The recent performance-fee settlements between five fund companies and the Securities and Exchange Commission will probably not shake investor confidence, but, shareholder advocates worry, they might rattle the companies considering adopting the more complicated model.

"As a general matter, performance fees are consistent with the promise of active management," said Mercer Bullard, founder of shareholder advocacy group Fund Democracy. "It more strongly aligns the manager's interest with that of shareholders."

But for fund companies, performance-based fees are more difficult to calculate, because rather than take a standard cut of the overall value of assets under management, these fees depend on performance, a variable that is constantly in flux.

The recent SEC sweep spotlighted this problem when five fund companies-Dreyfus of New York, Gartmore of Conshohocken, Pa., Kensington Investment Group of Orinda, Calif., Numeric Investors of Cambridge, Mass., and Putnam of Boston-were found by regulators to have overcharged investors at various times between 1997 and 2004. All agreed to repay their funds, with interest, for a collective total of $7.4 million.

"I'm concerned that the increasing reluctance to use performance fees will grow because they're more burdensome and complicated for funds," said Bullard, who is also a professor at the University of Mississippi School of Law in Oxford, Miss.

Already, relatively few funds use performance metrics to calculate fees. In fact, only about 3% of the roughly 9,000 U.S. mutual funds base their fees on performance, representing about 7% of all mutual fund assets under management, according to Kip Price, head of global fiduciary review for Lipper in New York.

Although only a small number of funds have performance-based fees, many of those that do are quite big; for example, Boston-based Fidelity's $45 billion Magellan Fund, Valley Forge, Pa.-based Vanguard's $41 billion Wellington Fund, and Denver-based Janus' $3.6 billion Contrarian Fund.

Often, the decision to use performance-based fees is that of the marketing team, Price said, and over time, neither the investor nor the fund company usually gains much. Some studies suggest that incentive-based fees can cause fund managers to take greater risks in hopes of bigger gains than they otherwise might, he added.

Regulators know that and pay close attention to funds that use performance fees, said Janaya Moscony, president of SEC Compliance Consultants in Phoenixville, Pa., and herself a former SEC examiner.

Still, those like Bullard and Andrew Goberty, a mutual fund analyst with Chicago-based fund-tracker Morningstar, say that if structured properly, and with adequate oversight from fund boards, performance-based fees favor investors.

But performance fees are more troublesome for fund companies, and those caught out of compliance in the recent SEC sweep highlight the challenge of balancing operations and reputation.

"The more variability you put into the calculation of anything, the higher the probability that you're going to have a processing issue," said Bob Fawls, a partner with the Basis Point Group, an operations consulting company in Boston.

"Mistakes happen, but the idea is to catch them as quickly as possible, and not just to catch actual errors, but to identify potential errors," Fawls said.

Although fund watchers agree that these cases will attract little attention, Moscony noted that "firms need to take into consideration how they're running their compliance programs. There's a cost to this reputation."

Both Putnam and Dreyfus responded to the news of the settlements with promises that they had corrected the problem, and assurances that going forward, the funds would not face the same issues.

"Putnam calculated these fees in good faith, but unlike many other fund companies, we were unaware that the methodology we used was not in accordance with the SEC," said spokeswoman Laura McNamara. The company revised its methodology in September 2004.

Dreyfus issued a similar statement. "Dreyfus is pleased the matter is behind us," it read. "Dreyfus provided the SEC staff its full cooperation, promptly discontinued the method it was using to calculate performance fees and subsequently reimbursed the funds with interest."

The other three companies did not respond to requests for comment.

The actual cost of these problems for investors, when averaged over the time period reviewed, is relatively minor.

So are the fines. Overall fee overages ranged between $2.9 million for Dreyfus to $632,217 for Gartmore. Moreover, the settlements involved no more than two funds in each family. In the case of long-embattled Putnam, its reputation still reeling from the late-trading and market-timing scandals of recent history, that represents less than 1% of their 109 funds.

"Let's put it this way: each of these firms is probably going to spend far more [than each was fined] answering inquiries about this," said Louis H. Harvey, president of Boston-based Dalbar, a fund research and ratings firm.

Software programs and other tools like those offered by companies such as Basis Point Group can help not only with controlling problems, but with proving to regulators that controls are in place to guard against shareholder-bruising errors, and help assuage SEC concern.

But software-processing programs and contracts with third-party vendors are not enough. "You should have policies in place for regular forensic testing," Moscony said. Individual firms looking to patch over public relations problems might consider leveraging those policies for marketing purposes.

And seeing action being taken on such relatively minor operational problems such should encourage investors, not daunt them, said Coalition of Mutual Fund Investors Executive Director Niels Holch. "This is not going to affect the confidence of 95 million [mutual fund] investors," said Holch, "but we'd like to see it done correctly."

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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