Investments, tenth edition

 Figure 26.7 

Incentive fees as a call option. 

The current value of the portfolio is 

denoted  S  

0

  and its year-end value is  S  

 T 

 . 

The incentive fee is equivalent to .20 call 

options on the portfolio with exercise price 

 S  

0

 (1  1   r  

 f 

  ).  

  

17

 S. J. Brown, W. N. Goetzmann, and B. Liang, “Fees on Fees in Funds of Funds,”  Journal of Investment Management  

2 (2004), pp. 39–56. 

bod61671_ch26_926-950.indd   944

bod61671_ch26_926-950.indd   944

7/25/13   2:04 AM

7/25/13   2:04 AM

Final PDF to printer

---

945

 Suppose a fund of funds is established with $1 million invested in each of three hedge 

funds. For simplicity, we will ignore the asset-value-based portion of fees (the manage-

ment fee) and focus only on the incentive fee. Suppose that the hurdle rate for the 

incentive fee is a zero return, so each fund charges an incentive fee of 20% of total 

return. The following table shows the performance of each underlying fund over a year, 

the gross rate of return, and the return realized by the fund of funds net of the incentive 

fee. Funds 1 and 2 have positive returns, and therefore earn an incentive fee, but Fund 3 

has terrible performance, so its incentive fee is zero. 

 Example  26.5 

Incentive Fees in Funds of Funds