Final answer:
The fund manager's incentive fee is based on 14% of the annual return, which is the difference between the total annual return of 18% and the hurdle rate of 4%.
Step-by-step explanation:
A hedge fund sets a hurdle rate at 4%, and it achieves an annual return of 18%. The percentage of the annual return upon which the fund manager's incentive fee is based can be calculated by subtracting the hurdle rate from the total annual return. This gives us:
18% - 4% = 14%
The fund manager's incentive fee is therefore based on 14% of the annual return.