Performance-based financial advisors charge fees based on the performance of the investment portfolios they manage. Performance-based fees are controversial in the financial services industry, as they are often seen as a way for advisors to earn money without providing much value to their clients. As performance fees can be hard to understand, it is important to do your research and understand what they mean before deciding whether or not to invest with a particular advisor. If you are unsure about how the fee will be calculated, it may be best to look for an advisor who does not use performance-based fee structures. Ultimately, a good advisor should be able to provide value and guidance even if they charge a performance-based fee.
Read below to understand what performance fees are, and the advantages and disadvantages of using an advisor that charges performance fees.
What are performance fees?
A performance fee refers to a payment made to an advisor based on the performance of the investments made on behalf of their clients. A contract with these advisors mentions a predetermined threshold. An investor is required to pay a performance fee on investments that meet this threshold. Do note that performance fees are not the same as management fees; rather, they are paid in addition to it.
A benchmark is determined at the time of the contract. If the portfolio returns cross this benchmark, performance fees are charged. If the performance does not outperform the benchmark, the client may only pay the management fees (management fees are a percentage of total assets being managed by the financial advisor). As the amount of money and volume of assets being managed goes up, the amount payable in management fees also goes up.
What are the advantages and disadvantages of performance fees?
While it may seem like an overhead expense, performance fees can be advantageous at times. Since it incentivizes the advisor, they will put in his best efforts to help you make maximum profits. As they seek profits in each investment, they may unlock greater value for their clients. On the contrary, many advisors who are content with management fees may be inclined to play safe and make only very conservative investments. This may stunt the growth of your portfolio.
However, the benefits are accompanied by significant risks as well. First, it could lead advisors to take major risks with your money in the lure of extra profits. The bait of a high performance fee could make them take chances with the entrusted money. Furthermore, if the investment tanks, the investor will bear the brunt of an overly ambitious, poorly researched investment decision. As a result, the advisor may lose out only on performance fee.
Another disadvantage of performance fees is closet indexing. Closet indexing occurs when a financial advisor restructures a portfolio to make it similar to the benchmark index. This strategy can help earn reasonable returns in bull markets. However, it may cause significant losses when the market conditions are not feasible. An advisor here may earn zero fees for years, which may cause them to make risky investments thereby, increasing the risk.
Furthermore, there is no concrete data to show that performance fees improve the return for investors. Instead, it increases risk when managers chase performance bonuses.
What are the regulations on performance fees?
According to the Investment Advisers Act of 1940, RIAs (Registered Investment Advisors) were prohibited from charging performance fees to their retail clients. However, the regulations were amended over the subsequent decades, and now advisors can charge performance fees, but only under specific circumstances.
The course of history for performance fees has been eventful. In the 1970s, Congress passed legislation to allow RIAs to charge ‘fulcrum fees’ for their advice to mutual fund managers. This was also charged once the returns outperformed a predetermined benchmark. However, RIAs were also mandated to reduce the fees proportionately if the portfolio underperformed.
The U.S Securities and Exchange Commission allowed advisors to charge performance-based fees from individual investors in 1985. However, these investors had to be qualified clients. The criteria that clients must meet for investment advisors to charge them performance fees as follows:
- Investors having a minimum AUM of $1 million
- Investors having a minimum net worth of $2.1 million
- Investors working for the RIA
How to know if your financial advisor charges performance fees
An important part when assessing financial advisors is to understand their source of income. You must know if your advisor uses a commission-based, fee-based, or follows the asset-based fee structure. Ask them whether they charge a performance fee, if any, and about any other hidden fees and charges at the time of interviewing the advisor. If you engage with a firm for advisory services, check for their records and filings. This can help you find out if the firm charges a performance fee or not. It will also mention how the fees are calculated.
If seen closely, the typical fee structure, i.e., AUM fees, is also a type of performance fee. This is because the advisor’s earnings grow as the investor’s assets grow, and the earnings go down if the investor incurs losses and the billable assets reduce. This is an ideal model because it is built on the interests of both investors and advisors. However, this structure isn’t free of certain drawbacks. This is because markets are anticipated to grow in the long run. And, in such times, advisors may adopt a passive approach and still earn their fee, even if the portfolio underperforms in comparison to the market.
Performance fees have significantly changed in relevance and impact over the years. Advisors no longer reduce their fees in case of underperformance as in the times of fulcrum fees. Even if the profits do not cross the predetermined threshold, advisors continue to earn the management fees. Since the investor has more at stake, careful consideration is necessary while assessing a financial advisor and their fee structure. While a performance fee may look like a small trade-off for returns, the risk and exposure taken may not be justified. Not to mention, it can cause a conflict of interest between the advisor and the client.
Over the years, performance fees have become less popular as the AUM model gained credibility. However, performance-based financial advisors are mandated to charge a performance fee to only qualified clients. As an investor, you must do your homework to know and understand an advisor’s fee structure of a financial advisor in detail before hiring them.
To summarize
If you wish to hire a financial advisor to help manage and grow your savings, it is important to understand how much they charge for their services before making the decision to hire them. This includes their fee and any other hidden charges they may charge you while providing their services. Use the free advisor match tool to get matched with 2-3 qualified financial advisors. The service is free and you are not obligated to hire the advisors you are matched with. Answer a few questions about yourself, and the match tool will connect you with advisors that are best suited to meet your unique financial requirements.