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(Article from Registered Funds Alert, May 2019)

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As active equity managers continue to lose retail inflows to passive investment vehicles, one approach some active managers have taken is to differentiate themselves on fees. Fulcrum fees, which adjust the adviser’s compensation up or down based on the fund’s performance, have been resurrected from near extinction and are now being heralded by some industry leaders and publications as the solution to active management’s passive problem. We disagree.

The fundamental nature of fulcrum fees ensure that they will not work as a viable means to combat the erosion of market share driven by the increase in popularity of passive funds. Although in theory fulcrum fees better align the interests of active managers with the shareholders of funds they advise, in practice the implementation of a fulcrum fee is quite complex, and the logistical restraints involved ultimately do not allow the flexibility actively managed funds really need to compete with passively managed funds on cost. Moreover, the regulatory design of fulcrum fees in effect requires that investors be overcharged for mediocre performance.

We believe the industry would be better served by pivoting its attention towards advocating for Congress to allow advisers to registered investment companies the option to charge performance fees similar to those charged by private funds (referred to herein as “traditional performance fees”). There would of course need to be limitations on what types of performance fees advisers could charge and mechanisms to prevent reckless management, but decades of negotiations between advisers and sophisticated institutional investors in the private fund space have done an excellent job of providing guiderails for what those restrictions should look like if the concept of performance fees were imported to retail funds. A properly constructed traditional performance fee does not incentivize asset managers to take inappropriate risks, fairly compensates advisers for outperformance, and does not overcompensate for underperformance; all of which aligns the interests of retail investors with the interests of their advisers.

In this Alert, we discuss why we believe the industry should move on from fulcrum fees as a potential savior and should instead focus on persuading Congress that it is time to revisit the ban on performance fees for registered investment companies.

The Active Versus Passive Problem

As it stands today, retail investors pay considerably more to invest in actively managed funds than passively managed funds, particularly with respect to equity funds, and that gap is due in large part to management fees charged by the advisers to the funds. The management fee pays for the adviser’s cost of employing the portfolio managers who make the investment decisions. For active strategies, these management fees typically range from 0.5% to 2%, depending on the fund’s strategy. For passive strategies, the management fees are far lower and typically range from 0.05% (or less!) to 0.25%.

Many investors would be happy to pay more for active management if it translated into better performance, but that often is not the case, especially for equity funds. Instead, while nearly all actively managed funds cost more than index funds, a smaller portion exceed their benchmarks. The reality is that it is difficult for investors to select fund managers that can reliably beat their peers and the index. And even when an investor makes the right selection and finds an active fund that beats the index, data shows that the manager’s out-performance is unlikely to persist long-term.

And so the question is, how can actively managed funds bring their base costs down to compete with low-cost passive strategies when the fund does not beat its benchmark, but fairly compensate the adviser when the active strategy outperforms the benchmark? Many industry observers and participants are looking to fulcrum fees to answer that question.

This focus stems from the fact that fulcrum fees are, at present, the only type of performance-based fees that advisers may charge to most types of registered investment companies. Section 205(a)(1) of the Advisers Act generally prohibits registered investment advisers from charging a fee based on a share of capital gains on, or capital appreciation of, the assets of a registered investment company.[1] These types of compensation arrangements, referred to as performance fees, were prohibited to discourage advisers from taking “unnecessary risks” with client funds in order to increase advisory fees.[2]

Accordingly, the overwhelming majority of retail funds charge a “flat” management fee that is calculated as a percentage of the fund’s average net assets and does not vary with performance.

However, in 1970 Congress created an exception to the performance fee prohibition, known as the “fulcrum fee.” Under that exception, advisers may adjust their management fee based on performance so long as they do so symmetrically—meaning the fee moves up or down based on outperformance or underperformance relative to a benchmark index over a specified period. Congress felt that the symmetry of the fulcrum fee was appropriate for registered investment companies because it “would insulate investment company shareholders from arrangements that give investment managers a direct pecuniary interest in pursuing high risk investment policies.”[3]

Nearly 50 years later, in the face of mounting fee pressure, some commentators are saying active strategies can be saved by setting fulcrum fees that start at a lower base rate than peer funds with flat management fees, but with the potential to earn the same or more as comparable active fund managers so long as they consistently outperform the benchmark. In this way, retail investors may be convinced that they are “paying for outperformance” and will be more tolerant of the comparatively high costs of actively managed funds.

There are numerous problems with this refrain. For one, there are serious and complex logistical difficulties in operating funds with fulcrum fee structures that make them unpalatable for advisers and potentially even detrimental to shareholders. These are highly technical considerations that have been pointed out in numerous prior critiques of fulcrum fees and are beyond the scope of this article, but suffice it to say there are good reasons why there have been very few fulcrum fee funds historically. The bigger problem we see with the fulcrum fee as savior argument, is the fact that the symmetrical nature of a fulcrum fee model creates an inherent structural flaw that does not benefit shareholders.

