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Performance Fees: An Idea Whose Time Has Come

The current approach to levying fees is outmoded and in need of change.

Jeffrey Ptak, 08/17/2017

Executive Summary

> Funds typically levy fees as a fixed percentage of assets under management, but this approach seems outmoded and in need of change.

> Performance-based fees, which vary based on how well a fund performs versus a specified benchmark, could better align fund managers and shareholders.

> While there are arguments against using performance-based fees, they seem to flout market reality and pale when compared with the benefits such fees can yield.

> The forthcoming AB “FlexFee” funds, which would make significant fee adjustments based on fund performance, represent a welcome advance that’s worth watching.

An Outmoded System
U.S. mutual funds typically levy fees as a fixed percentage of assets. If you’re lucky, the board has negotiated some breakpoints with the manager that tier the fees lower as assets increase, but that’s usually as good as it gets. For all intents and purposes, investors are paying the same freight for as long as they own a fund, in sickness and in health.

This has meant investors in active funds have typically paid the same fee regardless of how well the funds have done. Crush the benchmark? That’ll be 1% please. Get annihilated? 1%. Perform in line? Well, you get the idea.

That approach seems outmoded and in need of change. Investors are heading in droves to passive funds in large part because they want a fairer shake—that is, to pay fees commensurate with the value they feel they’re receiving. By this standard, active funds aren’t cutting it. And why? Because they charge a premium for a value-add that often fails to materialize.

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