Performance Fee

A performance fee (sometimes called an incentive fee) is the fee charged by a CTA or other investment manager on an account’s profits. Commonly their primary compensation, the performance fee acts as an incentive for account managers to maximize returns on behalf of their investors; a CTA’s performance fee earnings rise with the value of an investor’s account.

Performance fees are typically based on investment account gains, often whether realized or unrealized. (An investor earns unrealized gains when an asset’s market value increases, but does not collect realized gains until cash is received from the sale of the profitable asset.) In general, the portion of an account’s profit that is subject to a performance fee is determined using a high-water mark: the fee is assessed only on an account’s gains over its previous highest value, or high-water mark. Some managers also employ a hurdle rate—a level above which profits must rise before the fee will be collected—to calculate performance fees.

A performance fee is charged as a percentage of investment profits. On average, most CTAs and investment managers assess an annual performance fee of 20 percent of investment profits, which is usually collected in prorated monthly deductions. The actual amount of this figure may depend on several factors, including the manager’s trading philosophy and experience level. In addition, many CTAs offer adjustable fee scales based on investment level.

Like many other aspects of the investment industry, performance fees are subject to government regulation. The Investment Advisers Act of 1940 mandates that investment managers may only charge performance fees to clients who meet certain net worth and invested asset requirements, or those who the law deems to be “qualified purchasers.” The U.S. Securities and Exchange Commission adjusts these asset and investment thresholds every five years for inflation. By law, a CTA’s performance fee amounts and calculation methods must be clearly outlined in the manager’s disclosure document (D-Doc).