It is a widespread practice among mutual fund managers to voluntarily waive fees that they have a contractual right to claim. This fact is puzzling and changes how contractual fees should be interpreted by investors, regulators, and academic researchers. Notably, the effective fee charged may be substantially less than indicated in expense ratios and may vary over the year despite a constant contractual fee. This study argues that fund managers use fee waivers instead of a flat contracted fee because waivers provide flexibility. Flexible fees are desirable since managers can strategically adjust net advisory fees to current realization in performance as a means of attracting investors. However, it is costly for managers to attain full flexibility in fees since waivers are less effective in attracting investors than simply lowering contracted fees. Because waivers can change through time, investors prefer funds that lower contracted fees rather than waive. The model and the empirical results confirm this. In light of this cost, there is still incentive to waive. Managers choose waivers as a flexible means of bolstering net performance to attract investors and build asset size. Therefore, a fund is apt to waive when (i) the fund performs poorly and (ii) investors are extremely sensitive to net performance. Both these relations are found in the empirical tests of money market funds. In contrast, there is no evidence that waivers in equity funds depend on the gross returns of the fund. Instead, waivers in equity funds depend on a discrete measure of performance: Morningstar ratings. Gaining a Morningstar rating increases the investors attracted to the fund more significantly than moving ahead in the cross-sectional distribution of returns because Morningstar ratings are more easily understood and observed by investors. The incentive to waive is therefore high near the cut-off points between Morningstar ratings. In general, this analysis of fee waivers highlights that the fee decision is complicated by the combined decisions of the investor, manager, and regulators. From a researcher's perspective, there is more to mutual fund fees than meets the eye.
