The Hedge Fund Game: Incentives, Excess Returns, and Piggy-Backing.

Working paper

We show that it is very difficult to structure incentive schemes that distinguish between unskilled hedge fund managers, who cannot generate excess returns, and highly skilled managers who can consistently deliver such returns. Under any incentive scheme that does not levy penalties for underperformance, managers with no investment skill can "game" the system to earn expected fees that are at least as high, relative to expected gross returns, as they are for the most skilled managers. Various ways of eliminating this "piggy-back problem" are examined, but the nature of the derivatives market means that it cannot be eliminated entirely.

Authors: Foster, D; Young, H

• Publisher: Oxford-Man Institute of Quantitative Finance
• Series: Working papers
• Publication date: 2008-03-02
• Language: English