Long-only mutual funds with performance fees? You don’t see that every day…

Fees 05 Mar 2007

The plot thickens in the continued blurring of the lines between your friendly neighbourhood mutual funds and those dastardly hedge funds.  According to this story by Investment News, Lipper covers over 200 mutual funds with a performance fee.  But catch this: 56% of these funds are managed by one company: Fidelity.

Geoff Bobroff, a fund industry consultant based in East Greenwich, R.I. tells Investment News that it’s no surprise that privately-held Fidelity (and also Vanguard) use performance fees.  He says publicly-traded mutual fund companies can’t handle the revenue fluctuations that accompany such a volatile business model (although the success of recent hedge fund IPOs would suggest investors might be coming around).  Investment News points out that Janus’ approval of performance fees for 13 of its funds is a notable exception.

As regular readers will know, we believe that fees ought to be tied in some way to alpha generation.  This will help combat the growing scourge of index hugging that overtaken the mutual fund industry over the past few decades.  The trick, of course, is to somehow address the asymmetry that performance-based fees introduce.  (Mutual fund management fees are, after all, perfectly symmetrical.  The manager makes just as much on a given level of assets whether returns are positive or negative.)

Apparently, Fidelity is now expanding its performance fee model to encompass nearly 20 adviser-sold mutual funds.  The rationale, according to Investment News, is to provide a better incentive to managers to generate higher returns.  It all sounds a little too easy, though.  Simply increase the upside for managers and they’ll work harder?  But the chart below (courtesy: Investment News) show that it might actually be true…

Not only do the incentive-fee funds have a higher average and median return than the rest of the mutual fund universe, but they also have a lower best-to-worst range.

But before we get too excited, a story last November in Registered Rep explained one possible reason for this:

“A 2003 study in the Journal of Finance found that funds with performance fees returned on average 1 percentage point a year more than funds without them. But that is because they are willing to take on more risk, according to the study’s authors…”

And Registered Rep continued to rain on the performance fee parade:

“In 2003 and 2004, a combined $30 billion flowed into funds with performance-based fees, according to Strategic Insight, but last year [2005] saw net outflows of about $5 billion.”

Registered Rep cited a 1970 amendment to the Investment Company Act allowing performance fees on mutual funds as long as they were symmetrical. So these “performance fees” have a unique quality that hedge fund investors might want to learn more about – they can be negative.  In other words, the manager essentially has to “give back” fees if they under-perform the benchmark.

The SEC’s 1971 Annual Report (page 11) made reference to these changes (By the way, note how this could have easily been taken from the 2006 Annual Report):

“Competitive pressures on institutional portfolio managers for improved investment performance have led to the rapid growth of relatively exotic, aggressively managed investment vehicles -such as certain types of registered investment companies, hedge funds and offshore funds -and to increased willingness on the part of many institutions to adopt more aggressive investment strategies and trading practices.  Since these pressures have encouraged investment managers to assume higher levels of investment risk, the Commission concluded that improved disclosure of investment returns, portfolio volatility and short-term trading is needed from the managers of most types of professionally managed portfolios.  In addition, the Commission suggested that where incentive or performance fees are utilized, penalties should be structured for sub-standard investment performance, as is currently the case for registered investment companies.” [our emphasis]

Fidelity calls their performance fee a “fee adjustment to management fees”.  According to recent SEC filings, Fidelity broke the news February 9th in a letter to investors and advisers that began:

“Dear Valued Client:

Please be advised that our Board of Trustees authorized a proposal to add performance fees to 19 Fidelity Advisor equity funds, subject to shareholder approval. The proposed performance fees are adjustments to management fees, and are based on a fund’s performance relative to its benchmark.

Fidelity’s Performance Fee Structure

Fidelity’s standard performance fee adjustment range is between +20 and -20 basis points, using a rolling 36-month performance period. If approved, the performance of the funds’ Institutional share class will be used to determine the performance fee adjustment….”

This is essentially the same calculation that Fidelity’s Convertible Securities Fund has used since 1998.  A supplement to that fund’s prospectus described it this way:

“The management fee is calculated and paid to FMR every month. The amount of the fee is determined by taking a BASIC FEE and then applying a PERFORMANCE ADJUSTMENT. The performance adjustment either increases or decreases the management fee, depending on how well the fund has performed relative to a specified securities index.”

At the end of the day, long-only performance fees face some of the same accounting challenges that hedge fund performance fees have always faced (e.g. the dreaded “equalization accounting” and other issues contained in this posting).  But they go some way toward solving the asymmetry issue.  And at least picking the “specified securities index” (a.k.a. beta hurdle, see related posting) is a lot easier with long-only funds than with hedge funds (where the industry is currently groping the dark for indices containing the appropriate blends of various alternative betas).

– Alpha Male

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