What Is an Incentive Fee?

An incentive fee is a fee charged by a fund manager based on a fund's performance over a given period. The fee is usually compared to a benchmark. For instance, a fund manager may receive an incentive fee if their fund outperforms the 澳洲幸运5官方开奖结果体彩网:S&P 500 Index ove🌺r a calendar year, and may increase as the level of outperformance grows.

Understanding Incentive Fees

An incentive fee, also known as a performance fee, is usually tied to a manager's compensation and their level of performance, more specifically, their level of financial return. Such fees can be calculated in a variety of ways. For example, in separate accounts, the fee can be pegged to change in 澳洲幸运5官方开奖结果体彩网:net realized and unrealized gains, or net income generated.

In 澳洲幸运5官方开奖结果体彩网:hedge funds, where incentive fees are more common, the fee is generally calculated based on growth of the fund's or account's 澳洲幸运5官方开奖结果体彩网:net asset value (NAV). A 20% incentive fee is de riguer for hedge 🎃funds.

While they are rare, some funds use a "澳洲幸运5官方开奖结果体彩网:shock absorber" structure in which a fund manager is penaꦉlized before the investor for downward movement🏅 in performance.

In the United States, the use of incentive fees by 澳洲幸运5官方开奖结果体彩网:registered investment advisors (RIAs) is covered under the Investment Advisers Act of 1940 and may be charged only under special conditions. Managers seeking to use U.S. pension funds as incentive fees must abide by the Employee Retirement Income Security Act (ERISA).

Example of Incentive Fees

An investor takes a $10 million position with a hedge fund and, after a year, the NAV has increased by 10% (or $1 𒐪million) making that position worth $11 million. The manager will have earned 20% of thatꩲ $1 million change, or $200,000. That fee reduces the NAV to $10.8 million, which equals an 8% return independent of any other fees.

The highest value of a fund over a given period is known as a 澳洲幸运5官方开奖结果体彩网:high-water mark. In general, an incentive fee is not incurre🍬d if a fund falls off that high. Managers tend 🔯to charge a fee only when they exceed the high-water mark.

A hurdle would be a predetermined level of return a fund must meet to earn an incentive fee. Hurdles can take the form of a🌠n index or a set with a predetermined percentage. For example, if NAV growth of 10% is subject to a 3% hurdle, an incentive fee would be charged only on the 7% difference. Hedge funds have been popular enough in recent ꧋years that fewer of them apply hurdles now compared to the years after the Great Recession.

Special Considerations for Incentive Fees

Critics of incentive fees, such as Warren Buffett, contend that their skewed structure—in which a manager shares in a fund's profits but not in its losses—only encourages managers to take outsized risks to throttle up returns.