Why do experienced hedge fund managers have lower returns?

666 views
566 views

Published on

Published in: Economy & Finance, Business
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total views
666
On SlideShare
0
From Embeds
0
Number of Embeds
1
Actions
Shares
0
Downloads
8
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Why do experienced hedge fund managers have lower returns?

  1. 1. Why do experienced hedge fund managers have lower returns? Nicole M. Boyson* November 3, 2003 Abstract Several theories of reputation suggest that managers’ career concerns affect their decisions. We investigate these theories by studying the behavior of hedge fund managers over their careers. In contrast with mutual fund managers who incur more risk over time, hedge fund managers take on less risk over time. This finding is consistent with certain industry characteristics which imply that experienced managers have “more to lose” in personal wealth, current income, and reputation should their funds fail. Most important, the propensity of experienced managers to reduce risk explains their underperformance. These results have implications for fund selection and incentive contract design. * Purdue University, Krannert Graduate School of Management, West Lafayette, IN 47907. E-mail: nboyson@mgmt.purdue.edu. Phone: (765) 496-7877. This paper is a revised version of an earlier paper entitled, “How are hedge fund manager characteristics related to returns, risk, and survival?” I would like to thank Vikas Agarwal, Richard Brealey, Stephen Brown, Steve Buser, Mike Cliff, Mike Cooper, Dave Denis, Diane Denis, Jean Helwege, David Hirshleifer, Kewei Hou, Andrew Karolyi, Bing Liang, Bernadette Minton, John McConnell, Narayan Naik, Karen Wruck, and René Stulz (my advisor), and seminar participants at The Ohio State University, Purdue University, and London Business School's Centre for Hedge Fund Research and Education. All remaining errors are my own.
  2. 2. 1. Introduction A number of theoretical models hypothesize that managers will alter their risk-taking behavior as their careers progress. Avery and Chevalier (1999) posit an increase in risk over time, arguing that as managers gain experience they obtain more precise knowledge about, and confidence in, their own abilities. Hence, older managers will take bold or aggressive actions while younger managers will be more likely to mimic other managers, or to “herd.” Empirically, in studies of mutual fund managers, security analysts, and macroeconomic forecasters respectively, Chevalier and Ellison (1999b), Hong, Kubik, and Solomon (2000), and Lamont (2002) report results consistent with this theory: old herd less than young. By contrast, other models predict that risk-taking behavior will decrease as managers age (see Prendergast and Stole (1996), hereafter PS, and Graham (1999)). The PS model argues that managers wish to acquire a reputation for learning, and thus when faced with new information each period, young managers overreact (to show they have good information) while old managers underreact (so as not to signal that their actions in prior periods were wrong). Additionally, a large labor economics and management literature supports the more general idea that risk-aversion increases with age, causing a reduction in risky behavior.1 The empirical results of Graham (1999) (investment newsletters) and Li (2002) (securities analysts) show a decrease in risk over time. Also, in studies of CEOs and top managers, Katz (1982), Hambrick and Mason (1984), Finkelstein and Hambrick (1990), and Jaggia and Thosar (2000) obtain similar results. Perhaps the contradictory conclusions of these empirical studies owes to how well various industries and firms provide incentives to overcome the effects of “career concerns.” The “career concerns” literature, pioneered by Fama (1980), argues that principal-agent (agency) problems (which occur when the incentives of investors and fund managers are misaligned) can be mitigated by a manager's desire to keep his current job or obtain a better job (i.e., his “career concerns”). However, sometimes career concerns can work too well, resolving some agency problems while causing others (see Holmstrom (1982), and Holmstrom and Ricart i Costa (1986)). An alternative view is that “career concerns” are themselves a type of agency problem, 1 For example, see Salancik (1977), Morin and Suarez (1983), Holmstrom and Milgrom (1987), Kanodia, Bushman, and Dickhaut (1989), and Bernheim (1994), as well as related sociology literature (see Vroom and Pahl (1971), Kiesler (1971), and Kahneman, Slovic, and Tversky (1982). 2
  3. 3. which sometimes mitigate and sometimes exacerbate existing problems. This paper studies the implications of this literature in a new venue: the hedge fund industry. Two features of the hedge fund industry motivate this study: low agency costs relative to other money managers and career concerns that should change significantly over time. Hedge fund managers face low agency costs for a number of reasons. First, they are not required to publicly report their holdings, trades, or returns, which reduces their incentive to “window- dress.”2 Second, hedge fund manager compensation is based on profits (20% is typical), rather than on assets (1-2% is typical) as in the mutual fund industry. Arguably, this fee structure better aligns shareholder and manager interests. The empirical literature supports this concept: in an attempt to increase asset size, mutual fund managers increase risk when their funds underperform in the first half of a year (see Brown, Harlow, and Starks (1996) and Chevalier and Ellison (1997)). By contrast, hedge fund managers facing the same situation do not increase risk (see Brown, Goetzmann, and Park (2001) (hereafter, BGP)).3 The third reason that agency costs are lower for hedge fund managers is that they invest substantial personal assets in their funds. For example Bruce Cohen (who manages the SAC Capital Advisors' fund) has about $1 billion of his own capital in the fund.4 An article in the April, 2002 issue of Fortune notes that Crispin Odey and his team at Odey Asset Management have at least $30 million of their own assets in the fund. By contrast, mutual fund managers rarely have significant personal assets in their funds. Finally, hedge funds do not allow continual investment and redemption of shares. These “lock-up” periods reduce agency costs by encouraging managers to invest in longer-term strategies, and also reduce the amount of cash that a manager must hold for withdrawals. The second unique feature of the hedge fund industry is that career concerns are likely to change significantly over time. There are at least three reasons we would expect this to happen. First, hedge fund managers earn large salaries which are based on both the size and profitability of their funds. Since older managers have much larger funds on average, they can earn high 2 Window-dressing refers to altering one's portfolio near a required reporting period in an attempt to attract new customers. See Lakonishok, et. al. (1991). 3 Since hedge fund manager fees are asymmetrical (managers make money when their funds earn profits but do not lose money when their funds incur losses), perhaps managers will take on too much risk. However, the literature shows that these fees appear to encourage an “appropriate” amount of risk. See Starks (1987), Gibbons and Murphy (1992), Carpenter (2000), and Das and Sundaram (2002). 4 See Institutional Investor, June, 2002. 3
  4. 4. salaries at low returns, which provides incentives for young managers to take on more risk, and for old managers to reduce their risk levels as they age (and their funds grow in size).5 Second, failed hedge fund managers rarely start new hedge funds (see BGP, (2001)). By contrast, about 67% of “failed” or terminated mutual fund managers remain in their industry. And, the pay differential in the industries is tremendous: the average hedge fund manager in the sample has a salary of about $4 million, while an average mutual fund manager made about $440,000 (in 2001). So, not only does a failed hedge fund manager have to leave the industry, but also, he must take a very large pay cut if he moves to a different industry (for example, the mutual fund industry). Arguably, older managers with larger funds are more affected by this situation. Finally, experienced managers with larger funds probably have significant personal assets at stake. Thus an older manager will likely have greater career concerns than a young manager. For example, he has strong incentives to avoid failure in order to protect his wealth and reputation.6 Low agency costs and high career concerns imply that the predictions of the PS and Graham models are likely to be applicable to hedge fund managers. Specifically, if agency costs are low, career concerns will be relatively more important, and to the extent that career concerns increase over time, managers should become more risk-averse as their careers progress. This paper finds results largely consistent with this theory. With a large sample of hedge fund managers over the period 1994-2000, this paper tests the opposing theories by examining how the risk-taking behavior of hedge fund managers changes over time. Consistent with the predictions of PS, I find a strong negative relationship between manager experience and risk-taking behavior; i.e., older managers are have career concerns that induce them to take on less risk. This result is in direct contrast with previous empirical findings for mutual fund managers; in mutual funds, more experienced managers face 5 In the sample, when managers are divided into thirds based on their tenure, the average fund size for a “young” manager is about $10 million. By contrast, the average fund size for an “old” manager is over $250 million. Clearly, young managers have a motivation to earn high returns, both to increase their current salaries and grow their funds in order to increase future earnings. Old managers, by contrast, can earn much lower returns and still be compensated handsomely. 6 The opposing argument may also be made. A young manager arguably has more at stake in terms of expected future earnings than an older manager. However, a young manager also will not have had the success and past profitability of an old manager, so the transition from the hedge fund industry, to say, the mutual fund industry, may be less difficult for him. Regardless, the empirical results of this paper support the idea that hedge fund manager career concerns increase, rather than decrease, with age. 4
