Traditional fees based on assets under management reward the manager for superior performance to the extent that increasing returns increase the assets under management. Whether the performance comes from general market movements or from the manager’s skill in stock selection or timing, however, is irrelevant. A manager is as likely to be rewarded for good luck as for investment skill.
Incentive fees tie the manager’s reward more directly to his skill. Because performance is measured against some benchmark—a market index or the manager’s “normal” portfolio—the incentive fee rewards skill in active management, rather than merely passive performance. Furthermore, selection of the appropriate benchmark portfolio, the base fee, the maximum or minimum fee (if any) and the method of measuring return allows for a variety of fee structures that can be tailored to a variety of different client needs and manager styles.
Incentive fees are not without problems. Their complexity may allow managers to manipulate portfolio attributes in order to “game” the fee. They require continuous monitoring by the client. Poor and average managers are likely to fail faster with incentive fees than they would in a traditional fee environment. For good managers, however, incentive fees are likely to provide greater reward than traditional fees.