The Trouble with Performance-Based Fees

Performance-based fees have made their way into a small crop of mutual funds in the past couple of years, as investors have begun scrutinizing fees and fund boards look to align the interests of fund management and investors. When the portfolio manager does well, he is rewarded with a higher management fee; when he does poorly, investors pay less. But as you search for investor-friendly funds with great performance, you may find that a lot of these funds come up short.

Performance-based fees are already typical of hedge funds, and, in some ways, the move toward incentive fees among mutual funds is consistent with the larger trend of a convergence between mutual funds and hedge funds in recent years. Mutual fund companies have been rolling out absolute-return, market-neutral and long/short products in an effort to sate advisors' appetite for alternative investments — and to keep from losing talented managers to hedge funds. So why not test the fee structure, too?

Ideally, performance-based fees are designed to attract more talented portfolio managers, because a good manager stands to make more money if he can outperform his relative benchmark. But so far, there's no evidence that these incentive fees actually wring better performance out of managers. A 2003 study in the Journal of Finance found that funds with performance fees returned on average 1 percentage point a year more than funds without them. But that is because they are willing to take on more risk, according to the study's authors, Martin Gruber and Edwin Elton, finance professors at New York University's Leonard N. Stern School of Business, and Christopher Blake, a finance professor at New York's Fordham University. Recent data, however, shows a slight edge for funds with incentive fees. On average, they posted a trailing one-year return of 10.49 percent as of Sept. 30, according to Lipper, topping the 9.44 percent return for the average equity fund. For the three-year period, there was very little disparity with performance-fee funds netting a 13.84 percent gain and the average equity fund generating a 13.79 percent return.

Analysts aren't convinced that a performance-based fee will guarantee higher returns. After all, most funds don't outperform their index over the long haul — unless you're Bill Miller. “It hasn't worked as advertised,” says Kip Price, head of global fiduciary review at Lipper. “So far, it's been a wash.” Plus, there are some inherent flaws in the way the fees are structured, causing them to favor certain investors over others. The pay-for-performance model also creates conflicts of interest for the portfolio manager, who may succumb to style drift or take on excessive risk as he chases performance. In addition, performance-based fees can increase the volatility of a fund's cash holdings and revenue, tying the fund more closely to market fluctuations.

In 2003 and 2004, a combined $30 billion flowed into funds with performance-based fees, according to Strategic Insight, but last year saw net outflows of about $5 billion. Still, without significant usage across the industry, it's difficult to gauge their success. Funds with an incentive-based price sticker still only represent about 5 percent of the industry's assets: There are 220 mutual funds that carry a performance-based fee, and these funds hold assets of roughly $650 billion, according to Lipper. Within that universe, Fidelity dominates, with 78 performance-fee funds and 56 percent of total incentive-fee assets.

There are a few fund companies — such as RiverSource, USAA and Pioneer Investments — that use performance fees throughout their lineup. But most other shops that use them are still just experimenting. In March, Janus Capital slapped incentive fees on more than a dozen of its mutual funds, which together hold roughly $20 billion in assets. The Denver-based shop now runs the third-largest fund that carries a performance-based fee, the $3.7 billion Contrarian Fund. In January, Evergreen Investments attached a performance-based fee to its $1.9 billion Evergreen Large-Cap Equity fund; it charges 30 basis points, plus 15 basis points for good performance and minus 15 basis points for poor performance. Evergreen's board will be watching how the performance-based fee works on this fund in order to evaluate whether it should be applied to more funds.

Paying for It

Performance-based fee structures vary widely, so it pays to take a good look at how and when they are charged if you are considering using a fund of this type. Under a 1970 amendment to the Investment Company Act of 1940, incentive fees must be “symmetrical.” In other words, unlike hedge funds, mutual funds must calculate performance fees equally on the upside and downside. But beyond that, there are few rules about how they are applied. Some funds use buffer zones, which stipulate no change in the advisory fee within a certain range of outperformance or underperformance. Many funds cap the fee as well. For some funds, the fee adjustment is pegged to a percentage of assets. For others, it is set as a multiple of the base advisory fee.

Generally, the fee adjustments themselves tend to be relatively small — somewhere between 0.10 percent and 0.30 percent of assets, on top of the base management fee. If the performance fee is 0.15 percent of assets, that means if a manager outperforms his benchmark, he will get an additional 15 basis points on assets, and if he underperforms his benchmark, he will forfeit 15 basis points. The problem is that typically, even if the fund really does poorly, the investor still pays a base management fee, and because this performance fee is so small, the savings hardly make up for the losses.

A handful of funds actually levy much higher performance fees (and reimbursements), like the AIM Opportunity Fund (1 percent fee adjustment), the AIM Advantage Health Fund (1 percent) and the Birmiwal Oasis Fund (2.4 percent). But these funds mimic hedge fund strategies more closely than a lot of their peers, so it makes sense that they pay more handsomely when they do well and are penalized more harshly when they do badly. Fund manager Dunham and Associates has actually decided that its portfolio managers will only get paid 0.9 percent if they beat their benchmark, and as little as zero if they don't. (Interestingly, advisors can elect to get paid based on the fund's performance, as well.)

But here's another twist. For funds that peg the fee to assets, the asset number used can be somewhat arbitrary. A fund manager can apply the performance-fee formula against his fund's average assets for 12 months, 24 months or 36 months. And that formula can be applied at the beginning, middle or end of the period. It stands to reason then that the funds would choose the point in time with the highest assets to yield the most fee revenue.

Even the fund companies themselves seem to have trouble figuring out what and when to charge investors. In September, the Securities and Exchange Commission ordered five firms, including Dreyfus, Gartmore Investments, Kensington Investment Group, Numeric Investors and Putnam Investments, to return $7.4 million to investors for miscalculating their fees at various times between 1997 and 2004. It's not exactly an encouraging development for the funds. “The recent regulatory actions served as just one more impediment to their wider acceptance and usage,” says Jeff Keil, founder of Keil Fiduciary Strategies, a mutual fund consultancy in Littleton, Colo.

Ultimately, one of the biggest flaws in the performance-fee model is that the rewards and costs are not always shared equitably among original investors, new investors and management. For example, let's say a fund that outperforms its benchmark over a three-year period triggers the fee adjustment. Those who have held the fund for three years will pay a higher fee for the strong returns, but newer shareholders will also pay that higher fee without having reaped the rewards.

Another pitfall is that managers whose compensation is tied to performance may sacrifice style consistency in the name of performance. Given the fatter payout for outperformance, the portfolio manager faces “an inescapable temptation to push to exceed the benchmark,” which could skew the fund's objective and risk profile, Keil says. For example, many performance-based fee funds with the S&P 500 as their benchmark have significant exposure to small-cap stocks. “Fund boards must ask whether the existence of a performance-fee penalty changes the risk profile of the fund investor,” says Avi Nachmany, director of research at Strategic Insight.

For the fund managers, there are profitability concerns as well. A fee scale that rewards beating a benchmark and penalizing failure to beat that benchmark creates cash-flow uncertainty, which could hurt the firm's bottom line. “It makes their revenues a little more unpredictable,” Lipper's Price says.

In the end, critics charge that performance-based fees are often little more than a marketing ploy, particularly for fund shops like Putnam Investments and Dreyfus that have struggled with net redemptions of late. “It may not make up for poor performance, but it definitely helps those fund firms that are trying to win back investors,” Price says.

Winners & Losers

The best and worst funds with performance-based fees ranked by trailing three-year returns complete with Sharpe ratio and latest expenses.