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March 14, 2002


Prof. Theo Nijman
Department of Finance and CentER,
Tilburg University,
P.O. Box 90153,
5000 LE Tilburg,
...
Title:      Do Hedge Fund Flows Chase Performance? Evidence on
            Money flow & Risk-taking behavior of hedge fund...
Do Hedge Fund Flows Chase Performance? Evidence on
  Money flow & Risk-taking behavior of hedge fund managers



         ...
Do Hedge Fund Flows Chase Performance? Evidence on
  Money flow & Risk-taking behavior of hedge fund managers
Research Obj...
taking. This finding would be consistent with other managed portfolios such as
mutual funds and pension funds.


   Finall...
Do Hedge Fund Flows Chase Performance? Evidence on
  Money flow & Risk-taking behavior of hedge fund managers


Research M...
of high watermark that is important but the deviation of NAV from the weighted

average watermark that determines risk-tak...
References


Brown, K.C., W. V. Harlow, and L.T. Starks, 1996, “Of tournaments and
   temptations: An analysis of manageri...
Do Hedge Fund Flows Chase Performance? Evidence on
  Money flow & Risk-taking behavior of hedge fund managers


Proposed T...
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Authors: Dr. Vikas Agarwal , Assistant Professor of Finance

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Authors: Dr. Vikas Agarwal , Assistant Professor of Finance

