Academics Discover Two Plus Two Equals Four

I'm always amazed at how naive academics are about the real world of trading and investing.

Aside from such obvious delusions as the assertion that markets are efficient, they seem to have no real grasp of the human side of the business and its impact on investment decision-making.

Anybody who has ever traded for a living, or who has worked in close proximity to those do, will tell you that people who are losing money invariably have the urge to go for broke, and those who are underperforming targets will want to take on more risk, when some sort of deadline -- bonus time, the end of an evaluation period, a prospective margin call, you name it -- is approaching.

Not everyone yields to these feelings, of course, but skewed incentives -- like when the upside is unlimited but the downside is not -- boosts the odds that they will do what underlying investors and risk managers fear most.

Yet as the following report, "Hedge Funds Take Extra Risk to Lift Targets," from the Financial Times seems to suggest, the ivory tower-types have only just figured this out.

Hedge fund managers in danger of missing out on lucrative performance fees routinely raise their exposure to risk in a gamble to meet their performance targets, according to new research (PDF).

The study raises questions as to whether hedge fund managers are acting in the best interests of their investors - who may want a consistent approach to risk - or are more interested in maximising their own bonuses.

"The investor wants them [hedge fund managers] to carry on doing what they mandated them to do from day one. Maybe performance fees don't provide the right incentives," said Nick Motson, one of the authors of the report. "The initial finding was this does not look good."

Christopher Peel, chief executive of Blacksquare Capital, a fund of hedge funds manager, added: "I want to see managers consistently running risk throughout the year in accordance with the opportunity subset."

Mr Motson and Andrew Clare, both of Cass Business School in London, and Chris Brooks of the University of Reading, analysed the Cass database of 2,800 hedge funds, which typically will be remunerated with a 20 per cent performance fee on top of an annual fee of 2 per cent of assets under management.

They found that hedge funds that are "out of the money", defined as trading at less than 95 per cent of their high water mark, at which a performance fee kicks in, exhibit a high level of risk-taking with a standard deviation, a measure of variability of returns, of 8.5 per cent.

However, funds that are comfortably "in the money" and those that are close to their high water mark, termed "at the money", exhibited much less volatility, with standard deviations of 6.4 per cent and 4.9 per cent respectively.

"This surprised us a little bit," said Mr Motson, a former trader at First National Bank of Chicago, Industrial Bank of Japan and head of London trading at Wachovia.

"It does appear that as managers go below their high water mark they increase risk."

However, the research found that if hedge funds fall more than 10 per cent below their high water mark they tend to take risk off the table to attempt to stem deeper losses that prompt investors to withdraw money en masse.

Further research is planned, particularly into evidence of "calendar effects" such as managers increasing risk later in the year if they are below but close to their high water mark, and reducing risk if they above it.

"If you are sat there in November and you are 3 per cent below the high water mark and your average monthly return is 1 per cent, if you increase your risk you might make 1.5 to 2 per cent per month. The motivation might be there to increase risk to chase the incentive fee," said Mr Motson.

There is strong anecdotal evidence of such behaviour. "It's remarkable. December is always a fantastic month for hedge funds. I'm sure there is a connection to where hedge fund managers are relative to their high water mark," said one fund of funds manager.

Mr Peel saw the opposite effect, with successful managers reducing risk towards the year end.

"The calendar year risk is very pronounced. As managers get to the fourth quarter there is evidence that they take less risk. They want to bank their performance fees so they take risk off the table.

"As an investor you do not want people taking risk off the board because they have made money. Then you have dead money. I need to make sure my managers are firing on all cylinders."

The research runs counter to previous studies that have found little evidence of increased risk taking by "out of the money" hedge fund managers.