dr. alfred rappaport author profileThis is a special guest post by Dr. Alfred Rappaport. Dr. Rappaport is the Leonard Spacek Professor Emeritus at Northwestern University’s J. L. Kellogg Graduate School of Management. He is the author of the business classic Creating Shareholder Value: A Guide for Managers and Investors, and coauthor with Michael Mauboussin ofExpectations Investing. Rappaport has been a guest columnist for the Wall Street Journal, the New York Times, Fortune, and BusinessWeek. He created the Wall Street Journal Shareholder Scoreboard, an annual ranking by total shareholder returns of the 1,000 most valuable U.S. corporations, published annually from 1995 to 2008. Rappaport lives in La Jolla, CA. He recently authored a new book titled; Saving Capitalism From Short-Termism: How to Build Long-Term Value and Take Back Our Financial Future.

The obsession with short-term performance irrespective of longer-term consequences destroys companies and jobs, undermines economic growth and shortchanges retirement savings.  These damaging consequences are occurring at a most inopportune time: we’re living longer, unemployment is high, greater tax burdens loom, and it’s uncertain whether Social Security and Medicare will deliver their promised benefits.

Corporate managers are obsessed with quarterly earnings and the current stock price.  Investment managers focus on quarterly performance relative to their benchmark index and competing funds. Both do what they are rewarded to do.  Incentives matter. Not surprisingly, an essential cause of the 2007-9 financial crisis is a collection of perverse, short-term financial incentives that drove a chain of private-sector participants—homebuyers, appraisers, lenders, credit-rating agencies, corporate boards, investment banks, and institutional investors—to take reckless risks with other people’s money.  .

There is a better way.  Consider the case of actively managed equity funds.  How well do they help investors achieve their long-term financial goals?  Because the cost of active management is substantially higher than that of passively managed index funds, actively managed funds must underperform index funds in the aggregate.  In a typical year, about 60 percent of managers fail to beat the returns of their benchmark indexes. The percentage rises as you extend the performance evaluation period. Very few managers produce returns in excess of their benchmarks over the investment horizon of people saving for retirement. Even more distressingly, there’s little evidence of persistence in performance. Managers who have outperformed in the past are no more likely—and in many cases, are less likely—to outperform in the future than their below-average peers.

Costs, including fees, expenses, and transaction costs, are the primary factor driving this disappointing performance. But the way fees are structured affect the behavior of managers and thereby also affect the fund’s performance. By far the most common fee structure pays managers a fixed percentage of the market value of assets under management (AUM). But asset-based fees contain an inherent conflict of interest in that they reward managers for focusing on short-term asset gathering often at the expense of long-term performance. Because flows into and out of mutual funds are strongly correlated with recent performance, managers try to avoid underperforming their peers and benchmarks over the short term. This, in turn, leads to behavior that compromises long-term performance, including herding and closet indexing.

Another difficulty with the asset-based fee structure is that shareholders pay the fee whether the manager performs well or poorly. Funds with asset-based fees effectively include a charge for outperformance, whether or not that outperformance materializes. A fund with a 1.00 percent expense ratio, for example, charges a premium of more than 0.80 relative to index funds, which typically have expense ratios of less than 0.20 percent.

Moreover, actively managed funds charge management fees on all of their assets, even those that are invested in the benchmark index. So a fund with an active component of 33 percent and an expense ratio of 1 percent is effectively charging 3 percent for its active positions. In other words, the 33 percent active component of the portfolio must outperform the index by 3 percentage points in order to beat the index—a daunting challenge.

There is a superior alternative. Performance fees, or incentive fees, are the norm in the hedge fund world, where the standard fee structure is known as “two and twenty”: 2 percent of the fund’s net asset value plus a performance fee of 20 percent of the fund’s gains. Laws prohibit U.S. mutual funds from entering into this type of incentive arrangement, which enables managers to share the upside without a corresponding penalty on the downside. Performance fees for mutual funds must be symmetrical, so that fees increase or decrease by the same amount for a given level of performance above or below a fund’s benchmark. For example, suppose a fund that beats its benchmark by 2 percentage points collects an additional 0.50 percent in fees. If the fund underperforms its benchmark by 2 percentage points, the management fees must decline by the same 0.50 percent.

By most accounts, symmetrical performance fees are in place for fewer than 10 percent of mutual funds, and the typical fee swings are no more than 0.40 percent in either direction. Among the well-established fund companies, privately held Fidelity Investments and Vanguard and publicly traded Janus Capital employ performance fees. As long as shareholders are willing to accept asset-based fees, fund management boards are unlikely to adopt performance fees. Most managers presumably prefer to trade away the possible upside of performance-based fees in order to ensure steady fees in the event that they underperform their benchmark.

Performance fees are designed to align managers’ interests with those of the shareholders and to attract talented managers who believe that they can deliver superior returns and, as a result, superior pay for themselves. I don’t know whether investment managers would produce higher risk-adjusted returns if they used performance fees than if they didn’t. But we do know that fees would be more evenhanded. Also, if performance fees lead to competition that lowers asset-based fees, actively managed funds will improve their aggregate results relative to their passive benchmark indexes. Price competition aside, we know that if every fund used performance-based fees, total expenses would decline purely as a function of the fact that the majority of funds must underperform, even as the amount of their underperformance in the aggregate would fall as a result of lower expenses. If incentive fees attract managers with benchmarking-beating skills, their shareholders will do better than either the shareholders of funds whose managers operate under an asset-based fee structure or the shareholders of funds with performance-based structures that have managers who lack these skills. If this is valid, we would expect to see more funds adopt performance fees and underperforming funds close shop earlier and more frequently. Fund shareholders would benefit if more funds adopted performance-based fees.

The proper design of performance fees entails a number of important decisions, including choosing an appropriate benchmark index, determining the rewards for outperforming and penalties for underperforming the benchmark, and consideration of the length of the performance period.  Selecting an appropriate time period over which managers calculate the performance fees is critical to the plan’s success. If the measurement period is too short, short-term volatility could overwhelm the fees. Longer measurement periods of rolling 36 to 60 months moderate volatility, lengthen the manager’s investment horizon, and reduce the chance that managers will assume excessive risk in

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