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Abstract
The ideal fee structure aligns the incentives of the investor with those of the fund manager. Mutual funds typically only charge a management fee that is a proportion of the funds under management. Hedge funds, on the other hand, generally change an incentive fee that is a fraction of the fund’s return each year in excess of the high-water mark. The justification generally given for these incentive fees is that they provide the manager with the incentive to target absolute returns. As these incentive fees can be considered a call option on the performance of the fund, it is possible that the managers’ incentives might vary according to the delta of this option. A number of articles have examined the optimal investment strategies of money managers in the presence of incentive fees within theoretical frameworks with seemingly conflicting results. Using a large database of hedge fund returns, the authors examine the risk taking behavior of hedge fund managers in response to both their past returns relative to their high-water mark and their past returns relative to their peer group. An attempt is made to reconcile these results with the theoretical frameworks proposed.
- © 2009 Pageant Media Ltd
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