The Regulation of Fee Structures in Mutual Funds: A Theoretical Analysis

Existing regulations require fee structures used to compensate advisers in the mutual fund industry to be the "fulcrum" variety, decreasing for underperforming a given index in the same way in which they increase for outperforming it. In this paper, we offer a new model for analysing the mutual fund industry, and use this model to examine the impact of restricting the fee structures that may be employed. We find little justification for existing regulations. Indeed, we find that "incentive fees" in which the advisor 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 a fulcrum fee must be employed, the equilibrium fee is a flat fee with no performance component: while if incentive fees are allowed and leveraging is permitted the equilibrium fee is an incentive fee with large performance component. These results mesh well with observed fee structures in the mutual fund industry and the hedge fund industry, respectively.