Laxman Pai, Opalesque Asia: A report by the National Bureau of Economic Research based on data on 5,917 hedge funds over 22 years suggested that after incentive fees and management fees are assessed, investors received only 36 cents of every dollar earned on invested capital.
Over the 22 years studied, the capital invested in the hedge funds in the sample earned gross profits of $228 billion, said the report.
Hedge fund managers collected incentive fees of $133 billion, out of which $70 billion were residual fees. Extrapolating to the entire hedge fund industry over that period, the researchers estimated that the residual fees amounted to $194 billion.
In 'The Performance of Hedge Fund Performance Fees', researchers Itzhak Ben-David, Justin Birru, and Andrea Rossi used data on a sample of 5,917 hedge funds from 1995 to 2016 to investigate how hedge fund incentive contracts perform in practice.
They find that while the average contractual incentive fee in the sample is 19 percent, managers collected 49.6 percent of funds' cumulative gross profits above the hurdle rate as incentive fees.
Inclusive of management fees, fund managers collected 64 cents of every dollar earned, net of riskless returns, on invested capital, while investors took home 36 cents. The high share of returns paid to managers stems from asymmetries in the performance contract, investors' return-chasing behavior, and closures of underwater funds.
Researchers conclude that "the prevailing hedge fund compensation structure fails to protect investors from paying fees to fund managers that perform poorly in the long run" and that higher incentive fees may not ensure a tighter link between fees and fund performance.
Managers' compensation is composed of both an annual management fee and an incentive fee. The former typically ranges between 1 and 2 percent of assets under management, while the latter is often about 20 percent of earned gains. Incentive fees accrue only on gains that exceed a minimum hurdle rate - a risk-free rate - and exceed a previous high valuation. This way, investors pay incentive fees only on "new" gains.
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