Hedge Fund Compensation: Incentive Fees and Performance Intervals

31 Pages Posted: 30 Jan 2019

See all articles by Daniel Mitchell

Daniel Mitchell

University of Minnesota - Twin Cities - Department of Industrial and Systems Engineering

Kumar Muthuraman

University of Texas at Austin - Red McCombs School of Business

Sheridan Titman

University of Texas at Austin - Department of Finance; National Bureau of Economic Research (NBER)

Date Written: January 18, 2019

Abstract

Performance fees that are designed to incentivize money managers to exert more effort may also distort a manager's risk choices. In this paper, we analyze the impact of the standard performance fee contract that includes what is known as a high-water mark provision. We investigate the effect the fee collection frequency, manager wealth and fee magnitudes, have on the return to investors. We find that when performance fees are reduced but collected more frequently both the manager and the investor can be better off. We do this by modeling the manager's decision making process as a stochastic control problem with both discrete and continuous controls. We also develop a computational method to solve this class of problems and prove its convergence.

Suggested Citation

Mitchell, Daniel and Muthuraman, Kumar and Titman, Sheridan, Hedge Fund Compensation: Incentive Fees and Performance Intervals (January 18, 2019). Available at SSRN: https://ssrn.com/abstract=3318622 or http://dx.doi.org/10.2139/ssrn.3318622

Daniel Mitchell (Contact Author)

University of Minnesota - Twin Cities - Department of Industrial and Systems Engineering ( email )

111 Church St SE
Minneapolis, MN 55455
United States

Kumar Muthuraman

University of Texas at Austin - Red McCombs School of Business ( email )

Austin, TX 78712
United States

Sheridan Titman

University of Texas at Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States
512-232-2787 (Phone)
512-471-5073 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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