Locking in the Profits or Putting It All on Black? An Empirical Investigation into the Risk-Taking Behavior of Hedge Fund Managers

• Published in: The journal of alternative investments 2009-09, Vol.12 (2), p.7-25
• Main Authors: Clare, Andrew D, Motson, Nick
• Format: Article
• Language: English
• Subjects: Compensation; Fees & charges; Hedge funds; Incentives; Investment advisors; Investment policy; Investors; Mutual funds; Rates of return; Risk management; Studies
• ISSN: 1520-3255; 2168-8435
• DOI: 10.3905/JAI.2009.12.2.007

The ideal fee structure aligns the incentives of the investor with those of the fund manager. Mutual funds typically only charge a management fee that is a proportion of the funds under management. Hedge funds, on the other hand, generally change an incentive fee that is a fraction of the fund's return each year in excess of the high-water mark.The justification generally given for these incentive fees is that they provide the manager with the incentive to target absolute returns. As these incentive fees can be considered a call option on the performance of the fund, it is possible that the managers' incentives might vary according to the delta of this option. A number of articles have examined the optimal investment strategies of money managers in the presence of incentive fees within theoretical frameworks with seemingly conflicting results. Using a large database of hedge fund returns, the authors examine the risk taking behavior of hedge fund managers in response to both their past returns relative to their high-water mark and their past returns relative to their peer group. An attempt is made to reconcile these results with the theoretical frameworks proposed. [PUBLICATION ABSTRACT]