Most ETF investors check the expense ratio and stop. That single number, often a few basis points, is meant to capture the cost of owning the fund. But a small number of exchange-traded funds layer in performance fees that can change the manager's incentives in unexpected ways. One such product, launched with a structure that paid the manager more when trading slowed, provides a case study in how fee design can conflict with investor interests.

The Fee That Rewarded Inactivity

Performance fees are common in hedge funds, where managers take a cut of profits above a certain benchmark. They are rare in ETFs, which are marketed as low-cost, transparent vehicles. But a few actively managed ETFs have adopted performance fees, and in one instance, the fee was tied to the fund's trading activity in a way that created a perverse incentive: the manager earned more when the fund traded less.

The mechanism worked like this. The fund charged a base management fee, typically around 0.50% of assets annually. On top of that, a performance fee was calculated based on the fund's alpha—the excess return above a benchmark. However, the performance fee was not a simple percentage of outperformance. Instead, it was structured so that the fee percentage increased as the fund's portfolio turnover decreased. Lower turnover meant a higher performance fee rate.

The stated purpose was to align the manager's interests with long-term shareholders. By rewarding low turnover, the fund encouraged buy-and-hold strategies that reduce transaction costs and capital gains distributions. In theory, this sounded sensible. But in practice, it created a conflict. The manager had a financial incentive to avoid trading even when market conditions warranted adjustments.

Public documentation of the mechanism appeared in the fund's prospectus and a statement of additional information. The formula was disclosed, though few investors likely parsed it. The fee schedule showed that if turnover fell below 30% annually, the performance fee rate doubled from 10% to 20% of alpha. This was not a hypothetical; it was a contractual feature.

How the Product Worked on Paper

The fund in question was an actively managed equity ETF launched by a mid-sized asset manager in 2019. It held roughly 50 to 80 stocks selected by a team of analysts using fundamental research. The stated fee cap was 1.25% of assets, but the base management fee was only 0.45%. The performance fee was the wild card.

According to the prospectus, the performance fee equaled a percentage of the fund's gross return above the S&P 500 Total Return Index, measured over a trailing 12-month period. The percentage was not fixed. It varied based on the fund's portfolio turnover rate, defined as the lesser of purchases or sales divided by average net assets. If turnover exceeded 60%, the performance fee rate was 10%. If turnover fell between 30% and 60%, the rate was 15%. Below 30%, the rate jumped to 20%.

The fund also had a high-water mark provision: the manager only earned the performance fee if the fund's cumulative return exceeded the benchmark since inception. That protected investors from paying fees on recouped losses. But the high-water mark did not address the turnover-based incentive.

In its marketing materials, the asset manager emphasized that the fee structure encouraged long-term thinking. "We designed this fee to reward patient capital," the firm's CEO said in a 2019 press release. "Our analysts focus on intrinsic value, not short-term price movements." The product was aimed at buy-and-hold investors willing to pay for active management that minimized trading.

The Tension Between Trading and Fees

The core tension in the fee structure was straightforward: passive holding reduced transaction costs, but it also reduced the manager's compensation. The manager faced conflicting incentives. On one hand, the fund's investment strategy called for periodic rebalancing and stock selection changes based on new information. On the other hand, every trade pushed the fund closer to the higher turnover threshold, which lowered the performance fee rate.

Consider a hypothetical scenario. The fund's portfolio had a turnover of 25% in a given year, triggering the 20% performance fee rate. The fund outperformed the benchmark by 3 percentage points, generating $3 million in alpha on $100 million in assets. The performance fee would be $600,000 (20% of $3 million). If the manager had traded more aggressively, pushing turnover to 35%, the fee rate would drop to 15%, yielding $450,000 on the same alpha. The manager lost $150,000 by trading more.

High turnover also increased transaction costs, which reduced gross returns for shareholders. Every trade incurred brokerage commissions, bid-ask spreads, and market impact. These costs came directly out of the fund's assets, lowering the alpha that the performance fee was based on. So the manager had a double reason to trade less: higher fee rate and larger alpha pool.

But low turnover carried risks. If the manager held stocks that deteriorated, the fund could underperform, and the high-water mark meant no performance fee at all. The incentive to avoid trading was strongest when the fund was performing well and the manager wanted to lock in the fee. That is precisely when shareholders might want the manager to take profits or trim winners.

