Performance Fees: A Small Step in the Right Direction

Wishful Thinking? A press release from the consulting firm Casey Quirk states that 33% of the U.S. asset-management firms that Casey Quirk surveyed "currently use performance-based fees, and 62% expect to within the next five years." A fund-industry trade publication (Ignites) followed with a story about how more mutual fund companies will be adding such structures, for example, AB (Alliance Bernstein).

Well, I’m not sure about all that. Either Casey Quirk’s survey is cockeyed or all those organizations that use performance fees are doing so with investments other than mutual funds. Because my trusty Morningstar database tells me that only eight fund companies, for a total of 97 funds, now use performance fees. That’s a long, long ways from constituting one third of the industry.

(For the record, those eight firms are Calamos, ClearBridge, Eaton Vance, Fidelity, Perkins, Pioneer, Putnam, and USAA.)

In addition, there’s the awkward fact that two weeks ago the lone fund-company executive cited in the story, Peter Kraus of AB, was fired by his board of directors. That does not inspire confidence in the power of this trend.

Defining the Term Before proceeding further, here is a refresher on what performance fees are and how the operate. Unlike other fund expenses, which are static and ongoing--for example, a fund charges a management fee of 0.60% per year, which translates to 0.05% per month--performance fees are variable. They are calculated at the end of a time period. If a fund beats its pre-specified hurdle, which is typically the return of a market index, it receives a reward that is paid out of shareholder assets to the management company.

If a fund falls short of the mark, it may or may not be penalized. Hedge funds are not--they win if they win and don’t lose if they lose, which largely explains the attraction of running a hedge fund. Also unpenalized are most European mutual funds that have performance fees. In the U.S., however, mutual fund performance fees must be symmetrical. What goes up must also be permitted to go down, and by the same formula that governs the reward.

History Is Silent At this stage, a natural question is whether performance fees work. Alas, we don't know, because the sample size is so small. Indeed, trying to analyze the effects of performance fees is a lesson writ small in how to err with data analysis.

In the 1980s and early 1990s, Fidelity’s stock funds were terrific. As Fidelity offerings account for about half of all funds that carry performance fees, the conclusion seemed simple: Hey, performance fees seem to be helpful. Then Fidelity’s stock funds came back down to earth. Hey, performance fees don’t work!

Whatever Fidelity’s issues were--candidates include asset bloat, increased competition from rival fund companies, the departure of Peter Lynch, and losing young talent to hedge funds--they were not related to performance fees. Fidelity had done well with such fees, then not so well. Thus, articles on how funds with performance fees fare are in large part unintentional studies of how Fidelity’s fortunes changed over time.

The Positive Case Morningstar's Jeff Ptak--and my boss, so listen up!--gives his support to performance fees. "They are much better than the status-quo flat management fee with (if you're lucky) breakpoints as assets under management increase. That structure doesn't align sufficiently with investors' interests, doesn't scale the way it should, and incentivizes managers to keep funds open longer than they should."

Let’s examine Jeff’s three points--

1) The current approach doesn’t align sufficiently with investors’ interests.

In other words, the fund company gets paid no matter what. If both the financial markets and the fund decline, the fund company gets paid. If the former rises but the latter falls, the fund company gets paid. If both rise, but the fund does so by less than the markets, the fund company gets paid. Whatever the lyrics, always the same refrain: “The fund company gets paid.”

That is certainly true. However, I do question whether aligning the fund company’s interests with those of investors through the use of performance fees will meaningfully change how funds behave. Today, fund companies are not directly rewarded or penalized for the quality of their execution--but the indirect consequences, in terms of investor flows, are enormous. Fund companies do not lack for motivation; they are far better off if their funds beat their benchmarks than if they trail.

2) The current approach doesn’t scale the way that it should.

There’s no doubt about this claim, either. A $100 million fund that charges an annual management fee of 0.60% generates $600,000 in revenue for its sponsor. If that fund grows to $20 billion in assets and retains that same 0.60% charge, it will produce $120 million in fees. The investment-management costs will have scarcely changed. Even if the management fee does decline as assets grow, that discount is generally quite modest.

I am not sure how performance fees could fix that problem. Levy a very high performance fee for small funds and a very low performance fee (as expressed in percentage terms) for giant funds? Sure, that is possible, but one could take the same approach today with conventional management fees--and nobody does. I don’t think that performance fees get at the heart of this issue.

3) The current approach incentivizes managers to keep funds open longer than they should.

Once again, fair enough. Flat (or flat to slightly declining) management fees force fund companies to grow their asset bases if they wish to increase their revenues. Generally, that structure is not a bad thing, because the best way to grow an asset base is to treat existing shareholders very, very well. But there’s no doubt that, at times, fund companies will keep successful funds open when they should shut them down to preserve management’s investment abilities.

Performance fees could address this situation. They would need to be high relative to the regular management fee, however, and the fund company would need to believe that incoming assets would meaningfully damage the fund’s investment potential. Otherwise, the revenue calculation would favor accepting the inflows, even if they were to weaken the fund’s returns.

The Caveat Overall, it seems that mutual fund performance fees would be an improvement. I don't believe that the effect would be very large, but yes the presence of such fees would nudge funds in the right direction. Perhaps even more than a nudge for those funds that instituted a high proportion of variable to flat fees and that measured funds on their risk/return ratios rather than on total returns alone.

However, there is a reason why only eight mutual fund companies currently use performance fees: They cut both ways. It’s one thing to tout the power of active management; it’s quite another to risk the fund’s revenues on that promise. Given the dire consequences to a company if its funds’ returns disappoint, I think it highly unlikely that such fees will ever become widespread.

Edit--The mystery of Casey Quirk's findings has been resolved. In its survey, Casey Quirk contacted institutional asset managers--which might or might not be mutual fund companies. In addition, if those firms had mutual funds that did not feature performance fees, but other kinds of funds that did, then those companies would be counted as having performance fees.

An example of how numbers that seem very different at first glance can sometimes be reconciled when the full details are known.

Also, Vanguard uses performance fees with a number of its funds' subadvisors. That case is a bit different because the advisor's fee is not affected by performance, only that of the subadvisors (which is why those fees did not register in Morningstar's database). They are, however, a form of performance fee and could perhaps be added to the industry's overall count.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.