What motivates hedge fund managers?

The remuneration of hedge fund managers is important in understanding what to expect, and what to demand, from hedge fund arrangements and for judging whether enough value is likely to be left over for external investors.

The skill of any fund manager is subject to uncertainty. It is investors’ money that is used to discover the difference between skill and luck, even though in some instances skill will be obscured by bad luck, and in others lack of skill will continue to be obscured by extended good luck.

This highlights a disconnection between the interests of investors and the interests of hedge fund managers and is another aspect of the “principal-agent” problem which complicates relationships between investors and their advisers in many investment relationships (see Appendix 2). In hedge fund investing, the extent to which investor and hedge fund manager interests are aligned can change if and when a particular fund starts to prosper and the manager starts to accumulate wealth. In this case, hedge fund managers are likely to be much more concerned to preserve and grow rather than put at risk their own wealth, which is invested in the fund. This can lead to a subtle shift in hedge fund business strategy from the pursuit of performance to....