On the Regulation of Fee Structures in Mutual Funds

Abstract

AbstractWe offer an alternative framework for the analysis of mutual fund structure and use it to examine the rationale behind existing regulations that require mutual fund adviser fees to be of the “fulcrum” variety. We find little justification for the regulations. Indeed, we find that asymmetric “incentive fees” in which the adviser receives a flat fee plus a bonus for exceeding a benchmark index provide Pareto-dominant outcomes with a lower level of equilibrium volatility.Our model also offers some insight into fee structures actually in use in the asset-management industry. We find that when leveraging is not permitted and the fee structure must be of the fulcrum variety, the equilibrium fee in our model is a flat fee with no performance component; while if asymmetric incentive fees are allowed and leveraging is permitted the equilibrium fee is an incentive fee with a large performance component. These predictions match observed fee structures in the mutual fund industry and the hedge fund industry, respectively.