Telluride Investment Strategies, LLC
PO Box 1964
Telluride, CO 81435
November 9, 1998
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, NW, Stop 6-9
Washington, D.C. 20549
Re: Request for Comment on Proposed Amendments to
Rule 205-3 under the Investment Advisers Act of 1940; File No. S7-29-97
Dear Mr. Katz:
We are writing in response to the request of the Securities and Exchange Commission (the "Commission") for comment on proposed amendments (the "Proposed Amendments") to Rule 205-3 under the Investment Advisers Act of 1940, as amended (the "Advisers Act"). The Proposed Amendments would modify the rule's criteria for clients eligible to enter into performance-based compensation arrangements and eliminate required terms and disclosures with respect to those arrangements.
In our opinion the Commissions proposals are a step in the right direction, but unfortunately they limit the benefits of performance fee arrangements to large investors, while continuing to saddle smaller investors with the excessive fee structures currently existing in the mutual fund industry.
While the expansion of the mutual fund industry has been beneficial to the small investor in terms of variety of investment options, it clearly has not led to an improvement in performance or a reduction in fees and expenses.
According to John Bogle, ( Error! Bookmark not defined.) the average equity fund has under-performed its appropriate benchmark by 200-240 bp from 1982-1997. Perhaps 2/3 of this under-performance is attributable to fees and expenses (~150 bp ), the rest of the drag comes from trading costs in the form of commissions and bid/ask spreads due to high portfolio turnover (80% on average). With 4 trillion USD in equity mutual funds, this amounts to an 80 100 billion USD tax on mutual fund consumers. [This analysis is meant only to give a rough idea of the magnitude of the under-performance we are speaking of, and not to be definitive in any way.]
Now, the question naturally occurs why do consumers pay this cost if the evidence is widespread that performance is poor and they have alternatives like index funds that are much cheaper? The answer is three-fold we believe:
- Human psychology is such that it wants to believe in the ability of other humans to out-perform the market, all evidence to the contrary.
- The statistical distribution properties of large numbers of mutual fund returns guarantees that in the short-run some managers must out-perform the market, even as on average their peer-group falls considerably short.
- A good portion of the fees generated by the mutual fund industry is spent on advertising that exploits the above two effects by emphasizing out-performance in the few cases it exists and extolling the virtues of research departments and highly paid fund managers.
Obviously, this set of circumstances must not be news to the SEC. The question is is there any thing to be done about it? In our opinion, properly regulated performance fees could greatly reduce the inefficiencies and costs of mutual fund investment, especially for small investors.
The key phrase above is properly regulated. The performance fees we have in mind have the following properties, some of which the market would dictate, some of which would involve regulation:
- Small fixed fee, on the order of 50bp (market determined).
- Upside potential for the manager of up to 20% (regulated maximum) of benchmark (market determined) out-performance.
- Performance fees are calculated and subtracted from the account only upon withdrawal of funds from the account by the purchaser. The fees are calculated on performance over the entire life of the account.
This last point is key. This method of calculation keeps managers form simply overlaying excessive volatility and capturing fees on the occasional periods of out-performance. It should help to closely align long term performance with long term fees, while preventing managers from taking excessive risks.
Now, what would be the effect of adopting these regulations?
- Since this type of fee arrangement is vastly superior for the consumer, and vastly inferior for the mutual fund industry (they have to earn their fees!), a few principled mutual funds would seize upon this opportunity to offer fair, performance based fee accounts to their customers.
- As consumers become better educated, assets would shift into these types of accounts (along with index funds) as they realize that they dont have to pay excessive fees for under-performance.
- Eventually, most consumers would demand performance-based accounts. Since on average, most mangers would not outperform their benchmarks, total fees paid would be much lower than they are today.
It should be noted that these type of accounts will lead to much lower fees than fulcrum type accounts, where the managers typically set the fulcrum point very high and earn the fulcrum point fee on average.
Previously, small investors have been considered to be too unsophisticated to properly evaluate performance based fee structures. However, if constructed properly, with performance fees calculated over the life of the account, these arrangements have large benefits to the small investor with acceptable risk levels. The SEC has an obligation to allow these investors to escape the unjustified fees currently paid due to the SECs refusal to allow properly regulated performance-based fee arrangements.
James P. Crimmins
Telluride Investment Strategies, LLC