“It is a courageous step by Fidelity to change its 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.
“The risk profile of these companies will increase a lot if they are completely dependent on performance fees,” says Bouma. “It will lead to fluctuating earnings.”
When we asked fund selectors at the Expert Investor Alternative Ucits Congress in The Netherlands in October last year, they were overwhelmingly enthusiastic about Fidelity’s fee overhaul. But they were also sceptical. While almost two-thirds lauded the idea as good for investors, a majority also believed it won’t be sustainable.
David Karni, head of fund selection at BCC Risparmio & Previdenza in Milan, does not think 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.
Wouter Weijand, chief investment officer at Providence Capital, a Dutch wealth management boutique, believes that performance-related fees will work best for fixed income funds.
“In fixed income, fees take up a relatively large share of gross performance,” he notes, “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.”
Currently, fixed income fund fees account for between 17% and 32% of gross performance, according to research by the European financial regulator Esma. Second, bond funds more frequently outperform their benchmark than equity funds, according to 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 adds.
Carrot or stick
The all-important question is, of course, whether performance fees improve returns for investors. Henri Servaes, professor of finance at London Business School, is currently studying this question. “In general, funds that charge performance fees attract the best talent because they offer better pay,” he says.
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 fall short of the benchmark – so-called asymmetric performance fees – also encourages risky behaviour, explains Servaes.
In that sense, he thinks Fidelity’s proposal to introduce symmetric performance fees would be an improvement. And it’s also better for investors as, overall, fees will likely be lower, assuming fund performance does not improve dramatically after a fee overhaul.
But what about the performance of funds with these fee structures? While symmetric performance fees are virtually unknown in Europe, they are the only form of performance fee allowed by law for mutual funds in the US. Asymmetric performance fees, typically a fixed fee plus a 20% performance fee, are confined to the hedge fund space.
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. They found that funds with incentive fees exhibit better stock selection ability and have lower expense ratios than those without.
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 still with 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.
According to the 2003 research, funds with incentive fees are more successful at attracting net inflows than those without. And that’s where the benefits for asset manager come in. “If introducing incentive fees leads to more inflows,” says Servaes, “the increase in assets under management can compensate for a lower expense ratio.”
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 it is also widely regarded as a response to the rise of ETFs, which continue to take market share from active funds.
However, Servaes does not think the introduction of lower base and incentive fees will turn the tide in favour of active. “There would only be real competition with ETFs if Fidelity’s new base fees were similar to those 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,” he explains.
“Long term, costs remain the most reliable indicator of returns. For an investor in retail share classes of equity funds, it’s difficult to make the case for active investment.”