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PERFORMANCE INCENTIVE FEE FUNDSPOST DOWNTURN

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PERFORMANCE INCENTIVE FEE FUNDS POST DOWNTURN

SEPTEMBER 2012

1

Four years ago, Lipper conducted a study of US funds’ performance incentive fees.1 The data in the study went through December 31, 2007. In this paper, we will re-examine performance incentive fee funds to determine how they fared during the economic downturn in comparison to funds without performance incentive fees. Building on the findings from the original paper, we hypothesize that performance incentive fee funds will perform worse than their non-performance incentive fee counterparts during the downturn, but better during the recovery.

KEY POINTS:

• The top five complexes with performance incentive fee funds comprise 96% of assets of all performance incentive fee funds.

• The most common index used as a benchmark is the S&P 500 index.

• Performance incentive fee funds have lower excess returns in the quarters where performance during the downturn is included. Since then, the findings are mixed. While performance incentive fee funds have higher performance in some quarters this is not consistent across all quarters.

• Performance incentive fee funds seem to take on higher risk than their counterparts without incentive fees; however, these risks have not paid off when the economic downturn is taken into account, on average.

• Boards may want to consider if the performance incentive fee fund is taking on too much risk to beat the benchmark.

Please note that the views expressed in this document are intended as non-consultative and

do not constitute legal advice.

AUTHORED BY:SASHA FRANGERFIDUCIARY RESEARCH ANALYSTFIDUCIARY SERVICES, LIPPERsasha.franger@thomsonreuters.com

1 Jonathan Kreider. 2008. Paying for Performance. www.lipperweb.com

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PERFORMANCE INCENTIVE FEE FUNDS POST DOWNTURN SEPTEMBER 2012

US-domiciled funds have been using performance incentive fees for decades.2 Performance incentive fees are designed to give investors a break from management fees when a fund underperforms its benchmark and to reward management when a fund outperforms its benchmark. Theoretically, this helps align fund management and shareholders’ interests; however, interests are already aligned because managers earn a percentage of assets. A graphical representation of the structure of a performance incentive fee can be seen in Figure 1.3 This figure shows that a performance incentive fee is adjusted up or down depending on the percentage of outperformance or underperformance of the fund relative to its benchmark. It also shows that the incentive fee is equally applied on the positive end and on the negative end, and that the fee is in addition to the base fee. While performance incentive fee calculations vary across complexes and funds, the method employed by Putnam is an example of the trend in the industry. The following paragraph is the description Putnam provides for the performance incentive fee of their Growth Opportunities Fund:

“�Each�month,�the�performance�adjustment�is�calculated�by�multiplying�the�performance�adjustment�rate�and�the�fund’s�average�net�assets�over�the�performance�period�and�the�result�is�divided�by�twelve.�The�resulting�dollar�amount�is�added�to,�or�subtracted�from�the�base�fee�for�that�month.�The�performance�adjustment�rate�is�equal�to�0.03�multiplied�by�the�difference�between�the�fund’s�annualized�performance�(measured�by�the�fund’s�class�A�shares)�and�the�annualized�performance�of�the�Russell�1000�Growth�Index,�each�measured�over�the�performance�period.�The�maximum�annualized�performance�adjustment�rates�are�+/–�0.12%.�The�monthly�base�fee�is�determined�based�on�the�fund’s�average�net�assets�for�the�month,�while�the�performance�adjustment�is�determined�based�on�the�fund’s�average�net�assets�over�the�performance�period�of�up�to�thirty-six�months.�This�means�it�is�possible�that,�if�the�fund�underperforms�significantly�over�the�performance�period,�and�the�fund’s�assets�have�declined�significantly�over�that�period,�the�negative�performance�adjustment�may�exceed�the�base�fee.�In�this�event,�Putnam�Management�would�make�a�payment�to�the�fund.”�4

INTRODUCTION

2 This is in stark contrast to European funds. Ed Moisson. 2012. Performance Fees: Paying your Dues? www.lipperweb.com3 This is a reproduction of a figure in the paper by Jonathan Kreider4 2011. Putnam Growth Opportunities Annual Report.

BASE FEE

-6%

-0.129%

-5%

-0.107%

-4%

-0.086%

-3%

-0.064%

-2%

-0.043%

-1%

-0.021%

1%

0.021%

2%

0.043%

3%

0.064%

4%

0.086%

5%

0.107%

6%

0.129%

FIGURE 1 GRAPHICAL REPRESENTATION OF A PERFORMANCE INCENTIVE FEE

The structure of performance incentives allows for equal adjustment on the positive and negative side.

