IDEAS home Printed from https://ideas.repec.org/a/eee/ecmode/v132y2024ics0264999324000026.html
   My bibliography  Save this article

Hedge fund fee structure and risk exposure

Author

Listed:
  • 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
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0264999324000026
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.econmod.2024.106646?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to

    for a different version of it.

    References listed on IDEAS

    as
    1. Kouwenberg, Roy & Ziemba, William T., 2007. "Incentives and risk taking in hedge funds," Journal of Banking & Finance, Elsevier, vol. 31(11), pages 3291-3310, November.
    2. Paolo Guasoni & Gu Wang, 2015. "Hedge and mutual funds’ fees and the separation of private investments," Finance and Stochastics, Springer, vol. 19(3), pages 473-507, July.
    3. Paolo Guasoni & Jan Obłój, 2016. "The Incentives Of Hedge Fund Fees And High-Water Marks," Mathematical Finance, Wiley Blackwell, vol. 26(2), pages 269-295, April.
    4. Hodder, James E. & Jackwerth, Jens Carsten, 2007. "Incentive Contracts and Hedge Fund Management," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(4), pages 811-826, December.
    5. Hellwig, Klaus, 2004. "Portfolio selection subject to growth objectives," Journal of Economic Dynamics and Control, Elsevier, vol. 28(10), pages 2119-2128, September.
    6. 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.
    7. Sid Browne, 1999. "Beating a moving target: Optimal portfolio strategies for outperforming a stochastic benchmark," Finance and Stochastics, Springer, vol. 3(3), pages 275-294.
    8. Lan, Yingcong & Wang, Neng & Yang, Jinqiang, 2013. "The economics of hedge funds," Journal of Financial Economics, Elsevier, vol. 110(2), pages 300-323.
    9. Philip H. Dybvig, 1995. "Dusenberry's Ratcheting of Consumption: Optimal Dynamic Consumption and Investment Given Intolerance for any Decline in Standard of Living," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 62(2), pages 287-313.
    10. Jennifer N. Carpenter, 2000. "Does Option Compensation Increase Managerial Risk Appetite?," Journal of Finance, American Finance Association, vol. 55(5), pages 2311-2331, October.
    11. Congming Mu & Jingzhou Yan & Jinqiang Yang, 2023. "Robust risk choice under high-water mark contract," Review of Quantitative Finance and Accounting, Springer, vol. 61(1), pages 295-322, July.
    12. Itamar Drechsler, 2014. "Risk Choice under High-Water Marks," The Review of Financial Studies, Society for Financial Studies, vol. 27(7), pages 2052-2096.
    13. repec:bla:jfinan:v:59:y:2004:i:1:p:207-225 is not listed on IDEAS
    14. Sanford J. Grossman & Zhongquan Zhou, 1993. "Optimal Investment Strategies For Controlling Drawdowns," Mathematical Finance, Wiley Blackwell, vol. 3(3), pages 241-276, July.
    15. Mu, Congming & Yan, Jingzhou & Liang, Zhian, 2021. "Optimal risk taking under high-water mark contract with jump risk," Finance Research Letters, Elsevier, vol. 38(C).
    16. Andrea Buraschi & Robert Kosowski & Fabio Trojani, 2014. "When There Is No Place to Hide: Correlation Risk and the Cross-Section of Hedge Fund Returns," The Review of Financial Studies, Society for Financial Studies, vol. 27(2), pages 581-616.
    17. Black, Fischer & Perold, AndreF., 1992. "Theory of constant proportion portfolio insurance," Journal of Economic Dynamics and Control, Elsevier, vol. 16(3-4), pages 403-426.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Luo, Changqing & Fu, Xinxin & Chen, Carl R. & Dong, Liang, 2025. "Who is smarter? Evidence from extreme financial risk contagion in hedge funds and mutual funds," The North American Journal of Economics and Finance, Elsevier, vol. 75(PA).
    2. Dickinson, David & Han, Xuyuan & Liu, Zhenya & Zhan, Yaosong, 2024. "Fee structure and equity fund manager’s optimal locking in profits strategy," International Review of Financial Analysis, Elsevier, vol. 96(PA).

