Performance-based fees charged by investment advisors have been a topic of debate for many years. While some argue that performance fees better align advisors’ interests with clients’, others question the potential conflicts. This article examines the legality of performance fees, arguments for and against their use, and factors clients should consider when reviewing advisors who charge performance fees.
SEC rules allow performance fees under certain conditions
Under the Investment Advisers Act of 1940, investment advisors registered with the SEC are prohibited from charging performance-based fees to clients. However, exemptions exist for advisors who only service ‘qualified clients’. These include individuals with over $1 million invested with the advisor or institutions with over $2.1 million. Registered advisors can charge performance fees to qualified clients if they follow certain SEC rules, like basing fees on net returns and limiting them to no more than 20% of profits.
Performance fees align advisors’ and clients’ interests
Proponents argue performance fees better align advisors’ interests with clients’. Under a typical asset-based fee, advisors earn the same 1-2% of AUM regardless of actual portfolio performance. But with performance fees, advisors only earn additional compensation if client accounts grow. This provides a stronger incentive to maximize gains. As client portfolios increase in value, both parties share in the upside.
Potential conflicts around timing and risk
Critics argue performance fees could incentivize advisors to take excessive risks or make decisions based on fee timing rather than clients’ best interests. For example, an advisor might take on more risk near the end of a period if they are below the ‘high water mark’ needed to earn a performance fee. There are also concerns that clients may end up paying more in combined asset-based and performance fees versus just an asset-based fee.
Factors to consider in reviewing performance-based advisors
When evaluating advisors who charge performance fees, clients should consider factors like: – Fee structure details – High water mark provisions preventing fee churning – Advisor transparency on expected gross returns – Long-term performance records – Risk management discipline – Overall fee reasonableness based on services provided
Performance fees are allowed by the SEC for qualified clients under certain conditions. Properly structured, they can better align advisors’ and clients’ financial interests. But potential conflicts around timing and risk taking require diligent client review.