  5. 5. lower agency costs and have lower reputational concerns, leading to more risk-taking than their less experienced counterparts (see Avery and Chevalier (1999) and Chevalier and Ellison (1999b)). The remainder of the paper explains this negative relationship between manager age and risk-taking behavior in light of the unique career concerns of older hedge fund managers (i.e., older managers have “more to lose” should their funds fail). I hypothesize that this negative relationship is driven by older managers’ consciously reducing the types of risk that might be associated with fund failure. Consistent with this hypothesis, I show that high levels of risk- taking behavior do indeed lead to fund failure. These results are statistically and economically significant. Finally, this paper uses the finding that older managers reduce risk-taking behavior to explain the empirical result that older managers have lower returns. (See Liang (1999) and Edwards and Caglayan (2001).) While this difference cannot be explained by systematic differences in “market beta” risk (measured as coefficients from regressions of fund returns on a number of market factors), it can be explained by differences in volatility and “herding” behavior documented above.7 These results are rather compelling. For example, risk-taking behavior explains a large portion of the difference in returns at various levels of manager experience: while controlling for “market beta” risk and fund characteristics, but without controlling for the risk measures of interest (volatility and herding measures), the difference in returns between a 52 year-old manager and the average (47 year-old) manager is about 4.0% annually. However, when controlling for volatility and herding risk, this difference drops to about 2.1% per year. These results are consistent across all measures of volatility and herding risk, and robustness checks confirm that they are not likely due to survival bias or decreasing manager ability over time. The paper is organized as follows. Section 2 describes the data. Section 3 confirms the negative relationship between hedge fund manager experience and fund returns, which holds for both raw returns and when controlling for correlation with market indices. I hypothesize that career concerns of older managers lead to a decrease in the types of risk that could lead the fund 7 I calculate regression coefficients for a number of proxies for the “market.” These include various passive indices, hedge fund indices, and returns on dynamic trading strategies. While these factors are often relevant in explaining hedge fund performance, the coefficients on these factors do not systematically differ among young and old managers. 5
  6. 6. to fail, which causes the lower returns. The remaining sections confirm this hypothesis. First, Section 4 shows that experienced managers do indeed reduce certain types of risk-taking behavior. Next, Section 5 documents that increases in these types of risk-taking behavior are positively related to fund failure – providing an explanation for the observed low risk-taking behavior of older managers – and also finds that more experienced managers tend to have lower failure rates than less experienced, implying that managers are responding to this incentive. Finally, Section 6 shows that this decrease in risky behavior can explain a substantial portion of the fall in performance of experienced managers. Section 7 provides a number of robustness checks and Section 8 concludes. 2. Data Data was provided by Tremont Advisory Shareholders Services (TASS). TASS has been collecting hedge fund data directly from managers since the late 1980's, and currently has over 2,400 funds in their database, both living and dead.8 The database includes monthly net-of-fee returns, as well as expenses, fees, size, terms, age, and style of the funds. Many of the funds also include a biographical sketch of the manager, providing information such as age, schooling, professional designations, and prior work experience. TASS categorizes funds as “dead” when they stop reporting their monthly information to the database. Because the fund managers voluntarily report this data, there are a number of reasons why funds stop reporting, including failure, merger, or a more arbitrary reason, such as the fund manager's belief that being included in the database is not helping him raise additional investment dollars. While some of these reasons are clearly associated with poor performance (e.g., failure), others are less obvious. In most cases, TASS includes the reason for leaving the database. Section 5 performs a detailed analysis of fund failure.9 Each fund must have 24 months of consecutive returns and at least $5 million in assets during the period January, 1994 to December, 2000 for inclusion in the sample. Obviously, this 8 TASS has maintained data on dead funds since 1994. 9 Some managers might leave the sample because they are very successful and, from a marketing perspective, do not need to report their data any longer. However, as a preview of results from the analysis in Section 5, most funds that leave the sample are suffering from poor performance, and whether they actually “failed” at the time of leaving the sample or at some time thereafter (and got out of the sample beforehand to save face), most of them were not successful funds (they were smaller and had lower than average returns). 6
  7. 7. requirement represents a trade-off between sample size and ensuring that each fund has a long enough time series for meaningful regression results. At the beginning of its existence, a hedge fund undergoes an incubation period where the only significant investor is the fund manager. He hopes to compile a good track record before making the fund available to the public. Thus, most funds arrive in the database with a history of strong performance which was never available to outside investors, biasing returns upward. This difference is often large – using the TASS database, Fung and Hsieh (2000) calculate the bias as about 3.6% per year. TASS provides the incubation period for each fund; thus, to control for this bias I drop the data for the initial incubation period for each fund. The final sample includes 982 funds (of which 285 failed at sometime during the sample period). Variables included are fund returns and fund characteristics, including manager tenure. A smaller sample of 271 funds includes fund returns, fund characteristics, and also includes manager characteristics, such as age and education level. Since manager tenure is the variable of interest in many of the following tests, the large sample is used throughout most of the paper, with the smaller sample available for robustness tests. Table 1a includes summary statistics of the return, manager and fund characteristics variables. To facilitate the interpretation of test results from the large (982 fund) sample, Table 1b converts the manager tenure variable to a manager age variable. Using the smaller (271 fund) sample, the table divides the small sample into deciles by tenure, and then calculates average manager age for each decile. The tenure percentile estimates for the small sample are within a few months of the tenure percentile estimates for the large sample, so the age estimates appear to be reasonable. As a brief summary, the average hedge fund manager is 47 years old, has 22 years of work experience, manages a fund of about $113 million dollars, and comes from an undergraduate institution with SAT scores about 300 points over the national average. About half the managers in the sample have MBAs, and approximately 70% of the managers use leverage and have their own money invested in their funds. Clearly, this is an experienced, well- educated group. In comparison, the average mutual fund manager is about 3 years younger, 7
  8. 8. attended a school with average SAT scores about 200 points lower, and is slightly more likely to have an MBA than the average hedge fund manager.10 2.1. Measures of risk-taking behavior In order to understand how managers' risk-taking behavior changes over their careers, we need a measure of risk. This paper uses three measures. The first is the total standard deviation of a portfolio's returns. Standard deviation is an absolute measure in that it does not compare the risk of a portfolio to the risk of a benchmark. Hence, it may or may not be correlated with the coefficients estimated from a regression of returns on market indices, and as such, may contain additional useful information regarding managerial risk-taking behavior. Additionally, since hedge fund managers can engage in dynamic strategies, using leverage, options and other derivative securities, they may have some control over the standard deviation of their funds' returns. While standard deviation measures total risk, this paper also uses two relative risk (or “herding”) measures. The first is tracking error deviation measured relative to a fund-of-funds (FOF) index. A fund-of-funds is a professionally managed hedge fund that invests in other funds. Fung and Hsieh (2000) note that a fund-of-funds index is an appropriate benchmark for measuring hedge fund performance, which motivates its use in this paper. Tracking error measures the volatility in returns not explained by market volatility (specifically, it is the standard deviation of the residuals in a time-series regression of a individual fund's returns on the FOF index (and is calculated annually). Tracking error deviation measures how much a manager's tracking error differs from that of the average manager in the same style category (specifically, it is calculated by subtracting the average tracking error for a given fund’s style from the tracking error of that fund). Since it is measured relative to other managers, it is a type of herding measure. The second relative risk measure is beta deviation, following Chevalier and Ellison (1999b). Beta deviation uses each individual fund's time-series coefficient (beta) from a regression of that fund's returns on the FOF index, and is calculated as the difference between fund's beta on the FOF index and the average beta on the FOF index for all other funds in the 10 This data is obtained from Chevalier and Ellison (1999a). 8
