What’s the best incentive scheme for fund managers?

Here’s an argument hedge fund marketers make to tout hedge funds’ superiority over mutual funds. They point out that unlike mutual fund managers, who are paid solely based on assets under management, hedge fund managers also receive incentive compensation. The typical hedge fund compensation scheme is 2/20, or 2 percent of assets under management plus 20 percent of profits (or profits above some benchmark such as the rate of return on one-month Treasury bills).

The argument then goes: Relative to hedge fund managers, mutual fund managers have more incentive to minimize tracking error (minimizing the risk of underperformance) than to generate alpha (outperformance).

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