Performance fees are used by only 1 per cent of Unit Trusts and OEICs in the UK, three years after the ban on these fee structures was lifted, according to a new report by Lipper. A comparison between open-ended and closed-ended funds in the UK, found that only 30 retail-oriented open-ended funds have performance-related fees in place, representing only 1 per cent of such funds domiciled in the UK, while for closed-ended funds the figure is nearly 50 per cent. Closed-ended funds were unaffected by the Financial Services Authority's ban on performance fees, whereas their open-ended counterparts had only been able to charge such fees since 2004. To this extent, said the report, the different proportions of funds may reflect this historic difference, rather than a structural distinction. The use of performance fees varied widely around Europe. The UK had the smallest proportion of open-ended collective funds with performance fees in Europe. At the other end of the scale, in Italy over two thirds of collective funds had a performance fee structure in place. The research suggested that each of the other major European fund markets have between 10 per cent and 20 per cent of funds with performance fee structures. Under Securities and Exchange Commission regulations, US performance fees must have an upside and a downside, known as a “fulcrum fee”; when the fund performs better than its benchmark, the bonus is positive; when the fund underperforms, there is a deduction from the bonus of the same percentage. The largest companies using these structures include Fidelity, Vanguard and Janus, but Lipper research shows that the overall proportion of open-end funds using such structures remains at just over 2 per cent. In contrast to the UK, discussion has focused on better aligning fund company interests with those of investors during more difficult market conditions. In a previous report Lipper identified a divergence between the fee levels for active and passive funds in Europe: the former rising and the latter falling. Accentuating this was the growing number of collective funds aiming to generate alpha, which would encourage a fee structure more similar to hedge funds - including performance fees. These characteristics had been seen most obviously in the UK in the growing number of “130/30” funds. For the promise of delivering superior returns regardless of market conditions, hedge funds have a commensurate price tag: typically 1 or 2 per cent annual management fee, together with a median performance fee of 20 per cent of net gains. The report said it was likely to be these fee structures, rather than those found in the US, that would influence the performance fee levels of UK collective funds. In principle, said Lipper, one would anticipate fixed management fees to be lower for funds with a performance fee structure but administrative costs to be higher - potentially pushing up the Total Expense Ratio. For closed-ended funds, Lipper's findings showed that average management fees were lower for funds with performance fee structure by between 7 and 12 basis points, whereas average TER levels (excluding performance fees) the difference in average fees narrows. Indeed, the asset-weighted average TER for trusts without a performance fee was only very slightly lower than for those with a performance fee. For cross-border funds in Luxembourg and Ireland – actively managed equity funds promoted by US or UK promoters – the average management fee for those funds without a performance fee in place is higher than those with such a fee arrangement, by 14 to 20 basis points. Among cross-border funds, simple average TERs are lower for funds without performance fees, but the levels are similar. But when the TER averages were weighted by fund assets, those funds with a performance fee were able to overcome their significantly smaller size (£88.8 million ($180 million) compared to £170.5 million) and had an average TER well below those funds without such a fee. As a guide for investors and fund companies, the report provides a "checklist" of factors to be considered when assessing performance fees: • On what basis is the performance calculated? (For example, the return of the fund only, or the difference between the return of the fund and a reference benchmark). • What performance fee rate is applied? • Are there reference benchmarks (index and/or hurdle rate)? If so, what are these? • Is there a High Water Mark? If so, how is this structured? • What are the accrual and crystallisation frequencies? • Is there a sliding scale? If so, what is the rate? • Is there an equalisation system in place? What system is used? • Is there a minimum fee? Or a maximum fee? • Are there any penalties for under-performance?