The Hedge Fund Game
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.
References listed on IDEAS
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- Jens Carsten Jackwerth & James Hodder, 2005.
"Incentive Contracts and Hedge Fund Management,"
wp05-10, Warwick Business School, Finance Group.
- Vikas Agarwal, 2004. "Risks and Portfolio Decisions Involving Hedge Funds," Review of Financial Studies, Society for Financial Studies, vol. 17(1), pages 63-98.
- 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-.
- Hulebak, Karen, 2001. "Risk Management," Agricultural Outlook Forum 2001 33049, United States Department of Agriculture, Agricultural Outlook Forum.
- 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, 06.
- George A. Akerlof, 1970. "The Market for "Lemons": Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, Oxford University Press, vol. 84(3), pages 488-500.
- repec:knz:cofedp:0502 is not listed on IDEAS
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