Performance Based Fees

Lesson

Performance-based fees are a type of compensation structure for investment advisers where the fees are based on the performance of the client's investments.

Practice Question #1

Which of the following clients would be eligible for a performance-based fee arrangement with an investment adviser?

A) A client with a net worth of $1 million

B) A client with $500,000 in investments

C) A client with a net worth of $2.2 million

D) A client with $750,000 in investments

Select an option above to see an explanation here.

A) A client with a net worth of $1 million does not meet the qualified client threshold. B) A client with $500,000 in investments does not meet the qualified client threshold. C) A client with a net worth of $2.2 million meets the qualified client threshold for performance-based fee arrangements. D) A client with $750,000 in investments does not meet the qualified client threshold.

Terms

Performance-based fees:: Fees charged by investment advisers based on the performance of the client's investments.
High watermark:: A provision in performance-based fee arrangements ensures the adviser only earns fees on new profits, not on recovering previous losses.
Hurdle rate:: A minimum rate of return that must be achieved before an investment adviser can charge performance-based fees.
Fulcrum fee:: A performance-based fee structure that adjusts the fee rate based on the adviser's performance relative to a benchmark.
2 and 20 fee structure:: A common fee structure for hedge funds, where the adviser charges a 2% management fee and a 20% performance fee.

Practice Question #2

What is the purpose of a high watermark in a performance-based fee arrangement?

A) To ensure the adviser only earns fees on new profits

B) To set a minimum rate of return before fees are charged

C) To adjust the fee rate based on the adviser's performance relative to a benchmark

D) To limit the total amount of fees charged to a client

Select an option above to see an explanation here.

A) A high watermark ensures the adviser only earns fees on new profits, not on recovering previous losses. B) A hurdle rate sets a minimum rate of return before fees are charged. C) A fulcrum fee adjusts the fee rate based on the adviser's performance relative to a benchmark. D) A high watermark does not directly limit the total amount of fees charged to a client.

Do Not Confuse With

Flat fee:: A fixed fee charged by investment advisers regardless of the performance of the client's investments.
Assets under management (AUM) fee:: A fee based on the total value of the client's investments managed by the adviser.

Practice Question #3

Which of the following is NOT a requirement for investment advisers charging performance-based fees?

A) Disclosing the fee arrangement to clients

B) Only charging fees to qualified clients

C) Charging a flat fee in addition to the performance-based fee

D) Acting in the best interest of clients

Select an option above to see an explanation here.

A) Disclosing the fee arrangement to clients is a requirement for investment advisers charging performance-based fees. B) Only charging fees to qualified clients is a requirement for investment advisers charging performance-based fees. C) Charging a flat fee in addition to the performance-based fee is not a requirement for investment advisers charging performance-based fees. D) Acting in clients' best interest is a requirement for investment advisers charging performance-based fees as part of their fiduciary duty.

Historical Example

In the late 1990s, a prominent investment adviser was found to have charged excessive performance-based fees to clients without proper disclosure. This case led to increased regulatory scrutiny of performance-based fee arrangements and the importance of clear disclosure to clients.