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Congming Mu & Jingzhou Yan & Jinqiang Yang, 2023. "Robust risk choice under high-water mark contract," Review of Quantitative Finance and Accounting, Springer, vol. 61(1), pages 295-322, July.
    2. Dai, Na & Nahata, Rajarishi & Brauner, Aaron, 2022. "Does individualism matter for hedge funds? A cross-country examination," Journal of Corporate Finance, Elsevier, vol. 72(C).
    3. Bin Zou, 2017. "Optimal Investment In Hedge Funds Under Loss Aversion," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 20(03), pages 1-32, May.
    4. Escobar-Anel, M. & Havrylenko, Y. & Zagst, R., 2020. "Optimal fees in hedge funds with first-loss compensation," Journal of Banking & Finance, Elsevier, vol. 118(C).
    5. Constantin Mellios & Anh Ngoc Lai, 2022. "Incentive Fees with a Moving Benchmark and Portfolio Selection under Loss Aversion," Post-Print hal-03708926, HAL.
    6. Marcos Escobar-Anel & Vincent Höhn & Luis Seco & Rudi Zagst, 2018. "Optimal fee structures in hedge funds," Journal of Asset Management, Palgrave Macmillan, vol. 19(7), pages 522-542, December.
    7. Gong Zhan, 2011. "Manager fee contracts and managerial incentives," Review of Derivatives Research, Springer, vol. 14(2), pages 205-239, July.
    8. Zhao, Li & Huang, Wenli & Yang, Chen & Li, Shenghong, 2018. "Hedge fund leverage with stochastic market conditions," International Review of Economics & Finance, Elsevier, vol. 57(C), pages 258-273.
    9. Mu, Congming & Yan, Jingzhou & Liang, Zhian, 2021. "Optimal risk taking under high-water mark contract with jump risk," Finance Research Letters, Elsevier, vol. 38(C).
    10. Scheckenbach, Isabel & Wimmer, Maximilian & Dorfleitner, Gregor, 2021. "The higher you fly, the harder you try not to fall: An analysis of the risk taking behavior in social trading," The Quarterly Review of Economics and Finance, Elsevier, vol. 82(C), pages 239-259.
    11. Ewald, Christian-Oliver & Zhang, Hai, 2016. "Hedge fund seeding via fees-for-seed swaps under idiosyncratic risk," Journal of Economic Dynamics and Control, Elsevier, vol. 71(C), pages 45-59.
    12. Antje Mahayni & Judith C. Schneider, 2016. "Minimum return guarantees, investment caps, and investment flexibility," Review of Derivatives Research, Springer, vol. 19(2), pages 85-111, July.
    13. Ron Kaniel & Stathis Tompaidis & Ti Zhou, 2019. "Impact of Managerial Commitment on Risk Taking with Dynamic Fund Flows," Management Science, INFORMS, vol. 65(7), pages 3174-3195, July.
    14. Agarwal, Vikas & Ruenzi, Stefan & Weigert, Florian, 2017. "Tail risk in hedge funds: A unique view from portfolio holdings," Journal of Financial Economics, Elsevier, vol. 125(3), pages 610-636.
    15. Zongxia Liang & Yang Liu & Litian Zhang, 2021. "A Framework of State-dependent Utility Optimization with General Benchmarks," Papers 2101.06675, arXiv.org, revised Dec 2023.
    16. Junbeom Lee & Xiang Yu & Chao Zhou, 2019. "Lifetime Ruin under High-watermark Fees and Drift Uncertainty," Papers 1909.01121, arXiv.org, revised Oct 2020.
    17. Balder, Sven & Brandl, Michael & Mahayni, Antje, 2009. "Effectiveness of CPPI strategies under discrete-time trading," Journal of Economic Dynamics and Control, Elsevier, vol. 33(1), pages 204-220, January.
    18. Yang, Fan & Havranek, Tomas & Irsova, Zuzana & Novak, Jiri, 2022. "Hedge Fund Performance: A Quantitative Survey," MetaArXiv vq8cp_v1, Center for Open Science.
    19. Lan, Yingcong & Wang, Neng & Yang, Jinqiang, 2013. "The economics of hedge funds," Journal of Financial Economics, Elsevier, vol. 110(2), pages 300-323.
    20. Rui de Figueiredo & Evan Rawley & Orie Shelef, 2014. "Bad Bets: Excessive Risk Taking, Convex Incentives, and Performance," Discussion Papers 13-002, Stanford Institute for Economic Policy Research.

    More about this item

    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

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:ecmode:v:132:y:2024:i:c:s0264999324000026. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/inca/30411 .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.