The Optimal Size Of Hedge Funds by Chengdong Yin, Harvard Law School Forum
In my article, The Optimal Size of Hedge Funds: Conflict between Investors and Fund Managers, forthcoming in the Journal of Finance, I examine whether the standard compensation contract in the hedge fund industry aligns managers’ incentives with investors’ interests. One of the important ways in which hedge funds differ from traditional investment vehicles is in the design of managers’ compensation contracts. A key difference is that, in contrast to their peers in the mutual fund industry, hedge fund managers charge an additional performance-based incentive fee. The incentive fee allows hedge fund managers to charge part of fund profits as their compensation and is intended to motivate them to maximize fund performance.
However, evidence on the extent to which the standard compensation contract of hedge funds aligns managers’ incentives with investors’ best interests is mixed. Like other investment vehicles, such as mutual funds, hedge funds are likely to suffer from diseconomies of scale. Limited investment opportunities, potential negative price impacts from large block trading, and high transaction and administrative costs may erode fund performance when funds grow large. This decline in performance generates a conflict of interest between investors and fund managers. If managerial compensation contract design is effective, it should mitigate such conflicts of interest, and fund assets should match the optimal size for fund performance. Indeed, some hedge fund managers claim that they protect their investors by closing their funds to new investment. However, many hedge funds become too big to show profits. In addition, previous research such as Getmansky (2012) and Teo (2009) documents that diseconomies of scale continue to exist in the hedge fund industry. In other words, it appears that incentive fee contracts do not provide fund managers with sufficient motive to restrict fund growth and protect fund performance.
This study seeks to reconcile these apparently contradictory findings. The literature commonly overlooks the fact that the compensation of hedge fund managers, who care about their compensation in absolute dollar terms, also depends on fund size. This study overcomes this shortcoming by examining how hedge fund managers’ compensation is related to both fund performance and fund size. With a more accurate measure, I then examine whether the standard compensation contract in the hedge fund industry aligns managers’ incentives with investors’ best interests and, if not, how fund managers’ incentives influence fund growth and performance.
I first examine individual hedge funds and test whether there are diseconomies of scale in fund performance. Consistent with the literature, I find that fund growth erodes fund performance. The existence of diseconomies of scale suggests that there is an optimal fund size for fund performance. Theoretically, under effective compensation contracts, the optimal fund size for managers’ compensation should match the optimal size for fund performance. However, the two optimal sizes are different under the standard compensation contract. Measuring compensation in absolute dollar terms, I find that hedge fund managers’ compensation increases as fund assets grow, even when diseconomies of scale exist. There are two possible explanations for this finding. First, the performance-based incentive fee in absolute dollar terms increases with fund size. Because diseconomies of scale exist, this result implies that the increase in fund assets is faster than the decrease in fund performance. Second, when fund assets grow, the management fee increases, regardless of the changes in the incentive fee. Ultimately, the management fee may become the more important part of managers’ total compensation. Fund managers therefore likely have strong incentives to increase their assets under management. As discussed earlier, when diseconomies of scale exist, this is not in the best interests of hedge fund investors.
To increase fund assets, fund managers need to attract capital inflows and avoid capital outflows. For this reason, I next examine the association between capital flows and fund performance. Consistent with the literature, I find that investors chase performance with different sensitivities. Investors are most sensitive when funds are in the poorest and the best performance groups, and they are least sensitive when funds have average performance. Because hedge fund investors likely evaluate and compare fund performance within the same style category, I expect that fund managers need to maintain style-average performance to avoid outflows and hence restrict fund size when fund growth erodes performance to the style-average level. This notion is supported by fund closure decisions. I find that most funds close to new investment around the fund size at which they can provide style-average performance.
Another way for fund managers to increase their assets under management is to launch new funds. Accordingly, I also analyze performance and compensation at the fund family level. If fund management firms keep each fund at its optimal size for performance and collect more capital by increasing the funds under management, it is possible for fund families to boost compensation without hurting performance. However, the empirical results show that larger fund families underperform, while they generate much higher compensation than do their smaller peers. Therefore, fund management firms have strong incentives to increase total assets under management, even when family growth erodes family performance.
Although it appears that fund management firms do not restrict asset growth to protect family performance, they may protect the performance of certain funds, namely, their flagship funds. My analysis does not support this hypothesis. First, I document that flagship funds suffer from diseconomies of scale. This implies that fund managers do not restrict fund growth and collect capital more than optimal for flagship funds’ performance. Second, I observe that flagship funds’ performance rankings decrease following the launch of non-flagship funds, and flagship funds do not outperform their peers in the same style after they are closed to new investment. Thus, it seems that management firms keep collecting capital for all funds under management to maximize their compensation. This is consistent with the results at the individual fund level.
The full article is available for download below.