On Tournament Behavior in Hedge Funds: High Water Marks, Fund Liquidation, and the Backfilling Bias
George O. Aragon, Arizona State University
Vikram Nanda, Georgia Tech University

We analyze risk shifting by poorly performing hedge funds—and test predictions on the extent to which risk choices are related to the fund’s incentive contract, risk of fund closure and dissemination of performance information. Consistent with theoretical arguments, we find that the propensity for losing funds to increase risk is significantly weaker among those that tie the manager’s incentive pay to the fund’s high-water mark (HWM)—suggesting a possible benefit from such incentive structures—and among funds that face little immediate risk of liquidation. Risk shifting behavior is affected by both absolute and relative fund performance and is found to be more prevalent in the back filled period, when some funds may be at an incubation stage. Overall, the combination of factors such as high-water mark provisions, low risk of fund closure and the reporting of performance to a database appear to make poorly performing funds more conservative with regard to risk-shifting.

Although investment sponsors expect that their managers will faithfully follow agreed upon investment policies, managers often have incentives to manage to promote their own advisory services. This project examines the determinants of risk shifting by hedge funds when funds are underperforming. The results identify circumstances under which managers may give more weight to their own needs than might be appropriate, and methods for controlling this problem.


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