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Hedge fund fee structure and risk exposure

Author

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  • Braun, Matias
  • Riutort, Julio
  • Roche, Hervé

Abstract

We provide a closed-form solution for the optimal investment strategy of a hedge fund manager compensated by a management fee and a high-water mark (HWM) contract. The fraction of the assets under management (AUM) allocated to equity is an increasing and convex function of distance to the HWM, with the size of the incentive fee rate enhancing the convexity effect. Importantly, the management fee induces more risk-taking behavior because it provides insurance to the fund manager. Beating the HWM by small amounts is optimal because it mitigates the ratchet feature of the HWM and smooths revenue. The decomposition of revenues between the two fee types is also examined. An extension introduces fund termination triggered by a large AUM drawdown. Risk exposure is either a decreasing or a hump-shaped function of the distance to the HWM.

Suggested Citation

  • Braun, Matias & Riutort, Julio & Roche, Hervé, 2024. "Hedge fund fee structure and risk exposure," Economic Modelling, Elsevier, vol. 132(C).
    • Handle: RePEc:eee:ecmode:v:132:y:2024:i:c:s0264999324000026
    DOI: 10.1016/j.econmod.2024.106646
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    Keywords

    Hedge funds; High-water mark; Incentive fees; Management fees; Optimum portfolio rules; Ratchet effect;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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