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 and usually compared to a benchmark. For instance, a fund manager may receive an incentive fee if his or her fund outperforms the S&P 500 Index over a calendar year, and may increase as the level of outperformance grows.

BREAKING DOWN 'Incentive Fee'

An incentive fee, also known as a performance fee, is usually used to tie a manager's compensation to 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 fund 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 (RIA) is covered under the Investment Advisers Act of 1940 and may be charged under only special conditions. Managers seeking to use incentive fees to U.S. pension funds must abide by the Employee Retirement Income Security Act (ERISA).

Incentive Fee Example

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 isn't 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, 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 utilize hurdles now compared to the years after the Great Recession.

Incentive Fee Criticism

Critics of inventive 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 temps managers to take outsized risks to throttle up returns. 

RELATED TERMS
  1. Performance Fee

    A performance fee is a payment made to an investment manager ...
  2. Fee Structure

    A fee structure describes how an entity is to be compensated ...
  3. Fee

    A fee is a fixed price charged for a specific service and is ...
  4. Bank Fees

    Bank fees are nominal fees for a variety of account set-up and ...
  5. Service Charge

    A service charge is a type of fee collected to pay for services ...
  6. Junk Fees

    Nebulous charges assessed at the closing of a mortgage that go ...
Related Articles
  1. Personal Finance

    Do You Know How Your Financial Advisor Is Paid?

    It is important to understand how your financial planner is compensated.
  2. Investing

    Are Fees Depleting Your Retirement Savings?  

    Each retirement account will have a fee associated with it. The key is to lower these fees as much as possible to maximize your return.
  3. Trading

    Eddy Elfenbein on Asset Fund Management Fees

    The Founder of Crossing Wall Streets talks about buy-side fund managers having to stick to traditional incentive fees versus management fees.
  4. Investing

    The Costs of Investing

    text
  5. Financial Advisor

    How to Know if Your 401(k) Plan Fees Are Too High

    Finding out how much you are paying for your 401(k) plan takes some research, but you should know exactly what you are getting for your money.
  6. Investing

    Investors: Your Fees Are Probably Too High

    The lower your fees, the higher your returns. Here's how to find out if you're paying too much for your investments.
  7. Personal Finance

    Watch Out for "Junk" Mortgage Fees

    So many fees are tacked onto a mortgage, that it's easy to pay more than you have to.
  8. Personal Finance

    Cut Your Bank Fees

    Find out how to get the bank to pay you for using their services, not the other way around.
  9. Retirement

    The Hidden Fees in 401(k)s

    Learn about the conspicuously disclosed fees that lurk within your 401(k) investments.
RELATED FAQS
  1. What are typical trust fund management fees?

    Learn about trust fund management fees, such as the annual management fee, annual expense ratio, brokerage commissions, and ... Read Answer >>
  2. What kinds of fees are involved in futures trading?

    Learn what the various costs are that are charged by brokerage firms and trading exchanges to individual futures trading ... Read Answer >>
Hot Definitions
  1. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  2. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  3. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
  4. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency ...
  5. Interest Coverage Ratio

    The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a company can pay interest ...
  6. Cash Conversion Cycle - CCC

    Cash conversion cycle (CCC) is a metric that expresses the length of time, in days, that it takes for a company to convert ...
Trading Center