“In general, funds that charge performance fees attract the best talent because they offer better pay,” Servaes adds.
But the prevailing structure of performance fees in Europe, where managers can earn more when they beat the benchmark but don’t get punished when they fail to do so (so-called asymmetric performance fees), also encourages risky behaviour, says Servaes.
In that sense, the introduction of symmetric performance fees as proposed by Fidelity would be an improvement, thinks Servaes. And it’s also better for investors, of course, as fees overall will likely be lower, assuming fund performance does not improve dramatically following a fee overhaul.
A look at the US
But what about the performance of funds which such fee structures? Symmetric performance fees are virtually unknown in Europe, but they are the only form of performance fee allowed by law for mutual funds in the US. Asymmetric performance fees (a fixed fee plus a performance fee of typically 20%) are confined to the hedge fund space.
Back in 2003, three US-based scholars published a paper on the difference in performance of mutual funds with such ‘incentive fees’ and funds without such fees (contact the author of this article if you would like to receive a copy). They found that “funds with incentive fees exhibit better stock selection ability and have lower expense ratios than funds without incentive funds.”
Funds with incentive fees also have, on average, a beta of less than one. This explains the investor-friendly outcome of better risk—adjusted returns, yet lower fees. Add to that the better alignment of interests between fund managers and investors (sharing the pain and the gain), and it’s easy to understand why the concept would resonate with investors. And it does.
According to the 2003 research, funds with incentive fees are a lot more successful in attracting net inflows than funds without incentive fees. And that’s where the benefits for asset managers come in.
“If introducing incentive fees leads to more inflows, the increase in assets under management can compensate for a possibly lower expense ratio, and other companies may follow Fidelity’s example,” says Servaes.
An answer to ETF success?
Fidelity’s move to introduce symmetric performance fees in Europe has arguably been inspired by the success the structure has had in the US, but is also widely regarded as a response to the rise of ETFs, which continue to eat away market share from active funds.
But LBS professor Servaes doesn’t think the introduction of lower base fees and incentive fees will turn the tide in favour of active management.
“There would only be real competition with ETFs if Fidelity’s new base fees were similar to the fees investors now pay for ETFs. But I don’t expect that will happen,” he says.
“If a fund with a symmetric performance fee structure performs worse than the benchmark, the total fee will presumably still be higher than what you pay for an ETF. Long-term, costs remain the most reliable indicator of fund returns.
“For an investor in retail share classes [of equity funds], it’s difficult to make the case for active investment.”