  9. 9. same style category. It is also calculated annually.11 Like tracking error deviation, beta deviation is also a herding measure. 2.2. Measures of performance In addition to measuring risk-taking behavior of managers, we must also measure their performance, which we estimate in three ways. The first measure uses simple excess-of-risk- free-rate returns. The risk-free rate is the 30-day Treasury bill rate. The second performance measure adjusts the returns for exposure to a number of passive indices, the factors used by Carhart (1997), and a put option return as suggested by Agarwal and Naik (2003). The third performance measure controls for exposure to hedge fund indices, in the spirit of Sharpe's style analysis (see Sharpe (1992, 1994)), and as suggested by Fung and Hsieh (2001) and L'habitant (2001). These indices should proxy for the specific risks faced by hedge funds. The passive indices used in the second measure of performance are obtained from Datastream and include: the US Trade Weighted Dollar index to capture currency risk, gold and commodity indices, the Lehman Brothers Eurobond, 30-year Treasury bond, and U.S. aggregate bond indices, and the S&P 500, Wilshire 5000, and MSCI Eafe stock market indices. Additionally included are the Fama-French (1992,1993) SMB (a zero-investment portfolio constructed by subtracting the returns of large market capitalization firms from the returns of small capitalization firms) and HML (a zero investment portfolio constructed by subtracting the returns of low book to market ratio stocks from the returns of high book to market ratio stocks) factors, as well as Jegadeesh and Titman's (1993) momentum factor (MOM) – a zero-investment portfolio constructed as the spread between the performance of stocks which were in the top 30% of returns in the prior twelve months and those which were in the bottom 30%.12 Finally, the regressions include a simple option trading strategy as suggested by Agarwal and Naik (2003). For each passive index listed above, the return from investing each month in a one-month at-the- money put option, holding the option for a month, and then reinvesting in next month's option is 11 This measure differs slightly from that used by Chevalier and Ellison (1999b). For their sample of equity mutual funds, they calculate betas for each fund by regressing returns on a broad stock market index. For each fund, beta deviation is the absolute value of the difference between a fund's beta and 1 (since a well-diversified equity mutual fund would have a beta of about 1). For hedge funds, betas vary widely by style, and thus, the measure used in this paper accounts for these style differences by measuring each fund's beta deviation relative to the average beta in its style category. 12 These returns were obtained from the website of Kenneth French. 9
  10. 10. calculated, using the Black-Scholes model to estimate the option prices. Then, each month, an equally weighted average of all the index option returns is calculated and used as a regressor. As mentioned above, the third measure of performance uses hedge fund indices to control for market exposure. These indices are published jointly by Credit Suisse First Boston (CSFB) and TASS, and represent a number of hedge fund trading strategies. They are constructed so as to minimize survivorship bias. For further detail about the indices used, see Appendix A. Table 2 reports summary statistics for all indices used in the paper. For the second and third measures of performance (which control for exposures to passive indices and hedge fund indices, respectively), I estimate two-step Fama-Macbeth (1973) regressions. The first step performs time-series regressions to estimate each fund's loading on each index. The second step uses these loadings as controls for market exposure in cross- sectional regressions of each fund's return on fund and manager characteristics. A well-known problem caused by two-stage regressions is that to the extent the coefficients from the first-pass regressions are estimated with error, this error will then be included in the second-pass regressions. (Fama and Macbeth (1973) refer to this as the “errors- in-variables” problem.) They use portfolios of securities (or, in this case, hedge funds), rather than individual securities (hedge funds), in the first-pass regression, to “average out” the estimation error. Also, to maximize dispersion of coefficients among these portfolios, Fama and French (1992, 1993) use firm size as well as individual fund beta to form the portfolios.13 I follow the Fama-Macbeth approach, with one exception. While they form portfolios in one period (the formation period) and estimate the portfolio coefficients (betas) in a different period (the estimation period), I use entire time-series of data for both formation and estimation. Using separate periods reduces the likelihood of the “regression phenomenon”: when portfolios are formed and betas are estimated in the same period, errors from the individual fund regressions will be passed on to the portfolio regressions. However, due to the short time series of data available, this paper cannot use separate formation and estimation periods. Thus, while this approach of this paper addresses the “errors-in-variables” problem, it does not address the “regression phenomenon.” 13 One reason that Fama and French use fund size in addition to beta is that for individual firms, beta and fund size are not highly correlated. Their finding also holds for hedge funds: I calculate correlations between the betas on each index and hedge fund size as between -0.01 to 0.08. 10
  11. 11. To address this concern, I perform two robustness checks. First, I form portfolios based on size only, as opposed to both size and beta. This approach completely eliminates the “regression phenomenon,” since as noted above, estimated betas and hedge fund size have very low correlations. Using this method, the main results of the paper remain unchanged. The second robustness check sorts funds into portfolios based on the first two years of data, and estimates portfolio betas using the next two years of data. Then, cross-sectional regressions are performed using the remaining three years of data. Again, the results from this approach are similar to those obtained when all the data is used in the formation, estimation, and testing periods. These robustness checks provide comfort that the approach of using all the data for the formation, estimation, and testing periods does not cause a significant “regression phenomenon” problem. The specifics of the process are as follows. First, I perform time-series regressions using all the data, where I calculate “sorting” coefficients on each index for each fund.14 A single- factor model estimates the time-series coefficient (beta) for each fund for each index, as follows: i r t = α t + bs t INDEX t + ε t (1) where r it is fund i's return in period t (t=1 to 84 months), and (INDEXt) refers to the index used. Next, I sort funds into quartile portfolios, based on this “sorting” beta (bst) and fund size. This sort results in sixteen (16) portfolios for each index.15 Once the portfolios are formed, I calculate equally-weighted averages of excess returns (net of the risk-free rate) for each set of portfolios. Then, time-series regressions of the portfolio returns (rp) are performed for each index as follows: j r pt = α pj + b pj INDEX t + ε t (2) 14 Recall that there are two separate sets of indices used as controls for market risk factors, passive and hedge fund. Descriptive statistics of these indices may be found in Table 2. 15 The results are robust to using nine (9) or twenty-five (25) portfolios. 11
  12. 12. j where r pt are monthly portfolio returns in excess of the risk-free rate (number of months, t=84), and INDEX is the return on the INDEX used in the sorting process. Thus, sixteen (j=16) regressions for each INDEX are performed (one for each of the sixteen portfolios). I then assign the resulting coefficients (the bpj’s) to each fund in the sample, based on its portfolio classification. This process results in each fund being assigned a beta coefficient for each index. These coefficients are then used as market controls in the cross-sectional regressions in Section 3. The coefficients on the passive indices are used as market controls in the second measure of performance, while the coefficients on the hedge fund indices are used as market controls in the third measure of performance. 3. The relationship between returns and manager experience As an overview, this paper tests the following hypothesis, which is motivated by the work of PS (1996) and Graham (1999): Due to career concerns that increase over time, managers will decrease risk as their careers progress. This reduction in risk-taking behavior can explain the previous empirical finding that older managers have lower returns. Hence, we begin by confirming that the negative relationship between returns and age that was documented in prior studies also holds for this paper's data set. (See Liang (1999) and Edwards and Caglayan (2001).) Our dataset differs from theirs: Liang uses a sample of 385 funds from the Hedge Fund Research (HFR) database with at least three years of monthly returns for the period 1994 to 1996. Edwards and Caglayan use a sample of 836 funds with at least 24 months of returns from the MAR/Hedge database for the time period January 1990 to August 1998. I perform monthly cross-sectional regressions where the dependent variable is one of the three different performance measures as described in Section 2.2, and the independent variables are a number of manager and fund characteristics. The variable of interest in these regressions is manager tenure (and/or manager age). In the first set of regressions, the dependent variable is “excess” return, and no controls for market exposure are included. The second set of regressions controls for exposure to “passive” market indices using the “passive” betas calculated in Section 2.2, while the third set of regressions controls for exposure to hedge fund market indices using the “hedge fund” betas calculated in Section 2.2. 12
  13. 13. The regression for the first performance measure (excess returns) is as follows: J K r t = α t + ∑ b j ,t M + ∑ c k ,t F k ,t + ε t i i i j ,t (3) j =1 k =1 i where the r t ’s are the monthly returns (in excess of the risk-free rate) of fund i in month t, the i i M j ,t ’s are the manager characteristic variables of fund i in month t, and the F k ,t ’s are the fund characteristics of fund i in month t. The second and third cross-sectional regressions also include controls for market exposure. Regression two includes passive market controls, where regression three includes hedge fund market controls, as follows: J K L r t = α t + ∑ b j ,t M + ∑ c k , t F k ,t + ∑ d l , t E l ,t + ε t i i i i j ,t (4) j =1 k =1 l =1 i i i i where the r t ’s the M j ,t ’s and the F k ,t ’s are the same as in Equation (3) above, and the E l ,t ’s are the market control coefficients assigned to each fund i from the time-series regressions on passive (regression 2), or hedge fund (regression 3), indices as described in Section 2.2. Table 3 reports the results from these regressions. In the table, regressions 1a and 1b use excess return as the dependent variable as in equation (3) above, and do not control for exposure to market indices. Regressions 2a and 2b control for exposure to passive indices, and regressions 3a and 3b control for exposure to hedge fund indices, as in equation (4) above. For all specifications, regression a is performed on the small sample (271 funds), which includes all manager, as well as all fund characteristics, while regression b is performed on the larger sample (982 funds), which includes only fund characteristics and manager tenure. Consistent with previous literature, manager tenure is strongly negatively related to performance. This finding is robust to all specifications tested. The results are significant, both economically and statistically. For each year of experience, annual returns decrease by about 0.8%. (For ease of interpretation, the coefficients on manager age and tenure are annualized in 13
