A New Mutual Fund Scandal

If you know much about hedge funds, you probably know that their managers are often compensated via a "2 and 20" system, where they take 2% of your invested assets each year, regardless of performance, and also 20% of any profits. This means that they collect quite a windfall if they perform well, and even if they stink, they skim off a lot of money each year.

Traditional mutual funds might seem vastly preferable, but they present some problems, too. For one thing, the average actively managed stock fund's expense ratio (annual fee) is north of 1%, with many near 1.5%. That's not so far off from 2%, is it? It's true that they don't take 20% of your profits, but some might look at that fact and ask: What is the manager's incentive to do well?

That question is addressed in an interesting new book: The Investor's Dilemma: How Mutual Funds Are Betraying Your Trust and What to Do About It, by Louis Lowenstein. I haven't read it yet, and truth be told, I'm actually afraid to read it -- afraid I'll learn many depressing things. Lowenstein observes, "Managers profit by maximizing the funds under management because their fees are based on assets, not performance." Got that?

In many ways, it's all about the expense ratio (although some funds add to that by charging loads, which are sales fees; it's generally smart to look for no-load funds). If a fund has assets of $1 billion and an expense ratio of 1.2%, the management will reap $12 million for the year. If it can amass $2 billion more, its income will rise to $36 million.

The upside ...
This situation, in my eyes, isn't unilaterally bad. There is some incentive for fund managers to perform well, aside from the self-respect that we'd hope they have. Remember that they're paid according to asset size, not performance. Well, think about that for a minute.

How do their assets grow in size? There are many ways for a fund to draw more assets, not all of them noble. Many fund companies have deals with brokerages and advisors, whom they reward with commissions for sending clients' money their way. But one indisputable way is for the fund to perform well. If it does, it will be noticed and probably written up. Investors like you and me will learn about it and many of us will want to invest in it. Bingo -- swelling assets.

The downside ...
Still, there are plenty of worrisome aspects of today's mutual fund industry. Consider, for instance, those expense ratios. The New York Times' review of Lowenstein's book cites an interesting statistic: While fund assets rose 90 times between 1980 and 2004, from $45 billion to $4 trillion, the fees those funds charged rose nearly 130 times, from $288 million to $37 billion. In other words, fees grew almost half again as fast as assets under management. Hmm ...

That's particularly alarming because in theory, when a fund grows huge, its expense ratio should actually fall somewhat. Just because suddenly it may have twice as much money to invest doesn't mean that suddenly expenses to run the fund have doubled.

Another downside is that the bigger a fund gets, the harder it is to find enough compelling places to invest its money. Performance tends to suffer as a fund grows enormous.

Another concern of Lowenstein's is that many fund managers don't put much of their own money in their funds. If they did, that would certainly serve as a good performance incentive, don't you think?

Fortunately ...
Here's an important bit of good news: As conflicted and worrisome as the mutual fund industry may be, there are good funds out there, with long-term market-beating records, with managers who eat their own cooking, and with promising prospects.

Look, for example, at one of Lowenstein's favored funds, the Fairholme Fund (FUND: FAIRX). It has a market-beating, five-year average annual return of 19%, and its expense ratio is a reasonable 1%. The fund's top holdings recently included Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B), Sears Holdings (Nasdaq: SHLD), and XTO Energy (NYSE: XTO).

You can find such funds on your own, by screening for good ones and learning how to avoid stinkers. Or let us help you. I invite you to test-drive our Motley Fool Champion Funds newsletter, where I've found a bunch of winners, myself. Last time I checked, its recommendations were beating the market, on average, by about 19 percentage points.