Are performance fees justified?

• Author: Carroll, John B.
• Position: Pro and con

Are performance fees justified?

Should investment management firms be paid according to the size of the account they manage? Or according to the investment results they achieve? This issue is surfacing more and more in the dealings between corporate executives and portfolio managers. It is exacerbated by the increasingly large funds that are being managed.

At the recent annual conference of FEI's Committee on the Investment of Employee Benefit Assets, corporate spokesmen and investment managers took up each side of the issue. We present here the outspoken views of two of the participants. Given the increasing debate on how various fees are calculated, some of the comments may also have an application beyond the parameters of corporate pension fund managers.

YES

We announced to our 24 domestic equity managers in the last quarter of 1987 that it was going to be our policy to deal only with those who would accept a performance base fee. I'm pleased to say that all 24 have agreed. However, there were only a handful who were really enthusiastic about the program, considering it an opportunity to make more money. Most seemed resigned, offering no resistance, while six or eight were dragged kicking and screaming into the program.

Why did we decide to introduce performance-based fees at GTE? To answer that, I have to go back to the independent investment firms that came into the field in the late '60s and early '70s. It was not unusual in their business presentations for these new firms to promise a return of 600 to 800 basis points over the S&P 500, since they did not really have a track record. So fees rapidly went up from the roughly 30 basis points banks had been paying to 60, 80, and 100 basis points. And sponsors were willing to pay those higher fees because their expectations were raised. If you're going to get 500 basis points over the market, you've no problem paying 1 percent of market value in fees. Fees become immaterial.

However, the reality today is that about two-thirds of investment managers do not beat the S&P 500. So, the conclusion has to be that, in general, most firms underperform the market, while fees have gone up dramatically.

In fact, fees have doubled over the last five years because assets have doubled. But how many managers have produced value added to their clients along with the increased fees? I don't think the majority have. So, this seems to us to be a fairness issue. We think that fairness has to be part of the formula in how we compensate investment managers for what they're doing. We want to pay for the results we get. And we're not talking about something that's very difficult to analyze and come to an agreement about. They're very quantifiable results. We're not talking about an incentive issue here. I think that profit margins are incentive enough. The nature of the business produces enough incentive.

There are those who say that if managers are put on performance fees, they'll take more risks. But we all monitor each of the portfolios that we have our own program. We know the characteristics of each portfolio...