Role of Managerial Incentives and Discretion in Hedge Fund Performance

Using a comprehensive hedge fund database, we examine the role of managerial incentives and discretion in hedge fund performance. Hedge funds with greater managerial incentives, proxied by the delta of the option-like incentive fee contracts, higher levels of managerial ownership, and the inclusion of high-water mark provisions in the incentive contracts, are associated with superior performance. The incentive fee percentage rate by itself does not explain performance. We also find that funds with a higher degree of managerial discretion, proxied by longer lockup, notice, and redemption periods, deliver superior performance. These results are robust to using alternative performance measures and controlling for different data-related biases.     

Rewarding risk-taking or skill? The case of private equity fund managers

We examine whether typical private equity fund compensation contracts reward excessive risk-taking rather than managerial skill. Our analysis is based on a novel model of investment value, cash flows, and fee dynamics of private equity funds. Given the embedded option-like fee components, our results demonstrate that fund managers indeed have an incentive for excessive risk-taking when only fee income from the current fund is considered. However, when managers also consider potential compensation from follow-on funds, their risk-taking incentives depend on their individual skill levels, and skilled managers will have an incentive to reduce fund risk. We also show that managers must generate substantial abnormal returns in order to compensate investors for the given fee components.     

The Optimal Size of Hedge Funds: Conflict between Investors and Fund Managers

This study examines whether the standard compensation contract in the hedge fund industry aligns managers’ incentives with investors’ interests. I show empirically that managers’ compensation increases when fund assets grow, even when diseconomies of scale in fund performance exist. Thus, managers’ compensation is maximized at a much larger fund size than is optimal for fund performance. However, to avoid capital outflows, managers are also motivated to restrict fund growth to maintain style‐average performance. Similarly, fund management firms have incentives to collect more capital for all funds under management, including their flagship funds, even at the expense of fund performance.     

Incentives and Endogenous Risk Taking: A Structural View on Hedge Fund Alphas

Hedge fund managers are subject to several nonlinear incentives: performance fee options (call); equity investors' redemption options (put); and prime broker contracts allowing for forced deleverage (put). The interaction of these option‐like incentives affects optimal leverage ex ante, depending on the distance of fund‐value from the high‐water mark. We study how these endogenous effects influence performance measures used in the literature. We show that reduced‐form measures that do not account for these features are subject to economically significant false discovery biases. The result is stronger for low‐quality funds. We propose an alternative structural methodology for conducting performance attribution in hedge funds.     

Fund selection,style allocation,and active management abilities: Evidence from funds of hedge funds’ holdings

This study examines whether funds of hedge funds (FOHFs) provide superior before-fee performance through managers’ fund selection, style allocation, and active management abilities. Using reported holdings of Securities and Exchange Commission–registered FOHFs, we find that FOHF managers have fund selection abilities, as hedge funds held by FOHFs outperform their style indices and over half of the individual hedge funds in the Lipper Trading Advisor Selection System (TASS) database. We also find that FOHF managers add value through active management of FOHFs’ holdings, while evidence on their style allocation abilities is mixed. Our findings suggest that FOHFs generate superior before-fee performance and that FOHF managers’ skillset is broader than previously documented. Thus, our study helps explain why FOHFs continue to survive and suggests that FOHF fee structure reform merits consideration.     

Who Charges More: Hedge Funds or Mutual Funds?*

Explicit mutual fund fees are typically less than 1% of the assets under management. By comparison, the typical hedge fund charges a base fee of 2% plus a performance fee equal to 20% of net profits. Thus, hedge funds appear to charge far more for even comparable performance—unless one takes account of the following:

• ? For most mutual funds, a very high percentage of performance is driven by its passive exposure to the market, even though the fee is applied to the total fund.
• ? Many hedge funds are designed to provide returns that are completely independent of market performance.

Using these two assumptions, the author provides a simple example that shows that a representative mutual fund's performance can be replicated by combining an index fund, which represents the mutual fund's passive component, with a hedge fund, representing the mutual fund's active component. When analyzed in this way, the fee of the combined fund turns out to be remarkably close to the actual fee of the mutual fund. This in turn suggests that the implicit fee for the mutual fund's small active component is comparable to the fees of the hedge fund.     

Indirect Incentives of Hedge Fund Managers

Indirect incentives exist in the money management industry when good current performance increases future inflows of capital, leading to higher future fees. For the average hedge fund, indirect incentives are at least 1.4 times as large as direct incentives from incentive fees and managers’ personal stakes in the fund. Combining direct and indirect incentives, manager wealth increases by at least $0.39 for a $1 increase in investor wealth. Younger and more scalable hedge funds have stronger flow‐performance relations, leading to stronger indirect incentives. These results have a number of implications for our understanding of incentives in the asset management industry.     

