Typically it is computed as a fixed percentage of the total volume of assets under management (asset-based fee). In contrast, the incentive fee is increasing in the realized rate of return of the fund under consideration. Incentive fees are generally utilized with respect to hedge funds, while mutual fund managers most often only earn a fixed fee.
Incentive fees are considered to induce fund managers to work harder on portfolio optimization, as they participate in any excess return they are going to realize. Moreover, incentive fees should be most attractive for very competent fund managers.
Through a self-selection process, investment funds that utilize incentive fees should attract more able fund managers than investment funds that only offer a fixed fee. Hard working and talented fund managers should imply particularly high rates of fund return, which is in the investor’s interest.
However, incentive fees may also cause some adverse incentive effects such as excessive risk taking. This is particularly true, when negative incentive fees for fund managers are excluded, as is typical for the hedge fund industry.
For mutual funds, U.S. law requires incentive fees to be able to become negative as well: According to the 1970 amendment of the Investment Company Act 1940, incentive fees for mutual funds must be centered around an index and exhibit a symmetrical design of extra payments for results above the index and of penalty payments for a performance below the index. Because of risk aversion on the fund manager’s side, such a kind of incentive fee is seldom accepted so that incentive fees are not frequently utilized by mutual funds.
In fact, according to Elton et al. (2003), in 1999, only 108 out of a total of 6,716 bond and stock mutual funds in the United States made use of incentive fees. They all applied upper and lower limits in order to restrict maximum and minimum amounts of incentive payments. In no case, overall fees for a fund manager could become negative.
A sensible design of incentive contracts is a difficult task. Important components of incentive fees are a possible benchmark to assess the relative success of a fund manager, and contracting elements like the high watermark reduce the problem of only limited liability on the fund manager’s side. However, only hedge funds are completely free in designing their incentive contracts in a suitable way.