Practical Applications of The Myth of Hedge Fund Fee Diversification

Practical Applications Summary

In The Myth of Hedge Fund Fee Diversification, published in the Fall 2019 issue of The Journal of Alternative Investment, Fei Meng, David Saunders (both at the University of Waterloo), and Luis Seco (at the University of Toronto) provide clear insights for hedge fund investors. Recent developments in the hedge fund industry have made more types of fee arrangements available. This study examines the optimality of alternative hedge fund fee structures from an investor’s perspective.

Optimal fee structures correspond to the weights in a hedge fund portfolio that maximize its Sharpe ratio. The authors consider three types of hedge fund portfolios: one with a traditional fee structure, one with a first-loss fee structure, and one that is a blend of the other two (effectively a portfolio with a shared-loss fee structure). Results show that the optimal fee structure depends on a variety of factors—most notably, a hedge fund’s volatility.