Fidelity has announced it will be launching new share classes for 10 of its equity funds with an asymmetrical charging structure.
The share class will offer a lower base annual management fee (AMC) of 65 basis points with a variable amount determined by how far the fund outperforms or underperforms its benchmark, which has been referred to as a ‘fulcrum fee’.
This means that if the manager underperforms the benchmark Fidelity will receive less than the baseline, whereas if they outperform Fidelity will receive more. There will be a floor and a cap to the variable fee of 20 basis points.
Variable management fee for an Oeic fund with a 0.75% AMC
Source: Fidelity
This is a tweak on the old performance fee model that has fallen out of fashion in recent years. A performance fee is typically only paid if a manager outperforms an agreed benchmark, but usually is not symmetrical – there is no penalty to the manager if they underperform, they just receive the base fee.
In this regard, the structure of this new share class is preferable: it means the fund house’s interests are more aligned with unitholders – it will see less fee income if performance is below the benchmark.
However, other recent offerings from large fund managers are closer to the asymmetrical idea, although so far these innovations are restricted to the US.
Allianz is launching a US equity fund benchmarked to the S&P 500 that will take a fixed fee to cover costs of 5-15 basis points depending on the precise share class. The firm will only receive a management fee if it outperforms the S&P 500. It is also launching similar funds for US fixed income and managed futures. Alliance Bernstein are launching funds with a similar charging structure, also in the US.
This structure is even more aligned with investors’ interests, as the tiny fixed fee means the fund group may even lose money unless its products outperform.
In the UK, Orbis refuses to take any fees unless it outperforms its benchmark. It receives 50 per cent of the outperformance when its fund does outperform, however. The group will return this fee if it then underperforms in future years from a reserve created in years of outperformance – although some of the performance fee is non-refundable, and this can be a significant amount.
Whilst preferable to investors on the downside, this model can be expensive if the fund does well. However, the fund is more symmetrical in that the fund house will be operating at a loss unless it generates alpha against its benchmark. 
One advantage of a variable fee is that it reduces the incentive for large fund groups to ‘milk’ large funds. One of the problems with the most common ‘ad valorem’ charging structure, in which a manager receives a fixed percentage of the fund as a fee each year irrespective of performance, is that it rewards funds growing in size, not performance. But funds can grow through marketing and sales proficiency rather than because of performance (in fact, arguably the former is easier).
This means that once a fund is large and highly profitable for the firm the incentive to provide future outperformance diminishes: it could then become more of a concern to protect the revenue stream by ensuring the fund doesn’t underperform. In other words, the fund group may be less willing to allow a manager to be highly active in their decisions, as losing the handsome fees on a large fund is more of a deterrent than gaining a little extra income from growing the fund through performance would be attractive.
If investors paid a fee based on performance rather than on fund size, then this situation would be less severe and fund groups would have more incentive to outperform on larger funds. It is true that as performance fees are calculated with reference to the fund size, smaller outperformance will generate the same fees as the fund grows larger, so the problem is not entirely removed. This could be resolved by charging a performance fee relative to a reference value rather than the fund size, but this level of complication is not on the horizon.
One other difference between Fidelity’s proposals and the traditional performance fee model is the absence of a hurdle rate. Often performance fees are only paid once a manager beats a specific return target. Here Fidelity are taking a cut of everything made above the benchmark.
We would prefer there to be a lower fixed fee in this sort of case. The danger is of incentivising tiny gains above the benchmark, when academic research has shown that more active funds are more likely to consistently outperform. On the other hand, the advantage of Fidelity’s approach to that of Orbis is that an investor gets a greater share of the alpha in the case of exceptional outperformance.
One criticism of the fee structure made in the press is that it is potentially too confusing for investors as they will not know ahead of time how much they will pay each year. However, it shouldn’t be too hard for fund literature to include worked concrete examples in pounds and pence – if advisers are expected to do it, Fidelity and the like should be able to manage it too. And it is certainly not too confusing for professional investors.
We think passive funds have had very positive effects on the fund management industry. Over the past few years underperforming funds have closed and ‘closet trackers’ have been hunted down. Active managers are having to find more ways of improving their products to keep customers who now have a cheap and simple alternative. Fidelity’s proposals should be seen in this light: as an attempt by active managers to make their products more attractive compared to the low cost passives.
One issue to keep an eye on if this structure proliferates is the choice of benchmarks. It is easy for managers to try and game their choice of benchmark, and it is something we as investors spend a lot of time thinking about.
For this reason, we use quantitative techniques to select benchmarks we think are the most appropriate for a fund rather than simply using the benchmark the manager gives us. This means we would have to be convinced the benchmark the manager has chosen for this fee to be assessed against was the most appropriate and fair were we to ever invest in a fund with this charging structure.
This is often a contentious issue in the IA UK All Companies sector. In theory, a manager should outperform over the longer run if he invests in small- or mid-caps thanks to the small-cap premium. This means that it becomes questionable whether a manager who is consistently overweight the FTSE 250 should be judged against the FTSE All Share benchmark or rather a weighted composite of the FTSE 100, FTSE 250 and FTSE Small Cap indices which more appropriately reflects their average allocation.
The alignment of interests between managers and shareholders and investors is one of the key strengths of capitalism when it works well. Variable fees can bring these interests further together. However, the details are important, and charging structures can be pushed further in this direction than Fidelity’s innovation, as initiatives in the US, where the pressure from passives is even stronger, have shown.
Thomas McMahon is a senior analyst with FE Invest. The views above are his own and should not be taken as investment advice.