Profit Sharing in Hedge Funds

32 Pages Posted: 17 Jan 2018

See all articles by Xue Dong He

Xue Dong He

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

Steven Kou

Boston University

Multiple version iconThere are 2 versions of this paper

Date Written: January 2018

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 US 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 US 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

Suggested Citation

He, Xue Dong and Kou, Steven, Profit Sharing in Hedge Funds (January 2018). Mathematical Finance, Vol. 28, Issue 1, pp. 50-81, 2018, Available at SSRN: https://ssrn.com/abstract=3103420 or http://dx.doi.org/10.1111/mafi.12143

Xue Dong He (Contact Author)

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

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The Chinese University of Hong Kong, Shatin, N.T.
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HOME PAGE: http://https://sites.google.com/site/xuedonghepage/home

Steven Kou

Boston University ( email )

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Boston, MA 02215
United States
6173583318 (Phone)

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