Why Do Hedge Fund Managers Outperform?

Abstract

We rationalize the persistent performance of hedge funds with a simple model that takes into account the peculiarities of this industry. We show how incentive fees and the lack of benchmarking opportunities combine with the income-maximizing behaviors of managers to effectively align the interests of investors and managers. Through fee revisions, hedge funds manipulate their attractiveness toward investors and control their size. Therefore, performance-diluting flows do not occur and performance persists. The predictions of our model are consistent with the literature and are confirmed by our analysis of a unique dataset of hedge fund fee revisions. Our findings contribute to the regulatory debate by demonstrating that performance-based remunerations are beneficial to both investors and managers.