Fulcrum Fees: An Imperfect Solution For Active Managers?

Posted by John Braun on Mar 30, 2020 5:57:21 PM

Fulcrum fee arrangements have been used by certain actively traded registered funds for years but are of late garnering increased attention as active managers attempt to stave off passive investing and the lower fee structure often associated with it. The concept aligns the interest of the advisor with that of the investor by rewarding the advisor when it outperforms its benchmark and reducing the fees of the advisor (to that of an index fund-like fee or even zero) when it underperforms its benchmark.

A fulcrum fee arrangement is an advisory fee with two components:

  1. Base fee – annual rate based on net assets and accrued daily.Fulcrum resized
  2. Performance adjustment – adjustment to the base fee determined by a fund’s performance relative to a benchmark over a performance period accrued daily. There is usually a “null zone” which results in no performance adjustment if the performance of the fund is relatively consistent with the benchmark, and there are also usually minimum and maximum performance adjustments limiting the impact on the adjustment in scenarios where there is significant over/under performance to the benchmark.

There are many perceived positives and negatives of a fulcrum fee arrangement, and there are also many scenarios not often contemplated. Consider the following:

Aligned interest – As noted above, the advisor is effectively showing the investor that they are in the game by risking their ability to accrue fees on their performance. Certain fulcrum fee arrangements are structured such that if the advisor significantly underperforms the benchmark, they get no fee (net) for the period. However, if they significantly outperform the benchmark, the advisor’s fee increases. It seems reasonable that your average investor would be willing to pay a bit more to the advisor for outperforming the benchmark. Remember, a passive fund is effectively getting the benchmark return less a relatively small fee.

Cost as a differentiator – Fulcrum fees target directly the argument that passive funds thrive on – cost. While an active advisor would like to make the argument that there is value in active investing and therefore justification for additional cost, this argument only holds water if the advisor is able to beat the index or index fund in various market conditions and to an extent that provides value to the investor in excess of the relative cost.

Increased appetite for risk – Depending on the measurement period concept, there is an argument that an advisor can take on excessive risk in an effort to outperform the benchmark. To the extent that the risky investments do not perform well and the measurement period is not rolling, that risky bet can be wiped away with a reset of the measurement period. This argument assumes that the advisor is ignoring the impact that poor performance would have on the track record of the fund and the ability to attract investors through performance.

Fees are not based on absolute performance – This would seem to be the main selling point for active funds employing fulcrum fees when making an argument for investing in active funds with fulcrum fee arrangements versus investing in passive products. Remember, the performance adjustment is based on the fund’s performance relative to the benchmark. If the benchmark is up 10% and the fund underperforms the benchmark, there will either be no performance adjust or a performance adjustment to reduce the advisory fee, therefore bringing the net return of the fund closer to the benchmark and likely the comparable passively managed fund as well.

When the fund outperforms the benchmark is, obviously, when the active manager truly separates itself from the passively managed fund. Let’s assume the same 10% performance from the benchmark but further assume the fund was able to return 15%. While the performance adjustment will give the advisor a higher fee, the shareholder will still benefit compared to the passive fund in terms of net performance, as the passive fund will still be relatively consistent with the benchmark return.

Measurement period – Much of how this fee arrangement operates has to do with the measurement period. As discussed above, the base fee is usually a fixed rate annualized on current average net assets, but the performance adjustment is based on the return of the fund compared to its index over the measurement period and then applied to the average net assets over that same measurement period. In certain scenarios, the mismatch of the current period average net assets to the measurement period net assets can have some crazy results.

For example, if a fund using a three-year measurement period has a period of poor performance relative to its benchmark two years ago (when the Fund was significantly larger than it is currently), you could have a scenario where the base fees and even other expenses are completely stripped away by the negative performance adjustment. Alternatively, and assuming the same scenario with respect to everything except to say that the fund outperformed early in the measurement period, the investor could be paying excessive fees.  

Performance fees in a pooled investment vehiclePooled investment vehicles, and mutual funds in particular, are not perfect machines. Most of the mechanics and requirements of an actively advised fund are considered at the fund level and therefore assume continual investment by the shareholder base. Advisory fees are no different, as they are usually charged at an annualized rate and on a daily basis. Specific to fulcrum fees, this means that any given day’s advisory fee is one day’s worth of base fee and a performance adjust based on the performance of the measurement period through the prior day. In a perfect scenario, the performance (positive or negative) of the fund accumulates over the measurement period and the performance adjustment accrues in-kind. However, as one would expect, that rarely happens.

Consider the following scenarios:

Scenario 1 - Fund significantly outperforms the benchmark in month one of a 12-month measurement period and then performs relatively consistent to the benchmark for the remainder of the measurement period

  • Shareholder redeems in Month Two - In this scenario, the investor receives the return on investment real-time, but because the impact on the performance adjustment is annualized, the shareholder is only paying the higher advisory fee (base fee plus additional performance adjustment) for the time they are in the fund. The shareholder benefits in this scenario.
  • Shareholder subscribes in Month Two - In this scenario, the investor did not participate in the outperformance of the fund to the benchmark, but because the impact on the performance adjustment is annualized, the shareholder is paying the higher advisory fee (base fee plus additional performance adjustment) annualized until the underperformance of the fund falls out of the measurement period. The shareholder is harmed in this scenario.

Scenario 2 - Fund significantly underperforms the benchmark in month one of a 12-month measurement period and then performs relatively consistent to the benchmark for the remainder of the measurement period

  • Shareholder redeems in Month Two - In this scenario, the value of the investor’s shares is impacted by the investment real-time, but because the performance adjustment is annualized, the shareholder is only getting the benefit of the reduced advisory fee (base fee offset by the performance adjustment) for the time they are in the fund. The shareholder gives up the benefit of the reduced advisory fee in this scenario.
  • Shareholder subscribes in Month Two - In this scenario, the investor did not participate in the underperformance of the fund to the benchmark, but because the impact on the performance adjustment is annualized, the shareholder is getting the benefit of the reduced advisory fee (base fee offset by the performance adjustment) until the underperformance of the fund falls out of the measurement period. The shareholder benefits in this scenario.

Of course, advisors attempt to convince investors to stay the course and not invest for the short term, which would alleviate some of the considerations above. To this end, advisors can employ sales loads and redemption fees to induce investors to invest for the long term.

We have summarized some of the positives and negatives of fulcrum fees and also pointed out some of the imperfections of the fulcrum fee arrangement for pooled investment vehicles. On balance, the spirit of fulcrum fee arrangements would seem to make sense to the average investor and could make a solid case for continuing to invest in actively traded funds. The surge of investing in passive funds has largely been at a time when markets have performed well. It will be interesting to see how actively traded funds armed with tools such as fulcrum fee arrangements will fare in the current market conditions and if, ultimately, they can prove out their value proposition and maintain a place in the average investor’s retirement tool-kit.

Please reach out to us should you have any questions related to fulcrum fees and audit and tax considerations.

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