#07-42
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
market.
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