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Performance Fees: A Small Step in the Right Direction

The benefits (and limitations) of paying funds based on their performances.

John Rekenthaler, 05/12/2017

Wishful Thinking?
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!

is vice president of research for Morningstar.

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