Hedge Fund Fees: A Study on Manager Behavior

There was an article in the Journal of Alternative Investments regarding the effect of hedge funds' fees and the risk-taking behavior of fund managers.  It was written by Andrew Clare and Nick Motson.  Fees are controversial because of the size of them and because they may not provide the proper incentives to managers.  From 1994 - 2006, performance fees averaged 5.15% per year.  Adding on the standard 2% management fee leads to the investor paying the manager 7.15%.  The average equity mutual fund manager's fee is 1.3%.  Also, the manager participates on the upside but not on the downside.  The floor is the management fee.

Risk is defined as the volatility of returns of the portfolio.  A high risk fund has the possibility of having wild swings in returns.  A low risk fund will plod along at the same conservative rate.  The article asked if managers were below their high watermark, would they invest in riskier assets to earn a performance fee?  Conversely, if managers were after their high watermark, would they invest in less risky assets.

Clare and Motson found that managers adjusted the risk profile of their funds depending on their performance in the first half of the year.  Managers who were 15% or more above their high watermark at that time decreased their risk to lock in their performance fees.  Managers who were 10% or more below their high watermark also decreased their risk.  Since managers are large investors in their own funds, they would want to preserve their capital.  Also, there is a chance that other investors may withdraw their money. Managers that were in the middle increased their risk to try to earn incentive fees.

Another finding of Clare and Motson was that hedge fund managers are affected by their relative performance versus other managers.  They categorized managers after their performance in the first half of the year.  Those managers that were in the top half decreased their risk to maintain their rankings.  The managers in the bottom half increased their risk to move up in the rankings.  This is similar to the behavior of mutual fund managers.  It is called tournament behavior.

The article may be found here.