Fund manager AlllianceBernstein has started what the average investor might hope for: A flexible set of fees for funds in which the company receives only a nominal annual fee unless a fund outperforms a benchmark index.
The company’s new AB FlexFee Large-Cap Growth Portfolio FFLYX, +1.06% follows the same strategy as the $6.5 billion AB Large-Cap Growth Fund APGYX, +1.07% which has outperformed its benchmark index over the long term.
Index funds tend to have superior track records against actively managed mutual funds, in part, because of low fees. For example, the Vanguard 500 Index Fund’s investor shares VFINX, +1.16% have total annual expenses of a very low 0.14% of assets, according to Morningstar Direct.
A new approach to active-management fees
According to Frank Caruso, chief investment officer of U.S. Growth Equities at AllianceBernstein, the FlexFee funds have the “lowest possible” minimum levels. Caruso is the lead portfolio manager of the AB FlexFee Large-Cap Growth Portfolio. The fund’s benchmark is the Russel 1000 Growth Index RLG, +1.33%
If the fund’s performance after fees matches that of the index during a calendar year or trails the index, the management fee is 0.05% of assets, with another 0.05% charged for expenses, for a total expense ratio of 0.10%. The fees go up if the fund outperforms the index. The midpoint for the fees is a total expense ratio of 0.60% if the fund outperforms the index by 140 basis points. The maximum expense ratio is 1.10% if the fund outperforms the index by 280 basis points or more. Through the year, the fund’s net asset value (the share price) is adjusted daily to reflect whether or not the fund has continued to outperform the index.
According to Morningstar, the average actively managed large-cap growth fund (weighted by asset size) has annual expenses of 1.10%, while the median expense ratio for the category is lower at 0.89%. Those fees are charged regardless of performance.
Keep in mind that the new fund is following precisely the same strategy as the AB Large-Cap Growth Fund, which Caruso has been in charge of since 2012. That fund has many share classes, but according to Caruso, most new investors purchase the fund’s Advisor-class shares, which have no sales charge and annual expenses of 0.75%. Here’s how the A B Large-Cap Growth Fund’s Advisor shares have performed through April 2, after expenses:
| Average return - 3 years | Average total return - 5 years | Average total return - 10 years | Average total return - 15 years | |
| AB Large-Cap Growth Fund - Advisor Class | 12.6% | 16.6% | 12.7% | 11.3% |
| Russell 1000 Growth Index | 12.0% | 15.0% | 10.7% | 10.4% |
| S&P 500 Index | 10.0% | 12.8% | 8.9% | 9.7% |
| Morningstar Large-Growth Category | 9.9% | 13.3% | 9.3% | 9.8% |
| Sources: Morningstar, FactSet | ||||
Caruso said the new fee strategy “is an opportunity for us to be disruptive, to align the needs of our clients.” He said AllianceBernstein is “disrupting the disrupters” — index funds — by offering a new, safer way for investors to select active management. After all, if the fund doesn’t outperform the index, investors will pay only index-fund-level fees.
Outperforming the index
When discussing the long-term performance of the strategy, Caruso stressed that the AllianceBernstein’s large-cap portfolio managers and analysts focus on “the integrity of a business” and “the power of compounding.”
“From our point of view, the investment world is over-indexed to short-termism,” which he called a “disease,” as evidenced by the obsession of sell-side analysts and the financial media with companies’ quarterly “beats or misses” when earnings or sales results are compared to analysts’ estimates.
“The only way we can serve our clients is to be different, and that means focusing on a three-year to five-year period,” Caruso said. His team of managers and analysts will consider a company’s return on invested capital (ROIC), as well as the potential for reinvestment of cash to improve returns over the long haul.
The idea is for the growth portfolio to consist of solid businesses.
“We are not starting in that classic chase of finding a good stock,” Caruso said.
In other words, he will not buy a stock simply because he believes it is a bargain. He is more interested in the quality of the company itself and its ability to grow and improve profit margins by reinvesting the cash it generates, rather than using cash raised n the capital markets.
Caruso said that when he and his team meet with management teams of companies he is invested in or is considering for investment, some corporate managers are relieved to be able to discuss their plans to improve and expand their businesses, rather than the details of quarterly earnings reports.
