Rational Behavior of Hedge Fund Managers and Investors

Abstract:     
We propose a rational model of the behavior of hedge fund managers and investors that explains the variations of fees charged by hedge funds. Our work adapts the model of Berk and Green (2004) to the peculiarities of hedge fund remuneration schemes, in particular, to the fact that the fees paid depend on the timing of the investment and that remuneration is not linearly related to size. Flows rationally respond to expected abnormal returns. Managers modify their fees in order to maximize their income by capturing all the abnormal performance they generate. The predictions of our model are consistent with findings of other studies and are confirmed by our analysis of a unique data-set of fee revisions. We show that the marginal abnormal return is not significantly different from zero after fee increases. Investors respond by stopping to allocate to the funds that raise their fees. As a consequence, the remuneration of hedge fund managers remains constant after fee changes. All in all, our results are consistent with rational self-interested behavior of managers and investors.

Number of Pages in PDF File: 38

Keywords: Hedge Fund, Fee, Incentives

JEL Classification: G23, G29

working papers series