  14. 14. Table 3.) Thus, a 52 year-old manager has returns about 4% lower than the average (age 47) manager. Additionally, the coefficient on manager age is significant and negative, the same direction as the manager tenure variable.16 Both tenure and age are meaningful proxies for reputation, since a manager's reputation may have been developed before he became a hedge fund manager. Including the market control variables in regressions 2a and b and 3a and b provides additional explanatory power; however, the coefficient on manager tenure remains significant and negative. Most importantly, including these market control variables does not change the manager tenure coefficient by very much: it drops from -0.8%/year to -0.7%/year. In other words, although “market beta” risk explains a fair amount of the cross-sectional variation in returns – the R2’s from the regressions that do not include market control variables are about 0.07, while the R2’s from the regressions that do include the market risk variables are about 0.30 – the negative relationship between manager tenure and returns still holds. This section has confirmed the existence of a negative relationship between manager tenure and hedge fund performance, one that is not explained by other fund characteristics or by exposure to “market beta” risk. Now that this relationship has been confirmed, the next section begins to investigate this paper’s main hypothesis: that, motivated by career concerns, managers reduce risk as their careers progress, and that this reduction in risk can explain their lower returns. 4. The relationship between manager tenure and risk-taking behavior The first step in testing this hypothesis is to examine the relationship between manager tenure and risk-taking behavior. Consistent with other empirical studies, we use manager tenure (or age) as a proxy for manager reputation: as managers progress in their careers, their reputations become more established. Another reasonable proxy for the importance of a manager's reputation is fund size. As funds grow, their managers become better known and have more at stake (with respect to both wages and status). Finally, the interaction of tenure and size is another proxy: at the extremes, experienced managers with large funds should have “higher” 16 The number of years experience variable has coefficients and significance levels nearly identical to those found for manager age, so results are not reported in Table 3. 14
  15. 15. reputational concerns than inexperienced managers with small funds. Hence, all three measures (tenure, size, and the tenure/size interactions) are used as proxies below. First, we perform nonparametric tests. For each of the 982 funds, we calculate the mean values for manager tenure and fund size over the period 1994 to 2000. Funds are then sorted into thirds as either young tenure, middle tenure, or old tenure. Additionally, funds are sorted into three size categories: small, medium and large. Next, funds are cross-sorted into nine tenure/size categories based on these classifications. Finally, means of the risk measures (standard deviation, tracking error deviation, and beta deviation) are calculated for each tenure, size, and tenure/size interaction category. Table 4 reports these means, and shows results from Wilcox rank-sum tests for differences in means. Additionally, Figure 1 displays the risk measures by reputation proxies. This Figure and Table 4 clarify the general pattern of risk- taking behavior: managers reduce risk as they gain experience. The results are notable: for all risk measures, the Wilcox tests of the difference in means between the extreme categories (young and old, small and large, and small/young and old/large) are statistically significant at the 1% level. Figure 2 provides still more evidence: it plots the risk measures by the nine (9) fund tenure/size categories. The pattern is even more dramatic and shows a nearly monotonic decrease in risk by tenure/size category. While these findings are suggestive, they do not control for heterogeneity in fund characteristics, which could be influencing the results. Additionally, they aggregate the data over each fund's entire existence during 1994-2000, so that time-series variation is not considered. To address these issues, Table 5a presents results from a number of annual regressions where the dependent variable is the risk measure (either standard deviation, tracking error deviation or beta deviation) and the independent variable of interest is the measure of reputation (either tenure, size, or the tenure/size interaction). These regressions control for a number of fund characteristics listed in Table 1a. Panel A of Table 5a reports results from regressions of standard deviation against manager tenure and all fund characteristic variables (specification 1a), fund size and all fund characteristic variables (regression 1b), and the manager tenure/fund size interaction variable and all fund characteristic variables (regression 1c). Panels B and C (regressions 2a-3c) show results from the same three regressions for each of the other risk measures. The results in Table 5a are 15
  16. 16. consistent with the results in Table 4: for all specifications and for all risk measures, tenure, fund size, and tenure/size interactions are negatively related to risk-taking behavior. Managers with more reputation at stake (as measured by tenure, size, or tenure/size interactions) incur less risk. An additional result from Table 5a is worth investigating. The coefficient on “personal capital invested” (a 0/1 indicator variable) is positive and significant for two of the three regressions (standard deviation and beta deviation). This is puzzling, and contrary to our hypothesis that managers with personal capital at stake will likely incur less risk in order to preserve their assets. One reason might be that the “personal capital invested” variable is not very informative. As a 0/1 variable, it says nothing about the magnitude of the manager's investment or about the percentage of personal wealth that the investment represents. About 67% of managers answered “yes” to this question; their personal stakes in their funds likely vary. To address this result, Table 5b reports results from additional regressions which include additional independent variables: the reputation variable (either manager tenure, fund size, or tenure/size interactions) is interacted with the “personal capital invested” variable. The focus is on the personal capital interaction variables. A negative coefficient on these interaction variables indicates that managers with greater reputational concerns that also have personal capital invested incur less risk than managers with lower reputational concerns. The results from Table 5b, regression 1a, indicate that for the standard deviation risk measure, older managers with personal capital invested do indeed take on less risk (this result is significant at the 1% level). Also, for the beta deviation risk measure, the results in Table 5b, regressions 3a (and c) indicate that managers having large funds (and older managers with large funds) and personal capital invested also reduce risk. Thus, although the proxy for personal capital invested does not precisely measure a manager’s personal capital at risk, there is support that managers with greater career concerns and personal capital at stake do incur less risk. 5. Career concerns and risk-taking behavior We hypothesize that older managers have greater career concerns than young managers; as a result, older managers incur less risk to increase the probability of their funds’ (and their careers’) survival. The prior section confirms that older managers do, indeed, incur less risk. This section documents the link between risk-taking behavior and the likelihood of fund survival. 16
  17. 17. To study this relationship, we use a time-varying proportional hazards model which allows for the complete use of the time-series variation in the sample.17 Time-varying proportional hazards models (which are a category of the more general hazard functions) have several advantages over the more commonly-used probit and logit models. First, they put fewer distributional assumptions on the data; second, they calculate the conditional rather than the absolute probability of failure (conditional upon not having failed in a prior period); and finally, they do not introduce sample-selection bias into the data. Instead of using annual failure rates, they allow for monthly failure times which reduces bias and adds precision to the estimates. Recent work in finance has used this type of model. Examples include Helwege (1996), who uses a proportional hazards model to examine the determinants of Savings and Loan failures in the 1980's, Lunde, Timmerman, and Blake (1999), who use the model to examine the determinants of mutual fund failures, and BGP (2001) who use this model to examine the determinants of hedge fund failure, notably volatility and manager tenure. 5.1. Description of proportional hazards model The time-varying proportional hazard model estimates the relationship between the hazard rate (the likelihood of fund failure), λ(t), and a number of explanatory variables, z(t), that are permitted to vary over time. The proportional hazard function is specified so that the explanatory variables shift an underlying baseline hazard function up or down. The baseline hazard function, λo(t), can follow any distribution for which proportionality holds. Examples include the Weibull, exponential, and lognormal distributions. The time-varying proportional hazard function is described by the following equation: β z (t ) λ (t ; z (t )) = λ 0(t )e (5) where β is the set of coefficients to be estimated. Cox (1972) describes how β can be estimated by maximizing the partial likelihood function of the probability of failure observed in the sample. β is estimated from inferences on the conditional probability of failing in a given time period. Because of proportionality, the 17 Much of the following description closely follows Helwege (1996). 17
