Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance

Incentives

Broadly speaking, any number of fund terms or conditions can act as an incentive to influence manager behavior. Since investors are unable to observe a manager's activities each day and monitor behavior, they need to rely on incentives that can align interests and modify behavior in between fund reporting periods.

A management fee is the percentage rate of compensation reported to the database for each fund. It is a fixed percentage of the assets under management. The fee is calculated monthly and deducted from fund performance reported to the database. The management fee is set when a fund is launched and does not change over the life of a fund.

The performance fee is the variable percentage rate of a fund's returns after all expenses that is reported to the database and is payable to the manager at the end of each month. The incentive or performance fee rate is set when a fund is launched and does not change over the life of a fund.

Mutual fund managers generally get paid only a fixed fee to manage a portfolio, do not invest significant portions of their personal net worth in the funds they manage, and are rarely paid performance-based incentive fees to manage customer assets. Hedge fund managers, by contrast, get paid both a fixed management fee and an incentive fee based on fund performance. Hedge fund managers also tend to have a significant amount of their personal wealth in the fund they manage. Unlike mutual fund managers, hedge fund managers are highly motivated ...