The Efficiency of Performance‐Based Fee Funds

• Date: 01 September 2014
• DOI: http://doi.org/10.1111/j.1468-036X.2012.00654.x
• Published date: 01 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´

ıaz-Mendoza

Departamento de Fundamentos del An´

alisis Econ´

omico II, Universidad del Pa´

ıs Vasco, Spain

E-mail anasanvi@hotmail.com

Germ´

an L´

opez-Espinosa

Departamento de Empresa, Universidad de Navarra, Spain

E-mail glespinosa@unav.es

Miguel A. Mart´

ınez

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,

Spain

E-mail miguelangel.martinezs@ehu.es

Abstract

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´

ıaz-

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 n◦583 in the Fundaci´

on de las Cajas de Ahorros (FUNCAS) collection.

Correspondence: Miguel A. Mart´

ınez.

C

2012 Blackwell Publishing Ltd

© 2012 John Wiley & Sons Ltd

A. C. Díaz-Mendoza, G. López-Espinosa and M. A. Martínez

826

© 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).