What Is a Fee Structure?
A fee structure is a chart or list highlighting the rates on various business services or activities. A fee structure lets customers or clients know what to expect when working with a particular business. Potential customers should always examine a company's fee structure to make sure they find it satisfactory before deciding to do business with them.
Key Takeaways
- Fee structures describe the way that brokers or financial firms earn money from client business.
- Clients are increasingly able to select from a range of benefits based on different fee structures depending on the level of service desired.
- There are many ways to structure fees, such as using an incentive-based model, charging commissions, or asking for a flat fee.
How Fee Structures Work
The fee structure for an online auction website, for example, would list the cost to place an item for sale, the website's commission if the item is sold, the cost to display the item more prominently in the site's search results and so on. Fee structures with an incentive or outperformance component could encourage a "swing for the fences" mentality. This is likely because a manager enjoys a disproportionate upside.
As investment objectives and mandates become more tailored or sophisticated, fees will generally increase as well.
Types of Fee Structures
Classic Fee Structure
As another example, hedge fund's fee structure would show what the fund manager charges to run the fund, how much the fund manager will receive if the fund meets or exceeds predefined performance targets, and how much an investor must pay if they withdraw their funds prematurely.
The classic fee structure for hedge funds is "2 and 20." Meaning, a fund manager charges 2% on assets under management and another 20% for profits or outperformance over some threshold. This structure would be used to provide a base level of fees for the management of the fund (2%), plus an additional "incentive" fee that aligns the manager and investor interest. As the hedge fund fee structure shows, incentives often play a central role in selecting an appropriate fee structure.
Flat Fee Structures
Under a flat fee structure, asset managers often charge a simple, flat rate for assets under management. For instance, an institutional investment manager might charge a pension fund 1.25% for every dollar under management. In reality, in the management of another's capital, no fee structure is perfect. For example, a downside of the flat fee structure is that it could potentially stifle innovation, creativity, or drive since a fee is earned regardless of performance.
Free Fee Structures
Increasingly, some brokers are offering commission-free trading. Robinhood, for example, is an app-based trading platform that allows people to buy stocks and ETFs for $0. Some roboadvisors are also promoting $0 fee structures. The ways that these firms generate income is through other methods such as lending stock to short sellers, cash management strategies of clients' funds, receiving payment for directed order flow, or marketing other products to users through their platforms.
