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Duration of Poor Performance, Fund Flows and Risk-Shifting by Hedge Fund Managers

A typical hedge fund manager receives greater compensation when the fund has a strong absolute or relative performance. Asymmetric performance fees and fund flow-performance relationship may create incentives for risk-shifting, estimated in our study by the change in fund return volatility in the middle of the year. However, hedge funds that cannot attract new funds or have had poor performance for a long period may face different incentives. The combination of these two observations confronts hedge fund managers with a complex strategic decision regarding the optimal level of their funds’ return volatility. While an increase in return volatility generally increases the expected payoff of the compensation contract, excessive volatility is not sustainable. This paper empirically examines the factors that affect hedge fund managers’ decisions to risk-shifting. We show that (1) if the fund has had prior poor performance, the magnitude of risk-shifting is larger; (2) as the duration of poor performance increases, risk-shifting is reduced; (3) if the fund is experiencing capital outflows, the magnitude of risk-shifting is smaller and (4) funds that have outflows and also use leverage or have short redemption notice periods display a smaller degree of risk-shifting.