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Rethinking Fees: Pay for Performance

by Mike McLaughlin

Earlier this month, Fidelity announced its intention to add performance-fee adjustments to 19 more of its mutual funds. It's a simple concept: the more its fund managers trump (or lag) their benchmarks, the better (or worse) Fidelity will do.

According to Lipper, barely 200 funds (spanning 500+ share classes) use such performance-fee adjustments today. As a leader on this issue, Fidelity is effectively gambling on itself to the tune of tens of millions in profits.

Surprisingly, there is some hand-wringing over this move within the advisor community, with vague concerns about enhanced risk within the funds being the primary concern. I, on the other hand, am a huge fan.

Why? The primary reason is that such a structure directly aligns the interests of the:

• Firm
• Portfolio manager
• Financial advisors
• Fund shareholder

At the risk of simplifying things, everybody wins or everybody loses.

I also like that such an arrangement provides an avenue for differentiation for firms like Fidelity. Despite disclosure regulations, fees have long been a fuzzy part of the industry. However, competitive pressures and forces pushing for enhanced transparency, such as XBRL, are placing fees increasingly front-and-center in discussions about the industry and its products.

As a result, I see fees becoming a more important strategic weapon in the fight for assets. Outright price competition is one route, with pay-for-performance mechanisms another way for firms to take a potential liability and turn it into a strength.