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Aug 22 2008 12:30PM EDT

Why Hedge Fund Fees Make Sense

Remember those evil hedge funds. It turns out that, overall, they did a really good job of avoiding the fallout from the credit crunch. The big reason for this, says Columbia University's Charles Calomiris, is the hedge fund fee structure:

The standard hedge fund fee arrangement balances two considerations: the importance of incentive alignment (which encourages profit sharing by managers), and the risk aversion of asset managers (which encourages limiting the downside risk exposure for managers). The result is that hedge fund managers share the upside of long-term portfolio gains but have limited losses on the downside. Because hedge fund compensation structure is not regulated, and because both investors and managers are typically highly sophisticated people, it is reasonable to expect that the hedge fund financing structure has evolved as an "efficient" financial contract, which may explain the superior performance of hedge funds.

The typical hedge fund compensation structure is not permissible for other, regulated asset managers. Other asset managers must share symmetrically in portfolio gains and losses; if they were to keep 20% of the upside, they would have to also absorb 20% of the downside. Since risk-averse fund managers would not be willing to expose themselves to such loss, regulated institutional investors typically charge fees as a proportion of assets managed and do not share in profits. This is a direct consequence of the regulation of compensation, and arguably has been a source of great harm to investors, since it encourages asset managers to maximise the size of the funds that they manage, rather than the value of those funds. Managers who gain from the size of their portfolios rather than the profitability of their investments will face strong incentives not to inform investors of deteriorating opportunities in the marketplace and not to return funds to investors when the return relative to risk of their asset class deteriorates.
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