Management fees vs. performance fees: What's the difference and why it matters

Performance fees and how they work

Performance fees are compensation paid to investment managers based on fund profits. Unlike management fees, which are charged regardless of performance, these fees reward managers only when returns are generated, aligning their interests with investors. However, they can also incentivise excessive risk-taking if not properly structured.

The most common performance fee structure is the '2 and 20' model, which works like this:

• 2% management fee. Charged on assets under management (AUM), regardless of performance.
• 20% performance fee. Applied to net investment gains, often subject to additional conditions.

Example calculation:

• Investor capital: USD 10 million
• Fund return: 15% (USD 1.5 million profit)
• Performance fee (20% of USD 1.5 million): USD 300,000
• Net profit retained by investor: USD 1.2 million

Some funds charge performance fees on all profits, while others require managers to exceed a certain return threshold before earning incentive fees.

To ensure fairness and prevent excessive charges, many funds implement the following provisions:

High-water mark

A high-water mark ensures that fund managers only earn performance fees on new profits rather than recovered losses.

Example: A hedge fund's value drops from USD 100M to USD 90M. The manager cannot collect performance fees until the fund surpasses its previous USD 100M high-water mark.

This protects investors from being charged fees on simple recovery after a downturn.

Hurdle rate

A hurdle rate sets a minimum required return before performance fees are charged.

Example: A hedge fund has a 7% hurdle rate and earns a 12% return. The performance fee applies only to the excess 5% return above the hurdle.

Typical hurdle rates range from 6% to 8%, ensuring fees are only charged when managers deliver above-market performance.

Performance fees are prevalent in investment vehicles that rely on active management:

• Hedge funds. Often structured as '2 and 20,’ with additional provisions such as high-water marks and hurdle rates.
• Private equity & venture capital. Earn carried interest, typically 20% of realised profits, after meeting a preferred return hurdle (7-8%).
• Some actively managed mutual funds. A small subset of mutual funds charge performance-based fees, typically with hurdle rates to justify the additional cost.

Management fees vs. performance fees: Key differences

Investment funds use both management fees and performance fees to compensate fund managers, but these fee structures serve different purposes and impact investors in distinct ways.

When do funds use each fee type?

Management fees are found in most mutual funds, hedge funds, and private equity funds. They provide fund managers with a stable income to cover operational costs, regardless of performance.

Performance fees are typically found in hedge funds, private equity, and venture capital, where managers actively seek excess returns.

Some funds combine both fee types – using a lower management fee + performance fee to align manager incentives while keeping investor costs manageable.

While both fee types compensate managers, performance fees introduce an incentive-based structure that can drive strong results but also pose risks if not carefully regulated. Investors should assess whether the fund's historical performance and risk-adjusted returns justify these costs.

Are high fees justified? Evaluating value vs. cost

Some investment funds charge high fees, arguing that their strategies provide superior returns or access to exclusive opportunities. However, not all high-fee funds deliver value that outweighs their costs. Investors must evaluate whether fees are reasonable based on risk-adjusted returns, investment complexity, and long-term performance consistency.

When higher fees might be justified

Certain funds may warrant higher costs due to specialised expertise, unique market access, or active management strategies:

Consistent outperformance

In some cases, actively managed funds could outperform benchmarks, but that's not always the case. Investors should evaluate a fund's Sharpe ratio, Sortino ratio, and downside capture ratio to assess whether higher fees translate into superior risk-adjusted returns.

Niche or illiquid investments

Funds specialising in emerging markets, distressed assets, or private equity often require extensive research, deal structuring, and long-term capital commitments, leading to higher fees. Private equity and venture capital funds charge high fees because they invest in illiquid assets with long holding periods.

Advanced risk management & hedging strategies

Some hedge funds justify higher fees by employing hedging, risk arbitrage, or market-neutral strategies to protect against downturns. However, not all funds effectively reduce risk, and investors should assess historical downside protection, risk-adjusted performance, and past market cycle behaviour.

When high fees may not be worth it

Many actively managed funds charge high fees without consistently delivering excess returns. Investors should be cautious if:

The fund underperforms net of fees

If a hedge fund or private equity firm consistently fails to outperform a risk-adjusted benchmark, its fees erode long-term investor value.

Comparable low-cost alternatives exist

Index funds, smart beta ETFs, and factor-based funds offer similar market exposure at a fraction of the cost. Investors should compare active fund performance against passive or semi-passive alternatives before committing to high fees.

Performance fees incentivise excessive risk-taking

Some fee structures encourage managers to take high-risk, short-term bets to maximise their own compensation. Hedge fund fees often increase dramatically if returns break a certain threshold, incentivising managers to favour short-term performance over long-term stability. Funds that lack high-water marks, hurdle rates, or clawback provisions may create conflicts of interest where fund managers prioritise their fees over investor stability.

Conclusion: Investment fees are crucial for investors to understand

Investment fees directly impact long-term returns, making it essential for investors to understand how they are structured. Management fees provide fund managers with stable revenue but are charged regardless of performance, while performance fees incentivise fund managers to generate higher returns but may encourage excessive risk-taking.

Before committing capital, you should always assess whether a fund's fee structure aligns with its historical performance and risk-adjusted returns. Comparing management fees and performance fees helps determine whether the costs are justified, especially when low-cost alternatives are available.

While fees are unavoidable in actively managed investments, choosing funds with reasonable fee structures ensures that you can retain a greater share of your profits over time.