Performance fees are not necessarily a good guide to future returns and are typically more expensive, according to the London Business School’s Henri Servaes, whose joint study identified several issues with the fee structure. 
“Performance fee funds are controversial,” said Servaes. “On the one hand, they aim to improve performance by aligning the incentives of the portfolio manager with those of the investor, much like stock options or share ownership do for company executives.
“Both the investor and the fund manager do better when the fund performs well and, consequently, fund manager effort should be higher for funds with incentive fees.
“In addition, performance fees could be used as an incentive mechanism to attract the most talented individuals into the investment management industry.”
Yet, the academic said that it can be argued that performance fees lead to “excessive risk-taking” by fund managers.
The issue of performance fees was raised by the UK’s Financial Conduct Authority in its far-reaching asset management market study of 2017.
At the time, the regulator said while it was supportive of fee structures that align incentives between investors and asset managers, it would consider whether further action was required to make performance fee structures more equitable and take a closer look at asymmetric structures.
As such Servaes and colleague Kari Sigurdsson studied mutual funds offered for sale – both with and without performance fees – in the EU, Norway and Switzerland between 2001 and 2011.
Servaes said the study looked at several dimensions including returns, fees and risk-taking to give a better insight into the various arguments made by regulators, investors and fund managers.
More than 7 per cent of funds in study charged a performance fee, with the median fee coming in at around 20 per cent of excess performance, “very similar to what is being charged in the hedge fund industry”, said the academic.
While more than two-thirds (70 per cent) measured performance against a benchmark, 15 per cent compare performance to a fixed hurdle rate. Around 44 per cent had a high-water mark and had to recover losses before earning a performance fee.
The first finding of the study, said Servaes, was that performance fee funds perform worse than those without by around 50-70 basis points per year.
Much of the poor performance, he said, was concentrated in two sub-groups of funds: those that do not set a benchmark and those that set one that is easy to beat.
The second finding from the study was that the expense ratio of performance fee funds – which includes the fee itself – is approximately 30-35 basis points higher than that of other funds.
“Thus, performance fee funds charge more for their services than other funds, even though a substantial sub-set of these funds underperform,” noted Servaes. “In fact, over half of the underperformance of performance fee funds is due to higher expenses.”
Funds without a benchmark stood out, in particular, in terms of the magnitude of their fees, said the London Business School academic.
Servaes said there was no evidence that funds with performance fees take more risk overall relative to their peers, nor was there any evidence that these funds attract more flows because of their fee structure.
And there was one more trend that Servaes and colleague Sigurdsson noted: “A sub-set of performance fee funds change the terms of the contract after poor performance such that it becomes easier to earn performance fees in subsequent years.
“Such changes do not appear to be in the best interest of fund investors.”
As such, Servaes said investors should pay particular attention to the fee benchmarks set by funds using a performance fee structure, which in itself might not be sufficient to induce better performance or attract the best talent to the fund. 
Dan Brocklebank (pictured), head of UK at Orbis Investments, said the study had raised some interesting issues but that some of the performance fee models analysed in the study are no longer in use.
“The models that were being looked that were in existence over that time were, in my view, far from optimal,” he said. “It’s quite pleasing that he found no harm [to returns] on average. But he does make an important point that the benchmark choice is very important.
“Where the biggest value destruction happen for clients is where funds were using inappropriate benchmark choices for calculating performance fees.”
Orbis follows an asymmetric performance fee model and charges no annual management charge but levies a 50 per cent performance fee on any outperformance of a benchmark – subject to a high-water mark.
“The new models are pretty radical, last year our fees were negative,” he said.
“What does that mean? Well, because we underperformed the benchmark our fees were negative, and that refund improves the performance that the client experiences in the periods of underperformance.
“Often people say ‘yeah, but you’ll never pay that refund again’, but we’ve gone through a period of negative fees and that’s pretty radical when you think about it.”
Investors also need to think carefully about the structure of a fee model carefully, whether performance-related or not, to ensure they are getting value for money, said Brocklebank.
“Performance fees are not a panacea for finding better alpha and I think that’s clearly true,” said Brocklebank. “The fee structure manager used doesn't change the skill that a manager has. That skill is inherent in their approach. Performance fee structure doesn't impact that.
“But what a well-structured performance fee will offer clients is the ability to raise the chances that they get good value for money.”
The Orbis director said that traditional fixed fee model is structurally flawed and no longer the best way to incentivise fund managers, particularly in an environment where investors are increasingly turning to cheaper passive alternatives.
“What our ultimate goal is is to maximise the probability that clients receive value for money,” he said. “Because value for money in our industry is something that hasn't really been talked about very much up until relatively recently.
“The way we think about value for money is ‘what’s the chance that any alpha a manager generates is going to be taken up in fees’.”
He added: “The challenge you have is that nobody, not even a manager, can know the alpha level in advance that the manager is going to generate.
“So, if you use a fixed fee structure, as a percentage of assets under management, you’re just guessing as to what will be good value for money in the future.”