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We analyze how hedge fund attributes affect performance and the decision to offer a hurdle rate and high-watermark. Our results indicate that hurdle rate and high-watermark act as restrictions on fee collection rather than incentives. Hedge funds that take riskier positions are more likely to offer a hurdle rate and high watermark Controlling for fund size, our results also suggest that hedge funds that collect high performance fees are more likely to outperform those that collect low performance fees. Using three different measures of hedge fund performance in our cross sectional analysis and taking into account the risk profiles associated with different investment strategies, we confirm our results.

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INTRODUCTION

This paper investigates how hedge fund attributes affect performance with respect to the decision to offer specific managerial incentive schemes such as a hurdle rate and a high-watermark, which are common incentive schemes in the hedge fund industry. In contrast to many other investment vehicles and alternatives such as ETFs and mutual funds, hedge funds are not automatically open to all the investors who want to commit funds. Many hedge funds require investors to put up a minimum and often a significant amount as the initial investment, ranging from as low as $10,000 to as high as $10,000,000 or more. A common range is $250,000 and $500,000, which is likely to attract wealthy and sophisticated investors, many of whom are well informed about the distinct features of hedge funds. These include the level of risk, leverage, investment strategies, the often substantial amount of management and performance fees attached to hedge funds and restrictions on withdrawing funds. To attract investors, hedge fund managers often agree to modest fees until a certain return level is achieved. Traditionally, hurdle rates and high-watermarks are considered to be incentives in a way that if a certain level of return is achieved, investors pay part of their returns as a reward to the fund management team. In principle, hurdle rates and high-watermarks are devised for the same purpose: to protect investors' wealth and to promote better performance. A hurdle rate is a minimum rate of return that fund managers must achieve to collect performance fees without having to consider historical performance. A high-watermark requires fund managers to...

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