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The Hedge Fund Game

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Author Info

  • Peyton Young

    ()
    (Dept of Economics, University of Oxford)

  • Dean P Foster

    (Dept of Statistics, Wharton School)

Abstract

This paper examines theoretical properties of incentive contracts in the hedge fund industry. We show that it is very difficult to structure incentive payments that distinguish between unskilled managers, who cannot generate excess market returns, and skilled managers who can deliver such returns. Under any incentive scheme that does not levy penalties for underperformance, managers with no investment skill can game the system so as to earn (in expectation) the same amount per dollar of funds under management as the most skilled managers. We consider various ways of eliminating this “piggy-back effect,” such as forcing the manager to hold an equity stake or levying penalties for underperformance. The nature of the derivatives market means that none of these remedies can correct the problem entirely.

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File URL: http://www.nuffield.ox.ac.uk/economics/papers/2008/w1/HedgePaper2MAR08.pdf
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Bibliographic Info

Paper provided by Economics Group, Nuffield College, University of Oxford in its series Economics Papers with number 2008-W01.

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Length: 24 pages
Date of creation: 03 2008
Date of revision:
Handle: RePEc:nuf:econwp:0801

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Web page: http://www.nuff.ox.ac.uk/economics/

Related research

Keywords: incentive contracts; excess returns;

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References

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  1. Jens Carsten Jackwerth & James Hodder, 2005. "Incentive Contracts and Hedge Fund Management," Working Papers, Warwick Business School, Finance Group wp05-10, Warwick Business School, Finance Group.
  2. Hulebak, Karen, 2001. "Risk Management," Agricultural Outlook Forum 2001, United States Department of Agriculture, Agricultural Outlook Forum 33049, United States Department of Agriculture, Agricultural Outlook Forum.
  3. Vikas Agarwal, 2004. "Risks and Portfolio Decisions Involving Hedge Funds," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 17(1), pages 63-98.
  4. Jennifer Carpenter, 1997. "The Optimal Dynamic Investment Policy for a Fund Manager Compensated with an Incentive Fee," New York University, Leonard N. Stern School Finance Department Working Paper Seires, New York University, Leonard N. Stern School of Business- 97-11, New York University, Leonard N. Stern School of Business-.
  5. Carl Ackermann & Richard McEnally & David Ravenscraft, 1999. "The Performance of Hedge Funds: Risk, Return, and Incentives," Journal of Finance, American Finance Association, American Finance Association, vol. 54(3), pages 833-874, 06.
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Cited by:
  1. John Thanassoulis, 2011. "Bankers' Pay Structure And Risk," Economics Series Working Papers, University of Oxford, Department of Economics 545, University of Oxford, Department of Economics.
  2. John Thanassoulis, 2011. "Industrial Structure, Executives' Pay And Myopic Risk Taking," Economics Series Working Papers, University of Oxford, Department of Economics 571, University of Oxford, Department of Economics.

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