A performance fee can generically refer to the fee charged for the performance of some type of service. Typically, however, it's a term used in the financial industry and may also be referred to as an incentive fee. That's because a performance fee is a type of incentive-based compensation. Depending on their service contract, investment managers may collect a performance fee, or a percentage of the profits he or she realizes on an investment for a client. The structure of performance fees varies and not all investment managers are set up to receive them.
Performance fees are not the only way to compensate investment managers. Some managers are paid a regular salary for their work and do not have any form of incentive-based compensation. Others receive their compensation via performance fees — a percentage of the fund's profit to incentivize wise investments, as well as management fees — a percentage of the fund's asset value to compensate for the managers time and expertise in managing the fund.
Those managers that do receive compensation by way of performance fees may not structure their payment plan the same. First, the rate of the performance fee, usually a percentage of profits, may vary. For example, mutual fund performance fees normally range from less than 1% to 5%, but they can go as high as 15%. Hedge fund performance fees, on the other hand, can go as high as 40% or more.
The timing of performance fee payouts may vary among investment managers. Fees may be paid on an annual basis, though most managers take their fees on a quarterly or monthly basis. Some compensation structures that include performance fees based on asset value, not just profits, may include high water marks. This means that a performance fee will only be issued on the increase in value of an investment over it's previous greatest value. In these cases, even if an investment made a profit if that new value is below some previously higher net value, the manager will not receive a performance fee.
There is a lot of discussion on whether performance fee structures are fair or useful. Proponents argue that sharing the risk of the investment helps encourage managers to actively seek improved returns on investment since they get a cut of those profits. Critics, on the other hand, contend that performance fees may actually incentivize managers to take unreasonable risks in the hope of turning a large profit. These risks can not only affect the investor, but when done on a large scale they can affect entire markets. As a result, these critics suggest close scrutiny, if not government regulation, if performance fees are permitted.