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FRM Part I · FRM Exam Part I · Fund Management

A hedge fund with a high-water mark begins year 1 at NAV of USD 100 per unit. It loses 10% in year 1 and gains 20% in year 2, before incentive fees. Ignoring management fees, the incentive fee is 20% of profits above the high-water mark. What is the incentive fee per unit at the end of year 2?

The incentive fee is USD 1.60 per unit. NAV falls to 90 and then rises to 108, only 8 above the 100 high-water mark, and 20% of 8 is 1.60. Charging on the full 18 gain would wrongly give 3.60.

  1. AUSD 3.60Correct
  2. BUSD 4.00
  3. CUSD 2.00
  4. DUSD 1.60

Explanation

End of year 1 NAV = 90. End of year 2 before fee = 90 x 1.2 = 108. The high-water mark is 100, so profit above it = 8. Fee = 20% x 8 = 1.60. Charging on the full year-2 gain of 18 gives 3.60, which ignores the high-water mark. Correct value is 1.60.

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