SEC action casts doubt on performance fees

By David Hoffman

PHILADELPHIA — Action taken this month by regulators makes it harder for mutual fund advisers to rationalize charging performance-based fees, according to several industry experts.

That is a shame, because such fees, which go up or down depending on a fund's performance, can benefit investors, some of those observers say.

"They align management incentives with investor results," said Russel Kinnel, director of mutual fund research at Morningstar Inc. in Chicago.

But performance fees are unusual for mutual funds.

Of the thousands of mutual funds, just 348 — including multiple share classes — have performance fees, according to Lipper Inc. of New York.

The latest episode to suggest such fees might not be worth the trouble for managers came Sept. 8 when the Securities and Exchange Commission announced five fund managers had paid more than $7 million in reimbursements for excessive performance fees.

The Dreyfus Corp., New York paid $3.2 million; Putnam Investments, Boston, $1.6 million; Numeric Investors LLC, Cambridge, Mass., $1 million; Kensington Investment Group Inc., Orinda, Calif., $790,962; and Gartmore Mutual Fund Capital Trust, which does business as Gartmore Global Investors Inc., Conshohocken, Pa., paid $653,882.

The SEC also censured the firms and ordered them to cease and desist improperly charging the fees.

What exactly did the mutual fund managers do wrong?

According to the SEC, they didn't use the proper periods for calculating the performance fees.

It is an accounting mistake that isn't a big deal if the proper controls are in place, but it still may give some fund industry executives pause before considering performance fees, said Mr. Kinnel.

"I'm sure if the lawyers at any fund company get a vote, they'll vote against performance fees, given what's happened," he added.

After all, this isn't the first time a fund manager has run afoul of the SEC for improperly levying performance fees. Two years ago, Bridgeway Capital Management Inc. of Houston agreed to pay about $5 million for charging excessive performance fees on three of its funds.

But investors shouldn't blame the SEC for discouraging fund managers from charging performance fees, industry experts say. The recent crackdown is just one of several factors that make performance-based fees unattractive to advisers.

In fact, the main reason has nothing to do with the SEC, said Kip Price, head of global fiduciary review at Lipper; it is because there is little evidence that performance fees lead to better performance.

A 2003 study in the Journal of Finance found that funds with performance fees returned on average one percentage point a year more than funds without them. But that is because they are willing to take more risk, according to the study's authors, Martin Gruber and Edwin Elton, finance professors at New York University's Leonard N. Stern School of Business, and Christopher Blake, a finance professor at New York's Fordham University.

That raises a question, Mr. Price said: Do performance fees really align the interests of the fund adviser with those of the shareholder?

For the most part, they do, said Reuben Gregg Brewer, manager of mutual fund research at Value Line Inc. in New York.

If all else were equal and he were faced with choosing between a fund charging a performance fee and one that didn't, Mr. Brewer would probably choose the one with the fee, he said.

The reason most mutual funds don't have such a fee is because most fund managers underperform their benchmarks, Mr. Brewer said.

When a performance-fee fund underperforms its benchmark, the manager makes less money.

But the fund manager still might end up making plenty of money, said Lou Stanasolovich, chief executive of Legend Financial Advisors Inc. in Pittsburgh.

It depends on the base fee charged, he said. Investors will probably end up paying too much for the fund if the fee is high, despite its being adjusted up or down by some percentage, Mr. Stanasolovich said.

"I don't view (performance fees) as an improvement," he said. "It's just another way to charge clients."

David Hoffman is a reporter at InvestmentNews, a sister publication of Pensions & Investments.