The Incentive Fee Hypothesis : Do Large Incentive Fees Provide a Disincentive for Asset Hoarding Amongst Fund Managers?

Fund managers are paid a fixed management fee in proportion to their assets under management. This means to maximize revenue, managers hoard assets. Whilst this results in increased revenue for the manager often, due to diseconomies of scale, it results in lower returns for the investor. Here we explore if large incentive fees, based on performance, may mitigate this perverse incentive. The ‘incentive fee hypothesis' states that once managers become sufficiently incentivized to provide large returns to their investors they will reduce asset hoarding since they understand that diseconomies of scale will erode not only investor returns, but ultimately, manager incentive fee revenue too. As hedge fund fees are a combination of both a 2 percent management fee and a large incentive fee of 20 percent of the profits they provide a unique opportunity to test the incentive fee hypothesis. We measure if incentive fees reduce the incentive for asset hoarding implicit in management fees. We find that total fee revenue continues to increase as assets under management increase for the largest quintile of hedge funds, but at a reduced rate. The cause is a reduction in the rate of incentive fee revenue generated per dollar under management for these largest funds. It appears that incentive fees reduce, but do not completely eliminate, incentives for asset hoarding