A hedge fund manager’s performance-based incentive fees are indicative of his or her appetite for risk and leverage rather than skill, a study has found.
According to research conducted by Paul Lajbcygier and Joseph Rich of Monash University in Australia, high fee funds resulted in slightly higher average returns but did not generate superior risk-adjusted returns from 2001 to 2007.
The study found a 1% increase in incentive fees led to minimal average increase in annual returns, of only 0.058%. Higher fees also resulted in negligible changes in the Sharpe ratio, the authors said.
“In an industry that relies on outcomes-based contracting to mitigate agency costs, it would seem that even very large incentive-based fees fail to accurately signal performance as proxied by a fund’s ability to generate superior risk-adjusted returns,” Lajbcygier and Rich wrote.
High-fee managers took on more risk rather than implementing “more profitable strategies” that would exhibit “superior managerial ability,” the paper argued.
“High-fee funds may have no other choice but to take on more risk in order to generate a sufficient level of before-fee returns required to remain competitive,” the authors said.
Excessive risk-taking—facilitated by greater leverage—could be attributed to falling alpha combined with a drastic increase in assets under management in the hedge fund industry over the past decade, the paper said.
“Given the decreased level of exploitable arbitrage opportunities, it may be increasingly difficult for managers with high incentive fees to generate sufficient returns through unique investment strategies,” the authors said. “Thus, high-fee funds may have no other choice but to take on more risk in order to generate a sufficient level of before-fee returns required to remain competitive.”
The authors also argued that over the long term, hedge funds with incentive fees higher than the median 20% suffered from high rates of attrition, or low survival rates, largely caused by dangerous risk-taking tendencies.
However, high-fee funds were able to produce greater diversification benefits than their average-to-low fee counterparts, especially during times of extreme market volatility, the paper found. During the financial crisis, the high-fee funds had adopted strategies that provided low market exposures, which allowed them to outperform other funds.
Read the full paper here.
Related Content: Are You Lucky or Skilled?