The Efficiency of Performance‐Based Fee Funds

Date01 September 2014
Published date01 September 2014
European Financial Management, Vol. 20, No. 4, 2014, 825–855
doi: 10.1111/j.1468-036X.2012.00654.x
The Efficiency of Performance-Based
Fee Funds
Ana C. D´
Departamento de Fundamentos del An´
alisis Econ´
omico II, Universidad del Pa´
ıs Vasco, Spain
an L´
Departamento de Empresa, Universidad de Navarra, Spain
Miguel A. Mart´
Departamento de Fundamentos del An´
alisis Econ´
omico II, Universidad del Pa´
ıs Vasco, UPV/EHU,
Facultad de Ciencias Econ´
omicas y Empresariales,, Avda. Lehendakari Aguirre,83, 48015 Bilbao,
This paper compares the efficiency of mutual funds that charge management fees
based totally or partially on returns (performance) with those that charge them
exclusively on assets under management. We analyse Spanish risky mutual funds
during 1999–2009 for which both types of managementfees are authorised. Wef ind
that performance-based fee funds perform significantly better than the other risky
funds considered. Moreover, a strongly positive performance-expenses relation is
found for such funds, and negative for the other. These results seem to indicate
The authors would like to thank to an anonymous referee and John Doukas (the editor),
for helpful comments. We also like to thank the National Securities Market Commission for
providing the data used,and Marina Balboa for her valuable support. The paper also benefited
from discussions with seminar participants at the University of Navarra, the University of
La Rioja, the University of Valencia, the University of Barcelona, the University of the
Balearic Islands, and the European Financial Management 2010 Annual Conference, the
17th Annual Conference of the Multinational Finance Society, the 18th Spanish Financial
Forum, and the 35th Symposium of the Spanish Association of Economy. Ana C. D´
Mendoza and Miguel A. Mart´
ınez acknowledge research support from the Ministry of
Science and Innovation, grants ECO2008–00777/ECON and ECO2011–29268, and Basque
Government grant IT-241–07. Germ ´
an L´
opez-Espinosa acknowledges research support from
the Ministry of Science and Innovation, grant ECO2008–02599/ECON, from the University
of Navarra (PIUNA), and from Navar ra Government (Jer´
onimo de Ayanz program). Any
errors or omissions are our own. A previous version of this paper has been published as
Working Paper n583 in the Fundaci´
on de las Cajas de Ahorros (FUNCAS) collection.
Correspondence: Miguel A. Mart´
2012 Blackwell Publishing Ltd
© 2012 John Wiley & Sons Ltd
A. C. Díaz-Mendoza, G. López-Espinosa and M. A. Martínez
© 2012 John Wiley & Sons Ltd
more efficient management in performance-based fee funds, in contrast with their
low presence in the fund industry.
Keywords: risk-adjusted performance;expenses;eff iciency;evaluation models
JEL classification: G11, G12
1. Introduction
Since Jensen’s (1968) seminal paper, the literature on mutual fund performance
evaluation has generally concluded that, on average, equity funds under perform the
appropriate benchmark returns. The most frequent explanation for this is the fees
involved; indeed, fund performance is not signif icantly inferior when before-expenses
returns are considered (Grinblatt and Titman, 1989; Malkiel, 1995; Droms and Walker,
1996; Gruber, 1996; Cesari and Panetta, 2002). Mart´
ınez (2003) finds a similar result for
the Spanish market. Therefore, the amount of expenses charged to investors appears to
be a key element in mutual fund performance evaluation (Khorana et al., 2009; Ramos,
2009). This paper aims to analyse whether the way expenses are charged is relevant to
mutual fund performance evaluation and to the performance-expenses relation.
Mutual fund expenses include management fees, which investors have to pay to
managers for portfolio supervision services, custody fees, paid for asset administration
and custody,and other distribution, legal, and administrative costs. Of these, management
fees are the main component, typically accounting for 90–95% of the total. Management
fees are generally charged as a fixed percentage of total assets under management
(asset-based fees). Thus, managers are rewarded for asset growth rather than for returns.
However, since asset volume increases with both capital inflows and asset appreciation,
an incentive for good performance can be recognised in this fee structure.
Additionally, current worldwide mutual fund regulations usually allow management
fees to be charged totally or partially on returns (performance-based fees). Thus, mutual
funds could charge both a fee based on asset volume and an incentive fee based on
fund performance. In fact, all the country members of the International Organisation of
Securities Commissions (IOSCO) envisage this type of fee. In spite of this legal and
regulatory possibility, only a minority of fund use remuneration structures tied to fund
returns. Research from Lipper (2007) shows that the overall proportion of US open-
ended funds using such structures is just over 2%. In the case of the major European
fund markets, between 10% and 20% of funds use performance-based management fees.
The literature on managerial remuneration discusses various explanations for the
limited interest investors have had in performance-based management fees, such as the
incentive to excessive risky management1and its opacity (Damato, 2005). Thus, funds
that link management fees to performance seem to be only suitable for well-informed
and risk-conscious investors. Fromthe supply side, management companies also seem to
be reluctant to establish such fees. Regarding incentive issues, it is not easy, in practice,
to evaluate worthwhile incentives to good management besides the well-known increase
1Chevalier and Ellison (1997), Elton et al. (2003), and Low (2009) conclude that
performance-based fees may encourage managerial risk taking since increases in stock
return volatility lead to higher fees. However, since such fees can increase the sensitivity of
a manager’s portfolio to f irm stock price movements, little risk is assumed (Ross, 2004).

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