Note: The top set of numbers corresponds to a percentage of a hypothetical fund’s over/underperformance relative to a specified benchmark. The bottom set of numbers represents a hypothetical fund’s base fee plus a performance incentive adjustment.

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PERFORMANCE INCENTIVE FEE FUNDS POST DOWNTURN SEPTEMBER 2012

As of December 31, 2007, three percent of all funds—representing six percent of industry assets—were funds with performance incentive fees. As of July 31, 2012, the percentages have not changed: three percent of funds representing six percent of industry assets were funds with performance incentive fees.5 Since 2007, some complexes have added performance incentive fees, and some complexes have removed performance incentive fees, and the complexes in the top five complexes has changed. Table 1 compares the top five complexes with performance incentive fees from the previous paper to data as of July 31, 2012. The top five complexes with performance incentive fees still comprise over 90% of all performance incentive fee assets and over 65% of all funds with performance incentive fees; however, the complexes have changed around a bit. RiverSource is no longer in the top five complexes due to a merger with Columbia and a subsequent removal of many incentive fees. This allowed Janus and USAA to move up the list. In 2009, Puntam introduced six new funds with performance incentive fees. In the same year, they added performance incentive fees to 12 existing funds while simultaneously lowering their management fees. This earned them a spot on the list of the top five complexes with performance incentive fees. In their Guide to Performance Incentive Fees Putnam states, “The management fees adjust based on fund performance, which aligns the interest of fund management and shareholders,” as an explanation as for why the incentive fees were added.

2007

NAME NUMBER OF PORTFOLIOS NUMBER OF FUNDSTOTAL NET ASSETS 12/31/2007

($ MIL)Fidelity 57 120 450,310.6Vanguard 17 26 202,786.2RiverSource 31 191 40,683.3USAA 29 29 27,570.5Janus 11 32 25,940.1Top 5 Total 145 398 747,290.7Industry Total 213 588 777,034.1

2012

NAME NUMBER OF PORTFOLIOS NUMBER OF FUNDSTOTAL NET ASSETS 7/31/2012

($ MIL)Fidelity 78 200 344,005.2Vanguard 13 20 177,131.1Janus 17 107 50,000.0USAA 29 58 38,613.2Putnam 19 114 15,134.7Top 5 Total 156 499 624,884.2Industry Total 220 708 654,246.1

TABLE 1 TOP 5 COMPLEXES WITH INCENTIVE FEES

5 The universe consists of all open-end funds.

The top five complexes still comprise almost all of the funds with performance incentive fees.

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PERFORMANCE INCENTIVE FEE FUNDS POST DOWNTURN SEPTEMBER 2012

TABLE 2 TOP 3 BENCHMARKS

TOP 3 INDEXES NUMBER OF FUNDS

S&P 500 99

Russell 1000 Growth Index 49

MSCI EAFE Index 29

FIGURE 2 TYPE OF PERIOD FIGURE 3 LENGTH OF PERIOD

A majority of performance incentive fees are based on cumulative timeperiods.

Table 2 aandFigures 2, 3, and 4 provide more details on the kinds of performance incentives that are given to management. A total of 177 funds base their performance incentive fees against the S&P 500, Russell 1000 Growth, or the MSCI EAFE indexes, making these top three benchmarks used by performance incentive fee funds. By far the most common way to compare performance is by cumulative periods (91%), and the most common length of period is 36 months (65%). Figure 4 displays the dispersion of the amount of incentive fees. The median performance adjustment is 15 basis points (bps).

Rolling Cumulative 3-month 12-month 36-month 60-month

A majority of performance inventive fees are contingent upon a 36-month time period.

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PERFORMANCE INCENTIVE FEE FUNDS POST DOWNTURN SEPTEMBER 2012

High 2.400%

Low 0.019%

Median 0.150%

FIGURE 4 MAXIMUM PERFORMANCE INCENTIVE FEES

The previous Lipper paper on performance incentive fee funds found “on average, over the past ten years, incentive fee funds have outperformed their Lipper classification averages. However, typically they have taken on a slightly greater amount of risk (as measured by volatility of returns) in doing so.” This paper will determine if this remained the case throughout the economic downturn and ensuing recovery, or if a new pattern has emerged. The US economy started its downswing in late 2007 due to pressure from the subprime crisis. The economy bottomed out in the fourth quarter of 2008 and the first quarter of 2009, and has been on a vacillating incline since then. Based on the previous findings, Lipper expects that performance incentive fee funds underperformed funds without performance incentive fees during the downturn because of the greater risk they take on. However, we expect performance incentive fee funds to outperform in the years after the downturn.

