The Optimal Size of Hedge Funds: Conflict between Investors and Fund Managers

• Author: CHENGDONG YIN
• DOI: http://doi.org/10.1111/jofi.12413
• Published date: 01 August 2016
• Date: 01 August 2016

THE JOURNAL OF FINANCE •VOL. LXXI, NO. 4 •AUGUST 2016

The Optimal Size of Hedge Funds: Conflict

between Investors and Fund Managers

CHENGDONG YIN∗

ABSTRACT

This study examines whether the standard compensation contract in the hedge fund

industry aligns managers’ incentives with investors’ interests. I show empirically that

managers’ compensation increases when fund assets grow, even when diseconomies

of scale in fund performance exist. Thus, managers’ compensation is maximized at a

much larger fund size than is optimal for fund performance. However, to avoid capital

outflows, managers are also motivated to restrict fund growth to maintain style-

average performance. Similarly, fund management firms have incentives to collect

more capital for all funds under management, including their flagship funds, even at

the expense of fund performance.

ONE OF THE IMPORTANT WAYS in which hedge funds differ from traditional in-

vestment 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 in-

centive 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 con-

tract 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

∗Chengdong Yin is with the Krannert School of Management at Purdue University. I am in-

debted to my dissertation committee, Lu Zheng (Chair), Philippe Jorion, Christopher Schwarz,

Zheng Sun, and Philip Bromiley for invaluable guidance, support, and encouragement. I thank

Kenneth Singleton (Editor), an Associate Editor, two anonymous referees, David Hirshleifer,Vikas

Agarwal, Chong Huang, Tim Haight, John Bae, Lin Sun, and seminar participants at Purdue Uni-

versity,University of Pittsburgh, Hong Kong University, Shanghai Advanced Institute of Finance,

California State University, Fullerton, the 2014 MFA annual meeting, the 2014 Eastern Finance

Association annual meeting, the 2013 FMA annual meeting, the 2012 FMA doctoral student consor-

tium, and Merage School brown bag seminar for helpful suggestions and comments. All remaining

errors are mine. The author has financial support from Krannert School of Management at Purdue

University. I have read the Journal of Finance’sdisclosure policy and have no conflicts of interest

to disclose.

DOI: 10.1111/jofi.12413

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1858 The Journal of Finance R

should mitigate such conflicts of interest, and fund assets should match the op-

timal size for fund performance. Indeed, some hedge fund managers claim that

they protect their investors by closing their funds to new investment.1However,

many hedge funds become too big to show profits.2In addition, previous re-

search such as Getmansky (2012)andTeo(2009) documents that diseconomies

of scale continue to exist in the hedge fund industry.3In other words, it ap-

pears 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’ in-

centives influence fund growth and performance. These issues are important

for the design of managers’ compensation contracts as well as for hedge fund

investors, as a better understanding of managers’ incentives can help investors

choose among different funds and better monitor fund performance.

I first examine individual hedge funds and test whether there are disec-

onomies 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. The-

oretically, under effective compensation contracts, the optimal fund size for

managers’ compensation should match the optimal size for fund performance.

Effective compensation contract design should thus align managers’ incentives

with investors’ best interests.

However, the two optimal sizes are different under the standard compensa-

tion contract. In the Appendix, I provide a simple model to compare the two

optimal sizes. In the model, fund managers with limited abilities set fund size

to maximize their compensation in absolute dollar terms. The solution indi-

cates that the difference between the two optimal sizes is related not only

to the design of the compensation contract, but also to the performance-size

1For example, see “RBC Closes Hedge Fund to New Investors” (http://dealbook.nytimes.

com/2011/01/14/rbc-closes-off-hedge-fund-to-new-investors/) and “Some Hedge Funds, to Stay

Nimble, Reject New Investors” (http://dealbook.nytimes.com/2011/09/07/some-hedge-funds-

to-stay-nimble-reject-new-investors/), among others.

2For example, see “Billionaire John Paulson’s Hedge Fund: Too Big to Manage” (http://www.

forbes.com/sites/ nathanvardi/2012/12/21/billionaire-john-paulsons-hedge-fund-too-big-to-manage/),

“John Paulson’s Very Bad Year” (http://www.businessweek.com/printer/articles/59946-john-

paulsons-very-bad-year), “Too Big to Profit, a Hedge Fund Plans to Get Smaller” (http://dealbook.

nytimes.com/2012/08/01/hedge-fund-titan-plans-to-return-2-billion-to-investors/), and “Hedge

Funds Are for Suckers” (http://www.bloomberg.com/bw/articles/2013-07-11/why-hedge-funds-glory-

days-may-be-gone-for-good), among others.

3See Perold and Salomon (1991), Indro et al. (1999), and Chen et al. (2004), among others, for

a discussion of diseconomies of scale in the mutual fund industry.

The Optimal Size of Hedge Funds 1859

relationship.4For example, when fund assets increase faster than performance

declines, the deviation from the optimal size for fund performance becomes

larger.

My empirical analysis provides some supporting evidence for the model’s im-

plications. Measuring compensation in absolute dollar terms, I find that hedge

fund managers’ compensation increases as fund assets grow, even when dis-

economies 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.5Sec-

ond, 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 there-

fore likely have strong incentives to increase their assets under management.

As discussed earlier, when diseconomies of scale exist, this is not in the best

interest 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.6Investors 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.7

Another way for fund managers to increase their assets under management is

to launch new funds. Accordingly,I also analyze performance and compensation

4Agarwal, Daniel, and Naik (2009) argue that the incentive fee and the high-water mark

provision are normally set at the time when funds are established and do not change over time.

Agarwal and Ray (2011) document that about 8% of all hedge funds have changed their fee structure

and 7% of all hedge funds have changed their fee structure only once. Therefore, hedge fund

managers’ compensation contracts are relatively exogenous.

5Liang and Schwarz (2011) show that this is possible but do not investigate this issue thoroughly.

6See, for example, Naik, Ramadorai, and Stromqvist (2007), Fung et al. (2008), and Ding et al.

(2009) for a discussion of the flow-performance relationship and capacity constraints in the hedge

fund industry; Chevalier and Ellison (1997), Sirri and Tufano (1998), and Berk and Green (2004)

for a discussion of the flow-performance relationship in the mutual fund industry; and Spiegel

and Zhang (2013) for a discussion of a linear flow-performance relationship using market share-

adjusted fund flows in the mutual fund industry.

7Liang and Schwarz (2011) find no evidence that hedge fund closure can protect fund perfor-

mance. When funds reopen, they do not demonstrate superior performance. The authors argue

that performance-based compensation is not strong enough to prevent overinvestment and that

the primary goal of fund managers is to increase fund size. See Zhao (2004) and Bris et al. (2007),

among others, for a discussion of fund closure in the mutual fund industry.