Are Performance Fees a Solution or a Problem?
Written by C. Meyrick Payne   

In a bear market, mutual fund directors often ask themselves if a management fee based on performance is a good idea. This MPI Bulletin addresses this perennial issue. In earlier Bulletins, we have addressed the issue of what fund directors can do in response to poor investment performance. Certainly performance fees are a direct and understandable response. However the decision to implement one is not simple. This Bulletin argues both sides.

In Favor

The imposition of a performance fee is a clear, clean incentive for the manager to do better. The fund shareholders can readily appreciate the incentive and may well appreciate the fact that what is good for them is also good for the manager.

It is even possible that the imposition of a performance fee helps to market the fund. Financial planners and brokers can talk up the congruence of goals and this may provide a particular fund with a differentiating characteristic and consequently a selling advantage.

Some well-established, and generally well performing funds, in the Fidelity and Vanguard complexes have had performance fees for many years. In recent years USAA, AIM, Putnam and American Express funds have implemented performance fees on at least one of their funds. On the other hand, back in 1999 Fidelity eliminated performance fees on a couple of their funds. In aggregate only about 200 funds have performance fees out of a total population of nearly 8,000.

Another benefit is motivational in nature. Mutual funds often have difficulty in attracting, motivating and retaining the very best portfolio managers. Many of these executives are enticed away to hedge funds, where they can earn very large performance fees for themselves.

On the Other Hand

Fund sponsors have long resisted performance fees and not without some good cause.

First they can induce excessive risk taking, particularly where the benchmark is a risk implicit index such as the S&P 500 or Russell 2000. Some fund directors believe that an individual portfolio manager should be paid a performance fee on a personal basis but that the management company itself should not. Such an arrangement motivates the individual but ensures that his or her superior is not inadvertently rewarded for easing up on the risk management process.

Second, regular asset based management fees already have a substantial ³performance incentive². When performance is good, assets rise as a result performance and new investors are attracted. Some directors argue that leveraging this reward even further is risky.

Third, investment managers need a predictable revenue stream if they are to offer the best investment resources over the long term. Providing good client service and the latest technology require a predictable earnings flow. The addition of a performance fees makes this more difficult.

Many investment management companies have been acquired in recent years at rather high prices. The acquirers would rather avoid oscillations in their management fee. However, such a concern is not truly the business of the fund directors.

Typical Performance Fee Structure

The structure is usually a flat base fee based on the fund asset size coupled with a performance component. The bonus is calculated as percent of each fund¹s assets.

Under SEC regulations, a performance fee must have an upside and downside; and is generally set against a well-known benchmark appropriate to the specific investment objective of the fund. When the fund performs better than its benchmark, the bonus is positive; when the fund under performs there is a deduction of the same percentage.

A typical performance bonus is quite small, about six basis points. Thus a fund with $500 million in assets can gain or lose up to $300,000 per year. Generally these bonuses kick in when performance exceed the benchmark by some precisely defined margin, like 20 basis points in bond funds or 100 basis points in equity funds. If these variations are not reached, then there is no bonus or charge. Bond funds sometimes have a performance fee based on yield above benchmark rather than total return.

There are some funds where the performance fee can be quite large. One complex changed from an asset based fee of 100 basis points to 150 basis points on an aggressive small cap fund with the potential for an additional 100 basis points up or down. Such swings look appealing to management companies when they are beating the benchmark. But doing this consistently is extremely difficult as many of the best-known indexes, like the S&P 500, have no built-in expense component. In other words, an actively managed portfolio would first have to recover its expense ratio, usually about 100 basis points, merely to stay even with the index.

Fund directors are particularly inclined to implement performance fees on funds that are the most aggressive in the complex. In part because the fund shareholders expect the manager to use the incremental fees to reward their particular portfolio manager, just as occurs in a hedge fund. Conservative funds are unlikely to have performance fees.