Performance-based fees are scarce in the mutual fund industry and most likely will remain so, due to the complexity of managing them, the lack of industry standards and the fact that they tend to reward portfolio managers more than they do investors.

Only about 200 funds, or 5% of the 4,000 funds on the market, are tied to performance-based fees, according to Strategic Insight of New York. Excluding Fidelity Investments and Vanguard, which control 90% of the $600 billion of assets invested in such funds, less than $60 billion of equity fund assets are subject to performance-based fees. Half of the funds that employ performance-based fees have assets of more than $1 billion, while about 20% have assets of less than $100 million.

Boston-based Fidelity controls $45 billion of such assets in the Magellan Fund, Valley Forge, Pa.-based Vanguard has $41 billion in the Wellington Fund, and Denver-based Janus runs the third-largest fund tied to performance-based fees, the $3.6 billion Contrarian Fund.

"They are quite rare," said Mercer Bullard, founder of shareholder advocacy group Fund Democracy and professor at the University of Mississippi School of Law in Oxford, Miss. "This is due to inertia and the large amount of effort it takes to establish them."

"There has been an increased interest in understanding" how to set up and run effective performance-based fees, said Avi Nachmany, director of research at Strategic Insight. However, he doesn't expect a slew of fund companies to start gravitating toward such fees.

According to Strategic Insight, the performance-based fee structure tends to benefit the investment advisor more than the investor due to fund flows. Although by law the fee structure must be a fulcrum-where the percentage for rewards and penalties are equal-performance-based fees reward advisors more on the upside than on the downside because as a fund's performance improves, money tends to pour in.

With a larger asset base, the advisor's fee rises commensurately. But as a fund begins to do badly and assets go out the door, the dollar penalty to the manager shrinks. Investors, on the other hand, tend to buy into a hot fund late in a bull cycle.

In the end, the net effect of the rewards and penalties in performance-based funds cancels each other out and there is no overall benefit to either the advisor or the investor, according to Kip Price, global head of fiduciary review at Lipper of New York. "Most funds have not been particularity successful in implementing performance-incentive fees," Price said.

Additionally, performance-based fee funds differ significantly and there is no set standardized formula. "Fund companies can use whatever plus or minus formula they want," said Andrew Goberty, a mutual fund analyst with Chicago-based fund-tracker Morningstar. At some funds, performance-based compensation is a very large percentage of an advisor's overall fees. At others, a performance-based adjustment will kick in only in instances of extreme over- or underperformance, according to Strategic Insight.

The formulas for performance-based fees can be very complex. For example, instead of a fixed adjustment for each percentage point of difference between the performance of the fund and its benchmark, some funds set a sliding scale for performance adjustments. Several fund companies provide for linear adjustments, with maximum upward and downward adjustments to the base rate ranging from 25% to 67%-for a performance differential of more than 20% versus the index.

Also, a number of funds have used a methodology conflicting with their stated Securities and Exchange Commissionfiled formula, such as recent month assets instead of average assets over a period of time.

Compliance Concerns

Thus, the performance fee structure faces compliance challenges, as well, as it is hard for the SEC to regulate fund companies when every company has a different formula. This month, the SEC focused on the problem when it found five fund companies-Dreyfus, Gartmore Investments, Kensington Investment Group, Numeric Investors and Putnam Investments-overcharged investors at various times between 1997 and 2004. All agreed to repay their funds, with interest, for a collective total of $7.4 million.

Thus, in 2005, performance-based fee funds lost about $5 billion in net redemptions, mostly due to withdrawals from some of the largest funds in the category, according to Strategic Insight. Those numbers are a stark contrast to 2003 and 2004, when performance-based fee funds captured almost $30 billion of net inflows.

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.