Profit Sharing in Hedge Funds

34 Pages Posted: 19 Sep 2011 Last revised: 21 Jun 2016

Xue Dong He

The Chinese University of Hong Kong - Department of Systems Engineering and Engineering Management

Steven Kou

Risk Management Institute, NUS

Date Written: June 21, 2016

Abstract

In a new scheme for hedge fund managerial compensation known as the first-loss scheme, a fund manager uses her investment in the fund to cover any fund losses first; by contrast, in the traditional scheme currently used in most U.S. funds, the manager does not cover investors' losses in the fund. We propose a framework based on cumulative prospect theory to compute and compare the trading strategies, fund risk, and managers' and investors' utilities in these two schemes analytically. The model is calibrated to the historical attrition rates of U.S. hedge funds. We find that with reasonable parameter values both fund managers' and investors' utilities can be improved and fund risk can be reduced simultaneously by replacing the traditional scheme (with 10% internal capital and 20% performance fee) with a first-loss scheme (with 10% first-loss capital and 30% performance fee). When the performance fee in the first-loss scheme is 40% (a current market practice), however, such substitution renders investors worse off.

Keywords: cumulative prospect theory, portfolio selection, hedge funds, managerial incentive, first-loss scheme

JEL Classification: G02, G11

Suggested Citation

He, Xue Dong and Kou, Steven, Profit Sharing in Hedge Funds (June 21, 2016). Available at SSRN: https://ssrn.com/abstract=1929174 or http://dx.doi.org/10.2139/ssrn.1929174

Xue Dong He (Contact Author)

The Chinese University of Hong Kong - Department of Systems Engineering and Engineering Management ( email )

505 William M.W. Mong Engineering Building
The Chinese University of Hong Kong, Shatin, N.T.
Hong Kong
Hong Kong

HOME PAGE: http://https://sites.google.com/site/xuedonghepage/home

Steven Kou

Risk Management Institute, NUS ( email )

21 Heng Mui Keng Terrace
Level 4
Singapore, 119613
Singapore
6516-5062 (Phone)

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