Incentives and Risk Taking in Hedge Funds

Abstract

This paper presents a theoretical study of how incentives affect hedge fund risk and returns and an empirical study of the performance of a large group of operating hedge funds. Most hedge fund managers receive a flat fee plus a share of the returns above a certain benchmark. We investigate how these features of hedge fund fees affect risk taking by the fund manager in the behavioural framework of prospect theory. The performance related component encourages funds managers to take excessive risk. However, risk taking is greatly reduced if a substantial amount of the manager's own money (at least 30%) is in the fund as well. The empirical results indicate that returns of hedge funds with incentive fees are not significantly more risky than the returns of funds without such a compensation contract. Average returns though, both absolute and risk-adjusted, are significantly lower in the presence of incentive fees. Part of this is the actual fee itself. Fund of hedge funds with higher fees earn higher net returns on average.