  1. 1. March 14, 2002 Prof. Theo Nijman Department of Finance and CentER, Tilburg University, P.O. Box 90153, 5000 LE Tilburg, the Netherlands Dear Prof. Nijman Subject: Inquire-Europe Research Proposal Please find enclosed herewith nine copies of the proposal titled “Do Hedge Fund Flows Chase Performance? Evidence on Money flow & Risk-taking behavior of Hedge Fund Managers” coauthored with Dr. Vikas Agarwal and Dr. Naveen Daniel of Georgia-State University along with the curriculum vitas for financial support from Inquire-Europe. We would be happy to provide any other information you may need. Thanking you for your consideration, I remain Yours sincerely Dr. Narayan Y. Naik
  2. 2. Title: Do Hedge Fund Flows Chase Performance? Evidence on Money flow & Risk-taking behavior of hedge fund managers Authors: Dr. Vikas Agarwal , Assistant Professor of Finance Dr. Naveen Daniel , Visiting Assistant Professor of Finance Dr. Narayan Y. Naik, Associate Professor of Finance Addresses: Dr. Vikas Agarwal and Dr. Naveen Daniel J. Mack Robinson College of Business Georgia State University 35, Broad Street, Suite 1221, Atlanta, GA 30303 USA Dr. Narayan Y. Naik London Business School, Sussex Place, Regents Park, London NW1 4SA, United Kingdom Telephones: +1 404 651 2699 (Vikas) +1 404 651 2691 (Naveen) +44 207 262 5050 (Narayan) Facsimiles: +1 404 651 2630 (Vikas and Naveen) +44 207 724 3317 (Narayan) E-mails: vagarwal@gsu.edu nav@gsu.edu nnaik@london.edu
  3. 3. Do Hedge Fund Flows Chase Performance? Evidence on Money flow & Risk-taking behavior of hedge fund managers Abstract We have three primary goals in this paper. First, as hedge funds are legally restricted from marketing their product publicly, it is interesting to examine how the managers attract new money. One could expect investors to base their investment decisions largely on observable characteristics of hedge funds such as past performance (absolute as well as relative). We propose to examine the determinants of hedge fund flows. Second, we propose to examine the risk-taking behavior of managers in response to both implicit and explicit incentives embedded in their compensation contract. Finally, we plan to compare our results with those from related studies in the mutual fund literature (Chevalier and Ellison (1997) and Sirri and Tufano (1998)). This will allow us to shed light on the impact of institutional characteristics on risk-taking behavior of managers. We propose a four-step approach to address our research objectives. First, we plan to estimate net flows of hedge funds using their returns and their assets under management. Second, we propose to use regression-based methods to explain cross-sectional variation in net flows using fund and industry characteristics and performance data. Third, we intend to explain the cross-sectional variation in the changes in the portfolio risk using compensation contract features and manager’s past performance. Finally, we propose to compare our results with those in mutual funds data in order to contrast the findings for mutual funds with those for hedge funds. Identification of factors affecting the net flows is an important area of research. Our results should help investors make their purchase decisions given the absence of publicly available information. In addition, our empirical approach can serve as a valuable tool in understanding the relation between managerial compensation contract and their risk-taking behavior. Overall, our study will provide important insights that can be helpful while taking investment management decisions like asset allocation, portfolio construction, risk management etc. involving hedge funds.
  4. 4. Do Hedge Fund Flows Chase Performance? Evidence on Money flow & Risk-taking behavior of hedge fund managers Research Objectives and Related Literature: In recent years, there has been a substantial amount of money flowing into hedge funds even after the debacle of Long-Term Capital Management. According to a recent report by Tremont Advisers, the net flows during the third quarter of 2001 have been the largest ever in a single quarter since 1994, resulting in the total assets under management increasing to around $400 billion. In line with the increase in the managed capital, there has been a dramatic growth in the number of hedge funds from about 500 in 1990 to an estimated 5000 funds today. This has significantly increased the search costs for the investors trying to pick a fund from this large universe. In addition, the unique managerial compensation contract in hedge fund industry can induce managers to seek certain kind of risk-taking behavior. We address these issues through three primary goals in this paper. As hedge funds are legally restricted from marketing their product publicly, it is interesting to examine how the managers attract new money. One could expect investors to base their investment decisions largely on observable characteristics of hedge funds such as past performance (absolute as well as relative). We propose to formally investigate the relation between past performance and fund flows after controlling for the different macro-economic conditions and fund characteristics. Goetzmann, Ingersoll, and Ross (2001) make a limited attempt at relating hedge fund flows to past performance, but they do not control for fund and industry characteristics. To the best of our knowledge, this is the first detailed attempt to examine the determinants of hedge fund flows. Second, we propose to examine the risk-taking behavior of managers in response to both implicit and explicit incentives embedded in their compensation contract. The presence of hurdle rate and high watermark provisions in the compensation contract provides the manager with an explicit incentive to increase the portfolio risk. By doing so, the manager hopes to maximize expected compensation. The implicit incentive arises if the fund flows are a convex function of past performance (relative to peers). This results in manager’s compensation having call-option-like features that can induce the manager to indulge in excessive risk-
