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.
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- Hodder, James E. & Jackwerth, Jens Carsten, 2007.
"Incentive Contracts and Hedge Fund Management,"
Journal of Financial and Quantitative Analysis,
Cambridge University Press, vol. 42(04), pages 811-826, December.
- Jens Carsten Jackwerth & James E. Hodder, 2005. "Incentive Contracts and Hedge Fund Management," CoFE Discussion Paper 05-02, Center of Finance and Econometrics, University of Konstanz.
- Jackwerth, Jens Carsten & Hodder, James E., 2006. "Incentive Contracts and Hedge Fund Management," MPRA Paper 11632, University Library of Munich, Germany.
- Jens Carsten Jackwerth & James Hodder, 2005. "Incentive Contracts and Hedge Fund Management," Working Papers wp05-10, Warwick Business School, Finance Group.
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