The trouble with performance fees

Where do you stand on performance-related fees? A fascinating article in Investors Chronicle makes the case, in certain circumstances, for these charges, which a minority of investment companies still levy. Cost is not the only consideration when picking funds, the article quite rightly points out, and performance fees can incentivise managers to outperform.

Hmm. The trouble with performance fees is that while there are perfectly rational arguments to make for them in theory, translating those ideas into practice invariably proves difficult. Moreover, despite the principles of caveat emptor, buyers very often don’t beware; we explain that it is important to really drill down into the detail of any performance-related fee, but the reality is that many investors don’t.

Arguments for performance-related fees include the idea that you are getting something from a fund not available elsewhere else, that you’re rewarding managers for going above and beyond in some way, or that managers are, in return, agreeing to lower fees if performance disappoints.

All fine in theory, but difficult to justify in practice. On getting something extra, for example, one common place to find investment companies charging performance-relate fees is in illiquid asset classes, that investors would otherwise struggle to get exposure to. But while the costs of managing money in such asset classes might be higher, this is not a performance issue; those costs apply whether the manager does well or not.

Similarly, on going the extra mile, we already pay investment company managers to deliver the best possible returns they can – that is their job. If we offer extra fees if they do even better, might we simply be encouraging them to take on unwarranted levels of risk? And on the quid pro quo argument, where managers take less of a fee – or none at all – if performance comes up short, that very quickly becomes difficult to sustain; it may also encourage short-term decision making.

For all these reasons, the trend in the investment companies sector in recent years has been to move decisively away from performance-related fees. That has been part of a broader trend to simplify and reduce charges across the board, not least in the face of mounting competition from passive funds, which continue to capture the lion’s share of fund inflows.

This is not to say that there should be some sort of ban on performance-related charging. For a handful of funds, this model appears to work – and investors appear to be happy with it. And in the end, of course, investors and their advisers have the option of voting with their feet; if they decide a fund is delivering poor value, it is usually simple enough to move on.

Broadly speaking, however, performance-related fees should be consigned to the past, at least when it comes to funds marketed to retail investors. There may be intellectual arguments for charging in this way, but the application of those arguments very rarely works in investors’ favour in a convincing fashion. Indeed, the truth is that very often, investors in the fund would have got the same performance at less cost without such charging structures.