“Putting it all on black”

Over time, the somewhat arbitrary selection of the calendar year as a performance fee window has raised the hackles of some hedge fund investors.  Some argue that a year is too short a time and performance fees should be calculated – or at least paid out – only after several years.

While a longer performance fee calculation period seems to make perfect sense (it would reduce the “asymmetry” where the manager who can win but can’t lose), a new research study reveals one potential drawback of such a system.

In “Locking in the profits or putting it all on black?” Andrew Clare and Nick Motson of the Cass Business School examine whether hedge fund managers reduce risk at the end of a year when they are likely to receive a performance fee and whether managers “put it all on black” toward the end of years when they are not yet in performance fee territory.

This question has been raised before.  But it takes on a unique importance this year as around four-fifths of all funds are currently below their high water mark.  Clare and Motson’s conclusions are good news and bad news for investors.

First, the good news.  The duo finds that managers who are not in performance fee territory do not “put it all on black” in order to kick start a late-game rally.  They hypothesize that the downside risk for the manager – although indirect – is significant enough to given them second thoughts about taking in risk (downsides being potential liquidation and, we would add, reduced marketing potential and career risk).

The bad news is that managers also tend tend to reduce risk late in a year when they are about to earn a performance fee.  In other words, they lock-in gains and coast to December 31.  Plain old prospect theory comes into play here.  The upside dollars aren’t worth as much as the downside dollars.  So a fair bet has a way bigger downside than its upside.

They reach these conclusions by calculating the “risk adjustment ratio (RAR)” for the funds in TASS database.  The RAR is simply the ratio of the standard deviation of fund returns after an arbitrary month to the standard deviation of returns before that month.  Clare and Motson chose 6 months (i.e. June 30) as the break-point for the analysis.  They found that funds with below average mid-year relative returns were more likely to have a high RAR rather than a low one.  In other words, they were more likely to increase volatility in the second half of the year.  Conversely, funds that out-performed by June 30 were more likely to have decreased their volatility in the second half.

The following figure from their paper illustrates this finding (arranged by return deciles from lowest first half returns to highest).  As you can see, out-performing funds tend to reduce volatility in the second half, leading to a negative RAR:

The study then examines the relationship between the YTD relative performance at different months and the RAR using those different month as the break-points.  It turns out that managers are more likely to modify their fund’s volatility based on early-year YTD relative results than on late-year YTD relative results.

But this doesn’t mean that managers don’t care about returns later in the year.  Clare and Motson find that managers are more likely to judge themselves against an absolute benchmark (i.e. their hurdle or high water mark) later in the year when they can almost taste that juicy performance fee.

In their words:

“This result is extremely interesting since it can be taken to imply that hedge fund managers care more about relative return early in the year but more about the value of their incentive option (absolute return) later on in the year. One possible explanation for this is that as the year moves towards its end managers have less chance or opportunity of increasing their ranking but can attempt to maximise the fees they will receive by increasing risk…”

While they caution that their data does not fully support this particular hypothesis, there may be some truth to this conjecture.

But here’s the twist, the cold economic rationality that underpins such decisions is tempered by a fund’s performance relative to its peers.  In other words, Clare and Motson find that hedge fund managers keep an eye on both the performance fee hurdle and the performance of their peer group.

Previous research cited in this paper points to the same phenomenon in the mutual fund industry.  Apparently, mutual fund managers also have a tendency to “put it all on black” if they are under-performing their peers by mid-year.  Why?  Although they do not earn performance fees, their compensation rises along with AUM.  And as anyone in the mutual fund industry knows, most investors are performance chasers.  The net result (good relative performance=more AUM=higher bonus) is tantamount to a performance fee anyway.

In conclusion, Clare and Motson suggest a “rising scale of incentive fees” can be implemented at hedge funds to disincentivize outperforming managers from simply locking-in gains and cruising into a huge year-end bonus.

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