The Hedge Fund Game: Incentives, Excess Returns, and Performance Mimics
Dean P. Foster and H. Peyton Young, November 2007, updated September 2008

Abstract: We show that it is extremely difficult to devise incentive schemes that distinguish between fund managers who cannot deliver excess returns from those who can, unless investors have specific knowledge of the investment strategies being employed. Using a ‘performance‐mimicking’ argument, we show that any fee structure that does not assess penalties for underperformance can be gamed by unskilled managers to generate fees that are at least as high, per dollar of expected returns, as the fees of the most skilled managers. We show further that standard proposals to reform the fee structure, such as imposing high water marks, delaying managers’ bonus payments, forcing them to hold an equity stake, or assessing penalties for underperformance, are not enough to separate the skilled from the unskilled. We conclude that skilled managers will have to find ways other than their track records to distinguish themselves from the unskilled, or else the latter may drive out the former as in a classic lemons


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