The Costs and Benefits of Performance Fees in Mutual Funds
In this paper we study mutual funds offered for sale in Europe that charge so-called performance fees. These are fees charged on top of management fees and other expenses, when a fund has outperformed a pre-specified benchmark. Such fees can be symmetric or asymmetric. When a fund charges a symmetric fee, the performance fee earned for outperformance has to be equal to the fee reimbursement in case of underperformance. Asymmetric performance fees, on the other hand, are charged for outperformance only. Funds that charge asymmetric fees are banned in the United States.
Performance fee funds have been on the agenda of regulators for several years. In 2013, the European Parliament narrowly defeated a proposal by one of its members, Sven Giegold, to prohibit funds from charging performance fees. Mr Giegold had argued and continues to argue that performance fees are “a way of stealing profits” from investors. More recently, performance fees are again the subject of investigation by both the Financial Conduct Authority (FCA) in the United Kingdom and the European Securities and Markets Authority (ESMA).
To inform both investors and regulators about the merits of performance fees, we compare the returns, risk taking, and expenses of funds that charge performance fees to those of other funds. We find that funds with performance fees have annual risk-adjusted returns of 0.50% below other funds. This result is mostly due to funds without a stochastic benchmark against which performance is measured and funds with a benchmark that is easy to beat. It is not due to unobservable differences in fund manager quality – when we compare the performance of the same manager running different funds at the same time, we find that the returns on funds with performance fees continue to be lower. We also find that performance fee funds charge total expenses, including the performance fee, that are substantially higher than those of other funds, while there is no evidence that they have lower management fees.
We find no evidence that performance fee funds are more volatile than other funds, but they do take on more active risk, implying that their return deviates more from the return of the underlying investment objective. We also report that a subset of performance fee funds change the terms of the performance fee contract after poor performance such that it becomes easier to earn performance fees in subsequent years. Such changes do not appear in the best interest of fund investors.
Our results indicate that investors should pay particular attention to the benchmarks employed to compute whether performance fees are paid.