Why do just 3 percent of funds charge performance based fees? Those in the industry understand the effects of regulations on the fees fund advisors charge, but those reporters covering them may not. In today's Wall Street Journal, reporter Jesse Eisinger provides an interesting tale of how one new fund advisor set its fees, though he seems to miss the larger issue.

Eisinger makes it clear that he believes a world in which mutual funds charged fees in the same manner as hedge funds would be a better world. "... there's a better reform that hasn't been embraced: pay-for-performance," he writes in his opening paragraph.

Later he laments that "Only 3% of mutual funds charge performance fees. Worse, over the past five years, the numbers haven't changed much."

Clearly, in Eisinger's opinion funds would better serve their clients if they charged performance-based fees (or perhaps Eisinger just believes his readers see performance-based fees as the best).

So why do the overwhelming number of funds not charge performance-based fees.

Eisinger first blames the fund advisors greed.

"Mutual-fund companies tend to excel at asset gathering, not investing. Sure, it's nice to perform better than the overall market. But the reality is that it's a far riskier and more difficult method of increasing assets than vacuuming up dollars through the mutual-fund industry's pricey distribution system and aggressive advertising campaigns depicting trustworthy suits with salt-and-pepper hair sitting behind heavy desks," he writes.

He then, perhaps accidentally, hits on what may be the real answer for many funds as part of a profile of hedge-fund-manager-turned-mutual-fund-manager Whitney Tilson.

Tilson, reports Eisinger, tried to mimic the performance-based fees of his hedge fund in his new mutual fund. He soon found the task to be nearly impossible because of the regulations faced by fund firms.

The first stumbling block was the SEC rule requiring these fees to be symmetrical. For many fund firms this requirement would cap performance-based fees at a relatively small amount since they must continue to ensure revenue is available to pay for basic expenses and to pay their distribution partners no matter how well their fund performs.

Tilson then ran into the issue of how often to assess the fee. If he charged once per year, as most hedge funds do, savvy shareholders would be able to avoid the fee by selling and buying back their shares around the annual fee assessment date. Hedge funds, of course, typically tie up their investors stakes.

To overcome that problem, Eisinger reports that Tilson considered levying a fee each day based on monthly performance, but found that the SEC would not approve of any period shorter than a year for a performance-based fee.

As a compromise, Tilson settled on a base fee of 150 basis point with 45 basis points based on performance.

For some reason Eisinger holds this fund up as a paragon without realizing that even if Tilson misses his bogey he will still collect a 105 basis point fee (the article states this is the management fee, not the total fund expenses).

That fee is far from an investor friendly bargain. We will see if Eisinger notices.  

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