Performance Fees--Should They Stay Or Should They Go?

Morningstar analysts tend to be hawks on fees. And with good reason: Numerous studies have demonstrated that lower-cost funds tend to outperform over the long haul. Viewed in that light, it's unfortunate even when funds with strong managers charge steep prices. But it’s all the more disappointing to see high fees at funds with inferior investment results.

One way to ensure that funds at least have to perform well to earn a nice check is a performance fee. As its name implies, a performance fee fluctuates based on the actual performance of the fund. If the fund beats a preselected benchmark, then the fund's advisor gets paid a little more. If the fund fails to do just that, then the advisor doesn't get the extra payout. That seems only fair for the fund’s shareholders, who bore the brunt of the underperformance. Moreover, because performance fees have to be based on after-expense performance, they provide an added incentive to fund firms to make the base fee moderate.

Sound like a good idea? Well, it is, as long as it's applied to longer-term periods, but it really hasn't caught on in the mutual fund world. As much as fund company executives love to talk about free markets and the like, this economically sound idea hasn't attracted many fans likely because of the very real fear that profit margins would come under pressure if investors truly paid for performance. Indeed, while there are some notable performance-fee users, such as Fidelity, it's generally less-high-profile fund companies, such as Bridgeway and Numeric, that use them. (Of course, there are some fund companies that use these fees inappropriately, as my colleague Russ Kinnel has pointed out.)

The SEC's Take
As it turns out, though, the SEC has been looking into the computation of performance fees at a variety of shops, and it appears that they've found faults in many instances. Most notably, Bridgeway--a firm that we think highly of--had a run-in with regulators a few months ago. The problem arose in the way Bridgeway was applying the performance-based percentage to the funds' assets. Instead of applying the performance-based percentage to their average daily net assets over the performance period, as the SEC requires, Bridgeway multiplied the performance-based percentage by the most recent asset level. The firm eventually had to pay more than $4.5 million, much of it to be returned to shareholders.

More recently, Boston-based Numeric, another good small fund firm, seems to have gotten caught in regulators' cross hairs for similar reasons. Like Bridgeway, they too used an end-of-period asset figure instead of the average daily net assets over the period (in this case, 12 months). Moreover, there's an SEC rule from the 1970s that says that the base management fee (not the performance adjustment to that fee) actually can be calculated on end-of-period assets if that is explicitly stated in the prospectus. But Numeric failed to disclose that. Furthermore, the performance adjustment itself was incorrectly calculated using end-of-period assets. As such, shareholders of the Small Cap Value fund--which has beaten its benchmark handily--were overcharged about $920,000. Meanwhile, two other Numeric funds that have this type of fee (and also beat their bogy) actually shrank in size, so their shareholders were undercharged.

Another interesting difference between this case and Bridgeway's is that Numeric used an outside firm (which it declined to name) to perform the calculation. Here's the wrinkle, though: Numeric's accountant, PricewaterhouseCoopers, is fighting the SEC over the resolution of this case. The SEC wants the Numeric funds' net asset values to be restated for the period in question, which would be a hassle for PWC, especially if they have to do the same for other funds for which they keep the books.

Whatever the outcome, one thing is clear: There is confusion about how performance fees ought to be levied. By taking a stand, the SEC is clearly trying to stamp out that confusion and make sure fund shareholders are being treated absolutely fairly. That’s a worthwhile effort. The risk, though, is that the regulatory scrutiny either frightens off firms that are considering such fees or even forces firms already using fees to jettison them. That would be regrettable. If anything, the SEC should be thinking of ways to encourage other firms to adopt these fees, because the fees are very useful in motivating fund companies to align their interests with those of fundholders. It would be unfortunate if the SEC's actions instead have the reverse effect.

In Other News
Not only are we fans of performance fees, but we also favor truly active managers who employ disciplined strategies. Still, as we've pointed out numerous times, it's rare for even the best managers to get every call right, so investors should plan on living through some ups and downs if they are truly investing for the long haul.

Indeed, this point was brought home earlier this week when shares of  Biogen IDEC (BIIB) and  Elan  took a beating after the firms pulled multiple sclerosis drug Tysabri from the market. Some premier managers were significant investors in the stocks, so the funds they oversee took a beating. For example,  Vanguard PRIMECAP (VPMCX) lost 2.45% of its value in a single day, and  Smith Barney Aggressive Growth (SHRAX) lost 2.87% of its value.

Still, as useful as it is to demonstrate that even the best funds can have the occasional hiccup, the steep decline in shares of Biogen IDEC and Elan also highlighted the even greater risks associated with owning concentrated sector funds, which most investors simply don't need. For instance,  Fidelity Select Biotechnology (FBIOX) lost 10.76% of its value in a single day.