Performance fees are not inherently bad. If properly structured, they can help align a manager’s financial interests with those of investors.
However, light regulation and lack of meaningful point-of-sale disclosure mean they are too often implemented in ways that appear mostly to provide extra compensation to managers without much respect to investor interests.
There are often better ways to achieve an alignment of interests than a performance fee. The essential premise of any such fee is that it should motivate a fund manager to produce outperformance for fund investors versus the stated benchmark.
This premise, however, ignores the fact that active management fees are already far higher than those for passive fees, precisely because managers are supposed, at a minimum, to outperform a passive benchmark.
No-one of sound mind should knowingly agree to pay the high fees associated with active management (equity funds range between 75bps and 150bps) for a fund unless they expect it to outperform a cheap tracker or exchange traded fund, which can often be had for well below 30bps per annum.
For a performance fee to be justifiable on the basis of motivating outperformance, a fund’s management fee should be well below the norm for active funds.
Otherwise, the performance fee is simply a free lunch for the asset manager. They still get full active fees whether they do well or not, and they get an extra windfall if they beat their benchmark, which is ostensibly their job in the first place.
Beyond below-median management fees, there are other factors that will help better align a performance fee with the interests of fund investors.
The benchmark should be relevant to the asset class such that the manager isn’t simply compensated for beta. If a small cap equity fund has a performance fee, then it should be benchmarked against a small-cap equity index, for example.
In addition, there must be a high watermark to ensure the manager must at least earn back any prior period of underperformance before collecting a performance fee.
Finally, the fee should be crystallised at most once per year (or else the manager may collect a hefty fee based on a single strong quarter) and the fee should be reasonable for the asset class.
Regulators could take two simple steps to offset the risk of investor harm from a poorly-structured performance fee.
One way is a fulcrum fee, which means however much a manager may gain from outperforming, he must stand to lose at least an equal amount for the same magnitude of underperformance.
While this may not provide the optimal outcome in every situation, it is a clean solution that prevents managers from obtaining windfall profits without risk. It also ensures managers are not incentivised to take undue near-term risks.
There are better means to ensure a manager is motivated, and these include paying the managers variable compensation in fund shares that vest over a long period.
