Optimal fee structures in hedge funds

Abstract

This paper proposes a framework to analyze hedge funds fee arrangements in which the portfolio construction is determined by the hedge fund manager and the fees are determined via an optimal equilibrium between the manager and the investor. In this setting, fees include management fees ( $$\alpha$$ ) and performance fees ( $$\beta$$ ). We select the paradigm of Expected Utility Theory to determine the managers optimal strategy. Benefiting from the dependence of the optimal terminal payoff on the fee structure, we explore two criteria producing an equilibrium fee mutually satisfying the investor and the manager, one based on Pareto Optimality and the second on negotiable regions. The former also leads to a Pareto efficient frontier of fee structures. We obtain evidence that the popular fee structure of $$(\alpha , \beta )=(2\%, 20\%)$$ is not an equilibrium fee between manager and investor. Although such equilibrium heavily depends on risk aversion levels and market conditions, the pair $$(\alpha , \beta )=(0.5\%, 30.7\%)$$ stands out as a fair choice. Moreover, the expected utility of the investor is not monotone in the performance fee for many market conditions. In other words, we prove that fee arrangements which include performance fees are usually beneficial for the investor.