Why Fulcrum Fees Fall Flat

To illustrate why many observers believe that fulcrum fees are the solution, consider a scenario where an adviser wants to create a new product that competes with other active products that typically have 1.25% flat management fees, and is willing to accept that it should only receive that 1.25% when it outperforms benchmarks by 5%.[4] Under the fulcrum model, the adviser might set a fulcrum fee rate of 1%, and a performance adjustment schedule with two breakpoints, reaching a maximum or minimum adjustment of 0.5% when the fund exceeds the benchmark by 10%. The expected management fee compensation would be as described in the chart below:

Many have argued this scenario is a clear victory for shareholders and that this is how fulcrum fees will save active strategies, but this seems shortsighted. Yes, when compared to another active strategy with a flat 1.25% management fee, the hypothetical fulcrum fee model might well present a good value for investors. But offering a fee structure that is incrementally more shareholder friendly relative to other active funds does not address the active managers’ real problem – index funds.

By and large, active strategies are losing out to passive strategies, and they are losing on cost. An investor that is already in the mindset and position of choosing between an actively managed fund or an index fund is focused on the relative expense of the fulcrum fee product compared to an index fund, not its cost compared to other active products. Under the hypothetical fulcrum fee model, a fund would still be paying a 0.75% management fee for performance that is 5% below the benchmark. That is, of course, more appealing than the prospect of paying a flat 1.25% for similar underperformance under a flat management fee structure. But from the perspective of an investor who is deciding between an actively managed fund and an index fund, paying 0.75% for performance that is 5% below the benchmark is still an abysmal prospect compared to paying far less for an index fund that by definition seeks to track the performance of its benchmark.

This outcome—where active managers are still relatively highly compensated for mediocre, or even poor, performance—is the both the key concern driving investors towards passive options and an inevitable result of the forced symmetry of fulcrum fees. Because the performance adjustment cannot increase more than it decreases,[5] even if an adviser wanted to be as aggressive as possible under a fulcrum fee model, the lowest possible fulcrum fee they could set would be halfway between 0% and the targeted fee for outperformance.[6] This is extremely problematic given that actively managed funds today often have management fees that are multiple times higher than those of index funds, and the problem is only being exacerbated as index funds continue to drive their management fees towards zero. So long as active funds are structurally saddled with a 200% maximum spread between baseline fees and outperformance fees, they will be prevented from truly competing with passive funds on cost if they want to earn a realistic fee for outperformance. Put simply, the Congressional design of fulcrum fees requires retail shareholders to overpay for bad performance in a foolish effort to incentive managers properly. The chart below shows the fee structure for the manager trying to be as shareholder-friendly as possible with a fulcrum fee still getting paid 62.5 basis points for performance that is 4.9% below the benchmark.

Traditional Performance Fees Would Lead to Better Options for Retail Investors

Traditional performance fees would solve this fundamental problem with fulcrum fees by disconnecting the adviser’s base compensation from its incentive to outperform the index, thereby allowing advisers to offer products that put the risk of failing to beat benchmarks on the adviser. Unlike fulcrum fees, traditional performance fees, such as those used by most private funds, are separate from the fund’s base management fee. Under that model, a fund has a fixed base management fee, and then add an additional performance fee that it can earn for exceptional performance.

Decades of industry practice involving negotiations between sophisticated institutional investors and investment advisers have developed a set of features for modulating traditional performance fees that could be imported into the retail context and used to ensure retail investors are not exploited. Two features in particular, “hurdles” and “clawbacks,” are common devices in performance fee structures that manage the adviser’s risk tolerance while still incentivizing the adviser to meet a performance goal.

When a hurdle applies, no performance fee is paid unless the fund beats a specified performance threshold for the specific period. Many have hurdles that are based on a three year, twelve quarter, lookback period. This essentially means that that if the fund fails to meet its target at any point in the past three years, the fund will have to make up for that underperformance before the adviser can resume earning a performance fees. The potential for an adviser digging themselves into a hole that they will have to contend with for twelve quarters strongly disincentivizes unnecessarily risky strategies.

In the same vein, a clawback serves to protect a fund’s investors from the possibility of either the fund not achieving its targeted return levels due to poor performance or the adviser earning more than is permitted. Essentially, if at the end of a set period, the fund has not earned enough or the adviser has earned too much, the adviser may be required to pay part of its past compensation back into the fund. Though they accomplish it through different means, both hurdles and clawbacks achieve the same functional result as fulcrum fees, in that shareholders are not overcharged for mediocre long-term performance.

