Close Close

Portfolio > Alternative Investments > Hedge Funds

What Motivates Hedge Fund Managers?

Your article was successfully shared with the contacts you provided.
Index April 2004 QTD YTD Description
S&P 500 Index* -1.68% -1.68% -0.42% Large-cap stocks
DJIA* -1.28% -1.28% -2.18% Large-cap stocks
Nasdaq Comp.* -3.71% -3.71% -4.15% Large-cap tech stocks
Russell 1000 Growth -1.16% -1.16% -0.39% Large-cap growth stocks
Russell 1000 Value -2.44% -2.44% 0.51% Large-cap value stocks
Russell 2000 Growth -5.02% -5.02% 0.28% Small-cap growth stocks
Russell 2000 Value -5.17% -5.17% 1.39% Small-cap value stocks
MSCI EAFE -2.18% -2.18% 2.13% Europe, Australasia & Far East Index
Lehman Aggregate -2.60% -2.60% -0.01% U.S. Government Bonds
Lehman High Yield -0.68% -0.68% 1.65% High-yield corporate bonds
Carr CTA Index** -3.56% -3.56% 0.37% Managed futures
3-month Treasury Bill 0.25%
Estimates as of April 30, 2004. *Return numbers do not include dividends. **Return numbers updated through April 29, 2004.

Over the last ten years, hedge funds have done a fine job of navigating the treacherous, ever-changing economic landscape. Their mutual fund progenitors, however, have failed to keep pace with the major equity indexes and are currently mired in one of the worst scandals in the history of the financial services industry. The real differences between the performance of these two investment vehicles may not, as many believe, come down to the types of fees charged, but rather the amount of personal capital the managers have committed to the products they captain.

The mutual fund industry has traditionally levied a fixed management fee, which many feel encourages firms to raise assets even though it may adversely affect performance. Hedge funds, on the other hand, charge both a management and a performance-based fee, contending that such an arrangement provides a strong incentive for outperformance. The latter view is theoretically supported by utility theory, which suggests that rational investors will strive to maximize their gains and limit their losses. However, a recent study found few differences in manager behavior between performance-compensated and asset-based-compensated funds.

Conditions for Survival: Changing Risks and the Performance of Hedge Fund Managers and CTAs, by Stephen Brown of NYU’s Stern School of Business, William Goetzmann of Yale, and James Park of Paradigm Asset Management challenges several long-held beliefs associated with incentive fees. Contrary to expectations, the researchers found that hedge funds below a high-water mark took no added risk in order to make up the shortfall in order to earn a performance fee. Hedge funds that performed well in the first half of the year generally reduced their portfolio volatility for the remainder of the year. Even more noteworthy was how similarly managers behave regardless of whether they are compensated by a traditional asset fee or a combination of a management fee and incentive fee.

Consider, for example, a fund that is below its high-water mark through the first six months of the year. Rather than increase their portfolio exposure in an attempt to make up the deficit and earn a fee–a type of behavior predicted by utility theory–laggard funds seem more concerned with their rankings relative to their peers. They appear much more concerned with the prospect of termination than the potential of earning greater profits. In other words, increasing their portfolio variance to gain a performance fee is not enough of a motivational factor to risk going out of business.

According to the study, the incentive portion of the fee structure is similar to a call option. Out-of-the-money managers, or those below their high-water marks, are therefore rationally expected to increase the risk in their portfolio to make up for losses. In-the-money funds are most likely to lower their variance (i.e., take less risk).

Regardless of fee structure, ranking among peers plays an important role in manager behavior, often more important than performance. This is a curious inconsistency in an industry that is seen as a source of absolute returns. It also raises the issue of whether a hedge fund would incur greater risks to catch up to the group than to surpass a high-water mark if the fund was comfortably ensconced in the middle of the pack.

Manager compensation issues aside, there are some important differences between mutual funds and hedge funds. Besides the opportunity to hedge long positions (hedge funds can, mutual funds generally cannot), one of the biggest ways the two vehicles differ is the tendency for hedge fund managers to invest heavily in their own funds. This is virtually unheard of in mutual fund circles.

Although the relationship between proprietary capital and performance has yet to be formally studied, my take is that investing one’s own money in one’s product aligns client and manager interests better than any other factor.