Combine the standard hedge fund compensation model with the reality of declining fund performance as assets under management increase and you have a whopping conflict of interest.
Unlike mutual funds, hedge funds typically get an incentive fee, usually 20 percent of profits, in addition to a 1 or 2 percent annual management fee.
That's meant to align the interests of the investor and manager, but flaws in the contract design leave clients open to managers prioritizing their own financial interest.
A newly published study demonstrates that when it comes to hedge fund size the sweet spot for manager compensation is considerably higher than the sweet spot for shareholder returns.
"My empirical results indicate that the optimal size for managers' compensation differs substantially from the optimal size for fund performance. In other words, the standard compensation contract does not solve the conflict of interest between fund investors and fund managers in the hedge fund industry," Chengdong Yin of Purdue University writes in the Journal of Finance.
At the heart of the issue are diseconomies of scale, an ugly term which simply describes situations in which a given arrangement of resources gets less efficient the larger it grows. For hedge and mutual funds diseconomies of scale have been much studied and argued about, but there is broad agreement that it is harder to run a very large fund in a given strategy, and that these very large funds have a tendency towards underperformance. It can be harder finding good opportunities when you are large, much less getting meaningful exposure to them without driving the price up.
In mutual funds, diseconomies of scale and the potential conflicts of interest are, up to a point, self correcting. As fund flows follow fund performance, the biggest funds, if they lag, will lose assets, driving managers' pay down alongside.
For hedge funds though, the math is considerably different.
To examine the issue, the study looked at results from over 2,000 hedge funds of varying strategies from 1994 through 2009.
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