Think twice before embracing any new fund with high performance-related fees in your 401(k)

SEC Chairman Paul Atkins, a Wall Street veteran, wants to let Wall Street charge performance fees on mutual funds.

The Securities and Exchange Commission has just proposed allowing fund managers to charge members of the public extra "performance fees" if they do well.

That may sound fine in theory, but is almost certainly a terrible idea in practice.

The case for letting fund managers charge performance fees, where they get paid extra if their funds beat the market indexes or a benchmark, is very easy to make. Cue the usual language about incentives and giving managers "skin in the game," as well as various clichés about freedom, choice, competition, and did we mention freedom?

"At its core, this is a question of freedom and fairness," SEC Chairman Paul Atkins said as he unveiled the proposal. He also mentioned "enterprise," "opportunities," "dynamism" and "innovation."

The problem is, if performance fees actually worked in financial management, then hedge funds - which are already free to charge them - wouldn't suck.

But they do suck, and badly. Hedge funds typically perform worse than low-cost index funds, and the longer you own them, the worse they do. Consider, say, the past 10 years - a period of almost unprecedented turmoil, which should have been catnip for hedge funds.

According to HFR, the leading provider of hedge-fund data, the average hedge fund earned less than 7.1% a year on average, net of fees, over that spell.

The average "fund" of hedge funds, which is the kind of basket of hedge funds that would probably end up in your 401(k) under the SEC's new plan, did even worse, averaging 6.2% a year.

Meanwhile, a basic portfolio of 60% global stocks and 40% global bonds, through low-cost Vanguard exchange-traded funds? Er ... 8% a year on average, or nearly a full percentage point per year better.

This is despite, or maybe because of, the fact that hedge funds get to charge investors extra "performance fees" if they do well.

I'm not cherry-picking data, either. For this comparison, I've deliberately used a completely neutral global portfolio: 60% in the Vanguard Total World Stock ETF VT, 20% in the Vanguard Total Bond Market ETF BND, and 20% in the Vanguard Total International Bond ETF BNDX. (Vanguard now lets you effectively combine the latter two in a single fund, the Vanguard Total World Bond ETF BNDW.) No special Nasdaq weighting. No extra weighting toward U.S. stocks, which have done far better than most international markets during that time. And no steps to avoid full exposure to the bond market, which got shellacked in 2022 and is getting shellacked again right now.

So why don't performance-based funds do well?

Well, they do. They do very well - for the people managing the funds. These folks can earn 2% a year on the assets, plus 20% of any profits. (Oh, yes, and they get a special tax break on their earnings, too, thanks to a grateful nation.)

Some say they aren't trying to outperform anything, but just to provide "uncorrelated" returns. Well, putting 1% of your pension plan on black at Vegas will provide a return completely uncorrelated to the performance of global stocks or bonds, but I don't recommend it.

Others, even more cynically, play a form of Russian roulette with their clients' money. They take big gambles on trends - carry trades, momentum and so on. If those gambles pay off, the clients make it big and the managers pocket 20% of the gains. But if the gambles fail, the clients lose their shirts, but the managers do not have to cover 20% of the losses. (And the fund managers still get 2% even if the funds lose money.) It's a brilliant trick, at least until the music stops - which is what happened, for example, during the global financial crisis of 2007-09. And how.

Warren Buffett, who knows a thing or two about making money in the stock market, famously offered a $1 million bet in 2008 that an investment in a low-cost S&P 500 index fund would outperform a handpicked selection of five hedge funds over 10 years. He won. And that was true even though Buffett launched his bet at almost the worst possible time for the S&P 500, in early 2008.

Buffett has given instructions that after his death, his estate should be invested 90% in a low-cost S&P 500 SPX index fund and 10% in Treasury bills.

So you might want to think twice, or even more times, before embracing any new fund with high performance-related fees in your 401(k).

The real incentive a fund manager has is if they have a ton of their own personal wealth invested in the fund.

"Performance-based compensation can offer a rational and effective means to define and align adviser and investor goals," the SEC's Atkins said. "Expanding the ability for advisers to charge performance-based fees could incentivize advisers currently operating in the private markets as well as complex or differentiated public market strategies to bring diverse strategies to a wider group of clients and investors, including investors in regulated funds."

But Sen. Elizabeth Warren, the ranking Democrat on the Senate Banking Committee, replied in a statement that the proposed change would "override decades-old protections for Americans' retirements to allow Wall Street to start charging high, private equity-level fees on lower-cost retail funds." She said ordinary investors would be "used as piggy banks to boost the profits of Trump's Wall Street buddies."

The latest proposal doesn't come in isolation.

The Trump administration also changed the rules last year so that your 401(k) plan can be stocked with private-equity funds, which also charge extremely high fees.

Atkins says his latest proposal would build on that.

The commissioner, a Trump appointee, made over $300 million on Wall Street before getting tapped to take over the SEC. His clients on the street of shame included Sam Bankman-Fried and FTX, the cryptocurrency fraud, which collapsed in 2022, costing investors billions.

While Atkins now runs the SEC, Bankman-Fried is serving a 25-year stretch in federal prison for fraud. His latest appeal was turned down, but he is still hoping for a presidential pardon.

-Brett Arends