Royce Select Fund

Goodbye, and many thanks, to my favorite mutual fund ever

October 10, 2012: 5:00 AM ET

If you want to take advantage of the Royce Select Fund's uniquely fair fees - sorry - that ship has sailed.

FORTUNE -- There are times when an innovative and brilliantly designed product takes the world by storm and makes a fortune for its creators and marketers. Think iPhone. And then there are times when an innovative and brilliantly designed product just doesn't catch on. Think of the Royce Select Fund.

Never heard of Royce Select? Almost no one has. Which is the problem. So let me share with you the story about how a pioneering mutual fund that had a uniquely ethical and fair fee structure and was extremely lucrative for its long-term shareholders (including me) came and went while attracting almost no notice from the investing public.

Our tale begins in 1998 with mutual fund pioneer Chuck Royce, who was looking for a way to better align fund investors' interests with managers' interests. Managers typically get a fee based on the fund's size, and investors absorb its expenses. Even if investors get stomped, the managers still get their fee. Royce Select was designed to be different. Royce & Associates (now owned by Legg Mason (LM)) would get 12.5% of any profits that investors made, and would absorb all the expenses. If the fund's value declined after the managers took a fee, they wouldn't get any additional fees until the fund rose above the "high-water mark" at which the last fee had been paid.

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"I did it because I personally believed that this was a highly ethical way of entering into a profit-sharing arrangement with our customers," Chuck Royce told me. "There were drumbeats about hedge funds being the hot new investment vehicle, and I wanted to show that the best aspects of a hedge fund could be married to a [mutual] fund."

In fact, Royce Select was better for investors than a hedge fund, which typically charges a 2%-of-assets annual fee and takes 20% of profits above that. Royce, by contrast, had no annual fee and took only 12.5% of the profits.

Those of us who stumbled across Royce Select -- a friend told me about it -- did very well. Through Oct. 1, I had made about 450% in capital gains and reinvested dividends on my initial March 15, 1999, investment. That's about eight times the 57% that Wilshire Associates says the overall U.S. stock market returned during that period.

But despite its excellent long-term returns, the fund couldn't attract much in the way of assets. That's partly because it wasn't really marketed well, unlike the iPhone. And at least partly because the Securities and Exchange Commission severely restricts the investors allowed to buy funds that charge a variable fee.

The SEC requires you to be a (presumably sophisticated) "qualified investor" -- one with at least $2 million of assets -- in order to buy into a variable-fee fund. The idea, an SEC news release explains, is to make sure that unsophisticated investors don't fall prey to "'heads I win, tails you lose' arrangements in which the adviser has everything to gain if successful, and little if anything to lose if not."

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In addition to limiting the investor pool, the "qualified investors" requirement begat a ton of paperwork. I did my own -- but Royce had begun working through investment advisers, and there was no provision in Select's no-load, no-marketing-fee structure to compensate them for all that effort. So Royce Select (now Royce Select I (RYSFX)) and the four subsequent Select funds didn't catch on, and never attained critical mass.

When fund shareholders approved converting Select I to a conventional fee-plus-expenses structure on Sept. 28 -- I voted no -- it had only $49 million of assets, a pittance for a fund with a fine long-term record. Assets of the four other Select funds totaled less than $30 million. All five funds are now open to any investor who can write a check.

"You can't say I didn't stick with it," Chuck Royce told me as we sat in his office eating cookies and bidding a sad farewell to Royce Select's unique fee structure, which had lasted almost 14 years. "Maybe you and I can start an alumni fund," he quipped. I'd definitely be up for that. But I don't think the market would. Too bad.

This story is from the October 29, 2012 issue of Fortune.

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