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Performance Fees: The Case for Enhanced Disclosures and More Equitable Structures

What we told the European Securities and Markets Authority about policies on performance fees

Andy Pettit


On the surface, performance fees are an ideal way for funds to charge investors: They symbiotically align the interests of fund managers with the interests of their investors. But in practice, it’s not always so simple.  

Cognizant of this, the European Securities and Markets Authority, or ESMA, recently sought public consultation on potential guidelines for performance fees under UCITS, the pan-European equivalent of the '40 Act. 

Specifically, while performance-fee structures are permitted, little exists in the way of precise regulation. This has led to regulatory arbitrage, along with inconsistent use and enforcement of these fee structures across Europe. With more than 5,000 UCITS funds levying some form of performance fee, converging the rules of engagement is a valuable exercise. 

Here, we take a closer look at the current state of performance fees and our recommendations for ESMA. 

The problems with performance fees 

We see two main challenges with performance fees: 

  • They are often exceedingly complicated, requiring pages of explanatory text in fund prospectuses. Interpreting when the fees might be incurred and their likely level can be tough for experienced Morningstar analysts, let alone individual investors. 
  • The upside is often firmly weighted on the side of the fund. In some cases, performance fees exist alongside normal, fixed annual management fees. Or worse, they may be levied on outperformance of undemanding targets—like an employee getting a bonus for delivering no more than the minimum expected by their employer. 

Getting a better outcome 

The single most impactful gain for investors could be a simple, standardised summary of funds’ long explanations about their performance fees. 

For example, the summary could take the form of a list or table containing the items shown below. This list clearly shows the key information, such as whether there’s an index and if it’s relevant to the fund; the level of the fee and whether it’s capped or unlimited; and whether the fee is charged on any outperformance or only above a set threshold. 

  • Base Management Fee: 0.90% 
  • Performance Fee: 20% 
  • Hurdle: 0.90% 
  • Benchmark: FTSE 100 
  • High-water Mark (Absolute, Relative, None): Yes, Absolute 
  • Crystallisation Period: 3 Years 
  • Date HWM Last Reached: D/M/Y 
  • Ability to Reset HWM: No 
  • Date of Last Reset to HWM: N/A 
  • Fee Cap 2.50% 

Supplementing this with an example assuming a specific scenario would be even more helpful. 

What we told ESMA about performance fees 

Our comment letter to ESMA included the following points: 

  • Standardised disclosures would be a major benefit to investors. These disclosures would enable investors to more easily compare the terms of performance fees, form a view on whether they consider them fair and assess the likely level of costs. 
  • Funds should be held to selecting an appropriate benchmark. This is vital when it comes to assessing fund performance and critical in the case of setting performance fees. The chosen index’s starting factor should be reflective of the investable universe that a UCITS specifies in its investment objective, as shown in its Key Investors Information Document, or KIID. The investable universe is defined by factors such as the types of security, geography, currency, and market cap. 
  • Whenever possible, the index should be calculated on an equivalent basis to the UCITS fund, in terms of currency, hedging policy, and dividend income.  
  • Funds that tie some of their manager’s remuneration to a different benchmark than the one used to charge investors are worthy of further analysis. 
  • It is unnecessary for funds to only be able to levy a fee on absolute positive performance. We believe this approach, which the ESMA raised for discussion, would be unduly penal. For example, consider a global fund that levies a low fixed fee and a performance fee based upon outperforming the Morningstar Global Markets Index. In periods where the index loses value, but the fund loses less, it is still equitable for the fund to charge the fee based on that outperformance. 

Additionally, these same guidelines should apply beyond UCITS to all Packaged Retail Investment and Insurance-Based Products. If the UCITS performance-fee guidelines purport to be best practice, then retail investors should expect equivalent practices from similar products that are marketed to them. While alternative investment funds may be less constrained in areas such as their investment limits and liquidity, this does not mean that they should be subject to less rigor in the setting of their variable fees to the potential detriment of investors.  

To quote ESMA, “A lack of common practices across Member States could bring uncertainty for investors.” We contend the same would be true for a lack of common practices across the two most common types of investment fund. 

To learn more about how performance fees are impacting investors across markets, download our Global Investor Experience study.

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