From the April 2006 issue of Wealth Manager Web • Subscribe!

April 1, 2006

Performance Chasers

Fidelity has them. So does Vanguard. But once you look beyond those goliaths, mutual funds with performance fees are a rare breed. That's disappointing news for advocates of performance-based pricing. Yet all's not lost. Several companies have recently jumped on the bandwagon. Is a new age dawning for performance fees? If so, should you seek out such funds?

To be sure, there's hardly a groundswell of converts. It's easier by far to find funds that shun performance fees. That doesn't stop a number of analysts, fund managers and others from pounding the drums for the idea. They argue that performance fees move investors a step closer to the ideal of a client-manager relationship by aligning interests. It all boils down to the mantra that performance fees encourage superior performance.

Conceptually, it makes perfect sense, and satisfies every capitalist and free-market enthusiast along the way. If a fund beats its benchmark by a predetermined amount, the fee goes up. If the fund lags the benchmark, the fee goes down. Either way, investors benefit compared with a fixed-fee arrangement that stays constant regardless of results, or so advocates of performance fees assert.

So why aren't advisors demanding more funds adopt the performance-fee structure? "I'm surprised that the financial advisor community hasn't embraced these products," says Jeff Joseph, managing director of Rydex Capital Partners, which offers a performance fee of +/- 20 basis points for its Core Equity fund.

Embraced or not, performance-based fees are "good for investors and the fund companies," says Kip Price, head of global fiduciary review for mutual fund analysts Lipper. "Their incentives are aligned."

By that reasoning, incentive alignment is unusual in the mutual fund industry and widespread among hedge funds. Considering the potent influence hedge funds wield of late--including mutual funds trying to emulate their higher-priced competitors--it's conceivable that the pricing structure that's common to alternative investing will eventually find greater allure in conventional portfolio management.

To be sure, the hedge fund performance fee is a different animal altogether compared to its counterpart in mutual funds. Whereas hedge funds charge relatively large performance fees of 20 percent or more of profits, mutual funds tread lightly, adjusting the fee schedule up or down by, say, a mere 50 basis points.

Another distinguishing mark of mutual fund performance fees is their symmetrical design, as required by the Investment Company Act of 1940. A fund that promises a fee increase of 50 basis points for beating its benchmark must also pledge to shave its fee by no less when performance falls short of the bogey.

Perhaps the most conspicuous member of the performance-fee club among mutual funds is the massive Fidelity Magellan. In absolute dollar terms, Magellan's fee adjustments are considerable. According to the large-cap equity fund's annual report dated March 31, 2005, for instance, Magellan's then lagging results relative to its S&P 500 benchmark, translated into an $89.4 million reduction in fees. Even so, the adjustment is but a fraction of the fixed "basic fee," which nipped Magellan to the tune of $359.5 million for the year through 2005's first quarter. No matter, as that was pocket change for a portfolio bursting with nearly $60 billion.

In fact, there's hardly anything daring going on under the hood at Magellan when it comes to performance fees, at least in relative terms. The fund adjusts its 0.57% basic fee (as of March 30, 2005) by as much as 20 basis points, plus or minus, depending on performance. Like many fee adjustments of this type with mutual funds, the change is calculated based on the portfolio's average net assets over the trailing 36-month period.

The use of performance fees is familiar around the Fidelity family, finding a home in more than 40 retail funds managed by the Boston company. That equates to about one-third of Fidelity assets under management, says Fidelity spokesman John Brockelman. "We've used performance fees since the early 1970s."

Vanguard is the other prominent user of performance fees among mutual funds. That may come as a surprise, given the firm's emphasis on index funds, which are destined to track, not beat an index. Performance fees are necessarily pointless in a passively run fund. But while Vanguard excels in the land of indexing, it has a sizable presence in actively managed funds, too. Of its 37 portfolios run trying to deliver something more than benchmark results, 27 have performance fees, or incentive/penalty arrangements, as Vanguard likes to label them.

"The idea behind an incentive/penalty arrangement is to align the interests of shareholders and managers longer term," says Joe Brennan of Vanguard's portfolio review department. "With underperformance, there's a penalty; with alpha, there's a bonus."

The arrangement has recently found a fresh convert in Janus Capital Group, which adopted performance fees for 13 of its 59 stock and bond funds after shareholders approved the change in January. The tweaking of the base management fee amounts to an increase or decrease of 0.15 percent, depending on performance. The switch is said by some to be an effort to enhance the firm's image with the investing public after its regulatory stumbles of a few years back. Less generous pundits dismiss the new fee system as a marketing gimmick. But no matter what you call it, Janus has added a considerable $20-billion worth of mutual fund assets to the cause of performance fees.

