On Optimal Fee Structure

September, 2004

Kirill Ilinski, Vladislav Melezhik

Fusion Asset Management Working Paper No. FAM-02-04

Abstract:

Investors look at hedge funds as an opportunity to invest in uncorrelated with major asset classes, conservatively managed vehicles. Apart from redeeming from the fund, investors have no means to ensure that the manager ”sails” in a conservative and prudent way. We argue here that investor’s control of the fund money management can be effectively achieved by adjusting the pay-off structure, namely ratio of fixed and variable fees. With a good degree of accuracy, terminal pay-off for a hedge fund manager can be modeled as a fixed (management) fee, variable (incentive) fee subject to inter-temporal down-and-out barrier conditions on the largest possible running loss and maximal tolerable realized volatility. In this case we find the optimal relation between fixed and variable fees such that the optimal parameters of the pay-off maximize the investors’ utility function as defined by the expected terminal value of the investment conditional on not exceeding a particular volatility threshold, or by the Sharpe ratio.

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