The Relationship Between Hedge Fund Manager Compensation and Risk-Taking

Views and opinions expressed are those of the authors and do not necessarily represent official positions or policy of the OFR or Treasury.

Hedge funds have grown into large intermediaries, with estimated assets under management surpassing $4 trillion, and the risks their managers take can have implications for the broader market. Hedge fund performance and fund manager compensation are related. If a hedge fund fails to meet benchmarks, the fund manager will typically not receive performance-based fees. This may lead the manager to take on excessive risk as they try to achieve higher returns. Taking on more risk, though, can result in larger losses if markets move against the fund.

In their working paper, “The Who and How of Hedge Fund Risk Shifting,” OFR researchers Spencer Andrews and Salil Gadgil examine whether compensation incentives distort hedge fund managers’ risk choices. Using data from Form PF filings collected by the Securities and Exchange Commission, the authors identified that a fund’s relative and absolute performance affects the future risk-taking behavior of the fund’s managers.

As part of the research, the authors find that both funds that have performed poorly and funds that have performed well at midyear increase their portfolio volatility during the second half of the year. Underperforming hedge funds take on more risk by levering up and modifying their asset class allocations. Top performers also amplify volatility, but they do so by pursuing contrarian strategies that do not follow market sentiment.

Certain fund characteristics, like redemption policies and ownership structure, influence the extent to which managers respond to poor performance. Hedge funds that allow frequent redemptions and those with concentrated ownership bases raise volatility most aggressively, presumably because such funds are most susceptible to performance-based outflows.