Performance fees and hedge fund return dynamics

•Hedge funds allocate portfolio performance between different accounts.•Despite a lack of transparency, the strategy of allocation is publicly available.•Allocation strategies explain empirical facts observed in hedge fund returns.

A characteristic of hedge funds is not only an active portfolio management, but also the allocation of portfolio performance between different accounts, which are the accounts for the external investors and an account for the management firm, respectively. Despite lack of transparency in hedge fund market, the strategy of performance allocation is publicly available. This paper shows that, for the High-Water Mark Scheme, these complex performance allocation strategies might explain empirical facts observed in hedge fund returns, such as return persistence, skewed return distribution, bias ratio, or implied increasing risk appetite.