We have repeatedly shown that most active mutual funds struggle to beat category benchmarks. This is not just a trend seen in large cap funds –Active Large Cap Mutual Funds vs Nifty 100 performance analysis.
Contrary to popular belief, the trend is also seen among mid cap funds as well – Only 3 out of 28 mid cap MFs consistently beat Nifty Midcap 150! While active small cap funds manage to beat the small cap index, they come up short compared to a mid cap index – Why investing in small cap mutual funds does not make sense!
Aggressive hybrid funds are also no exception! Why we badly need an aggressive hybrid index fund!
The biggest grouse against an active fund is its high fee is the same regardless of performance. A fund can go for years and years without beating the benchmark, but it would still earn the same high fee and even increase it!
While this model will not disappear anytime soon, small fund houses or new ones can consider adopting a performance-linked fee model for their active funds.
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
🔥 🔥
How could this work? Suppose an active fund is launched with a fee of about 1.5% per year for the direct plan. This fee is deducted from the NAV since inception daily basis.
If, after a year of trading, the fund has beaten its benchmark (say by a margin of at least 0.25% after expenses) it can charge the same 1.5% next year as well. If the fund has fallen short, the next year’s TER is reduced by, say, half to 0.75%
Please note: I am not saying all active funds should follow this way or that the regulator should impose this. I think such a performance liked free structure should be offered as a variant by at least some fund houses.
There can be other variants as well. For example, if after deducting 1.5% fees for one year, the performance after the fee is below the benchmark, a portion of the fee can be distributed back to the fund.
Or the fund can charge a fee equal to an index fund, say about 0.5% a year, and if the performance at the end of that period is above a certain threshold (hurdle rate), a portion of the gain goes to the AMC, just like a PMS. For example, “20% of Profit over 10% gains” is a typical clause in many PMSes. To prevent misuse, the high watermark principle can be used.
If a one-year time frame is too harsh to judge an active fund, it can be done over two or three years (not more!). I don’t claim to be an expert on this matter, but the essence of the idea is simple: no performance = no higher fee (higher relative to an index fund)
What are the advantages? A person who seeks to beat the market with an active fund will pay a fair price. They will not be overcharged when the fund is doing badly and will pay a reasonable fee for outperformance.This will prevent fund managers from sleeping at the wheel.
What are the disadvantages? It could lead to deviations from the benchmark, from the investment strategy and higher risks to earn more returns and, therefore, fees. Conviction bets may drop, giving rise to higher churn and momentum chasing. Meaning only funds with a small size can adopt this. So the risks may increase. The regulator may need to keep a closer eye on such funds.
It won’t be perfect (what is?), but at least an informed investor can take a reasonable bet with such funds and not pay extra when the fund does not deserve it.
Do share this article with your friends using the buttons below.
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 1,000 investors and advisors use this!
New Tool!=> Track your mutual funds and stock investments with this Google Sheet!
Podcast: Let's Get RICH With PATTU! Every single Indian CAN grow their wealth!
You can watch podcast episodes on the OfSpin Media Friends YouTube Channel.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter with the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
Explore the site! Search among our 2000+ articles for information and insight!
About The Author
Dr. M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter, Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter what the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts you and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu gets a superpower!” is now available!
Most investor problems can be traced to a lack of informed decision-making. Wehave all made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about?As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it and teach him several key ideas of decision-making and money management is the narrative. What readers say!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.
Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & it's content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want 
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.
Your Ultimate Guide to Travel
This is an in-depth dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)
