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Compensation Option, Managerial Incentives and Risk-Shifting in Hedge Funds

We examine the impact of the optionality of performance fee on the risk-shifting behavior of hedge fund managers. Since performance fees earned by hedge fund managers have the characteristics of a call option, the moneyness of the option may have an impact on the risk-taking behavior of managers. We seek to determine if hedge fund managers adjust their fund's volatility in reaction to the moneyness of the performance option. We find that managers increase their fund's volatility when the compensation option is "out of the money". We find that managers of less liquid, small or young funds do not display that type of risk-shifting behavior. Further, we report that the longer a manager does not collect performance fees, the more likely she is to increase the fund volatility in the hope of increasing the fund value and thus collecting performance fees. Finally, we find that compared to absolute performance, relative performance has a stronger influence on the risk-taking behavior of hedge fund managers. This result is not uniform over all strategies.