Trimming Hedges

Date: Monday, February 9, 2009
Author: Economist.com

Studying the behaviour of hedge-fund managers

THE hedge-fund industry is struggling. Not only did it lose a record 18.3% in 2008, according to Hedge Fund Research, but investors withdrew $152 billion of capital in the last quarter of the year. As a result, the industry was some $525 billion smaller at the end of 2008 than at the start. Its economic power has reduced even more; funds have been forced by their prime brokers to cut back on their leverage. All this has clearly had its impact on the markets, with many managers being forced sellers of financial assets.

But what will hedge-fund managers do now? With corporate-bond spreads wide and equity markets down substantially from their peak, this could be the chance for managers to earn outsize returns. There could be a repeat of the bumper period that followed the collapse of Long-Term Capital Management, a fixed-income fund, in October 1998. On the other hand, managers may be traumatised by the failure of so many attempted rallies since the credit crunch began in the summer of 2007.

A clue to their future behaviour can be found in a paper from two academics at the Cass Business School in London. The paper is called “Locking in the Profits or Putting it All on Black? An Investigation into the Risk-Taking Behaviour of Hedge Fund Managers”, and the writers, Andrew Clare and Nick Motson, examine whether the incentive fee structure affects the way managers run their funds.

As is well known, hedge-fund managers take both an annual and a performance fee (two and 20% are standard). This means managers do well in boom years and poorly in bust years like 2008, but they never have to give back their past profits. This gives them an effective call option on performance—unlimited upside but limited downside.

Some protection is built into the structure. First, managers only earn performance fees after a high-water mark is reached. In other words, if markets rebound in 2009, managers will not be rewarded for recouping losses from 2008. Second, investors like to see managers place a substantial proportion of their own wealth in the fund. If they are reckless, they will lose money. Third, dissatisfied investors will withdraw their money; if enough of them do so, the fund will be forced to shut.

This last factor creates a very important business risk for managers—the same one that afflicts mutual-fund managers. They dare not underperform rival managers, in case the clients desert. Indeed, Messrs Clare and Motson find that managers who are underperforming their sector average increase their risk profile, while those who are outperforming it reduce risk. In other words, the laggards try to catch up while the leaders try to lock in their gains. This is understandable, but it does suggest that achieving an absolute (i.e. positive) return is not the managers’ primary motivation.