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Kitces: Why a maligned fee is back in vogue

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As advisors face increasing pressure to differentiate themselves in how they work with clients, a once-controversial fee structure is coming back into vogue: the performance-based fee.

Whereas the AUM model determines a fee based on total assets being managed or advised upon, the performance-based fee is calculated as a percentage of upside (on an absolute basis, or relative to a benchmark index), where the advisor’s fee is forfeited if they fail to achieve the required threshold or hurdle rate.

The virtue of this form of compensation structure is that it would compel investment advisors to eschew closet indexing and truly work to outperform their benchmarks.

This can be a very compelling proposition to prospective clients — and judging by the assets that firms with performance-based fee structures attract, clients don’t seem to perceive much downside.

However, performance fees have a dubious past, and the passage of time has done little to eliminate their faults.

This means that, while there are some potential marketing benefits for RIAs to pursue performance fees on investment portfolios, there are also many reasons why they shouldn’t do this.

One of the most popular and consumer-friendly aspects of the traditional AUM fee is its alignment of incentives between advisor and client. To the extent that the advisor charges a fee based on a percentage of the portfolio being managed, favorable investment results that grow the portfolio will also grow the amount the advisor can bill, and losses in the client portfolio will decrease the advisor’s billable assets.

Thus, advisors who are charging AUM fees have a strong incentive to be good stewards of their clients’ money, because growth for their portfolios also spells growth for the advisor’s business. This could appear to be a win-win situation.

Yet the AUM fee only goes so far to align the incentives of the advisor and client.

To the extent that markets themselves tend to grow — which will often happen independent of any one advisor’s effort — a portfolio’s AUM fee tends to naturally rise over time simply due to passive growth of the market itself. Yet the advisor is, in effect, rewarded for growth they weren’t responsible for in the first place.

In fact, an advisor who consistently underperforms a benchmark in a bull market will still earn the bulk of their annual fee increases.

For example, if the stock market rises by 10% and the advisor underperforms by 1%, the AUM fee will still increase by 9% for the year, despite this relatively poor performance.

And if the client’s portfolio declines, the advisor will still earn a substantial fee, despite the fact that the client has lost money.

As a result, there has been growing discussion around whether advisors, particularly those whose value proposition is built around their investment process, should be charging some kind of performance-based fee instead.

For instance, an advisor might charge a performance-based fee that provides for sharing 10% of the portfolio’s profits. Thus, the greater the profits, the more the upside for the advisor and the client, and, if the portfolio doesn’t earn a return, neither does the advisor.

Alternatively, the advisor might charge a fulcrum fee, which stipulates that the advisor earns a base fee, such as 1%, but will only earn an additional fee if a specific benchmark target is achieved.

Imagine that the advisor is compensated 10% of the outperformance above a return threshold, such as excess returns above a 7% per year hurdle rate, or for beating a certain benchmark — say, generating returns in excess of the S&P 500 for the year. Notably, a fulcrum fee would also penalize the advisor for underperforming; if the portfolio substantially underperforms the benchmark, the 1% base fee might be forfeited altogether, eliminating compensation for underperforming in a bull market.

Yet notwithstanding the intuitive appeal of fees tied to performance, they have a very troubled past. Indeed, many investment advisers are actually banned from charging such performance-based fees outright.

While performance-based fees provide greater reward potential for good managers, those same fees can also incentivize managers to take on more risk.

Consider an advisor who is going to manage a client’s equity portfolio, and who will be benchmarked to the S&P 500. The advisor’s performance-fee agreement stipulates that they will receive 20% of any outperformance above the benchmark.

If the advisor doesn’t beat the benchmark, they earn nothing, as the fee is zero, ensuring the advisor has a very strong incentive to outperform.

A closet indexer
However, the advisor’s investment strategy is not actually to try to pick superior investments and have a high active share.

