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.
A finding of interest was that a “subperiod analysis revealed that the difference in behavior is particularly strong during favorable market environments. By contrast, during unfavorable market environments, the difference in behavior is not significant because both types of fund managers avoid risk.”
Cai, Jiang and Molyboga explained that this is consistent with prior research that has found in negative market environments managers tend to be more concerned with career risk and thus engage in less risk-shifting. When fund mortality is high, survivorship is difficult and thus managerial career concern dominates. In contrast, when mortality is low and survivorship is easy, career concern is minimal.
The authors concluded that “fund managers care more about incentive fee income in good market environments but care more about survival in bad market environments. Thus, fund investors should be most worried about the moral hazard problem when the market environment is positive for fund managers.”
These findings have important implications for investors. Not only do features of the hurdle rate and HWM provisions—which supposedly are designed to protect investors—create an increased moral hazard environment, they have negative impacts on risk-adjusted returns, at least for discretionary fund managers. If you happen to be considering a hedge fund, or, specifically, a CTA, at the very least, you should be aware of the moral hazards—hazards that can be avoided, or at least minimized, when choosing a fund that invests systematically.
Discretionary Versus Systematic Funds
This strike against discretionary fund managers relative to systematic fund managers, in terms of the moral hazard risk, isn’t their only disadvantage. The other is that very strong evidence shows that the systematic approach to investing has delivered superior returns. Campbell Harvey, Sandy Rattray, Andrew Sinclair and Otto Van Hemert address this subject in the December 2016 paper “Man vs. Machine: Comparing Discretionary and Systematic Hedge Fund Performance.”
They analyzed and contrasted the performance of systematic hedge funds, which use rules‐based strategies involving little or no daily intervention by humans, with the performance of discretionary hedge funds, which rely on human skills to interpret new information and make the day‐to‐day investment decisions. The study covered the period 1996 through 2014 and included data on more than 9,000 macro and equity hedge funds. To adjust returns for exposure to common factors, they used stock factors (beta, size, value and momentum) and bond factors (term and credit), as well as FX carry and volatility.
Investors have a clear preference for discretionary funds, given that they make up about 70% of the hedge fund universe and control approximately 75% of the assets under management. However, the authors found no evidence to support such a preference. For equity hedge funds, they found both that, after adjusting for exposure to well‐known risk factors, risk‐adjusted performances were similar and that for discretionary funds (in aggregate), more of the average return and volatility of returns can be explained by risk factors.
In addition, when looking at what they called the “appraisal ratio” (the ratio of the average risk‐adjusted return to its volatility), the authors found that systematic funds outperformed 0.35 to 0.25. For macro funds, they found systematic funds outperformed discretionary funds both on an unadjusted and on a risk‐adjusted basis. The appraisal ratios were 0.44 for systematic funds and just 0.31 for discretionary funds. They concluded “the lack of confidence in systematic funds is not justified.”
The Advantages Of Objectivity
In their excellent book, “Quantitative Value,” Wes Gray and Tobias Carlisle provide further support for the power found in systematic, quantitative investing. They write that the objectiveness of the approach acts as a shield, protecting us against our own biases, while also acting as a sword, allowing us to exploit the cognitive biases of others.
To make this point, they presented the following example from Joel Greenblatt. Greenblatt’s firm, Gotham Capital, had compounded at a phenomenal rate of 40% annually, before fees, for the 10 years from Gotham’s formation in 1985 to its return of outside capital to investors in 1995.
In his own book, “The Little Book That Beats the Market,” Greenblatt describes an experiment he conducted in 2002. Greenblatt wanted to know if Warren Buffett’s investment strategy could be quantified. He studied Buffett’s annual shareholder letters and developed his “magic formula,” which he published. Gray and Carlisle show that study after study has found “the model is the ceiling of performance from which the expert detracts, rather than the floor to which the expert adds. Even Greenblatt has said the he cannot outperform the Magic Formula.”
We can perform another test in the ongoing battle of “machine (systematic) versus man (discretionary)” by examining the relative performances of two leading providers of passively managed funds, Dimensional Fund Advisors (DFA) and Vanguard. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)
The following table shows the Morningstar percentile rankings, adjusted for survivorship bias, for the 15-year period ending in 2016:
As you can see, Vanguard’s systematic approach outperformed 79% of actively managed funds and DFA’s systematic approach outperformed 90%. Given that the largest cost of active management in taxable accounts typically is taxes, these figures likely understate the advantage of systematic approaches for taxable investors.
The aforementioned evidence should lead you to conclude that, when you invest, it should be with a fund that uses a systematic approach to gaining exposure to markets, asset classes or factors.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.