What could possibly be wrong with performance-related fees?

What could possibly be wrong with performance-related fees? For years, investors, advisers and regulators alike have complained that the investment industry is the ultimate middleman, taking no risk because it gets paid whether it delivers decent performance or not. Yet performance-related fees, which appear to align the interests of managers with those of their clients, are rapidly going out of fashion.

It’s not entirely one-way traffic. Fidelity, for example, has just introduced performance-related fees on five open-ended funds it manages, including its much-admired Special Situations fund. But in the investment companies sector, managers are steadily abolishing such charges – more than half levied them five years ago, but today the figure is closer to a third.

Moreover, investment companies have been getting rid of these charges because many advisers don’t appear to like them. While you might expect clients to welcome a fee structure that only pays out when they’re doing better – or at least links charges to the returns they receive – many closed-ended funds have got rid of performance-related fees at the behest of their shareholders.

Why are investors making such requests? Well, the reality is some advisers don’t like uncertainty over fund charges. Performance fees divide investors’ views with some being favourable and others negative on them. Clearly investment companies want to increase their appeal to advisers and their investors.

One problem is complexity. Elaborate charging structures make it difficult to work out what a fund actually costs. A single annual charge, set at a percentage of assets, at least makes it straightforward to work out how much you are paying for a fund (leaving aside the arguments about how to define such charges for now at least).

More fundamentally, however, investors think performance-related fees have often been no such thing. They’ve watched as managers have earned higher fees when returns have been outsized but apparently suffered little detriment in leaner times.

Some of that disillusionment stems from the issue of relative performance. Managers that beat their benchmarks may still get paid more even when absolute performance is negative – that may be logical, but still sticks in the craw. But it’s also the case that some performance-related charges appear to have been deliberately designed to pay out whatever happens to returns.

It would be churlish to criticise investment companies for listening to their shareholders’ complaints and responding by getting rid of these charges. These are businesses run on behalf of their owners, after all. Still, it does seem unfortunate that the industry hasn’t been able to find a way to practically apply a concept that makes so much sense in theory.

Investment trust boards have a role to play here. Charged with ensuring funds are run in the best interests of shareholders, could they not find simple fee structures that properly align those interests with those of the managers they appoint?

Elsewhere in the publicly-listed space, boards have faced similar challenges. The backlash over high levels of executive pay across so many sectors follows the widespread adoption of ill-conceived and complex remuneration structures that seem to seek out every possible route to paying directors as much as possible.

But this isn’t to say performance-related pay – whether in the investment sector or broader industry – has to be this way. Maybe investment companies now backing away from these fees should instead focus on how to better design them.