The Myth of Hedge Fund Fee Diversification

Abstract

Many innovative hedge fund fee structures have been introduced in recent years in response to concerns about both the level of hedge fund fees and the incentives they may provoke. A traditional fee structure consists of a flat fee charged as a percentage of the assets under management, together with a performance fee consisting of a percentage of the profits earned. A fee structure that has become more popular recently is the first-loss structure, in which the manager receives a higher performance fee in return for providing some downside protection to investors by insuring some of their losses. Combinations of these fee structures have also been proposed, with the possibility that investors may benefit from some diversification among the fee structures. By considering the investors’ risk-reward tradeoff, the authors show that there is in fact very little benefit from such fee diversification. TOPICS:Real assets/alternative investments/private equity, performance measurement