Answer-first summary for fast verification
Answer: The principle-agent risk arises due to the incentive fee structure and the high water mark (HWM) but can be mitigated by agents (fund managers) who invest a sizable amount of their own wealth in the fund
According to Fung and Hsieh, the primary principal-agent risk in hedge funds stems from the incentive fee structure combined with high water marks (HWM). This creates misaligned incentives where fund managers may take excessive risks to earn performance fees. However, this risk can be mitigated when fund managers invest a significant portion of their own wealth in the fund, aligning their interests with investors. Option B accurately captures this dynamic: - **Incentive fee structure + HWM**: Creates potential for risk-taking behavior - **Manager co-investment**: Serves as a mitigating factor by aligning interests Option A is incorrect because Fung and Hsieh do acknowledge principal-agent problems exist. Option C mischaracterizes the information asymmetry issue. Option D focuses on AUM growth concerns but doesn't capture the core incentive fee/HWM dynamic that Fung and Hsieh emphasize.
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Which of the following is the best summary of the primary principal-agent risk (or problem) in the hedge fund industry, according to Fung and Hsieh?
A
Although "clearly of academic interest," there is neither credible evidence nor a plausible narrative in support of a realistic principle-agent problem in the hedge fund industry
B
The principle-agent risk arises due to the incentive fee structure and the high water mark (HWM) but can be mitigated by agents (fund managers) who invest a sizable amount of their own wealth in the fund
C
The principle-agent risk arises due to the fact that hedge fund managers have more information about the fund's investments than managers, and there is no easy solution to this principle-agent problem because the principals are not full-time investors themselves
D
The principle-agent risk arises due to the fact that the hedge fund manager, who charges a management fee as a percentage of assets under management (AUM), wants to grow the size of the firm rather than outperform, but this can be addressed simply by avoiding big funds in favor of small funds
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