Portfolio Manager Incentives and Compensation

A portfolio manager may charge a fee for portfolio management (actually making the trading decisions) in two ways: a management fee and a performance incentive fee. A management fee is typically an annual percentage that is typically paid quarterly, though it may be paid monthly. The management fee is typically a reflection of the portfolio managers style, skill, and track record. For example:

• A passive asset allocator may charge only 0.20% per year billed quarterly at 0.05% if the only service is asset allocation and re-balancing. 
• A conventional manager with a relative performance objective attempting to outperform a passive benchmark may charge a management fee of 1-1.5% depending on other factors. 
• An alternative investment manager with an absolute return objective who has a track record may charge a management fee of 2% or more. Alternative investment managers typically offer their investment programs in either as a private hedge fund structure (an LLC or LP) offered by private placement to Accredited Investors or in more rare cases as a separately managed account (the manager makes the trading decisions in an account at a brokerage firm or bank titled in your name). In addition, most alternative managers charge a perforamance incentive fee designed to allign their interest with investors. A performance fee is calculated as a percentage of the fund's net new high profits. By motivating the manager to generate returns, performance fees are intended to align the interests of manager and investor more closely than flat fees. Alternative investment managers use the performance fee ifor staff bonuses and so can be extremely lucrative for managers who perform well. Tyically, an alternative manager will charge a management fee of 2% annually and a performance incentive fee of 20% net new high profits. 

Below are some interesting definitions from other sources:

Management Fees

Management fees should be used to cover operating expenses only, and are not appropriate funding sources for staff bonuses, business reinvestment, strategy expansion, or wealth accumulation by partners. Managers should consider implementing a tiered management fee structure, as in the traditional asset management industry, so that large investors do not subsidize an unduly large share of operational costs. 

Asset managers’ incentive to run “asset gathering” businesses instead of “asset management“ businesses have been overstretched because of the profitability derived from the industry standard 2% management fee. Assuming economies of scale, costs should fall as managers grow their assets under management. Investors should consider management fee schedules that ratchet down as the firm or strategy AUM increase to certain hurdle rates. For example, management fees of a single strategy.

Performance Fees

Performance fees should create alignment of incentives through timing mechanisms (e.g. deferments, holdbacks, and/or claw backs), appropriate hurdle rates, and egalitarian terms for all investors. One of the greatest strengths of the hedge fund industry is the alignment of interest that is created with “pay for performance” carry fee structure. Performance fee terms should be amended to include payment that matches the duration of an investment horizon. Two examples:

1) performance fees ought to be paid at the end of a lock‐up period or

2) a deferred payment schedule where a portion of the performance fee (50%) is paid in year one and the remainder (50%) is paid in the following year.

Lastly, managers should not be paid carry for cash returns and investors should recoup at least a portion of management fees paid. All performances fee should be accrued above an appropriate hurdle of T‐Bills plus Management Fees.

Source: Utah Retirement Systems Investment Group, Summary of Preferred Hedge Fund Terms

From Wikipedia:

A hedge fund manager will typically receive both a management fee and a performance fee (also known as an incentive fee) from the fund. Hedge funds use varying fee structures,^[19]however they typically charge fees of "2 and 20", which refers to a management fee of 2% of the fund's net asset value each year and a performance fee of 20% of the fund's profit, although this charging structure has come under pressure recently as fund returns have declined.

Management fees

As with other investment funds, the management fee is calculated as a percentage of the fund's net asset value. Management fees typically range from 1% to 4% per annum, with 2% being the standard figure.^[21][22] Management fees are usually expressed as an annual percentage, but calculated and paid monthly or quarterly.

The business models of most hedge fund managers provide for the management fee to cover the operating costs of the manager, leaving the performance fee for employee bonuses. However, the management fees for large funds may form a significant part of the manager's profits.^[23] Management fees associated with hedge funds have been under much scrutiny, with several large public pension funds, notably CalPERS, calling on managers to reduce fees.

Performance fees

Performance fees (or "incentive fees") are one of the defining characteristics of hedge funds. The manager's performance fee is calculated as a percentage of the fund's profits, usually counting both realized and unrealized profits. By motivating the manager to generate returns, performance fees are intended to align the interests of manager and investor more closely than flat fees. In the business models of most managers, the performance fee is largely available for staff bonuses and so can be extremely lucrative for managers who perform well. Several publications provide estimates of the annual earnings of top hedge fund managers.^[24][25] Typically, hedge funds charge 20% of returns as a performance fee.^[26] However, the range is wide with highly regarded managers charging higher fees. For example Steven Cohen's SAC Capital Partners charges a 35–50% performance fee,^[27] while Jim Simons' Medallion Fund charged a 45% performance fee.

Average incentive fees have declined since the start of the financial crisis, with the decline being more pronounced in funds of hedge funds (FOFs). Incentive fees for single manager funds fell to 19.2 percent (versus 19.34 percent in Q1 08) while FOFs fell to 6.9 percent (versus 8.05 percent in Q1 08). The average incentive fee for funds launched in 2009 was 17.6 percent, 1.6 percent below the broader industry average.^[28]

Performance fees have been criticized by many people, including notable investor Warren Buffett, who believe that, by allowing managers to take a share of profit but providing no mechanism for them to share losses, performance fees give managers an incentive to take excessive risk rather than targeting high long-term returns. In an attempt to control this problem, fees are usually limited by a high water mark.

High water marks 

A high water mark (or "loss carryforward provision") is often applied to a performance fee calculation. This means that the manager receives performance fees only on increases in the net asset value (NAV) of the fund in excess of the highest net asset value it has previously achieved. For example, if a fund were launched at a NAV per share of $100, which then rose to $120 in its first year, a performance fee would be payable on the $20 return for each share. If the next year it dropped to $110, no fee would be payable. If in the third year the NAV per share rose to $130, a performance fee would be payable only on the $10 profit from $120 (the high water mark) to $130, rather than on the full return during that year from $110 to $130.

The mechanism does not provide complete protection to investors: A manager who has lost a significant percentage of the fund's value may close the fund and start again with a clean slate, rather than continue working for no performance fee until the loss has been made up.^[29] This tactic is dependent on the manager's ability to persuade investors to trust him or her with their money in the new fund.

Hurdle rates 

Some managers specify a hurdle rate, signifying that they will not charge a performance fee until the fund's annualized performance exceeds a benchmark rate, such as T-bill yield,LIBOR or a fixed percentage.^[20] This links performance fees to the ability of the manager to provide a higher return than an alternative, usually lower risk, investment.

With a "soft" hurdle, a performance fee is charged on the entire annualized return if the hurdle rate is cleared. With a "hard" hurdle, a performance fee is only charged on returns above the hurdle rate. Before the credit crisis of 2008, demand for hedge funds tended to outstrip supply, making hurdle rates relatively rare.

Withdrawal/redemption fees 

Some funds charge investors a redemption fee (or "withdrawal fee" or "surrender charge") if they withdraw money from the fund. A redemption fee is often charged only during a specified period of time (typically a year) following the date of investment, or only to withdrawals representing a specified portion of an investment.^[30]

The purpose of the fee is to discourage short-term investment in the fund, thereby reducing turnover and allowing the use of more complex, illiquid or long-term strategies. The fee may also dissuade investors from withdrawing funds after periods of poor performance.

Unlike management and performance fees, redemption fees are usually retained by the fund and therefore benefit the remaining investors rather than the manager.