  18. 18. estimation ignores the baseline hazard function, which makes specifying a functional form for the baseline unnecessary. Assume that there is a sample of n hedge funds, k of which fail during the sample period with failure times t1 < t2 < … < tk. The assumption of this model is that each failure occurs in a different time period, and the failures are ordered from 1 to k chronologically.18 The remaining n-k funds are censored and have no failure times during the sample period. However, these funds could fail some time after the sample period ends. Assign δt equal to 1 if a fund in period i fails and zero if it does not fail. Let zi(t) be z(t) for the fund with failure time ti and let zj(t) be z(t) for each fund at risk at time ti. Ri is the set of funds at risk of failure in period i. The partial likelihood function to be maximized is: δi n  e β z i(t i)  L( β ) = ∏  β z j (t )  (6) i =1  ∑∈R e i   i  Intuitively, Equation (6) examines each hedge fund that fails (one per time period) and compares its explanatory variables to the explanatory variables on the set of hedge funds that could have failed during the period but did not. If the values of the explanatory variables for those that failed differ from the values of the explanatory variables for those that survived, the coefficients will be significantly different from zero.19 5.2. Estimation of proportional hazard model In this section, I estimate a time-varying proportional hazard model, using the time that a fund drops out of the sample as the failure time for that fund. As noted in Section 2, there are a number of reasons that funds may be removed from the database. Some of the funds actually fail, while others voluntarily stop reporting their data. Although TASS often provides the reason 18 This methodology assumes no ties (that is, no funds failed in the same period). In the sample of interest, there are several tied failure times, which will be addressed later. For simplicity, the case with no ties is described here. 19 Maximum likelihood estimation is used to estimate the partial likelihood function. Since this process is computationally demanding, an approximation (see Breslow (1974)) is usually used to save time and computer resources. However, the Breslow approximation can be less accurate when there are many tied failure times (as is the case in the hedge fund data.) Thus, following estimation uses the exact method (see Kalbfleisch and Prentice (1980)). 18
  19. 19. that the fund has been removed, it is often difficult to interpret. Thus, the analysis below is performed on two samples: one that considers as dead all 285 funds that TASS categorizes as “dead” (out of the total sample of 982 funds), and another that considers as dead only the funds that clearly state that the fund had failed or gone bankrupt. The results for both samples are nearly identical, implying that most of the funds that left the sample had similar characteristics consistent with actual failure. Thus, Table 6 reports the results using the larger sample. Table 6 relates termination to risk-taking behavior. The regressions include controls for fund characteristics (described in Table 1a and Section 4, above) and seasoning (year effects). Including seasoning effects reflects the possibility that termination probabilities may vary from year to year due to factors such as evaluations based on absolute performance or changes in the labor market for hedge fund managers. The first column, regression 1, examines the relationship between termination and standard deviation. Columns 2 and 3 examine the relationship between termination and tracking error deviation and beta deviation, respectively. All regressions include the fund characteristic variables as well as a measure of fund performance (excess returns above the risk-free rate). In the table, a negative coefficient indicates a positive likelihood of survival, while a positive coefficient indicates a positive likelihood of failure. Examining the results in Table 6, two patterns emerge. First, as expected, good performance is negatively related to failure. Second, all three risk measures are positively related to failure. Funds that take on more risk have a higher likelihood of failing. This finding confirms our hypothesis: risk-taking behavior increases the likelihood of failure, which provides an incentive for managers with career concerns to reduce these risk-taking behaviors. The approach of this section has been to link various risk-taking behaviors to the probability of fund failure. It provides evidence that engaging in risky behavior significantly increases the probability of fund failure. Another way to think about risk-taking is to consider fund failure itself as evidence of risk-taking behavior. If a fund fails, its manager likely incurred some sort of risk, which may not be captured by the risk measures used in this paper. Therefore, we next focus on the relationship between fund failure and manager tenure, without regard to the pre-determined measures of risk. If the relationship between manager tenure and fund failure is negative, this provides indirect evidence that older managers have been taking on less risk. 19
  20. 20. In order to capture the effect of manager tenure without regard to risk-taking behavior, I re-estimate the model excluding the risk and performance measures. Column 4 of Table 6 shows these results. The coefficient on the tenure variable is -0.06, which indicates that for each month of manager experience, the average probability of failure decreases by 6%. Consistent with results in columns 1 to 3, this finding suggests that older managers decrease risk over time to reduce their likelihood of failure. To examine how this relationship varies by tenure and over time, I estimate the shape of the survivor function (which is the inverse of the hazard function). Holding all other variables constant at their averages, the function is estimated at nine levels of the tenure variable, representing the 10th through the 90th percentile of tenure categories. Figure 3 graphs the survival function at three percentiles: 10th, 50th, and 90th. Examining this Figure, it is clear that holding all else constant, more experienced managers have a much higher probability of survival. Interpreting fund failure as a proxy for risk, this Figure is consistent with the results that older managers reduce risk over time. In summary, this section provides evidence that risk-taking behavior leads to fund failure, establishing an implicit incentive for older managers with career concerns to reduce risk. 6. Do low levels of risk-taking behavior cause low returns? In Section 3, the negative relationship between hedge fund manager tenure and performance was confirmed. Sections 4 and 5 show that older managers take on less risk than young managers, and provide motivation for this behavior. This section provides a causal link between the two results, thus confirming the hypothesis of this paper. Specifically, we show that older managers’ propensity to reduce risk explains their lower realized returns. Table 7 presents results from a number of cross-sectional regressions. For all the regressions, the dependent variable is annual return less the risk-free rate, and the independent variables include manager tenure, all fund characteristics, and one of the three measures of risk- taking behavior -- standard deviation, tracking error deviation, and beta deviation. The methodology is similar to that in Section 3 (and Table 3), but the regressions in this section are performed annually instead of monthly, since the three risk-taking measures are estimated on an annual basis. To establish the baseline relationship between returns and manager tenure (on an annual level), the first set of regressions (Panel A) do not include the risk-taking variables as 20
  21. 21. regressors, so the first column (1a) includes as independent variables manager tenure and fund characteristics only. The second column (1b) includes controls for exposure to passive indices, while the third column of Panel A (regression 1c) also includes controls for exposure to hedge fund indices. The next three sets of regressions (Panels B-D) are identical to regressions 1b and 1c, except they also include either standard deviation (Panel B), tracking error deviation (Panel C), or beta deviation (Panel D) as independent variables. Table 7 indicates a positive relationship between the each of the three risk measures and annual returns, confirming that the risk-return relationship holds for this sample of hedge funds. In other words, risk-taking behavior is rewarded with significantly higher returns. Most important, the coefficient on the manager tenure variable decreases significantly when risk-taking behavior is considered. These results are economically interesting: without considering the impact of risk-taking behavior or correlations with “market beta” coefficients on returns, the difference in returns for a 52 year old manager versus the average (47 year-old) manager is about -4% per year. When “market beta” controls are included, this difference drops to about -3.5% per year. However, when both the “market beta” controls and the risk-taking measures are included, the difference drops to about -2% per year. Differences in risk-taking behavior explain nearly half the differences in returns between old and young managers. The remaining difference may be due to other risk factors that are more difficult to measure, or to omitted variables that capture dynamic trading strategies of these managers. Thus, the results of this section confirm the hypothesis that the negative relationship between manager tenure and returns can be explained by reduced risk-taking behavior of older managers. 7. Robustness tests This section includes two robustness tests. The first (see Section 7.1) attempts to rule out the following explanation for the above findings: Perhaps older managers are not reducing risk over time at all, but instead, they have taken on lower risk all along, which explains their increased probability of survival. The second robustness test (see Section 7.2) relates fee income to risk-taking to provide additional support for the idea that as managers' salaries increase, they reduce risk to protect their ever-increasing incomes. 21
