* Impact of Incentive Fees

Factor models are frequently applied to hedge fund returns in an attempt to separate the return from identified risk factors (beta) and from manager skill (alpha). More recently, these same techniques have been used to replicate the returns from hedge fund strategies with varying degrees of success.

In the following paper, researchers show that due to the particular nature of hedge fund incentive contracts, the use of net of fee returns can lead to considerably biased estimates of factor exposures which can distort the picture of fund manager performance. The solution they propose is to model the gross returns of hedge funds and the incentive fees independently, which gives a truer representation of the underlying return generating process.

Using a large sample of hedge funds, they quantify the effect of this bias on both performance attribution and replication. They find that using net of fee returns understates the return attributable to beta by up to 58 basis points per annum.

Following from this they find that some of the additional beta exposure can be captured by basing replication on gross rather than net returns. They also investigate the risk taking behaviour of fund managers conditional upon the delta of their incentive option and find that contrary to previous studies, there does appear to be evidence of increased risk taking for those managers who find themselves significantly below their high water mark.

Detail: The Gross Truth About Hedge Fund Performance and Risk: The Impact of Incentive Fees