Do Incentive Fees Signal Skill? Evidence from the Hedge Fund Industry

PAUL LAJBCYGIER, MONASH UNIVERSITY, JOSEPH RICH, MONASH UNIVERSITY

15 August 2014

We examine whether fee structure acts as a reliable signal of hedge fund performance. Recent theoretical work suggests that, given the unique asymmetries faced by hedge fund investors, managers use performance-based incentives to signal skill. We test this hypothesis empirically and find little support for the notion that high incentive fee funds generate superior risk-adjusted returns during normal market conditions. Rather, increases in incentive level are accompanied by an increased proclivity to take on risk and increased leverage. Consequently, higher incentive fee funds suffer higher rates of attrition. Higher incentive fee funds do demonstrate lower market correlations and thus provide enhanced diversification benefits. As a result, high fee funds exhibited remarkable outperformance during the recent global financial crisis.

In theory, skilled fund managers will be attracted to funds that reward them with large incentives to generate good performance. Hedge fund incentive fees are large, show considerable variation and do not change throughout the life of the fund. Therefore they provide a unique opportunity to test this theory.

Hedge fund managers may be paid a substantial portion of the profits they generate on behalf of the investor. Such large incentive fees should align manager and investor interests since significant investor profits will result in large manager profits as well. Furthermore, there exists considerable variation in incentive fees among hedge fund managers. This variation should signal skill because the largest incentive fees should accrue to the most skilled managers who generate the largest risk-adjusted profits and vice-versa.

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 significant, 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.

Importantly, high fee funds exhibit low market correlations during both ‘normal’ market conditions and periods of extreme market volatility. Thus, high fee funds demonstrated considerable outperformance in generating both raw and risk-adjusted returns during the recent global financial crisis. The results reject the notion that high fee hedge funds exhibit ‘market timing’ ability, that is, that they increase their exposure to the market during upswings, and decrease market exposure just before market downturns.

Finally, our analysis suggests that, over the long-term term, funds with higher incentive fees also suffer from higher rates of attrition. However, when we account for the number of days survived before liquidation, our findings demonstrate that high fee funds that do survive, exhibit comparable longevity with their low-fee counterparts. Further, during the 2008−09 global financial crisis, and with the exception of funds in the top incentive fee decile, funds with higher incentive fees demonstrated higher survival rates than their low-fee counterparts thus confirming the competitive advantage that these fee funds exhibit during periods of severe market instability.

Overall, our findings do not support the notion that incentive-based fees act as a signal of superior skill. The information that investors can elicit from incentive-based fees relates more to the manager’s propensity for risk, rather than their ability to generate superior returns. This is consistent with the notion that those markets in which hedge funds operate are efficient and that as a consequence persistent, abnormal returns cannot be easily generated, even when very large incentive fees are offered.