Ever wonder how performance-based compensation works when it comes to investment accounts?
Well, there are a few moving parts but it isn't all that complicated. It is important to determine whether or not you (the investor) have any protection from paying your adviser for the same performance more than once. Sounds funny right? But if you don't know what to look for your adviser could be "double-dipping".
Performance-Based Compensation is the amount of gain that the adviser retains for their profitable investment selections over a given period. This compensation is separate and in addition to typical management costs, which are calculated as a percentage of total assets under management.
What do look for:
- High-Water Mark - this is an amount at which the adviser begins to earn performance-based compensation. If your account value finishes the period under this level, no performance-based compensation is due. The high-water mark level only rises, and never re-sets down (except to account for distributions).
- Hurdle Rate - this works like a high-water mark but an adviser may still get to earn compensation for the same performance if the account value fails to overtake the high-water mark but does clear the hurdle rate. You might see a hurdle rate of 5%, for example. This basically means that the investor keeps the first 5% in any period and the adviser earns performance-based compensation for any gains over and above that hurdle rate.
- Low(er) Management Costs - if your adviser believes in their ability to create gains we believe the management costs should be reduced to a level at which the administrative costs of operating a portfolio or fund are covered by this item, but no real compensation for portfolio managers is expected to be generated in this manner.
- Gross or Net Calculations - some hedge funds out there, calculate both costs (management and performance-based) based on the total account value at the end of the period, instead of taking the base management cost out of the account before calculating the performance-based compensation. This is convenient and beneficial for the firm, not the investor.
Check out this visual for a guide for an example of how we do it at Elevate. Please don't hesitate to reach out to our office with any questions!
Shane Fleury, RICP® | Founder & CIO