A Novel Mutual Fund Fee Structure

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George Hoffer: “What do you think about the fee structure of the Royce Select Fund, a mutual fund which invests in the kinds of undervalued, overlooked stocks you espouse? They state:

The Fund’s expense structure is an all-inclusive management fee that will vary in direct relation to the Fund’s performance. The performance fee will equal 12.5% of the Fund’s pre-fee total return, and is payable only after negative returns have been recovered — during periods of negative performance, no fee will be paid. This all-inclusive fee is the only ordinary expense that shareholders will incur.

“The minimum investment is $50,000 and it says an investor must have a net worth of $1.5M before investing (how do they tell if you do?)”

Well, the easy question first: They know your net worth is that high because you say it is.

As to the fee structure, I sort of like it. It’s certainly smart from Royce’s point of view.

Say the market for the kind of small-cap stocks this fund targets will appreciate at 10% a year. And say Royce’s stock picks do no better or worse than average. In that case, net of transaction costs, Royce will actually do a little worse — maybe 9.75%.

(Royce cannot be blamed for this. If Royce buys a stock that rises 10% and then sells it, his 10% gain will be nicked by brokerage commissions and spreads, and by the possible cost of “moving the market” if his buying and selling affect the price.)

So maybe the market is up 10% a year compounded for the next decade and Royce Select Fund, if it does no better or worse at picking stocks, is up 9.75%. Your fee on this works out to a not-low 1.22%, leaving you with a net gain — before whatever taxes the fund may have exposed you to — of 8.53%. In a small-cap index fund, you would have gotten closer to the full 10%.

Of course, the point of investing in the Royce Select Fund is to beat the market, as Royce certainly may.

Say the market compounds at the same 10% a year, but that Royce is able to compound at 15%. That is a very superior result. Now the fee works out to 1.875% — very high — though you net a still terrific 13.125%.

If you’re persuaded Royce can do this, then Royce Select is a good deal — unless there are other funds that you think can perform as well that don’t charge high fees. (There are scores of top-flight mutual fund managers out there.)

Chuck Royce’s well-reasoned investment philosophy and long experience are appealing. And I love the premise of this fund — finding small stocks, possibly overlooked, that have the potential to do well.

But that would not be so different from, say, the Royce Low-Priced Stock Fund (RYLPX), which gained a whopping 22% in 1995 and 1996 (but the S&P 500 gained 37% and 22%) . . . which grew a fine 19% in 1997 (versus a finer 33% for the S&P) . . . and which eked out a 2% gain in 1998 (the S&P eked out 28%).

RYLPX did beat the S&P in 1999 (28% to 21%) and is way ahead this year. But overall, if you’d invested $10,000 at the start of 1995, you’d have had $28,000 or so, pre-tax, on July 31 — versus $34,000 or so in an S&P index fund. After tax, the index fund would have put you even further ahead.

Had this Royce fund had the same fee structure that the newer Royce Select Fund offers, Royce fees would have been much higher, lowering your return and widening the advantage of the index fund still further.

There are two reasons I can think of Royce might have come up with this structure — both of them good, from Royce’s point of view.

The first is that Royce believes he can compound your money at a high rate, and is willing to bet on his superior ability. Admirable. The second is that, even if privately he doesn’t think he can outperform the market, such a fee structure could have sufficient appeal to attract a lot of money. So even if the fund did perform only average, or sub-average, his fee income would rise — not because the rate rose, but because he had more money under management on which to levy it.

(Royce Select intends to stop accepting new investors once it reaches $150 million. But all those investors could keep investing new money, so, along with appreciation, this could become a $1 billion fund in a few years. Presumably, the Royce folks hope to attract the first $150 million as quickly as possible, and this fee structure may help them do it.)

I like the premise of the fee structure — it aligns Royce’s interests with its investors’ interests. But 12.5% is more than I’d want to pay. If Royce does really well, you’ll come out ahead despite the higher fee. If Royce does “average,” you’ll be paying a higher fee than you need to for average (index) performance. And if Royce underperforms, the lower fee will be little consolation.

I suspect that over a long time horizon, and especially after tax in a taxable account, you might well come out ahead in a broad index fund.

(Note: There is a 2% fee if you bail out of Royce Select before three years have elapsed.)