Performance fee-based contracts, which aim to align the interests of the fund manager with that of the investor, have been controversial in mutual funds markets, and are once again under review in Europe. This column presents empirical evidence showing that performance fee contracts do not improve fund performance, particularly in instances where contracts fail to specify a benchmark for results.

Some of the mutual funds offered for sale in Europe charge so-called performance fees.  These are fees charged on top of management fees and other expenses when a fund has outperformed a pre-specified benchmark. Performance fee (PF) funds are controversial. On the one hand, they aim to improve performance by aligning the incentives of the portfolio manager with those of the investor, much like stock options or share ownership do for company executives.  Both the investor and the fund manager do better when the fund performs well and, consequently, fund manager effort should be higher for funds with incentive fees.  In addition, performance fees could also be used as an incentive mechanism to attract the most talented individuals into the investment management industry.  

On the other hand, it has been argued that performance fees can lead to excessive risk-taking.  This concern prompted the US Congress in 1971, on the recommendation of the Securities and Exchange Commission (SEC), to prohibit the use of performance fees in US mutual funds unless they are symmetric, which implies that the extra compensation earned for outperformance has to be the same as the reduction in compensation for the same level of underperformance.  Another concern, voiced more recently by regulators in both the UK and the EU, is that PF contracts are difficult to understand by retail investors and, as such, could lead funds to charge fees that appear excessive because they have succeeded in gaming the PF contract. 

Similar thoughts have been circulating around the investment community for a long time. Grinold and Rudd (1987) point out that “incentive fees tie the manager’s reward more directly to his skill… Incentive fees are not without problems. Their complexity may allow managers to manipulate portfolio attributes in order to ‘game’ the fee”.  Robert Arnott, former editor of the Financial Analysts Journal, devoted the editor’s corner to performance fees – “Depending on the structure, [performance fees] can be a fair and useful tool to align the interests of a manager with those of the clients, a way for clients to cut their overall fee burden, or a way for an investment manager to expropriate large chunks of client wealth” (Arnott 2005).

Regulating performance fees

Over the last decade, regulatory interest in PF funds has increased.  When regulations on UCITS were being revised in the EU in 2013, Sven Giegold, a German member of the European parliament, proposed outlawing such fees in the EU altogether – he even compared charging performance fees to theft, writing in the Financial Times on November 18, 2012 that “if assets grow and the fund earns more as a result of good performance, then that’s fair. But ways of stealing profits from investors should be phased out”.  Eventually, his proposal was narrowly defeated and fund providers in the EU were allowed to continue charging performance fees.

Currently, performance fees are once again on the regulatory agenda.  Both the Financial Conduct Authority (FCA) in the UK and the European Securities and Markets Authority (ESMA) are investigating whether to continue allowing performance fees in funds domiciled in the EU.  One argument being made in the FCA’s Asset Management Market Study Report (FCA 2017) is that performance fee funds use benchmarks that are easy to beat and not consistent with their underlying investment objectives. The ESMA, on the other hand, wants to make sure that enough information is available to determine what a fund’s net returns are after the inclusion of all fees.

In addition to regulators, the investor community and fund managers in Europe have become keenly interested in the merits of PF funds since October 2017, when Fidelity International, which manages more than $250 billion in assets outside the US, announced that it will introduce (symmetric) performance fees for all its actively managed mutual funds, coupled with a reduction in their regular management fee. In the US, where few complexes offer PF funds, Alliance Bernstein introduced a series of FlexFee Funds in 2017, which also charge (symmetric) performance fees.  In an article commenting on this development, Morningstar wrote that “performance-based fees, while not a panacea, represent a potentially useful innovation that more funds ought to consider to better align with investors” (Ptak 2017).  This discussion is testament to the increasing prominence of performance fees in the fund industry.

Discussions about the merits of PF funds have been hampered by the lack of quantifiable evidence of the impact of charging such fees.  This is partly because (asymmetric) performance fees are banned in the US mutual fund industry, thus preventing empirical research on the topic using recent US data.  Work on PF funds in Europe and elsewhere has been limited to country-specific studies (Drago et al. 2010, Diaz-Mendoza et al. 2012, and Hamdani et al. 2017).

Our study and its main findings

In recent work (Servaes and Sigurdsson 2019), Kari Sigurdsson and I study all equity mutual funds offered for sale in the EU, Norway, and Switzerland over the period 2001-2011 and compare PF funds to other funds across several dimensions, including returns, fees, and risk-taking in order to shed light on various arguments made by regulators, investors, and fund management companies.  The sample consists of over 100,000 fund-year observations, comprising over 200,000 different fund-class-years.  Over 7% of these funds charge some kind of performance fee.  The median fee in our sample is 20% of excess performance, which is very similar to what is being charged in the hedge fund industry. 70% of the PF funds in our sample measure performance relative to a stochastic benchmark (such as the stock market index) to determine whether a performance fee can be earned.  15% compare their performance to a fixed hurdle, which is sometimes in addition to the stochastic benchmark – 44% have a high water mark, such that the fund has to recover prior losses before it can earn subsequent performance fees.

We report several results. First, we find that PF funds perform worse than other funds by between 50 and 70 basis points per year, with much of the poor performance concentrated in two subgroups – funds that do not set a benchmark against which performance is measured, and funds that set a benchmark that is easy to beat.  

Second, we find that the expense ratio of PF funds, which is inclusive of the performance fee itself, is approximately 30 to 35 basis points higher than that of other funds.  Thus, PF funds charge more for their services than other funds, even though a substantial subset of these funds underperform.  In fact, over half of the underperformance of PF funds is due to higher expenses.  Funds without a stochastic benchmark against which performance is measured stand out in particular in terms of the magnitude of their fees.

Third, there is no evidence that PF funds take more risk overall relative to other funds or that PF funds whose PF contract is out of the money in the middle of the year because of poor performance increase risk in the second half of the year.  Fourth, there is also no evidence that PF funds attract more inflows conditional on performance.  Fifth, a subset of PF funds change the terms of the contract after poor performance such that it becomes easier to earn performance fees in subsequent years.  Such changes do not appear to be in the best interest of fund investors. 

Overall, our evidence suggests that investors should pay particular attention to the fee benchmarks set by PF funds and that the PF mechanism alone is not sufficient to induce better performance and/or attract the best talent to the fund.