something altogether different to actually do it.

For years, investors and financial advisors have suggested that fund managers be paid only when they make money for shareholders. Yet when a fund company establishes a performance fee and puts its money where its mouth is, the idea gets shot down in the marketplace.

Some of the fault lies with the rules and some with investors, but as TFS Capital kills off the most aggressive performance-based fee structure in the fund business, it sends notice that true performance-based fees may be dead.

TFS is a Richmond, Va.-based investment firm that runs about $1.1 billion in two hedge funds and two mutual funds. The bulk of that money is in hedge funds, though the mutual funds have stellar records; both TFS Market Neutral Fund and TFS Small Cap Fund have earned five-star ratings from investment researcher Morningstar Inc.

(Full disclosure: When TFS started its funds, management invited me to be a director, an invitation that was refused because it posed a conflict of interest for a journalist covering the fund industry.)

Pay To Play 

Because hedge-fund managers make money only when shareholders profit, TFS management brought a pay-for-performance mentality to their mutual funds. They started TFS Small Cap with the aim of not only beating the Russell 2000 Index, but beating the benchmark by 2.5 percentage points; that's a lofty goal that sounds great but is hard to achieve.

So the managers created a fee structure under which management charged 1.75% if the fund topped the Russell index by 2.5 percentage points. But for every 0.02 percentage point difference between the fund and Russell-plus-2.5, the management fee changed by 0.01.

Thus, if the fund beat the Russell by more than 2.5 percentage points, management will be entitled to a bonus that, at its maximum, brought expenses to a level of 3% (by that point, management would be beating the benchmark by at least five full points). Lag the index, however, and management would rebate fees to shareholders, dropping expenses as low as 0.5%, or just enough to cover basic administrative costs.

The use of this kind of "fulcrum fee" has been around for years, though it is in place on fewer than one in 10 funds. Moreover, the typical performance-based fee swings in either direction by a small amount, usually no more than 0.4 points.

"We wanted to be paid nothing if we couldn't beat the benchmark, but the SEC rules would not allow it," said Larry Eiben, TFS's chief operating officer. "You'd like to have a simple structure, where you only pay the fund if it deserves it, but that's not really possible right now."

The worry about performance fees has always been that they would encourage managers to go crazy for risk, trying to max out their pay. That is why the normal range is so tame, and what made the TFS experiment so interesting.

The problem that TFS encountered, however, was that the fee structure lagged performance. Think of it this way: If you had a great 12 months last year, you get paid more this year, when results could be below-average. Thus, you are paying expenses based on past success or failure, unlike the hedge fund world where costs ride on current performance.

Thus, TFS Small Cap is currently charging the max, 3%, because it gained 65.4% in 2009, compared to just 27.2% for the Russell 2000. While the fund was racking up that performance, however, it actually was charging the minimum expense rate, because it lost 38.4% in 2008 to lag the Russell by roughly two points.

Eiben noted that the lag is a big part of the problem, because financial advisors wanted predictability and had a hard time explaining the structure and the timing disconnect to their clients. As the fund cancels the performance fee, it will set expenses at 1.75%; that's above-average for equity funds, but easy to explain to the buying public.

"It's disappointing to us, because we think everyone should be able to understand fees that are based on results," Eiben said. "But if people don't understand the structure-and the rules don't allow us to do something more simple and elegant-and they don't buy the fund, then we have to go to a structure they will understand."

That's a loss for fund investors, because it makes it less likely that other fund firms will take the performance-fee route in the future. Without a demand for change in fee structures, investors will be stuck with the payment setup they have now and fund managers will continue to bring in big paychecks, even when their performance is worthy of something less.

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