Managers adjust risk based on relative performance to peers

Hedge fund managers could be adjusting the risk profile of their funds in response to relative performance against peers, claims a research paper* by Andrew Clare and Nick Motson of Cass Business School, London.

The paper said managers of relatively poorly performing funds increased the risk profile of their funds while those with strong performances decreased it. This calls into question, concluded the paper, the idea that hedge fund managers target absolute returns and suggests instead that hedge fund managers pay attention to the performance of their peers.

The research investigated the influence of two factors on the risk taking behaviour of hedge fund managers. The first factor was past performance relative to the performance of each fund's peer. The second was the option-like features of the typical hedge fund manager's compensation structure.

The analysis takes account of the option-like features of compensation structures. This kicks into action only if a fund performs well. The typical hedge fund manager owns a call option on the performance of the fund. Using a large database of hedge fund returns to identify each fund's position relative to its peer group and the value of its performance incentive option, the paper examined whether hedge fund managers adjust the risk profile of their fund based on the relative performance of similar funds.

The analysis by Clare and Motson also found that managers whose incentive option is well in the money decrease the risk profile of their fund. Relatively speaking these managers are protecting the value of this option towards the end of a year. For investors who want managers to take risks in a consistent manner regardless of the time of the year, this result suggests there is an element of locking in behaviour particularly towards the end of the calendar year.

The paper found fund managers who find their incentive option to be well out of the money do not 'put it all on black' in order to recoup earlier losses and to increase the value of their incentive option.

This conservative behaviour may be due to the fear of investor' liquidation and/or to the often substantial manager stake in the fund that discourage the hedge fund manager from taking chances.

If past behaviour is any guide to future behaviour, and given that so many hedge fund managers ended 2008 with their incentive option well out of the money, this may come as some comfort to those investors who remain committed to this industry, concluded Clare and Motson.

* The Cass Centre for Asset Management Research: Locking in the gains or putting it all on black - An investigation into the risk-taking behaviour of hedge fund managers by Andrew Clare, Chair in Asset Management, Faculty of Finance, Cass Business School, and Nick Motson, FME/ESRC Fellow, Faculty of Finance, Cass Business School.