As financial advisors feel increasing pressure to differentiate themselves, a recently emerging trend for those who (actively) manage client portfolios is the idea of charging clients not an AUM fee that is a percentage of assets, but instead, a performance-based fee that is a percentage of upside (or outperformance of a benchmark index), where the advisor’s fee is forfeited if he/she fails to achieve the required threshold or hurdle rate. Such a compensation structure would compel active financial advisors to eschew closet indexing and really, truly, try to outperform their benchmarks – which can be a very compelling proposition to prospective clients.
However, the reality is that performance fees have a very troubled past. Because while a performance-based fee does incentivize the advisor to not be a closet indexer and own a substantially different portfolio than the benchmark, one of the “easiest” ways to do so is simply to take on more risk and amplify the volatility of the portfolio. After all, if the markets rise substantially – as they do on average – a high-volatility portfolio will often provide a substantial performance fee in a bull market. In when the inevitable bear market occurs, the “worst case” scenario for the advisor is simply a year of zero fees.
In fact, this “heads the advisor wins, tails the client loses” asymmetry of performance fees is why when Congress created the Investment Advisers Act for RIAs in 1940, it banned most financial advisors from charging performance-based fees at all to retail investors (and of course, brokers under a broker-dealer cannot charge performance fees because they are not serving as actual investment advisers in the first place!). It was only in 1970 that Congress partially relented and allow RIAs serving as investment managers to mutual funds to charge performance fees, and only then if it was a “fulcrum fee” where the advisor participates in both the upside for outperforming and at least some of the downside for underperformance. In turn, it wasn’t until 1985 that the SEC began to allow RIAs to charge performance fees in certain situations to retail clients, and even then the offering must be limited to “Qualified Clients” who meet one of three financial tests… either: a) $1M of assets under management with the RIA charging a performance fee; b) a $2.1M net worth (and thus are presumed to be financially experienced and “sophisticated” enough to understand the risks inherent in performance fees); or c) be an executive officer, director, trustee, or general partner of the RIA, or an employee who participates in the investment activities of the investment adviser.
In addition, it’s notable that research over the years on incentive fees in the context of mutual funds has failed to find any sign that incentive fees are actually associated with better risk-adjusted performance anyway. Instead, the research finds that – perhaps not surprisingly, given the problematic history of performance-based fees – mutual fund managers compensated by incentive fees tend to just generate higher returns by taking more risk, and then amplify their risk-taking activity further once they fall behind their benchmarks! Ironically, though, the researchers did find that mutual funds with incentive fees are more likely to attract client assets, suggesting that substantial consumer demand remains for paying investment managers via performance fees!
Nonetheless, the real-world operational challenges of executing what would be a more complex billing process, the revenue volatility that financial advisors introduce to their businesses (particularly if they use a fulcrum fee structure which means if the advisor underperforms, they really do take the risk of seeing their fees cut substantially), the limitations of only offering a Performance Fee structure to affluent Qualified Clients in the first place, and the conflicts of interest that must be managed, suggests that a widespread shift towards performance fees for RIAs is not likely in the near future… especially as many firms seek to shift their value propositions away from being centered around the investment portfolio and towards financial planning and wealth management instead! But for those RIAs who want to pursue charging performance fees on investment portfolios, it is an option… at least for their Qualified Clients who want to take the risk!
source https://www.kitces.com/blog/performance-fees-fulcrum-fees-qualified-client-ria-rule-205-3-advisers-act-risk-taking/?utm_source=rss&utm_medium=rss&utm_campaign=performance-fees-fulcrum-fees-qualified-client-ria-rule-205-3-advisers-act-risk-taking
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