Contrary to popular opinion, research shows that HF managers won’t necessarily go “all-in” to win big

Fees 19 Aug 2010

If there are two sins that mix extremely well together, it is booze and gambling. While the odds certainly favor the house on the gambling side of things, they increase even more once alcohol is thrown in, as many can certainly attest. Indeed, while hardly empirical, most pit bosses can certainly vouch that the more alcohol consumed, the greater the amount of risk that gets tossed onto the table.

A revised version of a paper published not too long ago by HEC Montreal PhD student Serge Patrick Amvella Motaze entitled, Managerial Incentives and the Risk-Taking Behavior of Hedge Fund Managers (click here to download from SSRN) considers roughly the same concept: Do hedge fund managers take greater risks when “drunk” off the potential of pulling in a greater reward for their efforts?

Using mathematical and statistical models, Motaze argues that even if a hedge fund manager wanted to maximize his or her fees, he or she still has the mandate to provide absolute returns; otherwise investors can withdraw their money which will lower the asset under management and in turn the manager’s future payouts.

In other words, even after a couple of drinks at the craps table, only a measured amount of caution is going to be thrown to the wind before the deterrent of spouse, kids, mortgage and job security kicks in  (at least for the majority of managers).

Motaze focuses on what he refers to as the “optimization problem,” where he includes the constraint of a minimum net-of-fees return to be delivered by the manager in order to renew his or her contract at the end of the year or to avoid asset outflows due to poor performance.

His results link the optimal volatility of the fund to the management fee rate, the incentive fee rate, the minimum net-of-fees return required by the investor, the expected return of the fund, the size of the fund and the so-called moneyness of the option contract – deemed as the spread between the high water mark and the fund value. The chart below contrasts critical and optimal volatility according to the level of moneyness.

His findings? That the first three parameters – management fee rate, incentive fee rate and minimum net-of-fees return – are negatively related to the optimal volatility – good news for investors, because they can act on these contractual parameters to moderate the risk-taking of the manager. Indeed, contrary to taking on more risk with more booze, in Motaze’s findings the opposite occurs: that a higher incentive fee rate actually contributes to reduce the optimal volatility for the manager.

“Not only does it constitute an incentive for superior performance, it is also a means of reducing the manager’s appetite for risk,” concludes the paper.

“As for the minimum net-of-fees return required by the investor, it is important to keep in mind that it cannot be superior to the expected return of the fund, otherwise the manager will not be able to meet investor expectations.”

Motaze recommends investors set a reasonable net-of-fees return as an of the contract, which in turn may contribute to moderating the risk-taking behavior of the manager. Another key factor that can reduce a manager’s optimal volatility is a liquidation boundary – the threat of pulling out, which in Motaze’s findings represents “a powerful tool for reducing the agency problem.”

Finally, Motaze throws a bit of a curve ball, particularly in light of recent negative focus on hedge fund compensation (click here for our synopsis of an AIMA-sponsored debate on whether hedge funds are worth the price). In contrast to the rest of the world, Motaze suggests the broader business world could actually learn a trick or two from the hedge fund compensation model when it comes to paying their executives reams of cash.

How? Very simply, since high water mark provisions typically contribute to lowering a manager’s appetite for risk, because he or she earns incentive fees only after recovering past losses, a high water mark on executive compensation could in effect accomplish the same thing.

“With the absence of a high water mark provision, as is generally the case in the compensation contracts of corporate executives, the option is at the money at the beginning of each year which does not help reduce the agency problem. Nowadays, where the compensation of corporate executives is increasingly called into question, hedge fund compensation contracts, although not perfect, could be a good source of inspiration.”

While not delving into the perennial “fee debate” nor analyzing corporate compensation practices, it would seem that a high-water-mark-style of remuneration might not be a bad idea.  You’d be excused for wondering if many corporate executives would likely have to be both three “sheets to the wind” and throwing dice on green felt before ever agreeing to being paid like hedge fund managers.

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