The Dynamics of Hedge Fund Fees * Prachi Deuskar Z. Jay Wang Youchang Wu Quoc H. Nguyen May 2011 Abstract In contrast to the perception of a common 2/20 fee structure, we find consider- able cross-sectional and time series variations in hedge fund fees using a large panel data set. New funds in small fund families tend to charge higher incentive fees and lower management fees than those in big families. Such an initial fee structure pre- dicts better performance and a higher survival rate, indicating that this fee structure acts as a signal of good ability. Good performance with a low tracking error leads to a management fee increase, while poor performance leads to fund closure or a management fee decrease. Funds that increase management fee more aggressively experience a bigger drop in subsequent money inflows, and are more likely to main- tain their good performance. This suggests fee increases, which typically apply only to new investors, may benefit existing investors by mitigating diseconomies of scale. Keywords: hedge funds, fee, incentives. JEL CLASSIFICATIONS: G23, G29 * Deuskar, Wang and Nguyen are from Department of Finance, College of Business, University of Illinois at Urbana-Champaign. Wu is from Department of Finance, Investment and Banking, School of Business, University of Wisconsin-Madison. Deuskar can be reached at pdeuskar@illinois.edu, Wang at zhiwang@illinois.edu, Wu at ywu@bus.wisc.edu, and Nguyen at qnguyen3@illinois.edu. We thank seminar participants at University of Illinois at Urbana-Champaign, Loyola University at Chicago, Shanghai Advanced Institute of Finance, University of Illinois at Chicago, and China Finance Review Annual Conference 2010. All remaining errors are our own.