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An investment management fee that varies depending on the manager's performance. Incentive fees are common for funds invested in futures markets; but, if the manager is a registered investment advisor (RIA), there are restrictions on incentive or performance fees. Specifically, rule 205-3 under the Investment Advisors Act of 1940, as amended, requires 'among other things, that: (a) the client being charged the incentive fee have at least $500,000 under the management of the RIA or a net worth in excess of $1,000,000; and (b) that any incentive compensation paid to the RIA be based on the net gains in the client's accounts for a period of not less than one year.' Except for mutual funds, the manager usually is not required to pay the client when the managed portfolio underperforms the benchmark; hence the incentive component of the fee can be thought of as an option granted to the manager to exchange the performance of the benchmark portfolio for the managed portfolio. In exchange for this option, the base component of the fee is usually set below the flat fee that the manager would otherwise charge.
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