After several years of explosive growth, the hedge fund industry has achieved a size of well over a trillion dollars under management. Not surprisingly, the size of the industry and its potential impact on financial markets has led to heightened regulatory interest in the management and structure of these funds and in their investment and risk-related choices. This is manifest, for instance, in recent legislation to achieve greater transparency of hedge funds and enhanced regulation by the SEC.
In this paper our objective is to investigate the risk choices of hedge fund managers and, in particular, to examine how such decisions are related to incentive contracts, risk of fund closure and whether the manager has a significant personal capital investment in the fund. A better understanding of hedge fund risk behavior would be useful for both investors and policy makers: for instance, by identifying factors that may curb ‘excessive’ risk taking by fund managers.
Our focus is on the risk-shifting choices by managers of hedge funds that perform poorly, including “tournament behavior”: the notion that poor performance relative to peer funds induces managers to increase risk. We also study variance strategies related to absolute performance, using the fund’s high-water mark benchmark. The notion underlying risk-shifting is that convex payoffs whether on account of asymmetric incentive contracts or an asymmetry in the response of investor flows to fund performance may induce fund managers to increase portfolio risk.
Such risk-shifting is likely to be detrimental to the interests of investors; there is also a broader policy concern that hedge fund managers acting in tandem could increase systemic risk. At the same time, it is recognized that a manager’s incentive to elevate risk might be moderated by factors such as his risk-aversion, personal stake and reputational concerns (e.g., Starks (1987) and Carpenter (2000)).
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On Tournament Behavior in Hedge Funds: High Water Marks, Fund Liquidation, and Managerial Stake
