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THE INCENTIVES OF HEDGE FUND FEES AND HIGH-WATER MARKS

Authors


  • We thank for helpful comments Andrea Buraschi, Hualei Chang, Jaksa Cvitanic, Damir Filipovic, Vicky Henderson, Robert Kosowski, Semyon Malamud, Stavros Panageas, Tarun Ramadorai, Mihai Sirbu, Xun Yu Zhou, and seminar participants at the U.K. Financial Services Authority, Oxford, Cornell, Imperial College, London School of Economics, Fields Instutute, UC Santa Barbara, TU Vienna, SUNY Stony Brook, Edinburgh, and TU Berlin. P. Guasoni is supported by the ERC (278295), NSF (DMS-1109047), SFI (07/MI/008, 07/SK/M1189, 08/SRC/FMC1389), and FP7 (RG-248896). J. Obloj is supported by FP6 (MEIF-CT-2006-040623).

Abstract

Hedge fund managers receive a large fraction of their funds' profits, paid when funds exceed their high-water marks. We study the incentives of such performance fees. A manager with long-horizon, constant investment opportunities and relative risk aversion, chooses a constant Merton portfolio. However, the effective risk aversion shrinks toward one in proportion to performance fees. Risk shifting implications are ambiguous and depend on the manager's own risk aversion. Managers with equal investment opportunities but different performance fees and risk aversions may coexist in a competitive equilibrium. The resulting leverage increases with performance fees—a prediction that we confirm empirically.

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