Understanding Incentive Fees: How Fund Managers Get Paid

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 S&P 500 Index over a calendar year, and may increase as the level of outperformance grows.

Key Takeaways:

• A fund manager might receive an incentive fee if a fund performs well over a given period.
• The fee amount can be based on net realized gains, net unrealized gains, or net income generated.
• A 20% incentive fee is typical for hedge funds.
• Critics of these fees suggest that they encourage managers to take outsized risks to boost returns. 

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 net realized and unrealized gains, or net income generated.

In hedge funds, where incentive fees are more common, the fee is generally calculated based on growth of the fund's or account's net asset value (NAV). A 20% incentive fee is de riguer for hedge funds.

While they are rare, some funds use a "shock absorber" structure in which a fund manager is penalized before the investor for downward movement in performance.

In the United States, the use of incentive fees by 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 million) making that position worth $11 million. The manager will have earned 20% of that $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 high-water mark. In general, an incentive fee is not incurred 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 an 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.