LO 71.9: Describe the problem of risk sharing asymmetry between principals and

LO 71.9: Describe the problem of risk sharing asymmetry between principals and agents in the hedge fund industry.
In the hedge fund industry, risk sharing asymmetry between the principal (investor) and the agent (fund manager) is a concern due to variable compensation schemes.
The problem occurs when the incentive fee that a hedge fund manager is entitled to, typically 1520% of new profits [profits above a high water mark (HWM)], encourages a fund manager to take outsized risks. This tends to increase the future loss-carried-forward if
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Topic 71 Cross Reference to GARP Assigned Reading – Constantinides, Harris, and Stulz, Chapter 17
and when these bets fail. If the fund fails, the same fund manager can start up a new hedge fund.
However, there is an opportunity cost involved in cases where a hedge fund manager closes a fund. It is costly in terms of harming the track record of the manager and affects reputation risk of both the manager and the fund company. All things considered, this cost does not totally mitigate the basic principal/agent conflict.
Investors may be best served to invest in funds for which the fund managers invest a good portion of their own wealth. As much as this issue has been discussed, the basic structure of how fund managers are compensated has not changed.
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