Performance sharing in risky portfolios: The case of hedge fund returns and fees

Institutional investors face different types of leverage and short-sale restrictions that alter competition in the asset management industry. This distortion enables high-risk unconstrained investors (e.g., equity long/short hedge fund managers) to extract additional income from constrained institutional investors. Using a sample of 1,938 long/short equity hedge funds spanning 15 years, we show that high-volatility funds deliver lower net-of-fees Sharpe ratios than do their low-volatility peers; furthermore, the managers of these funds usually charge higher fees. This evidence can be interpreted as a situational rent extraction or as compensation for the service of enhancing market functioning.