The First Financial Fund, and for that Matter All CEFs, Should Adopt Performance Fees (FF)

Shareholders of the First Financial Fund (FF) will be given the opportunity to vote on a proposed increase in the management fee paid to Wellington Management at the upcoming shareholder meeting. According to the proxy, the expense ratio would have been raised from 1.02% to 1.38% through 3/31/2006 if the proposed fee structure had been in place. With the board’s support, the fee increase should be easily approved, and if I were a First Financial shareholder, I would probably vote for the increase if Nicholas Adams would otherwise stop managing the fund.

However, instead of just raising the management fees, I would rather see the fund employ some sort of performance fee. This would be good for shareholders because they would not have to pay the higher fees if the fund does not continue to outperform its benchmarks, and it could be better for Wellington as long as the fund remains a top performer.

FF 1-yr chart:

Actually, I would like to see almost all closed-end funds adopt performance fees. This would more closely align the fund managers’ interests with those of the shareholders. Of all investment vehicles, performance fees would probably be most appropriate for closed-end funds because of their relatively stable asset bases. With open end funds, above average performance leads to more assets being invested in the fund, which means more fees for the managers. The opposite happens when there is poor performance. So these managers have a strong economic incentive to outperform their peers that closed-end managers don’t have.

In the end, I would prefer having to pay more in fees to an outstanding manager if it meant that I would not face insult being added to injury by having to pay the same fees for the worst performing fund in a category that someone else paid for the best performing fund.

I would still choose closed-end funds over open end funds in almost all cases for my own portfolio, but the addition of performance fees (partially offset by lower asset based fees) would make closed-end funds an even more attractive alternative.