Key Takeaways
- • Investors in a sample of 5,917 hedge funds (1995-2016) received only 36 cents of every dollar earned on invested capital after incentive and management fees, according to NBER Working Paper 27454 by Itzhak Ben-David, Justin Birru, and Andrea Rossi.
- • Managers collected 49.6 percent of cumulative gross profits above the hurdle rate as incentive fees, versus an average contractual incentive fee of 19 percent.
- • Residual fees, paid on gains later offset by losses, amount to 1.19 percent of assets under management per year across the sample.
- • Over 22 years, the sample funds earned $228 billion in gross profits and managers collected $133 billion in incentive fees, of which $70 billion were residual fees; the researchers extrapolate residual fees to $194 billion across the industry.
- • The researchers attribute the gap to fund-level fee calculation, lack of refunds after later losses, investor return-chasing, and fund liquidations that retain earlier incentive fees.
Summary
A study by NBER researchers Itzhak Ben-David, Justin Birru, and Andrea Rossi, published as NBER Working Paper 27454 and summarized by Linda Gorman, challenges the hedge fund industry's claim that its incentive structure tightly aligns manager and investor interests. The hedge fund model typically pairs a management fee of 1 to 2 percent of assets under management with an incentive fee of about 20 percent of gains, with incentive fees accruing only on returns above a risk-free hurdle rate and above a prior high-water mark.
Using data on 5,917 hedge funds from 1995 to 2016, the authors find that the average contractual incentive fee is 19 percent, but managers collected 49.6 percent of cumulative gross profits above the hurdle as incentive fees. Including management fees, managers took 64 cents of every dollar earned net of riskless returns, leaving investors 36 cents. The authors attribute the gap to three asymmetries: fees are assessed at the fund level so losses in one fund cannot offset gains in another; incentive fees paid on earlier gains are not returned when later losses occur; and funds with persistent losses liquidate without refunding earlier fees. Investor return-chasing, which leads to withdrawals after losses, compounds the effect.
The researchers separate incentive fees into "justified fees," earned on lifetime profits, and "residual fees," paid on gains later erased by losses. Residual fees equal 1.19 percent of assets under management per year in aggregate and are spread fairly evenly across the performance distribution. Over the 22-year period, sample funds generated $228 billion in gross profits, and managers collected $133 billion in incentive fees, $70 billion of which were residual fees. Extrapolating to the full industry, the authors estimate residual fees of $194 billion.
The authors conclude that the prevailing compensation structure "fails to protect investors from paying fees to fund managers that perform poorly in the long run," and that higher incentive fee rates would not necessarily tighten the link between fees and performance. The findings bear on allocators evaluating fee terms, fund-level versus series-level fee structures, and the net-of-fee returns they should underwrite.
Using data on 5,917 hedge funds from 1995 to 2016, the authors find that the average contractual incentive fee is 19 percent, but managers collected 49.6 percent of cumulative gross profits above the hurdle as incentive fees. Including management fees, managers took 64 cents of every dollar earned net of riskless returns, leaving investors 36 cents. The authors attribute the gap to three asymmetries: fees are assessed at the fund level so losses in one fund cannot offset gains in another; incentive fees paid on earlier gains are not returned when later losses occur; and funds with persistent losses liquidate without refunding earlier fees. Investor return-chasing, which leads to withdrawals after losses, compounds the effect.
The researchers separate incentive fees into "justified fees," earned on lifetime profits, and "residual fees," paid on gains later erased by losses. Residual fees equal 1.19 percent of assets under management per year in aggregate and are spread fairly evenly across the performance distribution. Over the 22-year period, sample funds generated $228 billion in gross profits, and managers collected $133 billion in incentive fees, $70 billion of which were residual fees. Extrapolating to the full industry, the authors estimate residual fees of $194 billion.
The authors conclude that the prevailing compensation structure "fails to protect investors from paying fees to fund managers that perform poorly in the long run," and that higher incentive fee rates would not necessarily tighten the link between fees and performance. The findings bear on allocators evaluating fee terms, fund-level versus series-level fee structures, and the net-of-fee returns they should underwrite.
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