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Rekenthaler Report

Give Performance Fees a Chance

What's to lose from trying?

Take a Chance
My acquaintance Ted Aronson takes a different approach to investment-management pricing. Clients of Ted's institutional money-management firm, AJO Partners (where Ted is the "A"), may select a standard management fee for their accounts, or they may modify that flat fee by adding performance-based fees.

Putting numbers to the words: A client placing $250 million in the company's Large Cap Absolute Value strategy could select among the following pricing options:

  1. A flat asset-management charge of 30 basis points (0.30%) per year.
  2. A performance-based fee that pays AJO 15 basis points if the account does not beat the Russell 1000 Value Index by at least 1 percentage point, 30 basis points if the account bests the Index by 2 percentage points, and 45 basis points if the account outperforms by at least 3 percentage points.
  3. A performance-based fee that pays AJO nothing if the account does not beat the Russell 1000 Value Index, 30 basis points if the account bests the Index by 2 percentage points, and 60 basis points if the account outperforms Index by at least 4 percentage points.

Those are but examples; other permutations of performance fees are also possible.  

Shared Successes (or Failures)
Performance fees offer investors two potential advantages.

First, if the performance fee is structured as with the above example, such that the hurdle rate exceeds the index's returns, then investors pay only for relative success. With option 3 above, the shareholder remits no fee if the fund does not beat its benchmark. From that point forward, AJO does levy charges, but at the relatively modest rate of 15% of excess profits for the firm, 85% for the shareholder.

In contrast, a mutual fund with a 1% expense ratio that beats its index by 200 basis points, net of expense, will have taken a third of the excess profits for itself, leaving two thirds for shareholders--a considerably worse ratio than with AJO's performance-fee illustration. Yet this would be regarded as an excellent result. Mutual funds that beat their benchmarks while taking $1 of relative returns out of $3 aren't criticized; on the contrary, they sell briskly.

Considering Incentives
The other potential benefit is managerial incentive. With a flat asset-based fee, the danger to a fund company from a year's worth of underperformance is indirect. Some shareholders might redeem, and new sales might suffer. With a performance fee, particularly with the stronger version, the danger is clear and present: Trailing the index means not getting paid. Doing that enough times, for enough accounts with performance fees, would mean extinction for the company.

Thus, investment managers who have their feet held to the performance-fee flames will work harder, and presumably more skillfully, than those who work more comfortably.

Such is the theory. Personally, I am skeptical. Many business-school conclusions, including much of the support for variable compensation, are arrived at through reverse engineering. The professors review how businesses operate, then explain why those policies are optimal. Other social sciences don't work that way. They don't start with the precept that what currently exists is ideal. The invisible hand is highly useful, but I think not omniscient.

That said, many knowledgeable observers take the opposite view. Fair enough, I will not stand in their way. Assuming that the performance fee is calculated over a sufficiently long period, so as to mitigate problems from investment managers attempting to game the system, it's hard to see what harm could come from implementing such fees. They are unlikely to be worse than the system they would replace.

Rare Birds
To date, however, they haven't much been tried. The mutual fund industry contains about 100 funds with performance fees, and the exchange-traded business has exactly one. The problem, as Jack Bogle would tell you, is that fund executives are loath to match their money with their mouths. It's one thing to run advertisements boasting of active management's advantages; it's quite another to place the company's fortunes--and one's own career--behind that bet.

I appreciate their reluctance. It's not as if the fund industry's critics, by and large, have been any braver. Those who run alternative funds accept the rewards for success but not the penalties for failure. Tenured academics, of course, occupy an even-safer position--as do bloggers (assuming their employer doesn't terminate their position). Asking mutual fund companies to wager their revenues is a sizable request.

P Shares?
But it's a challenge I would like to see accepted. The mutual fund industry, of course, has a menagerie of share classes, A, B, C, D, I, R, Z, and so forth. All are based on variations of front-end sales charges, back-end charges, and the level of their management fees. I figure, why not create one more: the P share, which uses a performance fee. The risk, at least initially, would be minimal for the fund company, because nearly all assets would be in the funds' other share classes.

Then, provide those funds' managers with "skin in the game." Guarantee them a portion of the performance fee generated from the assets in in P shares, should the fund fare well. (This would be an internal agreement, rather than an item for the prospectus.) Conversely, a poor fund showing would cut into that manager's bonus. Make the incentives feel real.

I doubt much would change. Making portfolio managers hungrier for success wouldn't improve their fund's results, any more than (to quote baseball manager Billy Martin) kicking a donkey in the butt won't make him a racehorse. However, that is only a guess. The truth is, nobody really knows how implementing performance fees would affect mutual fund managers. So why not find out?


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.