What is a Performance Fee?
A performance fee is a payment made to an investment manager for generating positive returns. This is as opposed to a management fee, which is charged without regard to returns. A performance fee can be calculated many ways. Most common is as a percentage of investment profits, often both realized and unrealized. It is largely a feature of the hedge fund industry, where performance fees have made many hedge fund managers among the wealthiest people in the world.
Understanding Performance Fees
The basic rationale for performance fees is that they align the interests of fund managers and their investors, and are an incentive for fund managers to generate positive returns. A "2 and 20" annual fee structure—a management fee of 2% of the fund's net asset value and a performance fee of 20% of the fund's profits—is a standard practice among hedge funds.
Example of a Performance Fee
Imagine an investor takes a $10 million position with a hedge fund and after a year the net asset value (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. If the fund falls from that high, generally a performance fee isn't incurred. Managers tend to charge a fee only when they surpass the high-water mark.
Hurdles and Performance Fees
A hurdle would be a predetermined level of return a fund must meet to earn a performance fee. Hurdles can take the form of an index or a set, predetermined percentage. For example, if NAV growth of 10% is subject to a 3% hurdle, a performance fee would be charged only on the 7% difference. Hedge funds have been popular enough in recent years that fewer of them utilize hurdles now compared to the years after the Great Recession.
Critics of performance fees, including Warren Buffett, opine that the skewed structure of performance fees — where managers share in the funds' profits but not in their losses — only tempts fund managers to take greater risks to generate higher returns.
Performance Fee Regulation
Performance fees charged by U.S. registered investment advisors fall under the Investment Advisers Act of 1940 and fees charged to pension funds governed by the Employee Retirement Income Security Act (ERISA) must satisfy special requirements. Hedge funds are, of course, outside of this group.
FAQs
The standard performance fee in the hedge fund is 20% of investment profit. As an example, if a fund has a profit of $1 million over the course of year, the hedge fund manager would receive a performance fee of $200,000. Many funds have a "hurdle rate" that a manager must exceed before they earn their performance fees.
What is an example of a hedge fund performance fee? ›
Example of a Performance Fee
Imagine an investor takes a $10 million position with a hedge fund and after a year the net asset value (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.
What is an example of performance fee calculation? ›
Fee calculation example
- The investment returns USD 100 in profit this month, bringing profit since inception to USD 100.
- The incremental profit is therefore USD 100 while the profit threshold is USD 0 (since this is the first month).
- This calculates the performance fee: (USD 100 - USD 0) * 10% = USD 10.
A typical FoF fee would be “1 and 5”, which means a 1% management fee on your investment plus a 5% performance fee on the gains from the investment. Similar to individual funds, most FoFs also have to meet a certain hurdle rate in order to receive their share of the performance fee, also known as 'carried interest'.
What is the difference between performance fee and incentive fee? ›
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.
What is the difference between carried interest and performance fee? ›
Carried interest is due to general partners based on their role rather than an initial investment in the fund. As a performance fee, carried interest aligns the general partner's compensation with the fund's returns. 1 Carried interest is often only paid if the fund achieves a minimum return known as the hurdle rate.
How do you determine the performance of a hedge fund? ›
Benchmarking Hedge Fund Returns
Traditional equity or fixed income performance is often evaluated by comparing the returns against an industry benchmark. This makes it possible to determine how much value the manager has added to the fund over what could have been achieved by investing in the benchmark fund.
How is a performance fee charged? ›
It is the fee paid to the fund managers to make an expected return on investment. How often are performance fees charged? The fee is calculated annually, quarterly, or monthly depending on the investment criteria. It is calculated via two methods: the measurement period and the other is the high-water mark.
What is a 20% performance fee? ›
The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a performance fee. 2% represents a management fee which is applied to the total assets under management. A 20% performance fee is charged on the profits that the hedge fund generates, beyond a specified minimum threshold.
What is a pay for performance fee? ›
A pay-for-performance fee structure, in relation to the investment industry, describes a management fee that is paid to a financial adviser or investment manager when their performance returns exceed those of their designated benchmark.
Incentive fee is usually calculated on profits net of management fees or on profits before management fee. Sometimes, the incentive fee is paid only if the returns exceed a hurdle rate. In some cases the incentive fee is paid only if the fund has crossed the high watermark.
Who can charge performance fees? ›
1 Rule 205-3 permits registered investment advisers to charge qualified clients a performance fee.
What is a fund performance fee catch up? ›
The purpose of a catch-up clause is to compensate the General Partner based on an investment's total return rather than the return in excess of the preferred return. In other words, a catch-up is used to compensate the GP for the incentive fees lost due to a preferred return.
What is performance fee on ETF? ›
In some cases, an ETF may charge a 'performance fee', which is charged only if the performance of the ETF is better than a specified benchmark over a defined period.
What is the accrual of performance fee? ›
An accrual for the performance fee is calculated on each Dealing Day and forms part of the Net Asset Value for each Share Class and therefore the performance fee accrual is reflected in the price of the Shares.
What is a high on high performance fee? ›
The SFC requires that performance fees can only be charged on a "high-on-high" basis, i.e. only when the fund has achieved absolute improvement in returns by consistently outperforming its previous "all time high" in terms of net asset value per unit.
What is an example of a fund management fee? ›
A simple management fee is applied as a percentage of the total assets under management. Suppose you're planning to invest $100,000, and an investment firm offers you an investment opportunity with a management fee of 0.45% per year. In this case, you would be charged $450 a year in management fees.
What is an example of hedging pricing? ›
So, if you own XYZ stock from $100 and want to hedge against a 10% loss, you can buy the 90-strike put. This way, if the stock were to drop all the way to, say $50, you would still be able to sell your XYZ shares at $90.
What are typical hedge fund expenses? ›
These typically include legal fees, audit & tax expenses, and third-party administration costs. They may also include more vague costs such as professional fees and research expenses. Operating expenses are costs charged to the fund and therefore are passed through as a cost to the investor.
What is a hedge fund performance fee high water mark? ›
A high-water mark ensures that investors do not have to pay performance fees for poor performance, but, more importantly, guarantees that investors do not pay performance-based fees twice for the same amount of performance.
