The emergence of a new kind of fund could 'radically alter' the investment industry

Passive investment has exploded in popularity, putting pressure on active managers who charge higher fees.
Variable pricing mutual funds are a way active managers can charge fees on a performance-driven basis, but they're not without their risks.

The popularity of low-fee exchange-traded funds has come at the expense of active managers, who now have no choice but to fight back. And to stay afloat, they're going to have to get creative.

That could very well involve reinventing themselves by charging fees based on performance. While that may seem obvious, most funds have historically charged their clients a flat management fee, regardless of returns.

Now it may be in their best interest to implement so-called variable pricing mutual funds, the adoption of which could "radically alter" money management as we know it, according to Citigroup.

"The rise of passive investment management has undermined the profitability of the asset management industry," Robert Buckland, the chief global equity strategist at Citigroup, wrote in a client note. "The stock market has recognized this. In the old days, asset managers used to outperform the bull market. That is no longer the case. Companies need to reinvent themselves."

How did it come to this?

Before we get into the specifics of the potentially game-changing variable pricing funds, let's take a step back and assess how we ended up in this situation.

At the root of the shift has been the proliferation of passive investment, as Buckland mentioned above. ETFs, which typically follow and index and stand in contrast to their actively managed mutual-fund counterparts, have become one of the world's hottest investment products.

According to the EPFR, passive equity funds have seen global inflows of $620 billion in the past 12 months, while active funds have seen outflows of $359 billion. In terms of sheer size, the combined assets of US ETFs hit $3.1 trillion in August, increasing roughly $700 billion in a single year, according to Investment Company Institute data.

A big part of this divergence in flows stems from how much cheaper passive funds are. Citigroup notes that the average charge for a US-based active equity mutual fund is 84 basis points, compared with just 11 basis points for passive. Hence the importance of active managers making their pricing more attractive.

The potentially game-changing role of variable pricing mutual funds

That's where variable pricing mutual funds come in. Pioneered by AllianceBernstein earlier in 2017, the methodology is simple: the bigger the outperformance, the bigger the fee.

Citigroup finds that this fee structure generally delivers investors better net returns than at the present time, except during periods of substantial outperformance. In other words, they may cap potential upside, but they also don't leave investors wanting more in the event of more average returns.

It also incentivizes the mutual-fund managers to crush their benchmarks, especially since they'll get a smaller fee if performance is middling. Here's a visual representation:

With all of that in mind, Citigroup says these funds will "radically alter" the industry in the following four ways:

In addition to the risks outlined above, Citigroup also sees active-manager margins coming under serious pressure during periods of market losses. And such a development would hit investors in the wallet, given the "significant cultural pressure on compensation" likely to result from lower fees.

Citigroup also warns that potential investors in variable pricing mutual funds could end up paying high fees for trailing performance that they didn't themselves enjoy. On the flipside, following weak periods, the firm says funds would have to worry about "free riding" — the mutual-fund version of value investing, which involves finding underpriced assets with strong upside.

Overall, variable pricing mutual funds are an intriguing proposition but one that certainly has its fair share of drawbacks. Still, no one ever said disruption was easy. And regardless of whether these vehicles become widespread, it's clear that active managers must somehow adapt to survive.