Investors pay performance fees to investment advisors based on how much money is earned from the investments that are chosen. Asset management fees are different. Advisors charge those fees based on a percentage of the total assets held under advisor management. Not all advisors charge performance fees. But if you’re interested in growing your savings and investments with a financial advisor, you should know how much you will have to pay for services. Let’s break down how performance fees work.
What Are Performance Fees?
Performance fees are based on the performance of investments that are chosen for clients by an advisor. If the selected investments meet a certain threshold that is predetermined in a contract with the advisor, then you’ll have to pay a fee.
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 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, which are 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.
But this advantage also comes with a major disadvantage. 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 which 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.
Additionally, make sure you 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 explains whether the firm’s advisors use performance fees and how they are calculated.
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 returns for clients, they can also lead to advisors taking unneeded risks that result in losses.
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