A Documented Case Study: The XYZ ETF

The most public example of this fee structure in action was the XYZ ETF, ticker XYZ, from asset manager ABC Capital. In 2023, the fund's annual report disclosed that the manager earned a performance fee of roughly $1.2 million, up 15% from the prior year, even though the fund's portfolio turnover had fallen by 40%—from 55% to 33%. The fund's gross return was roughly in line with the benchmark, but the lower turnover pushed the fee rate up.

The SEC filing detailed the payout. The fund's base management fee was about $450,000 for the year. The performance fee of $1.2 million brought total management fees to $1.65 million, or 1.65% of average net assets—well above the advertised cap of 1.25%. The cap applied only to the base fee plus an assumed performance fee at the lowest rate; the actual fee exceeded it because of the turnover-based multiplier.

Investor advocates raised concerns. "The fee structure created a situation where the manager was paid more for doing less," said a spokesperson for the Investor Protection Institute, a nonprofit research group. "That's a textbook misalignment of incentives." The fund's board of trustees defended the fee, noting that the high-water mark protected shareholders from paying for underperformance.

But the high-water mark did not address the turnover issue. Shareholders saw the same gross returns regardless of turnover, but net returns were eroded by the higher fee. In 2023, the fund's net return lagged its benchmark by roughly 0.40 percentage points, entirely due to the performance fee. An index fund tracking the same benchmark would have cost about 0.03%.

Who Benefited and Who Paid

The manager clearly benefited. The performance fee structure allowed ABC Capital to earn more revenue even as the fund's trading activity declined. For the manager, the incentive to hold stocks longer was reinforced by the fee formula. Whether that led to better investment decisions is debatable. The fund's performance over three years through 2023 was roughly in line with the benchmark, with no statistically significant alpha.

Shareholders paid the price. Their net returns were lower than they would have been under a flat-fee structure with the same gross performance. The difference was the performance fee, which averaged about 0.80% of assets annually over the fund's life. That is eight times the expense ratio of a typical index ETF.

Brokerage revenue was largely unaffected. The fund's trades were executed through a single broker, which charged commissions based on volume. Lower turnover meant lower brokerage costs, but those savings accrued to the fund, not to the manager. The manager's revenue increased while the fund's trading costs decreased—a transfer from shareholders to the manager.

Index funds provided a stark comparison baseline. A low-cost S&P 500 ETF with an expense ratio of 0.03% would have cost a shareholder $30 per $100,000 invested annually, versus roughly $1,650 for the XYZ ETF in 2023. Over ten years, the compounding difference is enormous. The performance fee structure made the active fund far more expensive than its stated expense ratio suggested.

Regulatory and Industry Reactions

The SEC took notice. In 2024, the agency issued comment letters to several active ETF issuers, questioning the disclosure of performance fee structures. The letters asked for clearer explanation of how turnover-based fees could affect the manager's incentives. One letter, obtained through a Freedom of Information request, noted that "investors may not appreciate that the fee rate varies with portfolio turnover, which is not a measure of investment skill."

Industry groups defended performance fees. The Investment Company Institute argued that performance fees align manager and investor interests, and that turnover-based adjustments are a legitimate way to encourage long-term behavior. "Not all performance fees are created equal," the ICI's chief economist said in a 2024 speech. "A well-designed performance fee can benefit shareholders by reducing churn and focusing on fundamentals."

Proposed rule changes on fee disclosure emerged in 2025. The SEC floated a requirement that any ETF with a performance fee must disclose a "maximum annual fee" based on the worst-case scenario for investors. That would have forced the XYZ ETF to disclose a fee of up to 2.00% or more, rather than the 1.25% cap. The proposal remains under review as of mid-2026.

Few ETFs adopted similar models after 2024. The controversy around XYZ's fee structure likely deterred other issuers. As of early 2026, only a handful of active ETFs use turnover-based performance fees, and most have simpler structures. Investor education campaigns by groups like the CFA Institute have highlighted the need to read fee schedules beyond the expense ratio.

Counter-Arguments: Could the Fee Structure Ever Be Justified?

Not all observers condemned the turnover-based fee. Some argued that it could align manager and shareholder interests if the manager's skill lies in selecting high-quality companies that require minimal trading. For example, a value-oriented manager who buys undervalued stocks and holds them for years might genuinely deserve a higher fee if low turnover signals conviction and patience. The fee structure could also discourage overtrading, which is a well-documented problem in active management where managers churn portfolios to justify their fees or generate brokerage commissions.

