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FRM Part II · FRM Exam Part II · Hedge Fund Investment Strategies

Which feature of a hedge fund's fee model most directly gives the manager a payoff resembling a call option on the fund's assets?

The incentive fee gives the manager a call-option-like payoff: a share of profits above a threshold such as the high-water mark, and nothing when the fund loses. This asymmetry can encourage risk-taking, unlike flat management fees or liquidity terms.

  1. AA flat management fee on assets under management
  2. BA performance fee on profits, with a high-water mark, paid only when returns are positiveCorrect
  3. CA redemption gate limiting withdrawals
  4. DA lock-up period for new investors

Explanation

The incentive fee pays the manager a share of gains but nothing on losses, giving an asymmetric, call-like payoff, with the high-water mark setting the effective strike. Management fees are linear in assets, and gates and lock-ups are liquidity terms.

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