Funds charging performance fees outperformed

Performance fees appear to deliver what they promise, at least by a little, according to a study by New York-based research firm Lipper Inc. In a first-time analysis of 213 portfolios that charge performance fees, Lipper found that over the past 10 years, the funds on average outperformed their Lipper classifications. The funds had annualized standard deviations of monthly returns that average 0.43%, 0.17% and 1.55% higher than their classification averages in the three-, five- and 10-year periods ended Dec. 31, respectively. "Even after accounting for risk, the funds earned slightly larger risk-adjusted returns," said Jonathan Kreider, a Lipper fiduciary research analyst. "The managers took on a marginally higher level of risk on average relative to their Lipper classification, but not substantially more," he said. But performance fees, which reward a fund manager when the fund outperforms a specific benchmark and penalize a manager for underperformance, should not be the sole criterion in selecting a fund, Mr. Kreider said. "They don't necessarily make a fund good for the investor," he said, and are just one of many factors that should enter into the fund selection process. Some financial advisers worry that performance fees serve as an incentive for portfolio managers to take greater risks. "Is this the right type of incentive?" said David Rosenthal, principal at Wealth Management Solutions LLC of Scottsdale, Ariz., which has $150 million in assets under management.

'SWING FOR THE FENCES?'

"If you are very close to the end of the year and you are close to making that mark, do you swing for the fences?" he said. "You are potentially taking unnecessary risks." According to Mr. Kreider, fees are calculated over a 12-month or 36-month rolling period. Fifty-three percent of the funds surveyed used the 12-month timeline, 46% used 36 months, and 1% used 60 months. "The expense ratio of these funds goes up and down depending on the fund's performance," Mr. Kreider said. Fidelity Investments of Boston, The Vanguard Group Inc. of Malvern, Pa., the United Services Automobile Association of San Antonio, RiverSource Investments of Minneapolis and Janus Capital Group Inc. of Denver offer the majority of performance fee funds. While some firms, such as Fidelity, have used the fees for decades, others have introduced them only recently. Janus began introducing the fee in 2006, and eight of its strategies have the fee. Among fund companies, Fidelity earned the most in performance fees, although the disparity among its funds was great. Fidelity's $78 billion Contrafund, for example, earned $477 million in performance fees over the 10-year period ending in 2007, Lipper found. "For Magellan, the incentive fee has been a negative $347 million," Mr. Kreider said. "The fund collected less than it otherwise would have assuming it had done as well as the [Standard & Poor's 500 stock index] over that 10-year time period." Fidelity introduced performance fees in the 1970s and currently employs performance fees in 67 equity funds. "We have found it aligns our interest with the shareholders' interest," said Sophie Launay, a Fidelity spokeswoman.

'PRETTY GOOD BARGAIN'

"The shareholder gets a pretty good bargain," said Geoff Bobroff, a Greenwich, R.I.-based mutual fund consultant. "It's basically saying to the manager ... 'I want you to participate alongside me.' The performance fee stimulates the manager because it's going to have an impact on the earnings." When the fund underperforms, at very least, the investor can take solace in the notion that the manager shares the pain. "Other than that, when you have an underperforming fund, you have one choice: redeem your shares and go somewhere else," Mr. Bobroff said. Some firms have discontinued performance fees because they weren't a benefit, said Carl Frischling, a partner at Kramer Levin Naftalis & Frankel LLP of New York and member of the board of directors for the Washington-based Mutual Fund Directors Forum. "I don't see everybody rushing to it as an industry," he said. "Generally, it's set at the beginning of the life of the fund." Firms are not likely to create performance-fee-based funds, Mr. Bobroff said. "It makes the business far less predictable," he said. "They also are concerned that fees [encourage] a manager to take greater risk. [But] at what cost?" Many fund boards worry about having the tools needed to monitor and measure that risk, Mr. Bobroff said. E-mail Susan Asci at sasci@investmentnews.com.