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The Hedge Fund Game

Author

Listed:
  • 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.

Suggested Citation

  • Peyton Young & Dean P Foster, 2008. "The Hedge Fund Game," Economics Papers 2008-W01, Economics Group, Nuffield College, University of Oxford.
    • Handle: RePEc:nuf:econwp:0801
    as

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    File URL: http://www.nuffield.ox.ac.uk/economics/papers/2008/w1/HedgePaper2MAR08.pdf
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    References listed on IDEAS

    as
    1. Vikas Agarwal, 2004. "Risks and Portfolio Decisions Involving Hedge Funds," The Review of Financial Studies, Society for Financial Studies, vol. 17(1), pages 63-98.
    2. 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 97-11, New York University, Leonard N. Stern School of Business-.
    3. Hodder, James E. & Jackwerth, Jens Carsten, 2005. "Incentive contracts and hedge fund management," CoFE Discussion Papers 05/02, University of Konstanz, Center of Finance and Econometrics (CoFE).
    4. Hulebak, Karen, 2001. "Risk Management," Agricultural Outlook Forum 2001 33049, United States Department of Agriculture, Agricultural Outlook Forum.
    5. Carl Ackermann & Richard McEnally & David Ravenscraft, 1999. "The Performance of Hedge Funds: Risk, Return, and Incentives," Journal of Finance, American Finance Association, vol. 54(3), pages 833-874, June.
    6. George A. Akerlof, 1970. "The Market for "Lemons": Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 84(3), pages 488-500.
    Full references (including those not matched with items on IDEAS)

    Citations

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    Cited by:

    1. Clauss, Pierre & Roncalli, Thierry & Weisang, Guillaume, 2009. "Risk Management Lessons from Madoff Fraud," MPRA Paper 36754, University Library of Munich, Germany.
    2. John Thanassoulis, 2011. "Industrial Structure, Executives' Pay And Myopic Risk Taking," Economics Series Working Papers 571, University of Oxford, Department of Economics.
    3. Marcus Miller & Ishita Mohanty & Lei Zhang, 2009. "The Illusion Of Stability—Low Inflation In A Bubble Economy," Manchester School, University of Manchester, vol. 77(s1), pages 126-149, September.
    4. Patrick Minford, 2010. "The Banking Crisis: A Rational Interpretation," Political Studies Review, Political Studies Association, vol. 8(1), pages 40-54, January.
    5. John Thanassoulis, 2011. "Bankers' Pay Structure And Risk," Economics Series Working Papers 545, University of Oxford, Department of Economics.

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    More about this item

    Keywords

    incentive contracts; excess returns;

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