How FlexFees Work 1.0 - The Concept
History of performance-based fees in mutual funds and AB’s innovation
Performance-based fees for mutual funds have existed for years, but without much success. For one, they were a bit complicated to understand. For instance, they were typically based on three-year rolling average performance, which meant that an investor coming into a fund was paying fees that were based on performance that may have been earned in the fund up to three years earlier. More importantly, though, prior attempts at performance-based fees were not much of a value proposition to an investor. Because the SEC requires that fees be symmetric around a benchmark return, funds that used these “fulcrum” fees would set an average active fee as the fulcrum to be earned if a market index (such as the S&P 500) were matched, and then would raise or lower these fees modestly around this middle fee. The problem is that earning the S&P 500 (or other market index) is in most cases easily done at much lower cost with passive options. Even in situations where the fund underperformed such an index, the fee, while lower than the middle fulcrum fee, was still quite a bit higher than passive. And, for modest premium performance, that may have been earned before an investor even invested, the fee could be increased. Perhaps it is not surprising that this structure never gained much in popularity – representing less than 5% of the AUM of all funds.
AB’s insight - developed by yours truly working under then CEO Peter Kraus, was that it is possible to stay within the SEC’s requirement for symmetry, while offering a much better value to investors. The first key was to recognize that the performance benchmark could be shifted by adding a premium commensurate with what active managers should be targeting anyway. Instead of choosing the S&P 500, a true active benchmark might be the S&P 500 plus some target active premium. So, with AB’s FlexFees, in such an example, the fulcrum or middle of the fee schedule, would only be earned when the manager outperformed the S&P by the targeted amount. With this small change, it became possible to create a truly competitive fee schedule since the fee could be lowered to equal passive fees if “only” the S&P 500 were matched. The upside would be a symmetric increase to the upside for after-fee performance exceeding S&P 500 by more than the target premium. And, since the down-side is capped (at 10 bps in Display 1 -- 50 bps below the middle fulcrum), then the upside is also capped (at 110 in Display 1 – 50 bps above the fulcrum). This approach maintained the SEC’s symmetry requirement while creating a very compelling value proposition to investors by using a truly “active” benchmark.
The second key was to switch the performance calculation period from a three-year rolling period to an annual period. With AB’s FlexFees, only performance earned in a given calendar year counts toward the calculation of the fee for that year. Once the year is over, the calculations start anew and past performance has no more impact on fees. So, while the fee for an investor who comes in mid-way through a year may not exactly match that investor’s performance experience that year, by the start of the next year, all calculations are reset. Anyone invested from January 1st will pay a fee that is based solely on the performance of the upcoming calendar year – not on any prior years. This minimizes the risk that investors entering the fund are stuck paying for old performance they did not earn.
AB’s FlexFees and most other new entrants into this space, including Aperture (Peter Kraus’ new venture) and Allianz utilize this or a similar approach. A few though, such as Fidelity, seem to be utilizing the old approach and are less interesting.