The median maximum performance incentive fee awarded is 0.150%.

Note: Figure 4 displays the high, low, and median maximum performance incentive fees. The individual gray hashmarks in the chart represent the maximum performance incentive for each fund, and the blue line is the median.

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PERFORMANCE INCENTIVE FEE FUNDS POST DOWNTURN SEPTEMBER 2012

Figures 5, 6, and 7 compare the performance of funds to performance incentive fees with that of funds without performance incentive fees. Only funds in the same classification as performance incentive fee funds were included in the analysis. The S&P 500 index is included for comparison purposes. Figure 5 displays the annualized performance of these funds. In each of the periods, funds with performance incentive fees slightly underperform funds without performance incentive fees. Figure 6 provides the opportunity to zoom in and see exactly which years funds with performance incentive fees outperform or underperform funds without performance incentive fees. An interesting finding emerges—funds with performance incentive fees outperform funds without performance incentive fees in all years except 2012 and the years corresponding to the economic downturn (2008 and 2009).

PERFORMANCE COMPARISON

FIGURE 5 ANNUALIZED PERFORMANCE

-2.00

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

1 Years 3 Years 5 Years 10 Years

Performance Incentive Funds Median Classification Median S&P 500

-25.00-20.00-15.00-10.00

-5.000.005.00

10.0015.00

20.0025.00

2012 2011 2010 2009 2008 2007 2006 2005 2004 2003

Performance Incentive Funds Median Classification Median S&P 500

Funds with performance incentive fees underperform in all four annualized periods.

Note: Figure 5 displays annualized total return performance net of expenses ended July 31, 2012. Only funds in the same classifications as performance incentive fee funds are included in the “classification median.”

In rolling periods, funds with performance incentive fees perform better than funds without performance incentive fees except in 2012 and the years corresponding to the economic downturn.

Note: Figure 6 displays annualized total return performance net of expenses ended July 31, 2012. Only funds in the same classifications as performance incentive fee funds are included in the “classification median.”

FIGURE 6 ROLLING ANNUAL PERFORMANCE

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PERFORMANCE INCENTIVE FEE FUNDS POST DOWNTURN SEPTEMBER 2012

20.00

15.00

10.00

5.00

0.00

5.00

10.00

15.00

Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Average Excess Return of Incentive Fee Funds

FIGURE 7 AVERAGE EXCESS RETURN OF INCENTIVE FEE FUNDS

Performance incentive fee funds fare worse in quarters that include the economic downturn.

Note: Figure 5 charts the average excess return experienced by performance incentive fee funds on a quarterly, rolling annual basis.

Figure 7 provides one final perspective for performance comparison. The line graph charts the excess return experienced by performance incentive fee funds since December 1999 for quarterly rolling one-year periods. The number of months when performance incentive fee funds outperform funds without performance incentive fees is evenly split. In 25 of the 50 quarters, funds with performance incentive fees outperform their classification average. The most deeply negative time for performance incentive fee funds was 2009, which would include fund performance during the height of the downturn. Since then, during the recovery, funds with performance incentives have performed similarly to funds without performance incentives with excess returns bouncing around the zero mark since June 2010. During the last two quarters of 2010 and the first two quarters of 2011 performance incentive fee funds’ performance was better on average than funds without incentive fees; however, they performed worse in the next three quarters. In the final quarter in this chart, performance incentive fee funds performed just slightly better (0.17%). Some of our expectations are borne by the data. Funds with performance incentive fees underperformed during the downturn. While there is some evidence that they are performing slightly better in more quarters post-downturn, there is not enough data at present to decisively conclude this.

