Most hedge fund managers receive a flat fee plus a share of the returns above a benchmark. We investigate how these features of hedge fund fees affect risk taking by the fund manager in the behavioural framework of prospect theory. The performance related component encourages funds managers to take excessive risk. However, risk taking is greatly reduced if a substantial amount of the
manager’s own money is in the fund as well.
Average returns though, both absolute and risk-adjusted, are significantly lower in the presence of incentive fees.A manager with an incentive fee increases the risk of the fund’s investment
strategy if the fund value is below the benchmark specified in the incentive fee contract. This risk taking behaviour is expected, as the fund manager tries to increase the value of the call option on fund value.
If the fund value rises above the benchmark the manager reduces volatility, in some cases even below the optimal volatility level of a fund without
incentive fees.

Most fund managers charge a fixed proportion of the fund value as management fee, to cover expenses and provide business income. Management fees should moderate risk taking, as negative investment returns reduce the future stream of income from management fees. Most fund managers invest their own money in the fund. This “eating your own cooking”, helps to realign the motivation of the fund manager with the objectives of the other investors in the fund.
The fact that hedge fund managers typically risk both their career and their own money while managing a fund is a positive sign to outside investors.
The personal involvement of the manager, combined with a good and verifiable track record, could explain why outside investors are willing to invest their money in hedge funds, even though investors typically receive very limited information about hedge fund investment strategies and also possibly face poor liquidity due to lock-up periods in some funds. We expect that the hedge fund manager’s own stake in the fund is an essential factor
influencing the relationship between incentives and risk taking.