In most cases, performance fees for mutual funds are not worth the headache. That appears to be the conclusion of the majority of mutual fund firms as they overwhelmingly reject the idea of linking management fees to fund performance.
Performance fee arrangements -- basing the fee a fund company receives on the fund's success in beating an investment benchmark -- subjects mutual fund companies to increased uncertainty about revenues. The arrangement also creates the need for additional compliance to ensure that a firm or manager does not take outsized risks to increase compensation, according to industry observers and executives.
The reward for these efforts is investor indifference, executives and observers say. Investors for the most part care about performance, not performance fees.
The market does not reward fund advisers for adopting performance fees, said Charles Trzcinka, a professor of finance at the State University of New York at Buffalo. "Investors are not going to choose a mutual fund on the basis that the adviser has a performance incentive."
Shareholders in the Destiny I and Destiny II funds of Fidelity Investments of Boston seemed to confirm the view that investors do not strongly favor performance fees. In a proxy vote in June, the funds' shareholders approved a Fidelity proposal to gradually eliminate performance fees and adopt a charge that does not vary based on performance. Fidelity, which based its proxy votes on the amount of assets a shareholder owns, reported that shareholders representing approximately 83 percent of the assets in each fund voted in favor of dropping performance fees.
Even professional advisors who pay particular attention to fund expenses find that performance fees are not the crucial factor in making investment decisions. Louis Stanasolovich, president of Legend Financial Advisors of Pittsburgh, said the existence of performance fees was among the last factors he considered.
Performance fees are not a requirement for either low cost or favorable performance. TIAA-CREF Mutual Funds of New York, for example, are known for both their low expenses and generally good performance. Nevertheless, the firm, which is operated as a non-profit organization, does not use the fees.
Dennis Foley, vice president in charge of mutual funds and annuities for TIAA-CREF, said that performance fees at TIAA-CREF motivate individual portfolio managers. Adopting performance fees for the funds themselves, however, runs the risk of increasing fund expenses, Foley said. That is inconsistent with TIAA-CREF's emphasis on low costs, he added.
The fund industry seems to have noted investor indifference to the performance fee issue. Currently, about two percent, or 163 funds, of the total of 13,343 open-end funds use performance fees, according to fund tracker Lipper Analytical Services of Summit, N.J. That total is down from 2.5 percent in 1994, according to Lipper.
The relative unpopularity of performance fees in the industry has not stopped some fund groups from advocating their use. The Vanguard Group of Malvern, Pa., is an outspoken proponent of the fees.
And Fidelity, despite the switch in charges on the Destiny funds, still has more than $250 billion in assets under management in 33 funds subject to performance fees, reported Jessica Catino, a Fidelity spokesperson. "We believe (performance fees) align shareholders' interests with our own interests," Catino said.
That is the consistent argument of performance fee proponents. American Express Funds of Minneapolis, for example, recently proposed adding performance fees to 11 of its funds. Shareholders approved that proposal in late June.