Canadian Securities Course (CSC) Level 2 Practice Exam

Which fee structure characteristic applies to incentive fees in hedge funds?

1. Paid only on new profits.

2. High water mark - paid only on new profits.

3. Short is risky, leverage will magnify losses.

4. Subject to high MER.

The correct answer is: High water mark - paid only on new profits.

The characteristic that applies to incentive fees in hedge funds is that they operate on a high water mark principle, meaning that the fund manager only earns performance fees on profits that exceed previous peaks in the fund's valuation. This ensures that investors do not have to pay incentive fees unless the fund recovers past losses and makes new gains. This aligns with the concept of aligning the interests of the fund manager with those of the investors, encouraging the manager to work toward producing consistent positive returns. If a fund has a poor performance and dips in value, the management will not earn incentive fees until it surpasses the highest value (high water mark) previously achieved. While incentive fees are indeed only paid on new profits, stating this alone without referencing the high water mark does not capture the complete mechanism of how incentive fees function in this context. Therefore, the correct answer emphasizes both the payment of fees only on profits exceeding prior high levels and the protection of investor capital by ensuring no fees on underperformance.