As the Securities and Exchange Commission considers the merits of instituting performance fees in the mutual fund industry, the agency needs to be careful not to scare away firms from using it, according to Morningstar.

Performance fees, which fund managers are paid based on the actual performance of their fund over a period of time, have been misused in the past by fund companies. For instance, the SEC is looking into Bridgeway Funds and Numeric Investors, both of which incorrectly applied the performance-fee based percentage to their funds' assets. Instead of applying the performance-based percentage to their average daily net assets over the performance period, as the SEC requires, Bridgeway and Numeric multiplied the performance-based percentage by the most recent asset level. While Bridgeway settled with the SEC for more than $4.5 million, Numeric's case is still ongoing.

Morningstar notes that performance fees, if used over longer-term periods, ought to provide fund companies to make the base fee moderate since the fees have to be based on an after-expense performance. Still, Morningstar says that there is confusion about how to levy these fees. Furthermore, the potential for regulatory probes is likely to discourage companies from using these fees.

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