  22. 22. 7.1 Do older managers take on less risk all along? This section examines whether older managers have been able to survive because they have taken on less risk throughout there careers. Examining this issue is difficult due to data constraints. The first problem is that data prior to 1994 is not free of survivorship bias. Thus, using this data to test this idea (perhaps with a fixed-effects regression) is not appropriate. The managers of failed funds – which are not included in the sample – would likely have taken on higher risk at the beginning of their careers. Using only the data after 1994 causes another problem: some of the funds in the sample have been in existence since the early 1980’s, so the early years of their existence (when their risk was likely to be the highest) are not included in the sample. Given these caveats, the following tests were performed. To test the alternative hypothesis (that older managers took on lower risk all along), all funds in existence during the year 1994 are followed forward to the year 2000. The following data is recorded: each of the risk measures (standard deviation, tracking error deviation, and beta deviation) for each year, and a yes/no variable indicating whether the fund failed at some point during the entire sample period. Then, the funds are sorted into deciles each year based on manager tenure. For each year, for each decile, the funds are then sorted into two categories: whether the fund was alive or dead at the end of the sample. The idea is to examine whether the risk-taking behavior – at the beginning of the sample period – of the funds that eventually failed differed from the funds that did not fail. If I find that the funds that eventually failed took on more risk at the beginning of their lives than the funds that did not fail, the alternative hypothesis is supported. However, if there is not a significant difference between risk-taking behavior for extant and failed funds at the early stages of their lives, then this paper's argument that risk- taking changes with age is supported. Using Wilcox rank-sum tests, I find that the risk-taking behavior of young managers (decile 1) at the beginning of the sample does not differ significantly between funds that survived the entire sample and funds that eventually failed. This indicates that at the beginning of their lives, funds have similar risk levels, which is consistent with the theory and empirical results presented: funds reduce risk over time in order to survive. Additionally, for decile 10 managers (those with the most experience) at the beginning of the sample, there is a significant difference between levels of risk-taking behavior among surviving and failed funds: failed funds have 22
  23. 23. higher levels of tracking error deviation and standard deviation than surviving funds, indicating that as these funds got older, those that reduced risk were able to survive, while those that did not were not. 7.2 Fee income One argument made earlier in this paper relates fee income to risk-taking behavior. The idea is that successful hedge fund managers are so well-paid that they will go to great lengths to protect their income. The opportunity set in the industry is such that hedge fund managers will almost surely take a very large pay cut if they lose their jobs. However, if they reduce risk and keep their jobs, they are able to maintain this earning potential, even if the reduction in risk leads to lower returns. Since managers earn a percentage of profits, as long as their returns are positive they are still paid. And, if their funds are large (as is likely the case with high fee earners in the past), they can still earn exceptional salaries on mediocre investment returns. To test this hypothesis, Table 8 regresses each of the three risk measures against a an estimate of cumulative fee income for each manager. To estimate this variable, I multiply each year's average fund size by the management fee percentage, and add the incentive fee, which I estimate as the annual return for the fund times the incentive fee percentage times the average total assets for the year. Each year, for each fund, I perform this calculation and sum the results over the life of the fund. The estimates for this variable are then sorted into thirds, and assigned 0/1 indicator variables representing the magnitude (high, medium, or low) of cumulative fee income. A number of caveats are in place: first, the fee income is not the only income managers earn from their funds. The majority (67%) have some of their own assets invested in the fund, which would increase the estimates of fee income. However, as noted above, this “personal capital invested” variable is likely not very useful, as it does not provide information about the magnitude of personal capital that managers have invested, nor what proportion of each manager's net worth that personal capital comprises. Second, the cumulative measure is only calculated from 1994 onward. Some of the funds in the sample have been in existence since 1982. However, since the data for these funds is not complete for these prior periods, the variable is calculated from 1994 forward. Both of these issues likely cause the estimate of cumulative fee income to be understated, which biases against finding any relationship in the 23
  24. 24. tests that follow. A final caveat is that some funds have “high water marks,” meaning that if the net asset value of the fund falls below the level of the prior year, the manager has to make up the difference before he can begin collecting fees again. This problem would cause the cumulative fee income variable to be overstated. Keeping these caveats in mind, Table 8 regresses each of the risk measures against the fee income indicator variables for high cumulative fee income and low cumulative fee income (the middle fee income variable is excluded). These regressions are performed in column a) of each panel (Panel A, column 1a uses standard deviation as the dependent variable; panel B, column 2a uses tracking error deviation as the dependent variable, and Panel C, column 3a includes beta deviation as the dependent variable). For each of these regressions, manager tenure, fund characteristics, and common risk and style factor controls are also included. For both herding measures of risk (tracking error deviation and beta deviation), the results are consistent with the hypothesis that managers with higher cumulative fee income take on the least risk, while those with lower cumulative fee income most risk. The coefficients for standard deviation are not significant. Next, another variable is created that interacts the fee income indicator variables (low, medium, and high) with the manager tenure variable (young, middle, and old). The idea is that old managers with high fees likely have more at stake than young managers with low fees. If this is true, we would expect to find negative coefficients on the old age/high fees variable. Consistent with the results for cumulative fee income, for two of the three regressions (tracking error deviation and beta deviation), the coefficients are as expected, indicating again that managers with “more at stake” reduce risk. These findings provide further evidence that manager career concerns are increasing with reputation: managers with high fee income have strong incentives to keep their jobs; these incentives are more important to more experienced managers. 8. Conclusion In this paper, I investigate whether differences in risk-taking behavior can explain why experienced hedge fund managers have lower returns. I find that as managers age, their risk- taking behavior changes: specifically, older managers reduce volatility and herd more than younger managers. Managerial career concerns motivate this behavior: should their funds fail, 24
  25. 25. older managers have more to lose in terms of reputation, current income, and personal wealth than do young managers. And, this reduction in risk-taking behavior can explain about half of the differences in returns between young and old managers. These empirical findings differ sharply from evidence from the mutual fund industry: in mutual funds, old managers take on more risk than young, which is consistent with the agency costs and career concerns of mutual fund managers. In the mutual fund industry, young managers herd so as not to risk a poor performance outcome relative to their peers. As their careers progress and they become more experienced, they are less likely to herd and take the chance of an unfavorable outcome for at least three reasons: first, the probability of failure for a poor outcome is much less than for young managers, second (in contrast to most experienced hedge fund managers) they do not typically have substantial personal assets invested in their funds, and finally, the flow/performance relationship indicates that the very best funds attract the most new inflows, which are directly related to a manager’s compensation.20 Likewise, the findings in this paper are consistent with the agency costs and career concerns of hedge fund managers. In hedge funds, older managers have “more to lose” than young should their funds fail – they usually have significant personal assets in their funds, they understand that risky behavior increases their probability of termination, and they know that it is difficult to start a new hedge fund if their current fund fails – all of which induce them to take less risk over time. Additionally, the pay structures in hedge funds encourage risk-taking among younger managers versus old: since hedge fund managers are compensated both by incentive fees (a percentage of profits) and management fees (a percentage of assets), young, smaller funds focus on maximizing profits for two reasons: first, high profits increase their incentive fees substantially, and second, high profits attract more assets to their funds, increasing their future management fees. For older managers with larger funds, they earn significant fees from the management fee component alone, which might induce them to take less risk This paper adds to the growing literature about the effect of career concerns on managerial behavior. The initial career concerns literature focused on how a the existence of an outside labor market and a manager’s concern for his reputation would cause him to avoid 20 Chevalier and Ellison (1997) document an asymmetry in the flow/performance relationship. While the very best funds attract significant inflows, the very worst funds do not experience significant outflows. Average funds experience net inflows. See also Gruber (1996), Goetzmann and Peles (1997), and Sirri and Tufano (1998). 25
