Will performance-based fees work?

Fund selectors applaud the “courageous” step by Fidelity to introduce performance-related management fees across all its funds by next year, but will the move really improve long-term performance after fees, and is the new model sustainable with most active funds failing to beat their benchmark?

When asked at our sister title Expert Investor’s Alternative Ucits Congress last month, fund selectors proved overwhelmingly enthusiastic about Fidelity’s fee overhaul. But they were sceptical at the same time. While almost two thirds lauded the idea as a great concept that’s good for investors, a majority also believed it’s not sustainable.

“It’s a courageous step by Fidelity to change their charging structure to reflect performance,” says Jaap Bouma, senior portfolio manager at Optimix in the Netherlands. But, he adds, it’s a risky move too, especially for listed asset managers with high fixed costs, such as Fidelity.

Flexible earnings, fixed costs

“The risk profile of these companies will increase a lot if they are completely dependent on performance fees. It will lead to fluctuating earnings,” says Bouma.

“If introducing incentive fees leads to more inflows, the increase in assets under management can compensate for a lower expense ratio" - Henri Servaes

David Karni, head of fund selection at BCC Risparmio & Previdenza in Milan, doesn’t think either that so-called symmetric performance fees (where investors pay a higher fee when a fund outperforms its index while receiving an equally large cut when there is underperformance) are sustainable for large asset managers.

“You can convince a fund manager to agree on a flexible salary that is dependent on his own performance, but large asset managers have a lot of fixed costs. The remuneration of their marketing and compliance departments, for example, is not related to fund performance,” he says.

‘Start with fixed income’

Wouter Weijand, chief investment officer at Providence Capital, a Dutch wealth management boutique, thinks performance-related fees will work best with fixed income funds.

“In fixed income, fees take up a relatively large share of gross performance. So, making fees dependent on performance would make a difference. Introducing a flexible fee along the lines of ‘10% of gross performance’ would be an interesting concept,” says Weijand.

Currently, fixed income fund fees take up between 17% and 32% of gross performance, according to research by the European financial regulator Esma.

Secondly, bond funds more frequently outperform their benchmark than equity funds, notes Weijand, so a performance-related fee structure would work better for the former. “Introducing performance-related fees for equity funds takes a bit of courage on the side of the asset managers,” he says.

Return impact

But the all-important question is of course whether performance fees improve returns for investors.

Henri Servaes, Professor of Finance at London Business School (LBS), is currently looking into this precise question, and expects to finish his research paper by the end of this year.

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