Should fund fees be tied to performance?

By MarketWatch

Putnam Investments is lowering costs for its mutual funds by reducing management fees. It's cutting some expense ratios and tying others to performance, adjusting pricing breakpoints and, in general, moving toward a structure that industry observers believe is ideal.

The move raises two big questions: What took so long, and why hasn't every big fund company done this?

Putnam takes a positive step

Some of its latest fee changes echo moves made by Fidelity. The question is, why aren't more fund companies following suit?

It's a question worth considering for investors who are dissatisfied with their funds. While there was no avoiding the market decline last year, high fees added insult to injury. Too many investors settle for the "industry average" on costs when there's ample evidence that many providers could swallow a pay cut, remain competitive and earn your trust and money by delivering improved investment returns.

Unless you invest with one of the low-cost leaders -- and companies such as Vanguard and Fidelity frequently are not available to average investors working for small employers with limited assets in their company retirement plans -- you'd be thrilled to get the kind of cost break that Putnam came up with.

For proof, substitute the name of your fund company for "Putnam" in the following:

Effective Aug. 1, Putnam dropped management fees on its bond funds by an average of 13% and on its asset-allocation funds by 10%, and it eliminated a "wrap fee" that had added 0.05% to the total costs of its target-date retirement funds.

Further, this fall the company will go through the proxy process necessary to institute performance fees on some of its stock funds, so that Putnam gets paid more only if its funds exceed index benchmarks and, thus, investor expectations. If Putnam funds underperform their index, the company -- which is footing the bill for the proxy vote rather than foisting it onto shareholders -- takes a hit right along with its customers.

As part of the shareholder-approval process, Putnam will create companywide breakpoints, where fees go down when the company's assets rise. Currently, breakpoints are calculated on individual funds, despite the fact that funds with a similar investment approach share research, analysts and infrastructure.

Putnam's bond funds already were priced below the industry average of 1.02%, according to Morningstar, but the cut, on average, dropped total expenses to 0.919% from 0.965%. (Management fees make up about 60% of that total; on average, management costs for Putnam's 20 fixed-income funds have been cut to 0.486%, down from 0.555%.)

Shared goals

Performance fees are a real reward or punishment. Take, for example, Putnam Voyager Fund (PVOYX), arguably Putnam's flagship fund. From 2003 through 2007, the fund was a below-average performer, lagging both its peer group and its index; while investors suffered that misery, the fund collected its standard fees. Like most stock funds, Voyager lost big in 2008, but it was much better than its peer group; over the last year, the fund has been at the very top of its category. Management got no extra rewards for the top results.

For Putnam, therefore, the emphasis was on getting assets in house and keeping them there, not on managing them better than the competition.

Under the new schedule, if Voyager beats the benchmark by 4%, Putnam earns an additional 0.12 point in performance fees; if the fund lags its benchmark by the same margin, costs fall by the same 0.12 percentage point. That's a real incentive or penalty; it makes results more important to the funds company than asset-gathering.

Continued: Making performance count

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