“The Costs and Benefits of Performance Fees in Mutual Funds” by Professor Henri Servaes
London Business School
This paper compares the returns, expenses, and risk-taking of mutual funds that charge performance fees with mutual funds that do not. Funds with performance fees earn risk-adjusted returns annually that are about 50 basis points below those of other funds, a result mostly due to a subset funds that do not set a stochastic benchmark against which performance is measured or that set a benchmark that is easy to beat. As a result, these funds charge total expenses, including the performance fee, that are substantially higher than those of funds without a performance fee structure. Using gross value added as a measure of skill, we find some evidence of skill for the median performance fee manager, but value added is zero, on average. There is no evidence that funds with performance fees are more volatile than other funds and only limited evidence that such funds increase risk during the second half of the year when they are below the performance fee threshold during the first half of the year; they do take on more active risk, however. Our results indicate that investors should pay particular attention to the benchmarks employed to compute whether performance fees are paid. These findings also inform the current debate in the European Union and the United Kingdom on the merits of performance fees.