Another new disciple is Evergreen Large Cap Equity fund, which announced plans to institute a new performance fee. Starting December 1, 2006, the fund's base management fee of 30 basis points will be raised or lowered up to 15 basis points, depending on performance results relative to the S&P 500.

If embracing performance fees is a trend with legs, one might wonder if the results have a history of living up to the hype. To a degree, yes, argues "Incentive Fees and Mutual Funds," a widely quoted paper in the Journal of Finance's April 2003 issue. Why? Slightly better performance of roughly 100 basis points a year over comparable funds sans fee incentives.

"The managers that have incentive fees tend to do slightly better than a similar set of managers with similarly matched funds without incentive fees," says Martin Gruber, one of the paper's authors, and a finance professor at New York University, in a recent interview with Wealth Manager.

The study's kicker is the explanation of what's behind the higher performance. "A lot of funds with incentive fees actually end up having lower expense ratios than the funds that don't have incentive fees," Gruber explains. In turn, that helps performance. Sounds good, except that the lower expense ratios reflect the fact that funds don't earn all their incentive fees, which is another way of saying performance isn't all that impressive. Still, funds that stopped using incentive fees posted higher overall fees compared to periods when performance fees were in place, Gruber notes.

Another mixed message is that performance fees may promote volatility. The incentive that springs from the promise of higher fees persuades some managers to chase greater risks, says Lipper's Price. "Funds with incentive fees can be a little more volatile; the manager may be taking on more risks," he explains.

The study that Gruber co-authored comes to the same conclusion, a point he reconfirms in 2006. Funds with incentive fees tend to have slightly higher risks, he says. That's not surprising, and arguably that's the goal. "You want to beat the index so you want to take higher risks," he says. That may be especially true when performance lags.

Gruber's bottom line: Don't confuse performance fees with a free lunch. Nonetheless, he still finds them a "pretty good tradeoff."

And what of the funds that deliver as promised, generating superior returns and cashing in by taking a bigger fee? "A lot of times investors will put up with a higher fee if they're making money," says Andrew Gogerty, a Morningstar analyst. "It's particularly agreeable in the large-cap space, where the primary benchmark is the S&P 500. That's not an easy benchmark to beat on an annual basis."

But delivering alpha, or benchmark-beating performance, doesn't always insure that the performance fee is assured an enduring role. Take Quaker Funds, a Malvern, Penn. shop that recently cancelled the performance fee on Quaker Small Cap Value and Quaker Capital Opportunities Fund, which are subadvised by Aronson+Johnson+Ortiz and Knott Capital Management, respectively. Success played a role in terminating the incentives-based pricing model, says Justin Brundage, chief operating officer at Quaker Funds. "Because of the good performance in both of those funds, the performance fees were higher than would have been paid with a flat-fee structure." He adds that the performance fees suffered "complicated formulas" and confused some shareholders and advisors.

Some might counter that the higher performance is the price of chasing and capturing alpha. If so, killing the incentive risks killing the goose that laid the golden performance eggs. But that's assuming the performance fees are managed correctly. In at least one case, something less unfolded. In 2004, Bridgeway Capital Management reimbursed more than $4.4 million, plus interest, to shareholders for "illegal performance-based fees that Bridgeway charged to three of its mutual funds," according to a Securities and Exchange Commission release. By several accounts, Bridgeway's overcharging was an honest mistake. Even so, the mishap reminds that performance fees, while simple in concept, can be complicated in practice, lending support to Brundage's point.

In the end, performance fees are but one variable to consider. The presence of a performance fee is hardly justification for buying a fund without further analysis. There's no law that says funds with performance fees are automatically great investments.

On that note, measuring a performance fee relative to the overall expense ratio can be revealing. All things being equal, a fund with a 0.50 percent performance fee that's a component in a 2.0 percent expense ratio overall faces an uphill battle when competing with a portfolio without performance fees and an expense ratio of just 1.0%. Similarly, buying a fund with a mediocre manager simply because of a performance fee doesn't make a lot of sense.

Some go as far as to question whether the performance fee has any value even in the best of circumstances. "In the end, it's a zero sum game," observes Max Rottersman, who runs the mutual fund consultancy in Hanover, N.H. In the long run, everything regresses to the mean, he says, and so measured over 10 or 20 years, the net effect of performance fees on returns is apt to be nil.

History arguably suggests as much. On the other hand, hope is forever in a bull market when it comes to actively managed funds. By that standard, performance fees may be destined for wider use after all.

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