BOSTON -- If the job of a mutual fund manager is to deliver returns that beat a stock market benchmark or that put them near the top of their peer group, then there is little doubt that most fund managers haven't earned their keep this year.

That hasn't stopped them from taking it.

Fund companies have raked in billions of dollars from investors, despite what can only be described as miserable, below-expectation performance.

The average funds in the large-cap growth, multi-cap growth, midcap and small-cap growth categories are all down more than 40% year to date, according to Lipper Inc.

The news isn't much better in the value and core classifications for those asset classes, as the average player in those asset categories has lost one-third or more of its worth this year.

There also has been no shelter in other equity categories, with the average emerging markets fund off more than 55% this year and the average international fund down 45%. Indeed, the average fund in every equity category is down by more than 20%.

Even among bond funds, 11 of the 16 categories tracked by Lipper are negative so far this year.

Pay for performance

The question is whether the downturn is enough to have investors -- and perhaps fund boards -- considering whether they should push for a change the way management is compensated, further aligning the interests of customers and management by taking no fees if they fail to keep pace with an appropriate benchmark.

The poster child for this kind of activity is TFS Small Cap Fund (TFSSX) , a portfolio that opened in March 2006 with a performance-fee structure completely different than anything used widely in the industry.

TFS Capital Management of Richmond, Va. is best known for hedge funds, though it has a market-neutral mutual fund that it started in 2004 which has attracted about $380 million in assets and earned a five-star rating from Morningstar Inc. (Full disclosure: TFS invited me to be a board member of the market-neutral fund, which I declined because it would have been a conflict of interest.)

Hedge fund managers typically make money only if shareholders profit, and that was precisely the mentality TFS management brought to its small-cap fund, where the stated goal is to beat the Russell 2000 index (RUT) by 2.5 percentage points.

By topping the Russell by more than 2.5 percentage points, management could earn a bonus. That extra payment -- based on how big the fund's outperformance gets -- would top out the fund's expense ratio at 2.5%, or double what management would get with ordinary, index-like results.

If management lags the index, however, it must rebate fees to the fund. The worse the performance, the bigger the rebate.

So far, TFS Small Cap has not made much money. The fund is down about 35% year to date, while the Russell 2000 is off by 32%. Meanwhile, the fund's losses since inception are slightly smaller than what an investor might have experienced in an index fund on the Russell, but they're not 2.5 percentage points better.

'Adding insult to injury'

And so, according to the fund's Statement of Additional Information, TFS Small Cap has reimbursed the fund for all of the management fees it collected. Since inception, management has turned away some $200,000-plus dollars that most management firms would have pocketed.

To be sure, TFS Capital is not alone in having performance fees, Strategic Insight, an industry research firm, estimates that roughly 5% of all equity funds have performance fees, with Fidelity, Vanguard and Janus among the firms that have sliding scales for payment. It's just that none of those other firms surrender everything when they fail to deliver.

TFS isn't making an enormous sacrifice. The firm's small cap fund has just a few million dollars in assets, and the paperwork suggests that 85 cents out of every dollar in the fund actually came from the managers, meaning that the firm is giving up fees that the firm's top dogs would actually have had to pay.

But TFS co-founder and manager Richard Gates is right when he suggests that charging fees during times underperformance is akin to "adding insult to injury when it comes to investors who have already suffered an erosion of their principal."

And while reduced or waived fees simply appear to be the "right thing to do," there's no rush of fund companies to make that happen.

Avi Nachmany of Strategic Insight notes correctly that performance fees have a number of practical issues which can make them hard to implement, and which also can lead to managers trying to game the system to inflate pay. As such, he doesn't expect them to start gravitating toward performance fees any time soon.

That's too bad. If fund companies are serious when they suggest that shareholders remain invested for some future turn-around, they could at least show some good faith and opt to waive or reduce fees to help ease the pain when it hurts the most.

Copyright © 2008 MarketWatch, Inc.