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.

Breaking Down 'Performance Fee'

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 — has become standard practice among hedge funds.

Performance 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. 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.

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.

 

RELATED TERMS
  1. Incentive Fee

    An incentive fee is a fee charged by a fund manager based on ...
  2. Brokerage Fee

    A brokerage fee is fee charged by a broker to execute transactions ...
  3. Redemption Fee

    A redemption fee is a fee charged to an investor when shares ...
  4. Layered Fees

    Layered fees are a type of fee schedule that leaves investors ...
  5. Costs And Expenses

    Costs and expenses are the expenses associated with running a ...
  6. Bank Fees

    Bank fees are nominal fees for a variety of account set-up and ...
Related Articles
  1. Investing

    8 Investing Fees That You Should Never Pay

    In investment management and financial planning there are a plethora of fees that are unnecessary.
  2. Investing

    Everything You Know About Investor Fees

    Investment fees are one of the main determinants of investment returns, and over time, minimizing fees tends to maximize performance. Use this guide today.
  3. Personal Finance

    Do You Know How Your Financial Advisor Is Paid?

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

    Are Hidden Fees Eroding Your Participants’ Return?

    Plan sponsors need to know the fees associated with their plan to determine if they are reasonable.
  5. Retirement

    How a 1% Annual Fee Can Ruin Your Nest Egg

    What kind of impact does an annual 1% fee have on your portfolio? The answer may surprise you.
  6. Retirement

    Stop Paying High Workplace Retirement Plan Fees

    Don't pay more in fees for your company-sponsored retirement plan than you have to.
  7. Retirement

    401(k) Fees You Need To Know

    Many workers are largely unaware of the various fees that their plans charge them, or what the fees are for.
  8. Investing

    Hedge Funds: Higher Returns Or Just High Fees?

    Discover the advantages and pitfalls of hedge funds and the questions to ask when choosing one.
  9. 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.
Trading Center