Rather, the advisor will be a closet indexer with a rather simple strategy: Because markets go up more often than they go down, the advisor puts all clients’ assets into a 2X leveraged fund that typically provides 200% of the daily return of the S&P 500 — e.g., ProFunds UltraBull S&P 500 Fund (ULPIX) — and waits for the bull market’s leveraged returns to produce stints of substantial outperformance on which the advisor will earn performance-based fees.

Yet if the investor had started with $1 million in the portfolio, the portfolio of ULPIX paying 20% performance fees would only be worth $1,226,744 after 20 years, for a cumulative return of just 1.1%/year.

Meanwhile, the advisor would have earned performance-based fees of $454,526, thanks in large part to ULPIX outperforming the S&P 500 in 11 of those years.

Had the investor simply bought the S&P 500 and held it, the portfolio would have grown to $2,867,761, for an average annual return of 5.7% over this same time period.

Consequently, by taking substantial risk with the client’s portfolio and amplifying the volatility, the performance-fee-based advisor was able to demonstrate several years of strong outperformance — for which he generated a substantial profit — while the client alone experienced losses in the down years.

In other words, the advisor was incentivized to and actually profited at the expense of the client’s amplified risk, while failing to add any actual value to the investment process.

That performance-based fees would incentivize investment managers to take additional risk is nothing new.

In fact, Congress recognized the problem in the aftermath of the bull market of the 1920s (and the subsequent crash).

When the Investment Advisers Act of 1940 was written, Section 205(a)(1) explicitly established a ban on most performance-based fees for investment advisors.

As Congress noted at the time, performance fees were effectively “heads I win, tails you lose” arrangements. Yet the SEC began to partially relax the performance-fee rules in 1970.

First, the Investment Advisers Act was amended to allow RIAs serving as the investment manager of a mutual fund to charge fulcrum fees under the then-new Section 205(b).

In 1985, the SEC further relaxed the rules by establishing Rule 205-3, which stipulated that investment advisors could charge certain performance-based fees when working with a qualified client.

For the purpose of performance fees, a qualified client is one who meets either an AUM test or a net-worth test, or is an executive or investment-related employee of the RIA itself.

The AUM test
The AUM test requires that the investment advisor actually be managing at least $1 million of the client’s assets. Meanwhile, the net-worth test requires the qualified client to have a net worth of at least $2.1 million, or be a so-called qualified purchaser — e.g., an ultra-high-net-worth individual, or certain institutions/entities — under Section 80(a)-2(a)(51).

This amount is now annually indexed, and, as of 2012, investors may not include the value of their personal residence in meeting this standard,

Lastly, the employee test requires that the qualified client either be an executive officer, director, trustee or general partner of the RIA, or an employee who participates in the investment activities of the advisor.

Notably, a Registered Investment Company — in essence, a mutual fund — is also able to charge performance fees, but only if it meets the fulcrum fee structure requirement of Section 205(b)(2) of the Investment Advisers Act.

On the other hand, hedge funds are permitted to charge any type of performance fees, although they in turn are limited to only accredited investors.

The key point here is that an RIA that wants to charge performance-based fees to its retail investor clients can only do so if they are considered qualified clients. And of course, Series 6 or Series 7 advisors under a broker-dealer are not permitted to charge performance-based or any advisory fees at all, as they can only be compensated for brokerage services — unless they become a hybrid advisor and separately join or become an RIA as well.

For advisors working with the aforementioned qualified clients, it is permissible to charge performance fees, but it’s still necessary to determine the actual structure of the fee itself.

Some firms simply arrange their fees to participate in a percentage of the upside, while others stipulate that their performance fees are only paid if they exceed a certain threshold.

In some cases the only payable fee is the performance fee itself, while in others the performance fee may include a baseline AUM fee as well — e.g., 1% of the portfolio plus 10% of the excess return above a certain threshold.