Selecting companies with strong balance sheets and management teams that have a proven ability to deploy capital efficiently is very important, Caruso said, because so many companies “play many games to manage the optics of their shares,” or make expensive acquisitions that will juice earnings and sales, but not set the stage for higher returns on invested capital.
Caruso stressed that he avoids making investment decisions based on macroeconomic trends and also doesn’t try to predict those trends. He cited President Trump’s election in 2016 as an example.
“It was pretty hard not to buy bank stocks” at that time, because “it was pretty obvious that if the new administration would pursue a tax and regulatory agenda, banks would be good stocks.”
But banks have “big balance sheets and low returns,” so they are not favored by his strategy, he said.
One company that fits the bill: Nike
Nike NKE, +2.58% is held by the AB FlexFee Large-Cap Growth Portfolio and the AB Large-Cap Growth Fund. Caruso said that for a long time his team observed that the retailers selling Nike shoes were running at higher profit margins than Nike itself was. The company is addressing this by moving more of its sales online. Nike Direct sales for the fiscal second quarter ended Nov. 30 totaled $2.48 billion, rising 16% from a year earlier. Direct sales to consumers made up 29% of total sales during the fiscal second quarter, up from 26% a year earlier.
“You can look at the prices of companies like Foot Locker FL, +4.25% and Finish Line FINL, +1.26% and see that Nike has had some success,” Caruso said. Shares of Foot Locker are down 22% over the past three years, while Finish Line’s stock has declined 41% and Nike’s stock has returned 39% over the same period.
Caruso said a member of his research staff had been looking closely at new patents filed by Nike about five years ago for robot-based manufacturing technologies “that in the moment didn’t seem important to other analysts.” But “the more work he did on the patents, the more obvious it became that this could help Nike achieve much higher margins in the future.”
Caruso said the biggest advantage is that Nike can build factories closer to its customers to save on shipping costs, as well as tariffs and duties.
Nike will go through cycles of sales volatility as it competes with Adidas ADDYY, +2.01% and Under Armour UA, +6.18% UAA, +6.36% but Caruso believes that the focus on improving profitability makes the company an excellent long-term investment.
A company that doesn’t fit the bill: Amazon
There’s no question that Amazon.com AMZN, +1.33% has been a spectacular business story and that it’s stock has been a long-term winner, but Caruso is not excited by the company’s prospects to improve its operating profitability.
“The challenge for us is they continue to throw a lot of capital at buying and investing in unbelievably ordinary businesses,” he said.
The Whole Foods acquisition and the company’s other efforts to increase its brick-and-mortar presence and logistics capabilities are examples of how “with each new dollar of capital they invest, it appears they are becoming more like the industries they were trying to disrupt five years ago,” Caruso explained.
“The real engine, economically, is Amazon Web Services,” he said. Amazon Web Services contributed only 9% to Amazon’s total sales during 2017 but accounted for 74% of the company’s operating income.
“Amazon is a great company if you think of exceptionalism in terms of revenue growth, but it is not in terms of profitability,” Caruso said.
Fund holdings
Here are the 10 largest equity positions of the AB FlexFee Large-Cap Growth Portfolio as of Feb. 28:
| Company | Ticker | Share of fund | Total return - 2018 through April 2 | Total return - 2017 | Total return - 3 years |
| Alphabet Inc. Class C | GOOG, +1.16% | 8.3% | -4% | 36% | 88% |
| Facebook Inc. Class A | FB, -0.65% | 6.9% | -12% | 53% | 91% |
| Visa Inc. Class A | V, +0.51% | 5.0% | 4% | 47% | 85% |
| UnitedHealth Group Inc. | UNH, +1.87% | 4.3% | -1% | 40% | 94% |
| Biogen Inc. | BIIB, +2.22% | 4.1% | -16% | 22% | -30% |
| Apple Inc. | AAPL, +1.91% | 3.7% | -1% | 48% | 41% |
| Home Depot Inc. | HD, +2.12% | 3.6% | -8% | 45% | 61% |
| Intuitive Surgical Inc. | ISRG, -0.38% | 3.5% | 10% | 73% | 137% |
| Zoetis Inc. Class A | ZTS, -0.02% | 3.1% | 13% | 36% | 79% |
| Adobe Systems Inc. | ADBE, +4.22% | 3.1% | 21% | 70% | 180% |
| Sources: Morningstar, FactSet | |||||