With financial advisors being required to report more thoroughly on fees and performance, the importance of delivering value for clients has been put into sharp relief. The basic premise is that if an investment does not get much return, high fees should not be justified.
With that in mind, it may be time to consider actually linking fees to performance. This is possible in a “fulcrum fee” structure, where the fee charged for managing a fund is dependent on how the fund did relative to a benchmark. The approach has been adopted for some mutual funds – and, according to a Financial Advisor
report, it is being applied to an ETF.
The newly launched AdvisorShares Equity ETF was deployed with fulcrum fees, which are supposedly meant to attract investors who are looking for reasonable value. The ETF has a stated expense ratio of 0.75%, but it can go up to 0.85% if its returns exceed the S&P 500 by at least two percentage points. The expense ratio would go down on a sliding scale, reaching a minimum of 0.65% if it were to lag the S&P 500 by two percentage points.
The fulcrum fee structure not only protects investors’ interests, but it also incentivizes fund managers to do well. However, it is also a risk to managers since they’ll take a hit in case they underperform the agreed-upon benchmark, so it’s still up in the air whether other ETF providers would care to follow AdvisorShares’ lead.
“Most ETFs are built to mimic benchmarks, not exceed them, so many funds lack an incentive to outperform,” said Todd Rosenbluth, director of ETF and mutual fund research at S&P Global Market Intelligence. However, the model does make sense for funds that aim to outperform, such as smart-beta ETFs and active ETFs.
Another hurdle for providers is the fact that advisors might find such a fee structure too complicated and unpredictable, which would dissuade them from considering funds that use such a structure for inclusion in their clients’ portfolios.
Still, with fee pressures foreseen to increase as CRM2 reporting standards are being rolled out, it may very well be in advisors’ and providers’ interests to adopt that sliding fee structure – one where they’ll at least be able to justify sliding fees upward.
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