The Performance of Hedge Funds: Risk, Return, and Incentives

Hedge funds display several interesting characteristics that may influence performance, including: flexible investment strategies, strong managerial incentives, substantial managerial investment, sophisticated investors, and limited government oversight. Using a large sample of hedge fund data from 1988–1995, we find that hedge funds consistently outperform mutual funds, but not standard market indices. Hedge funds, however, are more volatile than both mutual funds and market indices. Incentive fees explain some of the higher performance, but not the increased total risk. The impact of six data-conditioning biases is explored. We find evidence that positive and negative survival-related biases offset each other.     

Optimal Control of DC Pension Plan Management under Two Incentive Schemes

Since the late 1990s, a performance fee arrangement has been approved as a managerial incentive in direction contribution (DC) pension plan management to motivate managers. However, the fact that managers may take undue risk for the larger performance fees and thus reduce members’ utility has been a subject of debate. As such, this study investigates the optimal risk-taking policies of DC pension fund managers under both the single management fee scheme and a mixed scheme with a lower management fee, as well as an additional performance fee. The analytical solutions are derived by using the duality method and concavification techniques in a singular optimization problem. The results show the complex risk-taking structures of fund managers and recognize the win-win situation of implementing performance-based incentives in DC pension plan management. Under the setting of geometric Brownian motion asset price dynamics and constant relative risk aversion utility, the optimal risk investment proportion shows a peak-valley pattern under the mixed scheme. Further, the manager gambles for gain when fund wealth is low and time to maturity is short. As opposed to the existing literature, this study found that the risk-taking policy is more conservative when fund wealth is relatively large. Furthermore, the utilities of the manager and members could both be improved by appropriately choosing the performance fee rate.     

Does concurrent management of mutual and hedge funds create conflicts of interest?

This paper shows that conflicts of interest may exist in cases where a hedge fund manager starts a mutual fund but not in the opposite case. We compare performance, asset flows, and risk incentives to establish several key differences between these two scenarios: First, prior to concurrent management, hedge fund managers experience worse performance while mutual fund managers achieve better performance relative to their full-time peers. Second, hedge fund managers who choose concurrent management are disproportionately the ones with less experience. Their hedge funds tend to suffer a decline in performance after the event. By contrast, mutual fund managers who choose concurrent management tend to outperform their full-time peers. Based on our findings, we make important recommendations for policy makers and companies. The relevance of our recommendations extends beyond the small share of companies presently engaged in concurrent management.     

HEDGE FUNDS: WHAT DO WE KNOW?

Hedge funds are attracting increased attention because of their reputation for earning superior (risk-adjusted) returns. Hedge Fund Research Inc. estimates that in 2001 there were about 7,000 hedge funds with investor capital of about $600 billion. And yet the diversity of hedge funds, combined with a general lack of transparency, makes the hedge fund industry something of a "black box."
This article provides an overview of the legal structure of hedge funds, the various fund investment strategies, and the existing research on overall hedge fund performance. Without uniform and comprehensive reporting requirements, it is difficult to ascertain the size and scope of hedge fund investments. Nonetheless, current research provides persuasive evidence that hedge funds earn positive risk-adjusted returns, on average, in contrast to their counterparts in the mutual fund industry. In an attempt to explain these higher returns, the authors begin by noting that hedge funds are subject to considerably less regulation than other investment institutions because their client base is limited to wealthy individuals and institutions. Hedge funds can thus employ investment strategies that mutual funds and pension funds are prohibited from pursuing, such as short selling, high leverage, derivatives, concentrated holdings, and limited redemptions. As a result, the funds may be able to earn excess returns by operating in illiquid and specialized markets where there is a shortage of arbitrage capital. At the same time, and perhaps even more important, hedge funds are in a better position than conventional mutual funds to attract skilled managers because of their use of performance-based incentive fee structures.     

Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry

Investors in hedge funds and commodity trading advisors (CTAs) are concerned with risk as well as return. We investigate the volatility of hedge funds and CTAs in light of managerial career concerns. We find an association between past performance and risk levels consistent with previous findings for mutual fund managers. Variance shifts depend upon relative rather than absolute fund performance. The importance of relative rankings points to the importance of reputation costs in the investment industry. Our analysis of factors contributing to fund disappearance shows that survival depends on absolute and relative performance, excess volatility, and on fund age.     

Mutual fund performance when parent firms simultaneously manage hedge funds

This study examines the performance of mutual funds managed by firms that simultaneously manage hedge funds. We find that the reported returns of mutual funds in these “side-by-side” associations with hedge funds significantly underperformed those of mutual funds that shared similar fund and family characteristics but differed in that they were not affiliated with hedge funds. Digging deeper into performance, we find that the underperformance was confined to return gaps, a return measure that captures the impact of unobservable managerial actions. Interestingly, mutual funds with investment styles that were most closely aligned to affiliated hedge funds generated reported-return alphas and return gaps that underperformed by the greatest amount. Finally, we find that side-by-side mutual funds received less of a contribution to performance from IPO underpricing than similar unaffiliated mutual funds or affiliated hedge funds. Evidence does not support the hypothesis that affiliations with hedge funds allow side-by-side mutual funds to attract superior stock-picking talent. Our evidence does not allow us to rule out the possibility that management firms maximized fee income by strategically transferring performance from mutual funds to hedge funds.     

