Compensation and Incentives in Hedge Funds

Abstract

Although hedge funds typically report a 2 and 20 fee structure, some investors want to change this standard practice. Many funds sustained substantial losses as a result of the financial crisis of 2007–2008. Given the strategies used by hedge funds, they were not supposed to incur large losses. Subsequent underperformance to equity during the bull market recovery left many investors questioning the fee structure. Research shows the fee structure is more fluid than typically reported. The reluctance of many hedge fund managers to appear weak perpetuates the reported 2 and 20 fee structure. Fees respond to the relative bargaining power between managers and investors. Some investors speculate that the fee structure encourages managers to undertake high-risk strategies. However, fees and other incentive provisions, such as a high-water mark, provide better opportunities for talented managers to enter the industry, mitigating their subsequent risk-taking.