January 23, 1998 Jonathan G. Katz, Secretary Securities and Exchange Commission 450 Fifth Street Stop 6-9 Washington, DC 20549 Re: File No. S7-29-97: Proposed Amendments to Performance Fee Rule Dear Mr. Katz: The Vanguard Group, Inc. submits the following comments in response to the Securities and Exchange Commission?s proposed amendments to rule 205-3 under the Investment Advisers Act of 1940, the rule that permits investment advisers to charge performance or incentive fees to certain clients. Vanguard wishes to express its concerns and reservations with respect to any proposal to eliminate the ?look through? requirement of rule 205-3 for registered investment companies. Vanguard would oppose any change allowing mutual fund investment advisers to charge performance fees, for the following reasons: 1. There is no evidence that performance fees improve investment results. As noted by the Commission, critics have challenged whether any basis, theoretical or analytical, exists for concluding that performance fees improve investment returns. That being the case, it?s difficult to identify any benefits accruing to mutual fund investors under a performance fee arrangement. (Presumably, proponents of performance fees would not maintain that advisers would work harder or pay more attention to funds that pay performance fees.) The benefits of performance fees accrue only to advisers, who can seek higher fees with limited downside risk. 2. There already exist substantial incentives for good performance by mutual fund investment advisers. Mutual fund investment advisers do not need leveraged performance fee structures to encourage good investment results. Good performance serves to retain existing clients and attract new investors, thereby increasing assets under management and contributing to the adviser?s success. 3. Mutual fund advisers can charge performance-related fees through a fulcrum arrangement. Since 1970, investment advisers for mutual funds have been permitted under section 205(b) to charge performance-tied ?fulcrum fees?. Under a fulcrum fee arrangement, the investment adviser?s compensation increases and decreases depending upon how the fund performs relative to an appropriate index or benchmark over a specified period of time. Unlike performance fees, fulcrum fees are eminently fair to both advisers and investors, they are well-accepted in the marketplace, and they do not encourage excessive risk taking (indeed, there?s a price to pay for under-performance). For these reasons, the Commission should continue to limit performance-related fees for mutual funds to those of the fulcrum type permitted under section 205(b). 4. Performance fees for mutual funds would encourage excessive risk taking. Performance fees can disproportionately favor mutual fund investment advisers over fund shareholders by giving advisers a monetary incentive to take investment risks in order to increase advisory fees. The typical performance fee arrangement provides a minimum or base fee, with additional fees paid for high relative performance (i.e., there is a ?floor? but no ?ceiling?). Under this type of arrangement, the adviser can be rewarded handsomely for good performance, with little or no penalty for poor performance. The lack of tradeoff may encourage some advisers to pursue high risk investment policies for higher returns and greater fees, without risk of financial loss if the strategy proves unsuccessful. While the danger of excessive risk taking under performance fee arrangements is hard to quantify, there is the risk that some advisers would mismanage the arrangement and cause unexpected losses to mutual fund investors. 5. Performance fees are appropriate, if at all, where the adviser has substantial capital at risk. In Vanguard?s view, the only situation where performance fees can be fully justified is where the investment adviser has substantial investments at stake in the account or fund being managed. In this situation, the adviser?s economic interests are aligned with investors, just like with a fulcrum fee (i.e., the adviser wins and loses with other investors). If the adviser has no capital at risk, there is less of a justification for one-way performance fees. 6. Many mutual fund investors are not financially sophisticated or in a position to protect themselves from overreaching. A fundamental concern is the fairness of performance fees to investors. As characterized in the U.S. Senate Report to the Investment Advisers Act of 1940, performance fees are the proverbial ?heads I win, tails you lose? arrangement. The adviser has everything to gain and little if anything to lose, while the investor has little to gain and everything to lose. Encouraging such one-way fee arrangements for registered investment companies, which offer shares to small and often unsophisticated investors, is not appropriate, particularly at a time when the industry is already criticized for excessive fees. The basis for rule 205-3 is that certain investors, who are financially sophisticated or have sufficient resources to obtain sophisticated financial advice, are in a position to weigh the costs and benefits of a performance fee arrangement and to determine for themselves whether to enter into such an arrangement. On this basis, the proposed amendments to rule 205-3 would permit investment advisers to charge performance fees to clients who have at least $750,000 under management or a net worth of more than $1,500,000. Most mutual fund investors do not come near these levels of wealth and financial resources, and they do not otherwise have the resources or financial sophistication needed to fully appreciate the risks associated with a performance fee arrangement. In sum, Vanguard does not believe that allowing performance fees for mutual funds would be in the best interests of investors or the mutual fund industry. Accordingly, Vanguard would oppose any proposal to eliminate the look-through requirement of rule 205-3 for registered investment companies. Vanguard sincerely appreciates the opportunity to comment on the proposed amendments to rule 205-3. If there are any questions or comments concerning Vanguard?s views or you would like more information, please contact the undersigned. Very truly yours, Jeffrey S. Molitor Principal Director of Portfolio Review JSM/kyd cc: B. Barbash J. J. Brennan J. Choi K. Ireland H. Stam