The Hedge Fund Game

Dean P. Foster and H. Peyton Young

This is an updated version of a paper published Novermber 2007.


We show that it is extremely difficult to devise incentive schemes that distinguish between fund managers who cannot deliver excess returns from those who can, unless investors have specific knowledge of the investment strategies being employed. Using a ‘performance‐mimicking’ argument, we show that any fee structure that does not assess penalties for underperformance can be gamed by unskilled managers to generate fees that are at least as high, per dollar of expected returns, as the fees of the most skilled managers. We show further that standard proposals to reform the fee structure, such as imposing high water marks, delaying managers’ bonus payments, forcing them to hold an equity stake, or assessing penalties for underperformance, are not enough to separate the skilled from the unskilled. We conclude that skilled managers will have to find ways other than their track records to distinguish themselves from the unskilled, or else the latter may drive out the former as in a classic lemons market.


Hedge funds are largely unregulated investment vehicles that have become increasingly important in global financial markets.1 Currently there are nearly ten thousand funds that collectively have over two trillion dollars under management. Although hedge funds pursue a great variety of investment strategies, they have two key features that we shall focus on here. One is the fee structure: the great majority of funds have a two‐part structure consisting of a management fee plus a performance bonus that gives the manager a percentage of any excess returns he generates over and above some benchmark rate. Management fees are typically between 1% and 2% and the most common bonus is 20% (Ackermann, MacEnally, and Ravenscraft, 1999). A second key characteristic shared by many (though not all) hedge funds is lack of transparency: they need not, and often do not, disclose their positions or trading strategies to investors; all they are required to provide is regular audited statements of gains and losses.

These two features – fees based on excess returns and lack of information about how the returns were generated – create incentives for manipulation, as a number of authors have pointed out (Starks, 1987; Carpenter, 2000; Ackermann, MacEnally, and Ravenscraft, 1999; Lo, 2001; Hodder and Jackwerth, 2007). One problem is that the convexity of the fee structure encourages managers to employ strategies with high variance, especially as the date for meeting certain targets is approached. A second problem is that substandard returns in later periods do not offset the earnings from excess returns in earlier periods unless the contract contains clawback provisions, which are fairly unusual. Furthermore it is quite easy to ‘game’ standard measures of performance, such as the Sharpe ratio, Jensen’s alpha, and the appraisal ratio (Goetzmann, Ingersoll, Spiegel, and Welch, 2007; Guasoni, Huberman, and Wang, 2007).

This paper was featured in an article in 

The Financial Times

, March 18, 2008.