The typical hedge fund fee structure includes a management fee, calculated as a fixed percentage of a fund’s net asset value, plus an incentive fee, calculated as a percentage of its trading profits.
Some hedge funds use both hurdle rates and a high-water-mark (HWM) provision—the historical peak of the fund’s net asset value—in the calculation of incentive fees. These features are sold as a way to protect investors because the incentive fee is paid only on the portion of the gains that exceed either the hurdle rate and/or HWM.
Although hedge funds in managed futures, called commodity trading advisors (CTAs), typically don’t employ hurdle rates, they do generally still comply with the HWM provision that requires the fund manager to make up past deficits prior to earning the incentive fee.
The HWM feature is highly asymmetric and can be expressed as a long call-option position with a strike at the HWM. Therefore, hedge fund managers face a moral hazard issue because they have an incentive to increase risk when their previous performance has been disappointing.
For example, Stephen Brown, William Goetzmann and James Park, authors of the 2001 study “Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry,” found that poorly performing funds tended to increase risks due to the incentive fee and HWM provisions. This can create an unequal field in terms of incentives (agency risk), leading to the propensity to double-down on bets and take extreme risks when the incentive compensation is “out-of-the-money.”
Therefore, characteristics that appear “investor friendly” on the surface can, in fact, lead to increased risk. In addition, the HWM provision increases the likelihood of a fund terminating its existence and creating a new fund when it is “out-of-the-money” in terms of incentive compensation.
A Moral Hazard Problem
Li Cai, Chris (Cheng) Jiang and Marat Molyboga contribute to the literature on the agency risks of hedge funds with their study, “The Moral Hazard Problem in Hedge Funds: A Study of Commodity Trading Advisors,” which was published in the Winter 2017 issue of The Journal of Portfolio Management. By focusing on CTAs, the authors were able to classify the funds as discretionary or systematic (where trading is based on algorithms, not opinions), an important distinction. Their study covered the period 1994 through 2014.
They hypothesized that a manager “who systematically follows a trading methodology is more immune to the moral hazard problem than a discretionary manager who lacks the formulaic discipline of systematic trading.”
Cai, Jiang and Molyboga found that discretionary fund managers exhibit a significantly higher degree of risk-shifting than systematic fund managers. They also found that “tournament behavior is at work as evidenced by the relatively large increase in risk taking among the poorer performing funds.”
In other words, “discretionary managers who are underwater at midyear tend to increase their risk taking in the second half of the year.” Importantly, they found that “in most years, the impact on investors’ risk-adjusted performance has been negative, with investors getting exposed to greater risk without a corresponding increase in returns.” The impact of risk-shifting behavior was a 4.5% relative reduction in the Sharpe ratio.