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PERFORMANCE INCENTIVE FEE FUNDS POST DOWNTURN SEPTEMBER 2012

FIGURE 8 STANDARD DEVIATION OF MONTHLY RETURNS (ANNUALIZED)

One of the main findings in the 2008 paper was that funds with performance incentive fees take on more risk than funds without them. We wanted to re-examine this finding taking into account the economic downturn and recovery. Figures 8, 9, and 10 compare different measures of risk for funds with performance incentive fees and funds without performance incentive fees. If a classification has less than five funds, it was excluded from the analysis. Figure 8 compares the standard deviation of funds with and without performance incentive fees (the standard deviation measures how much volatility there is in returns). In all three periods, funds with performance incentive fees have a greater annualized standard deviation of monthly returns with the greatest difference occurring in the three-year period. This is an indication that funds with performance incentive fees are more volatile, and hence, are taking on more risk than funds without performance incentive fees. In the 2008 paper, Jonathan Kreider found that in the three-year and five-year periods, funds with performance incentive fees had a higher Sharpe ratio, which led to the conclusion that performance incentive fee funds had a higher risk-adjusted return compared to classification averages. This is not the case with current data, most likely because of the economic downturn. The rolling performance data (Figure 6) showed that funds with performance incentive fees performed relatively lower than funds without performance incentive fees during the worst years of the downturn. The Sharpe ratio (Figure 9) is lower for performance incentive fee funds in all three time-periods. This means that, on average, during the downturn, a performance incentive fee funds’ risk-to-return trade-off was lower than funds without performance incentive fees.

RISK

0.00

5.00

10.00

15.00

20.00

25.00

3 Years 5 Years 10 Years

Incentive Fee Funds All Funds Incentive Fee Funds All Other Funds

Funds with performance incentive fees have a higher average annualized standard deviation higher than funds without performance incentive fees in each of the periods examined.

Note: The chart displays average annualized standard deviations for three-, five-, and ten-year periods. Classifications with less than five performance incentive fee funds have been omitted.

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PERFORMANCE INCENTIVE FEE FUNDS POST DOWNTURN SEPTEMBER 2012

FIGURE 10 ALPHA

0.08

0.06

0.04

0.02

0.00

0.02

0.04

3 Years 5 Years 10 Years

Incentive Fee Funds All Funds

Funds with performance incentive fees have a lower average alpha.

Note: The chart displays average alpha for three-, five-, and ten-year periods. Alpha is measured against the appropriate Lipper index. Classifications with less than five performance incentive fee funds have been omitted.

A similar finding emerges in the comparison of performance incentive fee funds’ alpha to the alpha of funds without performance incentive fees. In all three time-periods, funds with performance incentive fees have lower alpha than funds without performance incentive fees. This indicates that their excess return is lower than funds without performance inventive fees. Again, this coincides with the years where funds with performance incentive fees underperformed. Taken together, the risk measures indicate two findings: Performance incentive fee funds are riskier than funds without performance incentive fees evidenced by their higher standard deviations, and when current years are included, this risk is not resulting in higher returns.

FIGURE 9 SHARPE RATIO

0.00

0.05

0.10

0.15

0.20

0.25

0.30

3 Years 5 Years 10 Years

Incentive Fee Funds All Funds Incentive Fee Funds All Other Funds

Funds with performance incentive fees have a lower average Sharpe ratio than funds without performance incentive fees in each of the periods examined.

Note: The chart displays average Sharpe ratios for three-, five-, and ten-year periods. Classifications with less than five performance incentive fee funds have been omitted.

Incentive Fee Funds All Other Funds

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PERFORMANCE INCENTIVE FEE FUNDS POST DOWNTURN SEPTEMBER 2012

When it comes to comparing peers, boards may want treat funds differently if they already have performance incentive fees or if many of their peers have performance incentive fees. In circumstances when a board is renewing a contract for a fund with a performance incentive fee, the board may want to consider whether the fund has to take on too much risk in order to outperform their benchmark. To make this evaluation, the board may want to identify which of their peers have performance incentive fees and which do not. From there they can examine risk profiles and return. “Too much” risk is something that would have to be determined by the board. From an expense standpoint, the board will most likely want to consider where the fund falls in comparison to peers when the full performance incentive is realized from both a negative standpoint and a positive standpoint. For boards that have peers with performance incentives fees, the board may want to identify those funds and recognize that they are taking on more risk and that their advisor fee is not set in stone. Funds with performance incentive fees can easily be identified in the Lipper books by consulting the Exhibit entitled “Contractual Management Fee Rates and Fee Schedules.”

BOARD CONSIDERATIONS

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