Alumni social networks and hedge fund performance: Evidence from China

Based on unique data of Chinese private hedge funds, we first construct the “strong alumni” (alumni of the same school and the same major) social networks of private hedge fund managers, and examine the impact of alumni social networks on the performance of hedge funds in China. We build a series of alumni networks using the educational background information of 4734 private hedge funds, and perform an empirical analysis on a sample of 1115 private hedge funds products from 2010 to 2019. Different from previous findings of mutual funds, we find that more central network positions of hedge fund managers are associated with better risk-adjusted fund performance. Hedge fund managers with more central positions conduct more active investment styles and receive lower fund flows.¹ The results supplement the evidence that information advantages brought by central position in social networks can influence managers' investment styles, thus improve hedge fund performance.     

Why Do Money Fund Managers Voluntarily Waive Their Fees?

Over half of money fund managers voluntarily waive fees they have a contractual right to claim. Moreover, as a consequence of fee waivers, funds on average collect one half of reported expense ratios. Variation in fee waivers is significant and relates to differences in relative performance. Both low-performing retail and institutional funds waive fees to improve their net performance. More interestingly, high-performing retail, but not institutional, funds use fee waivers to strategically adjust net performance to increase expected fund flows. Despite fund flow incentives, high-performing institutional funds do not waive more because they cannot significantly improve their relative performance.     

The performance of emerging hedge funds and managers

This paper provides the first systematic analysis of performance patterns for emerging funds and managers in the hedge fund industry. Emerging funds and managers have particularly strong financial incentives to create investment performance and, because of their size, may be more nimble than established ones. Performance measurement, however, needs to control for the usual biases afflicting hedge fund databases. After adjusting for such biases and using a novel event time approach, we find strong evidence of outperformance during the first two to three years of existence. Each additional year of age decreases performance by 42 basis points, on average. Cross-sectionally, early performance by individual funds is quite persistent, with early strong performance lasting for up to five years.     

High-Water Marks and Hedge Fund Management Contracts

Incentive fees for money managers are frequently accompanied by high‐water mark provisions that condition the payment of the performance fee upon exceeding the previously achieved maximum share value. In this paper, we show that hedge fund performance fees are valuable to money managers, and conversely, represent a claim on a significant proportion of investor wealth. The high‐water mark provisions in these contracts limit the value of the performance fees. We provide a closed‐form solution to the cost of the high‐water mark contract under certain conditions. Our results provide a framework for valuation of a hedge fund management company.     

A Time to Scatter Stones,and a Time to Gather Them: The Annual Cycle in Hedge Fund Risk Taking

Analyzing a sample of hedge fund daily returns from Bloomberg, we find a seasonal pattern in their risk taking. During earlier months of a year, poorly performing funds reduce risk. The reduction is stronger for funds with higher management fees, shorter redemption periods, and recently deteriorating performance, consistent with a managerial aversion to early fund liquidation. Toward the end of a year, poorly performing funds gamble for resurrection by increasing risk. It is largely achieved by increasing exposure to market factors, and can be linked to stronger indirect managerial incentives during the second half of a year.     

Implicit incentives and reputational herding by hedge fund managers

Several theories of reputation suggest that managers' incentives affect their propensity to engage in herding behavior. This paper investigates these theories by tracking hedge fund managers' herding behavior over their careers. I first examine managerial incentives for herding, and show that more senior managers that deviate from the herd have a significantly higher probability of failure and do not experience higher fund inflows than their less-senior counterparts. These implicit incentives should encourage managers to herd more as their careers progress. I find strong support for this hypothesis: using a number of proxies for herding, I show that more experienced managers herd more than less-experienced managers. Finally, I examine performance differences between more and less-experienced managers, and find that while more experienced managers underperform less-experienced managers, this underperformance does not appear to be caused by differences in herding. Overall, these results are in direct contrast with studies of mutual fund managers, reflecting important difference in implicit incentives between the two industries.     

The alpha and omega of fund of hedge fund added value

In spite of a somewhat disappointing performance throughout the crisis, investors are showing interest in hedge funds. Still, funds of hedge funds keep on experiencing outflows. Can this phenomenon be explained by the failure of fund of hedge fund managers to deliver on their promise to add value through active management, or is it symptomatic of a move toward greater disintermediation in the hedge fund industry? We introduce a return-based attribution model allowing for a full decomposition of fund of hedge fund performance. The results of our empirical study suggest that funds of hedge funds are funds of funds like others. Strategic allocation turns out to be a crucial step in the investment process, in that it not only adds value over the long-term, but most importantly, it brings resilience precisely when investors need it the most. Fund picking, on the other hand, turns out to be a double-edged sword.