Investors pay performance fees to investment advisors based on how the investments the advisor chooses perform. If the investments earn you money, you may have to pay a fee based on how much money you earned. Asset management fees are different. Advisors charge those fees based on a percentage of the total assets you have under management with the advisor. Not all advisors charge performance fees. If you are interested in working with one who does, it is helpful to know exactly what performance fees are and how they work before you move forward. SmartAsset’s free financial advisor matching service can help you find the right advisor for you based on a few simple questions.
What Are Performance Fees?
Performance fees are exactly what they sound like — fees based on the performance of the investments a manager selects for his or her clients. If the investments your advisor chooses for you meet a certain threshold, predetermined when you sign your contract with the advisor, you’ll have to pay a fee to the advisor.
These are different from management fees, which you’ll generally pay in addition to any performance fees. A percentage of assets under management generally determine management fee totals. The amount you’ll pay in management fees will also go up if your investments increase in value, because the amount of money you have in your account goes up. Some managers use a flat-fee system rather than charging a percentage of assets under management. This is much less common.
How do Performance Fees Work?
The exact way a performance fee is calculated will be determined before you sign on with a financial advisor. Generally, it will be charged as a percentage of investment profits. Fees can be charged on any profit, or they can only kick in if the management of funds outperforms a predetermined benchmark.
Hedge funds — investment products generally reserved for extremely wealthy investors — often use performance-based fees. These performance fees are a major part of how hedge fund managers make their money and how the top hedge fund managers become extremely wealthy themselves.
Pros and Cons of Performance Fees
As you consider how much a financial advisor costs, there is one major pro to performance fees — they incentivize your investment manager to earn you the most money possible, because it will in turn earn them money. This incentive could make advisors who are more inclined to be conservative and simply collect a management fee to think harder about investments and go for a big increase in value for their clients.
This also comes with a major con, though. Advisors who know that a major return could mean a big payday for them are more likely to take risks with their clients’ money that could result in a major loss of principal. While advisors are generally bound by fiduciary duty to act in the best interest of their client, performance fees could still lead advisors to take unnecessary chances with their client’s money in the hope of meeting benchmarks that will make them bigger performance fees.
How to Know if Your Advisor Charges Performance Fees
When you start a relationship with an advisor, you want to make sure you know exactly what you’ll be paying in fees. Ask questions about what types of fees he or she charges. Find out exactly what fees you’ll be paying and how they are calculated. Also be sure to ask if the advisor fees are fee-only or fee-based.
You can also check a firm’s SEC filings before you even start working with an advisor. Look up the firm with this search form. Find Item 6 in the firm’s Part 2 Brochure. This is explains if the firm’s advisors use performance fees and how they are calculated.
The Bottom Line
Some advisors charge performance fees in addition to management fees. Advisors charge these fees based on investment return. Generally the fee is a percentage of that return. Some performance fees apply to all returns. Some apply only to investment returns outperforming return expectations. While the addition of performance fees can make advisors seek bigger or returns for clients, they can also lead to advisors taking unneeded risks that result in losses for their clients.
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