  5. 5. taking. This finding would be consistent with other managed portfolios such as mutual funds and pension funds. Finally, we plan to compare our results with those from related studies in the mutual fund literature. For example, Ippolito (1992), Chevalier and Ellison (1997), Sirri and Tufano (1998), and Goriaev, Nijman, and Werker (2001b) have looked at the flow-performance relation in mutual funds. Del Guercio and Tkac (1999) examine the determinants of the flow of funds into pension funds and contrast it with mutual funds. In response to the finding of a convex flow-performance relation, Brown, Harlow, and Starks (1996), Chevalier and Ellison (1997), Busse (2000), Daniel and Wermers (2000), and Goriaev, Nijman, and Werker (2001a) have looked at the risk-taking behavior of mutual fund managers. Comparing our results with that obtained in the mutual fund literature will allow us to shed light on the impact of institutional characteristics, such as high water mark, hurdle rates, incentive fees, and leverage on the risk-taking behavior of hedge fund managers.
  6. 6. Do Hedge Fund Flows Chase Performance? Evidence on Money flow & Risk-taking behavior of hedge fund managers Research Methodology: We propose a four-step approach to address our research objectives. First, we plan to estimate net flows of hedge funds using their returns and their assets under management. Given that we know when funds accept new money and when funds allow redemption, it we can estimate the flows for any given period from the returns during the period, the net asset value at the beginning of the period and the net asset value at the end of the period. Second, we propose to use regression analysis to explain cross-sectional variation in net flows using fund characteristics, industry characteristics, and performance data. The key variables of interest are past performance (absolute performance, relative performance, and risk-adjusted performance) and features of the compensation contract (high watermarks, hurdle rates, incentive fees, and management fees). Other control variables would include fund reputation (proxied by fund age), fund size (since smaller funds can grow faster than larger funds), aggregate flows for different hedge fund styles (to control for style-level flows), and whether the fund belongs to a family and if so the performance of the family of funds as a whole (to investigate spillover effects). This study will help us understand the factors that investors consider before investing in a hedge fund. Third, we plan to examine the risk-taking behavior in more detail using a regression approach. If we find convexity in flow-performance relation, we would then expect to see results similar to Brown, Harlow and Starks (1996). Even otherwise, the compensation contracts of hedge funds have option-like features. For the new funds in our sample, we can construct a time-series of the weighted- average high watermark facing the fund manager. However, it is not the existence
  7. 7. of high watermark that is important but the deviation of NAV from the weighted average watermark that determines risk-taking behavior. We intend to explain the cross-sectional variation in the changes in the portfolio risk using compensation contract features and manager’s past performance. This methodology is superior to the standard 2X2 classification used in the literature as it allows for controlling for other variables known to affect risk-taking. For example, large funds will find it difficult to substantially increase their risk even if the option is out-of-the-money. Also, large funds would not like to loose their investor base. Hence, large funds are unlikely to increase risk. For example, Daniel and Wermers (2000) find that funds do not repeatedly gamble in order to catch up. Hence, we also plan to control for prior changes in portfolio risk. If we find spillover effects in the flow-performance relation, we would like to control for whether the fund belongs to a family. If investors form expectations about the manger’s ability by looking at the performance of other funds within the same family, then a fund belonging to a family is less likely to increase risk in response to the incentives facing the manager. Understanding the risk-taking behavior will help us to understand the optimality of the incentive features embedded in the compensation contract of hedge fund managers. Finally, we propose to compare and contrast our results with those for mutual funds in order to understand the differences in their institutional features that have implications for flow-performance relationship and risk-taking behavior of managers.
  8. 8. References Brown, K.C., W. V. Harlow, and L.T. Starks, 1996, “Of tournaments and temptations: An analysis of managerial incentives in the mutual fund industry,” Journal of Finance, 51(1), 85-110 Busse, Jefferey, 2000, “Another Look at Mutual Fund Tournaments,” Journal of Financial and Quantitative Analysis, 36(1), 53-73. Chevalier, Judith, and Glenn Ellison, 1997, “Risk Taking by Mutual Funds as a Response to Incentives,” Journal of Political Economy, 105, 1167-1200. Daniel, N. and R. Wermers, 2000, “Risk-taking behavior of mutual fund managers: Do managers “walk” away from the tournaments,” Working Paper, Georgia State University and University of Maryland. Del Guercio, D., and P.A. Tkac, 1999, “The determinants of the flow of funds of managed portfolios: mutual funds versus pension funds,” Working Paper, Federal Reserve Bank of Atlanta. Goetzmann, W. N., J. Ingersoll, and S. A. Ross, 2001, “High water marks and hedge fund management contracts,” Working Paper, Yale University. Goriaev, Alexei P., Theo E. Nijman, and Bas J.M. Werker, 2001a, “Yet another look at mutual fund tournaments,” Working Paper, CentER, Tilburg University. Goriaev, Alexei P., Theo E. Nijman, and Bas J.M. Werker, 2001b, “The dynamics of the impact of past performance on mutual fund flows,” Working Paper, CentER, Tilburg University. Ippolito, R.A., 1992, “Consumer reaction to measures of poor quality: evidence from the mutual fund industry,” Journal of Law and Economics, 35(1), 45-70. Sirri, Erik, and Peter Tufano, 1998, “Costly Search and Mutual Fund Flows,” Journal of Finance, 53, 1589-1622.
  9. 9. Do Hedge Fund Flows Chase Performance? Evidence on Money flow & Risk-taking behavior of hedge fund managers Proposed Timetable: October 2002: Purchase, cleaning and creating a comprehensive database of hedge funds using data from the three largest vendors: TASS, HFR and MAR. November 2002: Working paper draft (in time for WFA submission deadline). December 2002 – February 2003: Presentations at various Universities and practitioner forums. March 2003 onwards: Submission of findings to top Finance Journals (academic and practitioner) and follow up on the revise and re-submit process.

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