No Win, No Fee, No Free Lunch

Ordinarily, a small mutual fund’s closing after two years wouldn’t be news. The world has thousands of funds, and the universe turns over all the time. But when the Vinculum Global Equity Fund closed in mid-February, folks took notice. This fund was different: As manager Nigel Legge proclaimed to great fanfare upon the fund’s 2012 launch, “If we don’t deliver, we don’t get paid.” The so-called no-win-no-pay fee schedule was supposed to revolutionize the retail mutual fund industry—but few signed up. Individual investors knew better: That fee schedule didn’t align the fund manager’s incentives with their best interest. Wonderful as a fund manager’s aims might sound, incentives matter.

Now, this thesis largely applies only to the retail investing world—it’s different in the institutional world, where performance-based fees are common. There, firms’ (and pension plans’, etc.) bylaws and investment mandates give the managers strict guidelines on asset allocation and risk management. The manager is probably one of a handful the institution employs, perhaps even a specialist hired to manage a very specific strategy. Given those circumstances and objectives, performance-based fees may make sense.

Individual investors, however, usually don’t have that sort of personal, carefully negotiated arrangement with a big fund manager. They instead must (and do) look critically at the fee structure set by the fund manager, and weigh how it impacts the manager’s incentives and whether the manager will have the necessary resources to do well. At first blush, the UK-based Vinculum’s fee structure probably sounded fabulous. The annual fee was 0.25%, far below the industry average. But if the fund outperformed its benchmark, the MSCI World Index, in a given quarter, it would charge an additional fee equaling 20% of the spread. If the fund returned 2% while the benchmark returned only 1%, the excess return on each £1,000 invested would be £10—the £20 returned by the fund minus the £10 returned by the benchmark. Of this £10, the fund would take 20%, or £2. That’s a hefty price tag, but hey, it gives the manager an incentive to make you more money!

That’s the theory, anyway—reality differs.

Most industry professionals accept that constant outperformance is impossible. Even if a fund or manager outperforms over time, they’ll underperform during many short periods along the way. (Unless they’re using Bernie Madoff’s strategy, but then the issues are even more severe.) Vinculum’s managers likely knew those excess fees would be ephemeral—they’d come in unpredictable bursts. Not exactly ideal if you’re trying to run a business.

This gave them two incentives, and it was an either-or proposition. One, they could shoot for the moon, striving to maximize excess return when they did outperform. Two, they could keep costs as low as possible—including fund management costs—so their survival didn’t depend on earning that excess return fee.

Neither option is in individual investors’ best interests. Option one requires taking an extraordinarily high amount of risk. To widen the performance spread, the fund manager would have had to deviate wildly from the benchmark, likely with extremely concentrated bets. The result would be lower diversification and, if those bets went wrong, terrible lag. Most long-term growth-oriented investors eyeing a global equity fund just don’t want this level of risk—it doesn’t match their goals.

Vinculum, to their credit, didn’t go this route. They picked option two, keeping costs low. But in doing so, they left investors devoid of one expected aspect of a fund—expert portfolio management and a cohesive strategy. Instead, they went with an automated platform that takes 35,000 plus global stocks, ranks them according to eight valuation metrics, and spits out a list of the top 50. The brains behind it claim you get the 50 companies with the strongest earnings and financial positioning—a truly objective snapshot that strips out bias and misinterpretation. Vinculum’s fund management strategy consisted of buying these 50 companies, selling (and replacing) any that fall off the list, and rebalancing every June to have each company be 2% of the total portfolio.

The problems with this are myriad. For starters, you end up with 50 essentially randomly selected companies—no thought is given to sector and country representation. It’s also entirely backward-looking. Markets are pretty darned efficient, and corporate earnings and financial positions are generally widely known. By the time a company’s earnings and financial health improved enough to land it into the top 50, markets would have known for a long while and already digested it. Follow Vinculum’s strategy, and you’re trading on the past without any eye to the future—companies with strong earnings and balance sheets in the recent past don’t always stay so healthy moving forward. Nor do they automatically perform wonderfully. Trading on those financials alone is a fool’s errand and a likely recipe for disappointing returns. Incidentally, that’s what Vinculum ultimately achieved—they lagged in each year of their short existence, though they managed to outperform in four individual quarters, collecting those excess fees even though investors never outperformed over more meaningful stretches of time, and the fund offered no aid in developing asset allocation or other counsel. That’s a raw deal, folks.

Getting ahead usually requires being forward-thinking—analyzing the macroeconomic, geopolitical and regulatory environment and forecasting how these factors will impact profitability and sentiment within each industry, sector and country, and whether individual companies within those categories are positioned to capitalize on opportunities or over-exposed to risks. This takes resources—and resources take money. Without strong, predictable revenues, Vinculum simply had no resources.

Investors doing their due diligence on the fund likely realized this—that as great as the promise of paying only for outperformance sounded, the reality would be far more disappointing. For many folks, going the standard route—paying a bit more of their total assets invested, regardless of performance—likely makes more sense. Does it sound more expensive? Sure. But it also gives the manager more resources to deploy for the investor’s benefit. And it aligns the manager’s and investors’ goals and incentives.

If your goal is to grow your assets over time, you want a manager who is incentivized to do the same. If they’re charging a steady percentage of assets invested, they have an incentive to grow that pool over time while without taking enormous risks, which likely lines up with your own objectives. This isn’t the only determinant of whether a manager will do well or whether they’re right for you—their values, philosophy, expertise, track record and investment approach matter. But determining how fees impact a manager’s decision-making should be a critical part of every investor’s due diligence.