We examine the relation between incentive fees and hedge fund performance. In an industry where information asymmetries (and the consequent risk of agency problems) are severe, the efficacy of such outcomes-based contracting to align investor and manager interests is of fundamental importance to investors.
Consistent with theory, we find that the higher a hedge fund’s incentive fee the higher its average returns. Although the incentive fee is positively linked to average returns, the relationship is economically small. Crucially, those managers with greater incentive fees do not generate superior risk adjusted returns. Rather, we find that higher incentive fee funds take on more leverage, and most importantly, take on considerably more financial risk.
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