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Will Mutual Funds Start Paying for Loyalty?

Richard Satran

A half-billion-dollar income fund based in Dallas is trying to do for investor loyalty what airlines did with frequent flier programs. The NexPoint Credit Strategies fund is paying shareholders a bonus of 2 percent on new fund shares they hold for a year.

In what industry sources say is the first such loyalty program, NexPoint has already starting paying out on the first full year. Participation is relatively small for the option - just 6.5 percent of shareholders in the $550 million fund took advantage of the program amid some confusion over the unheard-of offer. But the fund's managers say they think the total will grow.

"The overall perception has been very positive, though we get a lot of, 'This is too good to be true' reactions and we fight through that," says Brian Mitts, chief operations officer for Highland Capital Management, which runs NexPoint. "But once we get past initial skepticisms, we think more will buy into it."

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Will loyalty points and bonuses catch on in the fund industry? There are a number of legal and practical hurdles to offering them, especially for conventional mutual funds. NexPoint, a closed-end fund, is in a special situation.

Big mutual funds mostly compete aggressively to offer the lowest fees, and a program that adds costs is not likely to catch on with established fund providers.

But all investment managers are struggling to acquire and retain loyal investors, especially with many baby boomers and displaced workers rolling out of 401(k) workplace savings plans and into individual retirement accounts. Most are looking for ways to retain that huge customer base.

So why not offer loyalty programs for fund holders who stay put? Frequent flier miles were a big success for the airline industry. Indeed, American Airlines parent AMR Corp. used the popularity of its free miles to entice investors to its own mutual fund family, which awarded a small number of American Airlines frequent flier miles to loyal investors each year. (AMR sold its fund assets in 2008 as it went through restructuring.)

Frequent flier miles remain a favorite tool for mutual fund marketers and other financial services companies trying to attract new customers. Fidelity and other leading firms use them. But they are not used to reward shareholders for staying invested.

Still, the success of matching funds at spurring workplace savings growth shows that consumer-friendly programs can work, so cash incentives could make people hold onto funds. In a 2009 Fidelity Investments study, the firm said employees' savings rates are nearly 10 percent higher when their employer provides a significant match. But that might be less appealing than simple cash payouts.

"I can't see why fund loyalty programs like this would not be as successful as workplace matching funds have been," says Lisa Szykman, associate professor of business at the College of William & Mary who researches the impact of such programs.

"It's very difficult to motivate consumers to sacrifice a short-term benefit for a long-term one," she says. "So, if we have some sort of freebie that serves as the short-term benefit and also leads me to have long term success, it's a win-win."

[Read: Money or Honesty? Which Do Investors Want From Money Managers?]

Instead, fund companies impose penalties for disloyalty. Mutual funds often charge fees of 1 percent to 2 percent for shareholders who sell funds in less than 30 to 90 days, and sometimes up to a year. Those fees, in theory, cover the funds' costs of more trading fees and the disruptions in the funds' long-term trading strategies.

"If a loyalty program meant people would be trading less, that would be a benefit," says Anthony Webb, senior research economist at the Center for Retirement Research at Boston College. But he is skeptical that any such program would really benefit investors. "Ultimately, these would have to come out of investors' hides. The funds would be paying it out of expenses you pay to the fund."

Rather than wait for loyalty points, savers should be aware of the big impact fees have on retirement plans. Fees can drain tens of thousands of dollars over the life of an average individual account. "The best thing fund companies can do to reward you for being loyal is to charge you low prices every day. Just like Wal-Mart wins your business in stores - just as Vanguard does with low-cost funds," Webb says.

NexPoint says it does not see itself as a pioneer in the loyalty points program. It's using its rebate to solve a special problem related specifically to closed-end funds like NexPoint. Since closed-end funds are pools of assets - equity or income - that trade as shares on exchange, the share value can dip below the value of the holdings. That creates still more churn as some short-term investors swoop in to buy them at discount for a quick gain.

"This [loyalty program] is very interesting for advisors who sell the closed-end funds," says Rose F. DiMartino, a partner in the Asset Management Group of Willkie Farr & Gallagher in New York. "They worry about losing assets in closed-end funds."

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The program also distorts the value of the shares, Mitts says. His fund trades at a 12 percent discount to value despite having a strong total one-year return of 26.81 percent and a three-year annual return of 12.62 percent as of August 31. The fund, with a 2.26 percent expense ratio (which, it should be noted, is higher than the 2 percent rebate), invests mostly in floating-rate notes, which are non-investment grade senior bank loans. It rates a modest two-star from Morningstar, but Fitch rates NexPoints's own credit as AAA. The fund saw big losses during the credit crisis of 2008, however, and floating-rate issues are vulnerable to defaults in weaker economic times.

Will others funds follow NexPoint? They're likely watching with skepticism. DiMartino says other fund companies will look at what happens with NexPoint, but the closed-end sector might be the asset group in which a rebate makes the most sense. Traditional mutual funds are not as likely to follow anytime soon.

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