Mutual Funds With Money-Back Guarantees: Wave Of The Future?

Mutual funds that offer money-back guarantees for poor performance may gain traction as more and more investors become educated about the benefits of index funds and difficulties of identifying superior active management. Since typically fewer than 30% of mutual funds manage to be the S&P 500 over any extended period of time, the easiest and most logical way to earn above-average returns is simply to buy the index.

You Don’t Get What You Pay For

The mutual fund industry is one of those rare cases where you don’t get what you pay for. In fact, funds with the lowest expense ratios consistently out-perform their more expensive competition. Since active management is out of necessity more expensive than simply tracking an index, active fund managers need to offer an incentive to take on the risk of under-performing the index. I think money-back guarantees are one way to do that. Few investors would have any qualms paying a higher expense ratio if it reliably translated into higher returns but paying extra only to lag the market adds insult to injury.

Money-back guarantees, such as those instituted by TFS Capitalout of Richmond, Virginia, operate in the following way. TFS Capital sets a goal of beating say the Russell 2000 index by 2.5% points per year. If it fails, the fund company forfeits the majority of its management fee minus administrative and overhead costs. However, if it succeeds it receives an astronomical 2.7% of assets with the option of charging yet still higher fees. Since the fund company isn’t likely to beat its benchmark (assuming it’s a valid benchmark) by more than 2.5% per year, fund investors get a decent deal. Investors don’t get charged for poor results in down years but still reap the benefits of out-sized returns when management performs well. This is a model I think most other fund families should adopt, for investors’ sake.