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Hedging Bets

Monday, June 19, 2017

 Person Holding Dollar Sign

Ideally, hedge fund managers would maximize returns for their investors. In practice, however, portfolio managers are likely to take excessive levels of risk to boost their own paycheck, indicates new research from Chengdong Yin and Xiaoyan Zhang from Purdue University’s Krannert School of Management.

In their paper, “Gambling or De-Risking: Hedge Fund Risk Taking vs. Managers' Compensation,” the coauthors use fund level data from the Lipper TASS database over the period from 1994 to 2015 to examine the general pattern of hedge fund managers’ risk-taking behavior and link those choices to managers’ compensation and other potential explanatory variables.

Unlike most previous research, Zhang and Yin find that hedge fund managers’ de-risk when the management fee becomes more important in total compensation. Because the management fee provides a more stable source of income, fund managers would take less risk to increase their survival probabilities and protect their existing assets and fee incomes.

When funds are below their high-water marks, however, managers increase risk taking to recover past losses. Surprisingly, the researchers found that managers also take more risk when funds are above their high-water marks, possibly to increase their compensation even further. Those findings differ from theoretical predictions possibly because many models assume an infinite horizon for hedge fund managers.

“In real practice, however, hedge funds only survive a few years,” says Zhang, a professor and the Duke Realty Chair in Finance. “When fund value is far enough above the high-water mark, fund managers take more risk to further enhance their compensation instead of reducing risk taking to lock in their gains.”

“We also examine how the risk-taking choices affect fund performance in the future and how investors react to those choices,” says Yin, an assistant professor in the Krannert School’s finance area. “When fund managers take more risk, they do not generate better future style-adjusted returns and thus do not benefit investors.”

Zhang and Yin also examined the risk-taking behavior of fund managers during the recent financial crisis, which produced another interesting finding.

Many hedge funds suffered huge losses and fell below their high-water marks during this period, leaving managers with the dilemma of increasing risk to make up the losses or reducing risk to enhance survival probabilities.

Managers increased style betas but reduced residual volatility during the crisis period. “In other words,” Zhang says, “managers herded more with other funds in the same style to increase survival likelihood.”

So, what’s the bottom line for investors and managers alike?

“Our results can help investors better manage their portfolios’ risk and shed light on future compensation contract design,” say the research duo. “Investors need to realize that fund managers take more risk both below and above their high-water marks. They should also understand the importance of the management fee.

“Due to mediocre performance, a few hedge funds have recently begun to charge zero management fee in an effort to attract investors. That may not be a wise choice. Our rational expectation is that without a management fee, hedge fund managers would be motivated to take more risks, but that doesn’t necessarily deliver better returns.”

More information and a PDF download of “De-Risking: Hedge Fund Risk Taking vs. Managers' Compensation” is available at



Writer: Eric Nelson,

Sources: Chengdong Yin,; Xiaoyan Zhang,