Most money managers may now choose between three broad categories of compensation—fixed-dollar fees, asset-based fees and incentive fees. Under a fixed-dollar fee, the manager receives a specific sum of money for managing an account over a specific time period—for example, $100,000 per year. Under an asset-based fee (currently the most common form of compensation), the manager receives a percentage of the market value of assets under management, the amount of the fee varying with this value.

Incentive fees include those that are contingent upon account performance versus an independent index and those based upon a percentage of the portfolio’s absolute net gains over some time period. Whatever form the incentive fee takes, the client and manager must decide whether the fee will involve a penalty for underperformance, the length of the period over which performance is to be measured, the relative magnitudes of the base fee and the incentive, and whether an incentive fee is appropriate to the account.

Like any compensation scheme, an incentive fee should be fair and reasonable in light of the manager’s and client’s circumstances. The fee should be clearly understood by both client and manager. And the fee should not provide the manager with an inherent incentive to take actions that may benefit the manager but may not be in the best interests of the client.