Utilizing these features, a traditional performance fee model could allow an adviser to offer an actively managed fund with considerably more variance between base compensation and total compensation than is currently permitted by the fulcrum fee model. Considering the same scenario as above where an adviser is seeking to earn 1.25% of net assets if it beats a benchmark by 5%, if traditional performance fees were allowed, an adviser could offer a product with a base management fee of 0.25%, which is competitive with index funds, but that also has a 1% performance fee with a hurdle of 5% over the benchmark, measured quarterly with a twelve quarter lookback period. If the fund only meets the benchmark, the adviser would only receive its base management fee, which would put investors in a position that is competitive with purely passive strategies. If the fund meets its performance target, the adviser would receive its 1% performance fee, and investors would be happy to pay it. If the fund underperforms the benchmark, the adviser’s ability to earn performance fees in the future is reduced proportionately, thereby incorporating the same disincentive for risky strategies as fulcrum fees.

The structural constraints on fulcrum fee models that make them inviable as solution to the passive problem are most apparent when fulcrum fee models are compared side-by-side with a fund using a traditional performance fee model.

In the more practical 1% fulcrum fee example, the potential to pay significantly more than an index fund for underperformance makes the fulcrum fee product almost as unattractive as regular flat management fee active funds. The improvement is marginal, and unlikely to sway the types of investors who are currently fleeing from actively managed options.

In the more aggressive 0.625% fulcrum fee example, the value proposition is better, but the potential cost for performance in line with the benchmark is likely still considerably more expensive than investing in a typical index option. Moreover, from a sheer practicality standpoint, it is unlikely that an adviser would consider it a sound business proposition to have the potential to earn 0% management fees for an actively managed product. Given that fulcrum fee products cannot effectively be structured to sway the types of investors that are actually leaving active management, and that they are likely to be less attractive commercial propositions than traditional retail funds with flat management fees, it is unsurprising that fulcrum fee funds remain rare, despite the recent uptick in their offering. A product that utilized a traditional performance fee, on the other hand, could effectively be structured to provide parity with a passive strategy when performance is similar, and compensate the adviser fairly for exceeding the benchmark, all without compromising investor protection.[7]

Conclusion

Fulcrum fees are interesting in theory, but a 50-year old solution is not the answer to a very modern problem. The shift towards passive strategies is driven, in large part, by the digital age making it relatively easy to track the market. As it stands today, professional fund managers, in the aggregate, control most of the money in the markets. Thus, it is unsurprising that index funds that track the overall movement of a market consistently do their task well. But what happens if active managers are driven out of the market by their inability to effectively compete with passive strategies on price? Eventually, the index becomes more and more a reflection of a few, concentrated movers and a mob of followers, and its utility as an investment tool drops dramatically. High net worth individuals and institutional clients will always be able to afford quality active management, but retail investors could be left out in the cold. Ensuring the long-term viability of numerous and diverse active management options for the retail market is essential to protecting retail investors and their retirement savings.

The industry would be better served by focusing its energies on finding ways to convince Congress to revisit the ban on performance fees for registered investment companies. As Commissioner Peirce argued last fall, “allowing funds to experiment with performance fees may . . . facilitate the continued availability of actively managed funds.” If active managers are forced out of the retail space because they cannot compete effectively on cost, retail investors will be the ones most harmed. Moreover, the restrictions on performance fee structures are already hurting retail investors for the reasons we have described above. Congress acting to allow advisers to charge some form of traditional performance fees would provide retail investors the flexibility to choose products that are responsive to their actual concerns, and will allow a critical industry to adjust to life in modern times.

[1] Advisers of registered funds and business development companies owned solely by “qualified clients” (as defined in Rule 205-3(d)(1) under the Advisers Act) are exempt from the prohibition on charging performance fees on capital gains or capital appreciation. Additionally, business development companies are exempt from the prohibition if as certain requirements set out in Section 205(b)(3) of the Advisers Act are met, including that the incentive fee on realized capital gains, computed net of all realized capitaSubhead5625l losses and unrealized capital depreciation, does not exceed 20%.

[2] H.R. Rep. No. 2639, 76th Cong., 3d Sess. 29 (1940).

[3] H.R. Rep. No. 1382, 91st Cong., 2d Sess. 41 (1970); S. Rep. No. 184, 91st Cong., 1st Sess. 45 (1969).

[4] The figures used in this and other examples are selected in large part for the computational ease of the hypotheticals. These precise figures may not necessarily represent commercially realistic scenarios, but we believe they do still illustrate the greater structural concern with fulcrum fees.

[5] While there is guidance that suggests a fulcrum fee can be asymmetrical, it can only be asymmetrical such that the fee decreases faster than it increases. This would not resolve the problem, which is that advisers must set relatively high base management fees in order to realize the appropriate upside fees for outperformance.

[6] Theoretically negative management fees would be permitted under the rule, but would likely be commercially impractical.

[7] It may well be that for such a product to be commercially viable, the performance fee charged would have to exceed what would be charged by an active fund with a flat management fee structure. We do not believe this would materially change the analysis regarding the various approaches, as that flexibility still would not be available under the fulcrum fee model.