What is Performance-Based Compensation

Performance-based compensation is an incentive-based form of compensation that can be paid to portfolio managers. Regulated mutual funds with performance-based compensation may add approximately 0.20% to their management fees for performance-based incentives. Within the investment industry, hedge fund managers are most well known for receiving high levels of performance-based compensation.

BREAKING DOWN Performance-Based Compensation

Performance-based compensation is an incentive-driven compensation schedule for paying portfolio managers. It can be used in traditional investment management. In the hedge fund industry it is generally standard for funds to charge performance-based fees.

Investment Company Compensation

The Investment Company Act of 1940 governs the mutual fund industry and sets certain requirements that have helped to shape the compensation standards for portfolio managers. Investment companies must have a board of directors that approves the compensation schedule of managers. Companies must also file a registration statement including a prospectus and statement of additional information, clearly and transparently outlining all the information on the fund including compensation. Standards and documentation for publicly traded funds are generally expected to be consistent across the industry for easy comparison by investors. This consistency has also generally led to standardized fees charged by mutual fund managers as part of the fund’s total annual operating expenses.

Mutual fund portfolio management fees can range from 0.50% to 2.50% with active fund managers requiring a higher compensation. Portfolio management fees typically comprise the majority of a mutual fund’s total annual operating expenses. Across the industry mutual fund managers can also receive performance-based fees. These fees are detailed in their registration statement documentation and approved by the board of directors.

Fidelity is one mutual fund company offering performance-based compensation for many of its funds. The fund company has integrated performance-based compensation into its management since 1970. Approximately two-thirds of the funds managed to active equity investment objectives include performance-based compensation. The compensation is much lower than hedge funds with the mutual fund’s potentially allowing for an extra 0.20% added to the management fee when a fund meets certain performance criteria. Inversely, fees can also be substracted when fund performance is below expectations.

Hedge Fund Manager Compensation

Across the investment industry, hedge fund managers are more broadly known for their performance-based fees. Hedge funds are much less regulated than traditional mutual funds and therefore have greater latitude for fee schedule structuring. Hedge fund managers will typically charge a "two and twenty" fee schedule requiring higher management fees than mutual funds from their investors. The two and twenty hedge fund fee structure indicates a flat 2% fee as well as a 20% performance fee. The 2% fee is based on the fund’s assets under management. The 20% fee is a performance-based compensation that is typically triggered when performance outperforms a benchmark by a specified amount. The 20% fee is paid to the hedge fund manager from the fund’s profits.