A symmetrical performance fee, the kind US mutual funds must use, and why its expected cost equals the base.
A fulcrum fee is a base fee that moves up and down by the same amount for the same outperformance or underperformance against an index: fee = base + slope × excess return, capped both ways. On an illustrative $2,000 million fund with a 0.60 per cent base, 0.02 per cent of fee per point of 36-month excess return and a 0.20 per cent cap, beating the index by 6 points over three years lifts the fee to 0.72 per cent, $14.4 million, and lagging it by 6 points cuts it to 0.48 per cent.
Worked in full in Asset Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Most performance fees are one-way: the manager shares in outperformance and charges the base fee when it underperforms. A fulcrum fee is symmetrical. The base fee is the fulcrum, the fee earned for matching the index, and the adjustment is a straight line through it. In the United States it is, in practice, the only form of performance fee a mutual fund can pay its adviser: the Investment Advisers Act of 1940 generally prohibits performance fees, and section 205(b)(2) exempts a registered investment company's contract only if the fee increases and decreases proportionately with performance against an appropriate index. Rule 205-3 allows one-way fees for qualified clients, but a registered fund would need every shareholder to qualify. Outside the US the term is used more loosely, and UK and European funds that charge performance fees follow their own rules, often one-way with a high-water mark. Where a symmetrical fee is chosen, it is for the reason the US rule exists: it stops the manager from being paid for volatility.
| Term | Value |
|---|---|
| Average net assets for the year | $2,000,000,000 |
| Base fee (the fulcrum) | 0.60% |
| Performance period | rolling 36 months |
| Slope: fee change per point of excess return over the period | 0.02% |
| Maximum adjustment, either way | 0.20% |
| Fund return, 36 months, cumulative | 31.0% |
| Index return, 36 months, cumulative | 25.0% |
The cap is reached at 10 points of excess return either way, so the fee runs from 0.40 to 0.80 per cent. Real fund contracts differ in their slope, cap, period and in how assets are averaged (US funds commonly apply the adjustment to assets averaged over the performance period); these terms are illustrative.
Excess = 31.0% − 25.0% = 6.0 points
Adjustment = slope × excess = 0.02% × 6.0 = +0.12%, inside the ±0.20% cap
Fee rate = 0.60% + 0.12% = 0.72%
Fee = 0.72% × 2,000,000,000 = 14,400,000, of which 12,000,000 is the base and 2,400,000 the performance adjustment
Excel, with excess in points in B1: =Base+MAX(-Cap,MIN(Cap,Slope*B1)). A one-way fee is the same formula with the adjustment floored at zero: =Base+MAX(0,MIN(Cap,Slope*B1)).
| Excess, points | Adjustment | Fee rate | Fee, $ |
|---|---|---|---|
| −15 | −0.20% | 0.40% | 8,000,000 |
| −10 | −0.20% | 0.40% | 8,000,000 |
| −6 | −0.12% | 0.48% | 9,600,000 |
| −3 | −0.06% | 0.54% | 10,800,000 |
| 0 | 0.00% | 0.60% | 12,000,000 |
| +3 | +0.06% | 0.66% | 13,200,000 |
| +6 | +0.12% | 0.72% | 14,400,000 |
| +10 | +0.20% | 0.80% | 16,000,000 |
| +15 | +0.20% | 0.80% | 16,000,000 |
The fee can swing by $4,000,000 a year either side of the $12,000,000 base. How much of the outperformance does the manager keep? Six points over three years is roughly 2 points a year, worth about $40,000,000 a year to the fund's investors; the fee rises by $2,400,000, so the manager takes about 6 per cent of the value added. A hedge-fund style 20 per cent share of the same 2 points would cost 0.40 per cent a year. Fulcrum slopes are shallow by design.
| Excess, points | Probability | Fulcrum fee | One-way fee |
|---|---|---|---|
| −12 | 10% | 0.40% | 0.60% |
| −6 | 20% | 0.48% | 0.60% |
| 0 | 40% | 0.60% | 0.60% |
| +6 | 20% | 0.72% | 0.72% |
| +12 | 10% | 0.80% | 0.80% |
| Expected | 100% | 0.600% | 0.644% |
With no skill, the fulcrum fee is expected to cost exactly its base, 0.600 per cent. The one-way fee with the same base, slope and cap is expected to cost 0.644 per cent: 4.4 basis points, $880,000 a year on this fund, paid for nothing but dispersion. A manager on a one-way fee gains from taking more active risk whatever its skill; on a fulcrum fee it does not. To make a one-way fee as cheap in expectation, its base would have to fall to 0.556 per cent. The base itself is still the bigger number, and whether any active fee earns its keep is worked in how much alpha an active fund needs to beat an index fund.
Take the excess return over the whole performance period, multiply by the slope, cap it both ways and add the base: here 0.72 per cent on 6 points of outperformance and 0.48 per cent on 6 points of underperformance. The symmetry is the point: it makes the expected fee equal to the base when there is no skill. Fee breakpoints on the base, the other lever in a mandate, are worked in how to calculate a tiered management fee, and the book's mandate, with its fee and four returns, is in the free Asset Management workbooks.
The Investment Advisers Act of 1940 generally bars performance fees, and section 205(b)(2) exempts a registered investment company's contract only if the fee increases and decreases proportionately with performance against an appropriate index. In the worked case the fee rises 0.12 per cent for 6 points of excess return and falls 0.12 per cent for 6 points of shortfall, around a 0.60 per cent base.
With the same base, slope and cap and a symmetric spread of outcomes, the illustrative one-way fee is expected to cost 0.644 per cent against 0.600 per cent for the fulcrum fee: 4.4 basis points, or $880,000 a year on $2,000 million. The difference pays the manager for dispersion rather than skill.
Usually a small one, because slopes are shallow. Six points of excess over 36 months, about 2 points a year, adds roughly $40,000,000 a year for investors in the worked fund, while the fee rises $2,400,000: about 6 per cent of the value added, against 20 per cent on a typical hedge fund fee.
This article is one calculation from Asset Management. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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