A performance fee is designed to provide a more direct relation between the fee an investment manager receives from his client and the performance of the portfolio he manages for that client. Performance is typically measured relative to some stated objective. A common structure for a performance fee calls for a base fee that is substantially less than the manager’s normal fee, and which is paid regardless of the portfolio’s performance.

The manager receives bonuses as the portfolio return begins to rise above an agreed-upon benchmark return. When the portfolio return equals the performance objective (e.g., 2 per cent above the S&P 500), the manager earns his normal fee. If the portfolio outperforms the objective, the manager continues to receive bonuses up to some maximum fee.

A performance fee can be calculated over any time period at least as long as the one-year minimum set by the Securities and Exchange Commission. Simulations indicate that a moving three-year time period provides a good balance between smoothing the manager’s fee revenue and reducing his opportunity to “game” the fee by altering portfolio risk.