What is a Fulcrum Fee
A fulcrum fee is a performance-based fee that adjusts up or down based on outperforming or underperforming a benchmark. Fulcrum fees can be charged by a financial adviser or an asset manager to qualified clients to link outperformance (or lack thereof) to compensation.
Breaking Down Fulcrum Fee
A fulcrum fee is the only performance-based fee that financial advisers are permitted to charge clients. The Investment Advisers Act of 1940 first prohibited performance-based fees, as they give advisers too much incentive to take undue risks with their client money. It wasn't until 1970 that congress permitted performance-based fees, such as a fulcrum fee — but only by Registered Investment Advisers (RIA) serving as investment managers to mutual funds. It wasn't until 1985 that the Securities and Exchange Commission further allowed advisers to use fulcrum fees with retail clients, and only because the adviser participates equally in the downside and the upside of an investment. A couple of conditions must be met in order for an adviser to charge a fulcrum fee:
1) The returns must exceed the appropriate benchmark (and if they don't, the base fee must be reduced).
2) The only clients that can be charged this way are: individuals or registered investment companies with an account value greater than $1 million or a net worth greater than $2.1 million. Such clients are known as "qualified clients," defined under Rule 205-3 of the Investment Advisors Act of 1940.
Fulcrum Fees: Recent Developments
In 2016, fulcrum fees accounted for less than 2% of U.S. registered funds (194 funds; $790 billion). Fulcrum fee use is expected to increase as pressure builds on asset managers to either lower fees on actively managed funds or justify them with better performance. Fulcrum fees are already in use in exchange-traded funds.
In late 2017, Fidelity International announced that it would overhaul its equity fee strategy to a fulcrum fee model. In effect, it would offer a new share class for 10 active equity funds that would carry a management charge that was 10 basis points lower than current prices. Depending on the performance of the funds, that fee would either rise or fall by 20 basis points (performance would be measured on a three-year rolling basis).
The reason why a fund management giant would employ a fulcrum fee on actively managed funds is because they continue to underperform lower-cost index (passive) funds, which have captured the lion's share of net inflows in the U.S. over the last decade. To make active equity funds more popular, Fidelity is essentially lowering their cost but allowing themselves to participate on the upside if they beat their bogey.
Fidelity is not alone in selectively using fulcrum fees; Vanguard, Janus and Alliance Bernstein, as well as other fund managers, also employ them.
Fulcrum Fees: Do They Work?
According to research, incentive fees for mutual funds have not shown any association with improved risk-adjusted performance. Rather, mutual funds managers paid via incentive fees tend to achieve higher returns simply by taking on more risk. Worse yet, when then lag their benchmarks they add more risk. Despite this, such performance-based fees remain popular with investors.