Incentive Fee

What Is an Incentive Fee?

An incentive fee is a fee charged by a fund manager in view of a fund's performance over a given period. The fee is typically compared to a benchmark. For example, a fund manager might receive an incentive fee on the off chance that their fund outperforms the S&P 500 Index over a calendar year, and may increase as the level of outperformance develops.

Understanding Incentive Fees

An incentive fee, otherwise called a performance fee, is normally tied to a manager's compensation and their level of performance, all the more explicitly, their level of financial return. Such fees can be calculated in different ways. For instance, in separate accounts, the fee can be pegged to change in net realized and unrealized gains, or net income produced.

In hedge funds, where incentive fees are more normal, the fee is generally calculated in light of growth of the fund's or alternately record's net asset value (NAV). A 20% incentive fee is de riguer for hedge funds.

While they are rare, a few funds utilize a "shock absorber" structure in which a fund manager is punished before the investor for descending movement in performance.

In the United States, the utilization of incentive fees by registered investment advisors (RIAs) is covered under the Investment Advisers Act of 1940 and might be charged exclusively under special conditions. Managers seeking to utilize U.S. pension funds as incentive fees must abide by the Employee Retirement Income Security Act (ERISA).

Illustration of Incentive Fees

An investor takes a $10 million position with a hedge fund and, following 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 lessens the NAV to $10.8 million, which equals a 8% return independent of some other fees.

The highest value of a fund over a given period is known as a high-water mark. As a general rule, an incentive fee isn't incurred assuming a fund tumbles off that high. Managers will generally charge a fee just when they surpass the high-water mark.

A hurdle would be a predetermined level of return a fund must meet to earn an incentive fee. Hurdles can appear as an index or a set with a predetermined percentage. For instance, if NAV growth of 10% is subject to a 3% hurdle, an incentive fee would be charged exclusively on the 7% difference. Hedge funds have been famous enough in recent years that less of them apply hurdles currently compared to the years after the Great Recession.

Special Considerations for Incentive Fees

Pundits of incentive fees, like Warren Buffett, fight that their slanted structure — in which a manager shares in a fund's profits yet not in its misfortunes — just urges managers to face outsized challenges to choke up returns.

Highlights

• Pundits of these fees recommend that they urge managers to face outsized challenges to help returns.
• A fund manager could receive an incentive fee on the off chance that a fund performs above and beyond a given period.
• The fee amount can be founded on net realized gains, net unrealized gains, or net income produced.
• A 20% incentive fee is ordinary for hedge funds.