What Motivates Hedge Fund Managers?

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.