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Invest for a fee or a share of gains ?

According to Henny Sender of the Financial Times, the disgraced Bernard Madoff "did not charge his investors fees but was paid through commissions on his trades instead." In this way, Mr. Madoff's incentive compensation was aligned with the number of trades he generated and had little to do with his returns.

In contrast, most fund managers are typically compensated with a fixed management fee and a variable incentive fee. The management fee is a set proportion (typically 0.5% to 2% per year) of a fund's assets under management and is paid regardless of the manager's performance. The incentive fee, on the other hand, depends squarely on the manager's ability to generate positive returns. Specifically, the incentive fee is computed as a percentage (anywhere from 0% to 50%) of gains above a certain threshold known as a hurdle rate. The hurdle rate is typically set at a level (0% to 3% per month) above the last highest cumulative return value delivered by the manager. The last highest cumulative return value of the fund is known as the high watermark level. Most of the income of a successful fund manager is derived from his incentive fee.

Several academic studies have analyzed the relationship between fund fees and future fund performance. The results show that while the management fee has no relation to future fund performance, the incentive fee does. Furthermore, most studies suggest that the higher the investment fee, the higher fund's return is likely to be in the future.

Opinion: Did Madoff's Fee Structure Predict His Demise?

By Irene Aldridge, ABLE Alpha Trading Ltd.
Friday, December 19, 2008 11:50:12 PM ET


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