  26. 26. shirking or consuming excessive perquisites, thus reducing agency costs. (See Fama, 1980). The results of this paper and others that study mutual funds, securities analysts, and macroeconomic forecasters provide additional evidence regarding careers concerns: specifically that the existence of career concerns can make a manager more or less risk averse depending on his compensation structure, indirect incentives, and the odds of losing his job. Additionally, the results of this paper indicate that differences in risk-taking behavior explain about half of the differential in returns between young and old managers. These results have implications for investors in hedge funds: young managers are substantially better than old, which they achieve by using more aggressive trading strategies and avoiding herding behavior. However, the increased probability of failure from young to old funds is striking: for a manager with one year of tenure, the probability of surviving the next six years is only about 35%. For a manager with four years of tenure, the probability of surviving the next six years is nearly 90%. Due to the trade-off between returns, risk, and survival, fund selection by investors should take into account this relationship: these results indicate that selecting very young or very old funds are not likely in investors' best interests. Finally, these results have ramifications for the appropriate design of incentive contracts. While it has been thought that the incentive fee structure used by hedge fund managers appropriately aligns the incentives of managers and investors, this paper provides evidence that, at least in some cases, it does not. Particularly among older funds, the desire to survive and remain in the industry can outweigh the desire to take the necessary risks to achieve superior returns. Thus, as suggested by Dybvig, Farnsworth, and Carpenter (2001), perhaps contracts should be designed that encourage managers to take on more risk. For younger managers, these contracts reward them for actions they already are taking, and for older managers, perhaps these contracts could provide incentive to take on more risk. This is a fruitful area for future research. 26
  27. 27. LIST OF REFERENCES Ackerman, Carl, Richard McEnally, and David Ravenscraft, 1999, The performance of hedge funds: Risk, return, and incentives, The Journal of Finance 54(3), 833-873. Agarwal, Vikas and Narayan Y. Naik, 1999, On taking the alternative route: Risks, rewards, style, and performance persistence of hedge funds," The Journal of Alternative Investments 2(4), 6- 23. Agarwal, Vikas and Narayan Y. Naik, 2003, Risks and portfolio decisions involving hedge funds, forthcoming, The Review of Financial Studies. Asness, Clifford, Krail, Robert, and John Liew, 2001, Do hedge funds hedge?, The Journal of Portfolio Management, Fall 2001, 6-19. Avery, Christopher N. and Judith A. Chevalier, 1999, Herding over the career, Economics Letters 53, 327-333. Baquero, Guillermo, ter Horst, Jenke, and Mario Verbeek, 2002, Survival, look-ahead bias, and the persistence in hedge fund performance, Working paper, ERIM Report Series Research in Management, www.erim.eur.nl. Bares, P.A., R. Gibson, and S. Gyger, 2002, Performance in the hedge funds industry: An analysis of short and long-term persistence, Working paper, Institute of Theoretical Physics Swiss Federal Institute of Technology Lausanne EPFL, Switzerland. Bikhchandani, Sushil, Hirshleifer, David, and Ivo Welch, 1992, A theory of fads, fashion, custom, and cultural change as information cascades, The Journal of Political Economy 100(5), 992-1026. Breslow, N., 1974, `Covariance analysis of censored survival data, Biometrics 20, 89-99. Brown, Keith C., and V.W. Harlow, 2002, Staying the course: The impact of investment style consistency on mutual fund performance, Working paper, University of Texas. Brown, Keith, Harlow W.V., and Laura T. Starks, 1996, `Of tournaments and temptations: An analysis of managerial incentives in the mutual fund industry, The Journal of Finance 51(1), 85-110. Brown, Stephen and William Goetzmann, 1995, Performance persistence, The Journal of Finance 50(2), 679-698. Brown, Stephen and William Goetzmann, 2001, Hedge funds with style, NBER Working Paper 8173, www.nber.org/papers/w8173. Brown, Stephen, William Goetzmann and Roger Ibbotson, 1999, Offshore hedge funds: Survival and performance 1989-1995, The Journal of Business 72, 91-117. Brown, Stephen, William Goetzmann, and James Park, 2001, Conditions for survival: Changing risk and the performance of hedge fund managers and CTA's, The Journal of Finance 56(5), 1869- 1886. 27
  28. 28. Brown, Stephen, William Goetzmann, Roger G. Ibbotson, and Stephen A. Ross, 1992, Survivorship bias in performance studies, The Review of Financial Studies 5(4), 553-580. Carhart, Mark M., 1997, On persistence in mutual fund performance, The Journal of Finance 52(1), 57-82. Carhart, Mark M., Jennifer N. Carpenter, Anthony W. Lynch, and David K. Musto., 2002, Mutual fund survivorship, The Review of Financial Studies 15(5), 1439-1463. Carpenter, Jennifer, ``Does option compensation increase managerial risk appetite?, 2000, The Journal of Finance 55, 2311-2331. Chevalier, Judith and Glenn Ellison, 1997, Risk-taking by mutual funds as a response to incentives, The Journal of Political Economy 105(6), 1167-1200. Chevalier, Judith and Glenn Ellison, 1999a, Are some mutual fund managers better than others?, The Journal of Finance 54(3), 875-899. Chevalier, Judith and Glenn Ellison, 1999b, Career concerns of mutual fund managers, Quarterly Journal of Economics 114(2), 389-432. Christopherson, Jon A., Ferson, Wayne E., and Debra A. Glassman, 1998, Conditional measures of performance and persistence for pension funds, Research in Finance 16, 1-46. Cox, D, 1972, Regression models and life tables (with discussion.), Journal of the Royal Statistical Society 34, 187-220. Das, Sanjiv and Rangarajan Sundaram, 2003, Fee speech: Signaling, risk-sharing, and the impact of fee structure on investor welfare, forthcoming The Review of Financial Studies. Diamond, Douglas, 1991, Reputation acquisition in debt markets, The Journal of Political Economy 97, 828-862. Edwards, Franklin R. and James M. Park, 1996, Do managed futures make good investments?, Journal of Futures Markets 16(5), 475-517. Edwards, Franklin R. and Mustafa Caglayan, 2001, Hedge fund performance and manager skill, Journal of Futures Markets 21(11), 1003-1028. Elton, Edwin, Gruber, Martin J., and Christopher R. Blake, 1996, Survivorship bias and mutual fund performance, The Review of Financial Studies 9(4), 1097-1120. Elton, Edwin, Gruber, Martin J., and Christopher R. Blake, 1996, The persistence of risk-adjusted mutual fund performance, The Journal of Business 69(2), 133-157. Fama, Eugene, 1980, Agency problems and the theory of the firm, The Journal of Political Economy 88(2), 288-307. 28
  29. 29. Fama, Eugene F. and James D. MacBeth, 1973, Risk, return, and equilibrium: Empirical tests, The Journal of Political Economy 81, 607-636. Fama, Eugene and Kenneth R. French, 1992, The cross-section of expected stock returns, The Journal of Finance 47, 427-465. Fama, Eugene and Kenneth R. French, 1993, Common risk factors in the returns on bonds and stocks," Journal of Financial Economics 33, 3-53. Finkelstein, Sydney and Donald Hambrick, 1990, Top-management team tenure and organizational outcomes: The moderating role of managerial Discretion, Administrative Sciences Quarterly 35(3), 484-503. Fung, William and David A. Hsieh, 1997, Empirical characteristics of dynamic trading strategies: The case of hedge funds, The Review of Financial Studies 10(2), 275-302. Fung, William and David A. Hsieh, 1999, A primer on hedge funds, Journal of Empirical Finance 6, 309-331. Fung, William and David A. Hsieh, 2000, Performance characteristics of hedge funds and commodity funds: Natural versus spurious biases, Journal of Financial and Quantitative Analysis 35, 291-307. Fung, William and David A. Hsieh, 2001, The risk in hedge fund strategies: Theory and evidence from trend followers, The Review of Financial Studies 14(1), 313-341. Fung, William and David A. Hsieh, 2003, Asset-based hedge fund styles and portfolio diversification, forthcoming Financial Analysts Journal. Gibbons, Robert and Kevin J. Murphy, 1992, Optimal incentive contracts in the presence of career concerns: Theory and evidence, The Journal of Political Economy 100(3), 468-505. Glosten, Lawrence and Ravi Jagannathan, 1994, A contingent claim approach to performance evaluation, Journal of Empirical Finance 1, 133-160. Goetzmann, William N. and Roger G. Ibbotson, 1994, Do winners repeat?, The Journal of Portfolio Management, Winter 1994, 9-18. Goetzmann, William N. and Nadev Peles, 1997, Cognitive dissonance and mutual fund investors, The Journal of Financial Research 20(2), 145-158. Graham, John R., 1999, Herding among investment newsletters: Theory and evidence, The Journal of Finance 54(1), 237-268. Grinblatt, Mark and Sheridan Titman, 1989, Adverse risk incentives and the Design of performance- based contracts, Management Science 35(7), 807-822. Grinblatt, Mark and Sheridan Titman, 1989, Portfolio performance evaluation: Old issues and new insights, The Review of Financial Studies 2(3), 393-421. 29
  30. 30. Grinblatt, Mark and Sheridan Titman, 1992, The persistence of mutual fund performance, The Journal of Finance 47(5), 1977-1984. Grinblatt, Mark and Sheridan Titman, 1994, A study of monthly mutual fund returns and performance evaluation techniques, Journal of Financial and Quantitative Analysis 29(3), 419-444. Grinblatt, Mark, Titman, Sheridan, and Russ Wermers, 1995, Momentum investment strategies, portfolio performance, and herding: A study of mutual fund behavior, The American Economic Review 85, 1088-1105. Gruber, Martin J., 1996, Another puzzle: The growth in actively managed mutual funds, The Journal of Finance 51(30), 783-810. Hambrick, Donald and Phyllis Mason, 1984, Upper echelons: The organization as a reflection of its top managers, The Academy of Management Review 9(2), 193-206. Helwege, Jean, 1996, Determinants of savings and loan failures: Estimates of a time-varying proportional hazard function, Journal of Financial Services Research 10, 373-392. Hendricks, Darryll, Patel, Jayendu, and Richard Zeckhauser, 1997, The j-shape of performance persistence given survivorship bias, The Review of Economics and Statistics 74(2), 161-170. Hirshleifer, David and Anjan V. Thakor, 1992, Managerial conservatism, project choice, and debt, The Review of Financial Studies 5(3), 437-470. Holmstrom, Bengt, 1982/1999, Managerial incentive problems -- A dynamic perspective, NBER Working Paper #6875. Holmstrom, Bengt and Paul R. Milgrom, 1987, Aggregation and linearity in the provision of intertemporal incentives, Econometrica 55, 303-328. Holmstrom, Bengt and Joan Ricart I Costa, 1986, Managerial incentives and Capital management, Quarterly Journal of Economics 101(4), 835-860. Hong, Harrison, Kubik, Jeffrey D., and Amit Solomon, 2000, Security analysts' career concerns and herding of earnings forecasts, RAND Journal of Economics 31(1), 121-144. Huddart, Steven, 1999, Reputation and performance fee effects on portfolio choice by investment advisers, Journal of Financial Markets 2, 227-271. Ineichen, Alexander, 2000, In search of alpha, UBS Warburg, www.ubswarburg.com/researchweb. Ippolito, R., 1989, Efficiency with costly information: A study of mutual fund performance 1965- 1984, Quarterly Journal of Economics 104, 1-23. Jaggia, S. and Satish Thosar, 2000, Risk aversion and the investment horizon: A new perspective on the time diversification debate, Journal of Psychology and Financial Markets 1(3), 101-125. 30
