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.

Key Takeaways

  • A fulcrum fee is a performance-based fee that adjusts up or down depending on whether or not performance benchmarks are met.
  • Fulcrum fees must exceed the appropriate benchmark to qualify for a higher fee, or if not, the base fee must be reduced.
  • Only qualified clients are eligible for fulcrum fees as stipulated by the Investment Advisers Act of 1940.
  • Investment advisors implement fulcrum fees to make active funds more attractive than passive funds, which have been outperforming them.
  • Fulcrum fees are shown to not particularly improve a fund's performance but rather lead to managers taking on more risk to try and beat the benchmark.

Understanding a 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's 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.

Then in 1985 the Securities and Exchange Commission (SEC) further allowed advisers to use fulcrum fees with retail clients, and only because the adviser participates equally in the downside and upside of an investment.

The reason why a fund management giant would employ a fulcrum fee on actively managed funds is that 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.

Fulcrum Fee Conditions

A couple of conditions must be met 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 Advisers Act of 1940.

Do Fulcrum Fees Work?

According to research, incentive fees for mutual funds have not shown any association with improved risk-adjusted performance. Rather, mutual fund managers paid via incentive fees tend to achieve higher returns simply by taking on more risk. Worse yet, when they lag their benchmarks they add more risk. Despite this, such performance-based fees remain popular with investors.

Real World Example

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).

Fidelity is not alone in selectively using fulcrum fees; Vanguard, Janus, and AllianceBernstein, as well as other fund managers, also employ them.