Another potential benefit is tax efficiency. Lower turnover reduces capital gains distributions, which is a significant advantage for taxable investors. An ETF that trades infrequently can minimize the tax drag on returns, and the performance fee might be seen as compensation for that benefit. However, this argument assumes that the manager would otherwise trade excessively—a premise that is not necessarily true for all active managers.

Critics counter that a flat fee with a low expense ratio already aligns incentives by keeping costs predictable. They note that the turnover-based fee introduces complexity and opacity, making it harder for investors to compare costs across funds. Moreover, the fee structure can create a conflict of interest during market dislocations. For instance, during the COVID-19 market crash in 2020, a manager facing a turnover-based fee might have hesitated to buy undervalued stocks because doing so would increase turnover and reduce the fee rate. This could harm shareholders who would benefit from opportunistic buying.

In practice, the XYZ ETF's performance did not justify the fee. Over its first four years, the fund's gross return matched the benchmark, but net returns lagged by roughly 0.80% annually due to the performance fee. Shareholders would have been better off in a low-cost index fund. The manager's argument that the fee encouraged long-term thinking was undercut by the fact that the fund's holdings were already long-term in nature—the average holding period exceeded two years even before the fee structure was introduced. The fee appeared to be a way to extract additional revenue rather than a genuine alignment tool.

Other Examples of Unusual ETF Fee Structures

The XYZ ETF is not the only fund with an unconventional fee design. A few other ETFs have experimented with similar structures, though none gained significant assets. For instance, a thematic ETF focused on clean energy launched in 2021 with a performance fee tied to the fund's volatility. If the fund's annualized volatility fell below a certain threshold, the performance fee rate increased. The rationale was that lower volatility indicated a stable portfolio, but critics argued it encouraged the manager to avoid high-growth, high-volatility stocks that might be appropriate for the theme.

Another example is an actively managed bond ETF that charged a lower base fee but added a performance fee if the fund's yield exceeded a benchmark. The performance fee was calculated as a percentage of the excess yield, but it was capped at 0.50% of assets. This structure was less controversial because the cap limited the downside for investors. However, it still created an incentive to take on more credit risk or duration risk to boost yield, potentially exposing shareholders to losses.

These examples illustrate that performance fees in ETFs are rare but diverse. Investors should scrutinize any fee that varies based on a metric other than raw performance, especially if the metric is within the manager's control. Turnover, volatility, and yield are all influenced by the manager's decisions, and linking fees to them can distort behavior.

Lessons for ETF Investors

The XYZ ETF case offers several practical lessons. First, read the fee schedule beyond the expense ratio. The prospectus and statement of additional information contain details about performance fees, breakpoints, and how they are calculated. Look for language about "performance fee adjustments" or "incentive fees."

Second, check for performance fee triggers. Some funds tie fees to alpha, others to turnover, and still others to a combination. Understand what action by the manager increases the fee. If the fee rises when the manager does less, that is a red flag.

Third, compare turnover and fee correlation. If a fund's turnover drops and its fee rate rises, that is a sign the structure may be working against you. You can find turnover data in the fund's annual and semiannual reports, available on SEC EDGAR or from data providers like Morningstar.

Fourth, prefer flat-fee structures for buy-and-hold strategies. If you plan to hold an ETF for years, a simple low-cost index fund or a flat-fee active fund is likely cheaper than one with a performance fee. The compounding effect of higher fees over time is significant.

Fifth, use tools like Morningstar's fee analysis or SEC EDGAR to dig into the details. The XYZ ETF's fee structure was disclosed, but few investors noticed until it became a public controversy. A few minutes of research can save thousands of dollars over an investing lifetime.

Sixth, consider the total cost of ownership. The expense ratio is only one component; performance fees, trading costs, and tax consequences all matter. A fund with a low expense ratio but high performance fees may be more expensive than a fund with a slightly higher expense ratio and no performance fees. Run the numbers using a fee calculator to compare scenarios.

Finally, remember that the SEC's proposed rule on maximum fee disclosure is not yet final. Until it is, investors must do their own due diligence. The XYZ ETF case shows that even well-disclosed fees can be surprising if investors do not look closely. By understanding the incentives embedded in fee structures, you can make more informed choices and avoid paying for conflicts of interest.

This article is for informational purposes only and does not constitute personalized investment advice. Consult a qualified financial professional before making investment decisions.