The Optimal Size of Hedge Funds: Conflict between Investors and Fund Managers

Abstract

This study examines whether the standard compensation contract in the hedge fund industry aligns managers’ incentives with investors’ interests. I show empirically that managers’ compensation increases when fund assets grow, even when diseconomies of scale in fund performance exist. Thus, managers’ compensation is maximized at a much larger fund size than is optimal for fund performance. However, to avoid capital outflows, managers are also motivated to restrict fund growth to maintain style-average performance. Similarly, fund management firms have incentives to collect more capital for all funds under management, even at the expense of fund performance, including their flagship funds.

Keywords: Hedge Fund, Optimal Size, Conflict of Interest, Incentive

JEL Classification: G20, G23, G29