Financial advisers should embrace performance-based fees

It is time for financial advisers to consider adopting performance-based fees. If you believe that institutional money management practices tend to trickle down to wealth managers and advisers, the handwriting is on the wall: Performance-based fees are catching on, even if they never become the primary pricing model for the financial planning industry.

An increasing number of institutional investors are trying to hold money managers accountable by asking them to put at risk the fees they were guaranteed, according to John Bosley, chief operating officer at Bonaire Software Solutions LLC.

Bonaire surveyed more than 100 money managers and high-end wealth management shops in December and found that 41% of the firms were charging some form of performance fees on traditional portfolios.

“Some money managers are being dragged into it, and some are turning to performance fees as a way to put something on the table as a way to compete,” Mr. Bosley said.

It turns out that performance fees aren’t just for hedge funds anymore. The pressure to introduce them is coming from investors, not money managers.

Still, the mere mention of such fees, whether as an enhancement to asset-based fees or in place of commissions, whips the financial planning industry into a near frenzy of opposition.

Based on some of the comments I received recently about performance fees, it seems that part of that opposition is based on misinformation.

Some advisers insist that it is illegal to charge these fees. Some say that it is logistically impossible, while others claim that charging based on portfolio performance is a breach of fiduciary duty.

All those claims are false.

The industry’s general confusion and specific aversion to performance-based fees has led TFS Capital LLC to scrap a fulcrum fee structure on its TFS Small Cap Fund (TFSSX). Fulcrum fees allow a fund to increase and lower fees, depending on whether its portfolio meets a target benchmark.

TFS said it was surprised and disappointed by the reaction it received from advisers over the four years it promoted the fee structure, which fluctuated from 50 to 300 basis points. The advisers’ main frustration, according to chief operating officer Larry Eiben, was the unpredictable nature of the performance-based fee.

In its place, TFS — whose fund had been one of the more than 200 mutual funds that employ some variation on performance fees — has imposed a fixed 1.75% total expense ratio on its small-cap fund.

Clearly, such a pricing system turns up the heat, and many advisers are reluctant to introduce performance-based fees into their own practices. It’s an act of great self-confidence to stake one’s livelihood on something as capricious as the market.

Some advisers say they could be forced to take on more risk to generate the returns that earn higher fees.

On the other hand, it could lead to a more deliberate approach that would destine a portfolio to lag behind its benchmark.

The real value in performance pricing comes in the form of a measurable performance history that could serve as a marketing tool for advisers, as well as another way for investors to evaluate advisers.

“The benchmark would have to be a good fit for each client portfolio, but I think a fulcrum fee would be a pretty good thing to give investors a reasonable base to measure their adviser’s performance,” said Russel Kinnel, an analyst with Morningstar Inc. “It also might be good if it became a way for advisers to publish more of their performance.”

For years, the mantra from proponents of fee-based-pricing models has been that they align advisers’ interests with those of their clients.

True, when a client’s portfolio loses value, the adviser has less of a asset base from which to draw a fee.

For a real shared experience, though, imagine risking a portion of that fee when a client’s portfolio fails to keep pace with a benchmark.

“I love the concept of fulcrum fees at the adviser level,” Mr. Eiben said. “I’d be wary of any financial adviser not willing to have that discussion.”

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].

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