Hedge Fund Investing Chapter 10: Fund Terms and Incentives

Why do hedge fund managers charge so much? And does paying more actually get you better results? Chapter 10 of Mirabile’s book tackles this. Turns out, the way you structure a fund’s fees and terms has a real effect on how the manager behaves. And how the manager behaves determines your returns.

Let me break it down.

The Fee Machine

Hedge funds charge two types of fees.

Management fee is a fixed percentage of assets under management. Usually 1-5%. You pay it no matter what. The manager uses it to keep the lights on: rent, salaries, Bloomberg terminals, fancy coffee.

Performance fee (also called incentive fee) is a cut of the profits. Usually 5-50%, with 20% being the classic number. This is where the real money is for managers.

Compare this to mutual funds. A mutual fund manager gets paid a flat rate, maybe 0.1% to 1.5% of assets. That is it. No performance bonus. No skin in the game. No personal money in the fund.

Hedge fund managers, by contrast, often have a big chunk of their own wealth in the fund. They eat their own cooking. This changes behavior.

High-Water Marks and Hurdle Rates

Two terms that keep managers honest.

High-water mark means the manager only gets a performance fee when the fund is profitable AND has recovered all previous losses. So if your fund drops 10% one year, the manager earns zero incentive fee until they make back that 10% plus generate new profits. No double-dipping on recovery.

Hurdle rate is even tougher. It is a minimum return the fund must hit before any performance fee kicks in. Less than 5% of funds have one, though. Managers prefer to skip this one for obvious reasons.

Both features push managers to work harder. Goetzmann’s 2003 study found that high-water marks actually forced funds to take more risk and aim for higher performance to hit their compensation targets.

But here is a twist. Panageas (2009) found that hurdle rates made managers more careful, not more reckless. Managers with hurdle rates allocated capital efficiently and avoided excessive risk. They wanted to protect their shot at the incentive payment.

Agency Theory: Why This Matters

There is a formal name for this whole dynamic: agency theory.

The basic idea is simple. You (the investor, or “principal”) give your money to someone else (the manager, or “agent”) to invest. Problem: you cannot watch what they do every minute. They might act in their own interest, not yours. They might take crazy risks. Or they might do nothing and collect fees.

So how do you keep them in line? Two options.

Monitor them. Daily reporting, regulatory oversight, ability to fire them fast. This is the mutual fund approach. Cheap to implement, works okay for simple tasks.

Incentivize them. Pay them well when they perform, pay them nothing when they don’t. Give them ownership. This is the hedge fund approach. Better for complex, creative work where you can’t easily watch over someone’s shoulder.

This is not new. Carlos (1992) studied trading companies from the 1600s. The Hudson Bay Company and Royal African Company paid premium wages to ship captains to prevent them from skimming profits during overseas voyages. When you can’t monitor someone sailing across the Atlantic, you make sure they are paid enough to stay loyal. Same logic applies to hedge fund managers today.

The Evidence: Do Higher Fees Actually Help?

Mixed, but mostly yes.

Jensen’s famous 1967 study showed mutual fund managers (low fees, no incentives) almost never beat their benchmark. Lakonishok found pension fund managers actually subtracted value compared to the S&P 500. Stoughton (1993) argued flat-fee contracts lead to underinvestment and lack of effort. Makes sense. If you get paid the same whether you return 5% or 15%, why put in the extra work?

On the hedge fund side, Golec (1993) was one of the first to show that incentive compensation was positively related to returns. Higher fees, higher returns. But also higher risk. Chevalier and Ellison (1997), Liang (1999), and Agarwal et al. (2009) all confirmed: funds with stronger incentives performed better.

DeSouza (2003) offered a nice explanation. He said it is not that fees cause performance. It is that skilled managers signal their confidence by charging more. If you know you are good, you ask for 25% of profits instead of 15%.

Not everyone agrees. Brown et al. (1999) found higher fees did not lead to significantly better results. So the picture is complicated.

Manager Discretion: Lock-ups, Redemptions, and Notice Periods

Beyond fees, another big factor is how much freedom the manager has.

Lock-up period is how long your initial investment must stay in the fund before you can pull it out. Could be months. Could be years.

Redemption period is how often you can take money out after the lock-up. Monthly, quarterly, annually, or even less frequently.

Notice period is how many days in advance you must tell the fund you want to redeem.

Why does this matter? Because a manager who knows investors can pull money out any day will behave differently than one who has capital locked up for two years.

More discretion means more time to think. More time to let trades play out. More freedom to buy illiquid assets that take longer to generate returns. Academic studies overwhelmingly show a positive link between discretion and performance.

Finkelstein (1998) found that high-discretion environments increase a CEO’s ability to directly influence firm results. Caza (2011) showed the same for business unit managers. And in hedge funds, Agarwal et al. (2009) found that greater managerial discretion was associated with better performance.

There is a risk, though. More discretion with limited personal liability can lead to bad behavior. Diestre (2005) warned about this. His fix: co-investment. When the manager’s own money is at risk, discretion is less likely to be abused.

Young Funds vs. Old Funds

One more thing Mirabile covers: fund age.

Younger funds tend to outperform. Why? Motivation. A new manager needs to build a track record to attract assets. Their fund costs come out of their own pocket in the early years. If they don’t perform, they shut down within five years. That creates serious urgency.

Boyson (2008) found something interesting. Each additional year of experience led to a 0.08% decrease in annual returns. More experience, lower returns. He attributed this to decreasing risk-taking as managers get comfortable.

So young and hungry beats old and comfortable. At least in the data.

Where You Sit Matters Too

The chapter also covers location effects. Hedge funds cluster in places like New York, Greenwich, Chicago, London. This is not random. Being near other funds, prime brokers, and service providers creates advantages through what economists call “economies of agglomeration.”

Better access to talent. Better access to information. Better access to capital. Marshall wrote about this back in 1920 for industries in general. It applies to hedge funds too, though the empirical evidence for a direct performance boost from location is still thin.

The Bottom Line

Pay your managers well, give them skin in the game, lock up capital so they have room to operate, and put high-water marks in place so they can’t collect fees on recovery alone.

That is the formula Chapter 10 suggests. Not all studies agree on every detail, but the direction is clear: aligned incentives beat flat-fee structures for complex investment tasks.

The old ship captains of the Hudson Bay Company could have told you the same thing 400 years ago.

Previous: Chapter 9 | Next: Chapter 11 Part 1

This is part of a series retelling of “Hedge Fund Investing” by Kevin R. Mirabile.