  31. 31. Jegadeesh, Narisimhan and Sheridan Titman, 1993, Returns to buying winners and selling losers: Implications for stock market efficiency, The Journal of Finance 48, 93-130. Jensen, Michael C. and Kevin J. Murphy, 1990, Performance pay and top-management incentives, The Journal of Political Economy 98(2), 225-264. Jovanovic, Boyan, 1979, Job matching and the theory of turnover, Journal of Political Economy 87, 972-990. Kahneman, D., Slovic, P., and Tversky, A., 1982. Judgment under Uncertainty: Heuristics and Biases. Cambridge, NY: Cambridge University Press. Kalbfleisch, J. and R. Prentice, 1980. The Statistical Analysis of Failure Time Data. New York: John Wiley & Sons. Kanodia, Chandra, Bushman, Robert, and John Dickhaut, 1989, Escalation errors and the sunk cost effect: An explanation based on reputation and information asymmetries, Journal of Accounting Research 27, 59-77. Katz, Ralph, 1982, The effects of group longevity on project communication and performance, Administrative Science Quarterly 27, 81-104. Kiesler, C., 1971. The Psychology of Commitment. New-York: Academic Press. Lakonishok, J., A. Shliefer, R. Thaler, and R. Vishny 1991, Window dressing by pension fund managers, America Economic Review, Papers and Proceedings 81, 227-231. Lamont, Owen, 2002, Macroeconomic forecasts and microeconomic forecasters, Journal of Economic Behavior and Organization 48, 265-280. Lehmann, Bruce N. and David M. Modest, 1987, Mutual fund performance evaluation: A comparison of benchmarks and benchmark comparisons, The Journal of Finance 42(2), 233-265. L'habitant, François-Serge, 2001, Assessing market risk for hedge funds and hedge fund portfolios, Working paper, HEC University of Lausanne. Li, Xi, 2002, Performance, herding, and career concerns of individual financial analysts, Working paper, Vanderbilt University. Liang, Bing, 1999, On the performance of hedge funds, Financial Analysts Journal 55(4), 72-85. Liang, Bing, 2000, Hedge funds: The living and the dead, Journal of Financial and Quantitative Analysis 35(3), 309-336. Lo, Andrew, 2001, Risk management for hedge funds: Introduction and overview, Financial Analysts Journal 57(6), 16-33. Lunde, Asger, Allan Timmermann, and David Blake, 1999, The hazards of underperformance: A Cox regression analysis, Journal of Empirical Finance 6, 121-152. 31
  32. 32. Malkiel, Burton G., 1995, Returns from investing in equity mutual funds 1971 to 1991, The Journal of Finance 50(2), 549-572. Mitchell, Mark and Todd Pulvino, 2001, Characteristics of risk and return in risk arbitrage, The Journal of Finance 56(6), 2135-2175. Morin, Roger A. and A. Fernandez Suarez, 1983, Risk aversion revisited, The Journal of Finance 38(4), 1201-1216. Prendergast, Canice and Lars Stole, 1996, Impetuous youngsters and jaded old-timers: Acquiring a reputation for learning, The Journal of Political Economy 194(6), 1105-1134. Salancik G.R., Commitment and the control of organizational behavior and belief, in B. Staw and G.R. Salancik (eds.), New Directions in Organizational Behavior, St. Clair Press, Chicago, 1977, 1-54. Scharfstein, David S. and Jeremy C. Stein, 1990, Herd behavior and investment, The American Economic Review 80(3), 465-479. Shumway, Tyler, 2001, Forecasting bankruptcy more accurately: A simple hazard model, Journal of Business 74(1), 101-124. Sirri, Erik R. and Peter Tufano, 1998, Costly search and mutual fund flows, The Journal of Finance 53(5), 1589-1622. Starks, Laura T., 1987, Performance incentive fees: An agency theoretic approach, Journal of Financial and Quantitative Analysis 22, 17-32. Vroom, Victor and Bernd Pahl, 1971, The relationship between age and risk-taking among managers, Journal of Applied Psychology 35, 399-405. Weismann, Andrew, 2001, Conservation of volatility and the interpretation of hedge fund performance, Alternative Investment Management Association, June/July 1998. Welch, Ivo, 2000, Herding among security analysts, Journal of Financial Economics 58, 369-396. Wermers, Russ, 1997, Momentum investment strategies of mutual funds, performance persistence, and survivorship bias, Working paper, University of Maryland. Wermers, Russ, 2000, Mutual fund performance: An empirical decomposition into stock-picking talent, style, transaction costs, and expenses, The Journal of Finance 55(4), 1655-1695. Zitzewitz, Eric, 2001, Opinion-producing agents: Career concerns and exaggeration, Working paper, Stanford Graduate School of Business. Zwiebel, Jeffrey, 1995, Corporate conservatism and relative compensation. The Journal of Political Economy 103(1), 1-25. 32
  33. 33. Table 1a: Summary statistics: Return, manager and fund characteristics Below are summary statistics for the return, manager, and fund variables used in the paper. Each statistic is first calculated by fund, and then across funds. CFA, CPA, MBA, Ph.D., Other Advanced Degree, Law Degree, Listed on Exchange, Onshore, Open to New Investment, Open to Non-Accredited Investors, Uses Leverage, and Personal Capital Invested are (0/1) indicator variables set to one if the value is "yes" and zero if the value is "no". The first column in each category shows statistics for the small sample (for which all manager and fund characteristic variables are available), and the second shows statistics for the large sample (for which only manager tenure and all fund characteristics are available.) HF market-adjusted. return is calculated by estimating the market exposure for each fund for each hedge fund index (see Section 2.2 for details), weighting each of these exposures by the performance of the hedge fund index, and subtracting these weighted exposures from the simple excess return of the fund. Passive market-adjusted return is calculated in the same manner as HF market- adjusted return, but passive indices are used instead of hedge fund indices. See Section 2.2 for detail on the hedge fund and passive indices. 33
  34. 34. Table 1a (continued): Summary statistics: Return, manager and fund characteristics Mean Median Maximum Minimum n=271 n=982 n=271 n=982 n=271 n=982 n=271 n=982 Returns (Return - risk free rate) (monthly) 1.01% 0.85% 0.75% 0.66% 116.07% 137.12% -77.94% -85.89% (Return - style average) (monthly) 0.09% 0.10% -0.02% 0.02% 110.56% 127.85% -73.01% -79.85% HF market-adjusted return (monthly) -0.25% -0.25% -0.22% 0.03% 0.92% 0.98% -2.00% -2.38% Pass. market-adjusted (monthly) 0.08% 0.01% 0.05% 0.00% 1.87% 1.87% -1.50% -3.02% Manager education, experience CFA 0.10 n/a - n/a - n/a - n/a CPA 0.02 n/a - n/a - n/a - n/a MBA 0.49 n/a - n/a - n/a - n/a 34 Ph.D. 0.03 n/a - n/a - n/a - n/a Other advanced degree 0.08 n/a - n/a - n/a - n/a Law degree 0.10 n/a - n/a - n/a - n/a Average undergraduate institution SAT score 1323 n/a 1361 n/a 1475 n/a 958 n/a Number of years experience 22 n/a 20 n/a 47 n/a 6 n/a Manager age 47 n/a 44 n/a 72 n/a 31 n/a Manager tenure (years) 7.79 n/a 6.93 6.01 19.60 24.35 2.00 2.00 Fund features: location, risk Listed on exchange 0.15 0.18 - - - - - - Onshore 0.51 0.44 - - - - - -
  35. 35. Table 1a (continued) : Summary statistics: Return, manager and fund characteristics Mean Median Maximum Minimum n=271 n=982 n=271 n=982 n=271 n=982 n=271 n=982 Fund features: location, risk (cont.) Open to new investment 0.89 0.88 - - - - - - Open to non-accredited investors 0.13 0.15 - - - - - - Personal capital invested 0.73 0.67 - - - - - - Uses leverage 0.74 0.72 - - - - - - Fund policies and size Lockup redemption period (months) 12 19 4 12 260 260 1 1 Lockup entrance period (months) 16 25 12 12 260 260 1 1 Minimum investment (millions) $.91 $.78 $.50 $.50 $25 $50 $.002 $.001 35 Size as of 12/31/00 (millions) $161 $113 $52 $30 $1,800 $1,893 $5 $5 Fund fees Management fee (% of assets) 1.20% 1.30% 1.00% 1.00% 3.00% 6.00% 0.00% 0.00% Incentive fee (% of profits) 18.85% 17.79% 20.00% 20.00% 33.00% 50.00% 0.00% 0.00% n/a = not available
  36. 36. Table 1b: Conversion of tenure values to age estimates Manager tenure is divided into percentiles based upon the large sample of 982 funds. Manager age is divided into percentiles based on the smaller sample of 271 funds. The values shown are the means for each percentile. Percentile Manager Tenure in Years Estimated Manager Age 10 1.2 41.6 20 1.9 42.4 30 2.5 43.3 40 3.1 44.0 50 3.8 45.0 60 4.7 46.0 70 5.8 46.9 80 7.3 48.9 90 11.0 51.2 36
  37. 37. Table 2: Summary statistics: Index returns Below are mean buy and hold monthly returns and other summary statistics for the "market" indices used in the paper. The period is January, 1994 to December, 2000. All returns are in excess of the risk-free rate. The sources for the indices are Datastream (passive) and CSFB/Tremont (hedge fund). The returns on HML (a high book value minus low book value stock portfolio), SMB (a small-capitalization minus large-capitalization stock portfolio), and MOM (a momentum portfolio) were obtained from Kenneth French's website. Panel A shows statistics for the passive indices, while panel B shows statistics for the hedge fund indices. For a detailed description of the hedge fund indices, see Appendix A. Panel A: Passive Indices Mean Median Max Min Std Dev Skew Kurtosis US Dollar Weighted Index -0.19% -0.24% 3.78% -5.18% 1.73% -0.06 0.14 Gold -0.73% -0.94% 20.51% -7.11% 3.69% 2.34 12.29 Commodities 0.42% 0.47% 16.81% -13.43% 5.40% 0.19 0.41 S&P 500 0.95% 1.56% 9.23% -14.98% 4.16% -0.79 1.38 LB Aggregate Bond -0.43% -0.26% 3.60% -3.66% 1.26% 0.00 0.81 LB 30 Yr. US T-bond 0.15% 0.10% 8.61% -7.78% 2.81% 0.00 0.70 SMB -0.36% -0.46% 14.23% -21.51% 4.93% -1.01 4.83 HML -0.28% -5.35% 15.40% -11.66% 3.83% 0.71 3.12 Momentum 1.56% 0.81% 18.23% 8.98% 4.43% 0.99 4.03 Panel B: Hedge Fund Indices Mean Median Max Min Std Dev Skew Kurtosis Managed Futures 0.08% -0.25% 9.56% -9.82% 3.32% 0.18 1.31 Convertible Arbitrage 0.45% 0.73% 3.13% -5.06% 1.44% -1.68 4.41 Emerging Markets 0.14% 0.43% 16.14% -23.41% 5.93% -0.45 2.40 Distressed Securities -0.33% -0.53% 22.32% -9.08% 5.52% 0.99 2.37 Market Neutral 0.54% 0.57% 2.89% -1.53% 0.98% 0.01 -0.16 Event Driven 0.56% 0.67% 3.43% -12.16% 1.91% -3.64 23.23 Fixed Income Arbitrage 0.14% 0.40% 1.61% -7.35% 1.25% -3.31 16.07 Global Macro 0.74% 0.83% 10.14% -11.94% 4.12% 0.00 0.68 Long/Short Equity 0.91% 0.95% 12.63% -11.82% 3.65% 0.00 2.21 Fund of Funds Index 0.24% -0.10% 4.92% -3.73% 1.83% 0.32 -0.18 37

×