Investments, tenth edition

 Example  26.4 

Black-Scholes Valuation of Incentive Fees 

 The major complication to this description of the typical 

compensation structure is the    high  water  mark.       If  a  fund 

experiences losses, it may not be able to charge an incentive 

fee unless and until it recovers to its previous higher value. 

With large losses, this may be difficult. High water marks 

therefore give managers an incentive to shut down funds that 

have performed poorly, and likely are a cause of the high attri-

tion rate for funds noted above. 

 One of the fastest-growing sectors in the hedge fund uni-

verse has been in    funds  of  funds,      which are hedge funds 

that invest in one or more other hedge funds. Funds of funds 

are also called  feeder funds,  because they feed assets from 

the original investor to the ultimate hedge fund. They are 

marketed as providing investors the capability to diver-

sify across funds, and also as providing the due diligence 

involved in screening funds for investment worthiness. In 

principle, this can be a valuable service because many hedge 

funds are opaque and feeder funds may have greater insight 

than typical outsiders. 

 However, when Bernard Madoff was arrested in December 2008 after admitting to 

a massive Ponzi scheme, many large feeder funds were found to be among his biggest 

clients, and their “due diligence” may have been, to put it mildly, lacking. At the head 

of the list was Fairfield Greenwich Advisors, with exposure reported at $7.5 billion, but 

several other feeder funds and asset management firms around the world were also on 

the hook for amounts greater than $1 billion. In the end, it appears that some funds had 

in effect become little more than marketing agents for Madoff. The nearby box presents 

further discussion of the Madoff affair.  

 The option-like nature of compensation can have a big impact on expected fees in funds 

of funds. This is because the fund of funds pays an incentive fee to each underlying fund 

that outperforms its benchmark, even if the aggregate performance of the fund of funds is 

poor. In this case, diversification can hurt you!  

17

     

S

0

(1 

+ r

f

)

S

T

Incentive Fee

Slope 

= .20