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Three essays on hedge fund fee contracts, managerial incentives and risk taking behaviors
Abstract
Under the principal-agent framework, the first essay studies and compares different compensation schemes commonly adopted by hedge fund and mutual fund managers. We find that the option-like performance fee structure prevalent among hedge funds is suboptimal to the symmetric performance fee structure. However, the use of high water mark (HWM) mitigates the suboptimality, though to a very limited extent. Both our theoretical models and simulation results show that HWM will induce more managerial efforts only when a fund is slightly under the water but it will unfavorably dampen incentives when a fund is too deep under the water and when the manager’s skill is poor. Allowing managers to invest personal wealth in their own funds, however, helps align interests and provides positive managerial incentives. Existing literature has detected a ”tournament behavior” among mutual fund managers that mid-year underperformers tend to take relatively higher risk than peers in the second halfyear. The second essay reexamines this issue and provides empirical evidence that such behavior does not exist among hedge fund managers, either at fund level or risk style level. Instead, hedge fund managers shift risk at mid-year in response to the moneyness of their incentive contracts. Also, risk shifting decisions are more driven by underperformance than by outperformance. High Water Mark can strongly rein in excess risk-taking and therefore better aligns interests. Last, risk shifting on average does not improve either performance, moneyness of incentive contracts, or cash inflows. The third essay uses factor models and optimal changepoint regression models to capture the intra-year risk dynamics of hedge fund managers. Those risk shifting managers are further divided into Informed’, ’Uninformed’ and ’Misinformed’ groups, according to their post-shifting risk adjusted performance. We find evidence that supports the existence of an ’Adverse Selection’ problem of managers compensation schemes. Namely, incentive contracts, designed to share risks and align interests, induce the strongest risk taking from the least informed or skilled hedge fund managers, whose risk-shifting decisions result in undesired or even deteriorated risk-adjusted returns for investors. We also find that the High Water Mark has only limited influence on mitigating excessive risk shifting.
Subject Area
Behavioral psychology|Management
Recommended Citation
Zhan, Gong, "Three essays on hedge fund fee contracts, managerial incentives and risk taking behaviors" (2011). Doctoral Dissertations Available from Proquest. AAI3482676.
https://scholarworks.umass.edu/dissertations/AAI3482676