Page 48

INCENTIVE FEE AS MOTIVATOR

The incentive fee structure is the key. Managers are compensated on performance, not just a fixed percentage of assets under management. The best and the brightest go into hedge fund management because they get a 1 percent management fee and 20 percent incentive fee, compared with mutual funds where they get a 0.5 percent management fee and no incentive fee. To understand what this means in dollar terms, assume that both managers are managing $100 million, and this is their initial equity. The hedge fund manager takes in 1 percent of $100 million or $1 million on an annual basis, regardless of performance. This is a fixed fee. The mutual fund manager, managing the same amount of assets, takes in $500,000 in management fees (i.e., one-half of 1 percent of $100 million). Now assume both managers are up 20 percent for the year. The mutual fund manager gets nothing extra. The hedge fund manager, however, gets a 20 percent incentive fee or $20 million, for a total compensation package of $21 million.