In the case of mutual funds, Congress explicitly required under Section 205(b)(2) of the Investment Advisers Act that the fee must provide for:

“Compensation based on the asset value of the company or fund under management averaged over a specific period, and increasing and decreasing proportionately with the investment performance of the company or fund over a specified period in relation to the investment record of an appropriate index of securities prices.”

In other words, a valid performance fee in the realm of mutual funds must have some set measuring period in which investment performance would be compared to the underlying index, and the advisor’s compensation must both increase and decrease proportionately and accordingly.

It’s also important to note that, since IA Release 721 in 1980, an indirect version of a non-proportionate fulcrum fee — where the advisor just receives a base fee and not a percentage of the performance upside, but forfeits their fee for underperformance — will still be treated as a performance-based fee, necessitating a qualified client arrangement.

That said, a subsequent 2004 SEC No-Action letter to investment firm Trainer, Wortham & Co. affirmed that a “satisfaction guarantee” refund option — whereby the investor can request a refund if they are unhappy with their advisor, regardless of performance results — is permitted as long as the advisor’s fee isn’t predicated on meeting any specific investment performance threshold.

In the case of performance fees for state-registered investment advisors — RIAs with less than $100 million under management — the RIA must adhere to state-level rules on performance-based fees, which may but will not always conform to the SEC’s regulations under the Investment Advisers Act.

Worth it?
While there is some clear intuitive appeal to performance-based fees, the mixed record of actual outcomes still leaves much to be desired.

Congress banned performance-based fees for RIAs more than 75 years ago, because of the consumer harm they ended up causing.

And while the rules have relaxed to some extent, it has only been for more-affluent qualified client investors who — right or wrong — are presumed to be more financially experienced and sophisticated, and at least recognize the risks of the arrangement.

Though in the general context of advisors, performance-based fees introduce non-trivial business execution challenges as well.

For instance, they fan a natural temptation to make trades for the biggest clients first.

After all, in the same favorable trade that outperforms the benchmark, the performance fee is bigger for outperformance on a $10 million portfolio than on a $1 million portfolio.

This is less of an issue for performance fee-based hedge and mutual funds, because all clients participate equally in a pooled investment.

But for an RIA working with retail investors, the issue of how trades are sequenced and allocated — along with fair execution and being able to demonstrate that the RIA meets its best execution obligations — really does matter.

Bookkeeping nightmares
In addition, while modern technology makes it possible for each performance-based fee to be calculated individually for each client, there may still be substantial bookkeeping nightmares when clients start at different times and thus have performance fees calculated from different starting points.

This is not to mention the sheer revenue volatility that is introduced for the RIA itself, as a year of bad performance can mean no performance-based revenue coming in to pay staff salaries.

And of course, even as performance-based fees come back into vogue, there’s little evidence that they actually lead to better investment outcomes.

An especially well-cited analysis by Edwin Elton, Martin Gruber and Christopher Blake in the Journal of Finance found that funds charging performance fees tended to have positive stock selection ability, but the best funds tended to actually have lower betas. As a result, the total return was not improved and the incentive fee often wasn’t even earned.

Practically speaking, the biggest caveat and limitation to an advisor charging performance-based fees is that — beyond the compliance oversight obligations — it’s necessary to be under an RIA and not a broker-dealer, and it limits the firm to working with qualified clients who meet the portfolio and/or net-worth requirements in the first place.

This may be feasible for a subset of the largest RIA firms with the most affluent clients — but the largest RIA firms are already enjoying the fastest growth, thanks to their marketing economies of scale and the fact that more-affluent clients already tend to gravitate to them, regardless of whether a performance-based fee structure is offered.

And of course, focusing on performance-based fees may be very unappealing for holistic planning firms that are trying to focus clients on the broader range of services they provide, rather than accentuate investment results alone.

Nonetheless, for RIAs that want to charge performance-based fees and are ready and willing to work with qualified clients, the option exists under current law.

But it’s still crucial to properly manage the firm’s conflicts of interest, particularly when it comes to trying to earn performance fees by taking more risk with clients’ investment dollars.

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