Larry Swedroe on how a systematic approach can help mitigate the problem.
The typical hedge fund fee structure includes a management fee, calculated as a fixed percentage of a fund’s net asset value, plus an incentive fee, calculated as a percentage of its trading profits.
Some hedge funds use both hurdle rates and a high-water-mark (HWM) provision—the historical peak of the fund’s net asset value—in the calculation of incentive fees. These features are sold as a way to protect investors because the incentive fee is paid only on the portion of the gains that exceed either the hurdle rate and/or HWM.
Although hedge funds in managed futures, called commodity trading advisors (CTAs), typically don’t employ hurdle rates, they do generally still comply with the HWM provision that requires the fund manager to make up past deficits prior to earning the incentive fee.
The HWM feature is highly asymmetric and can be expressed as a long call-option position with a strike at the HWM. Therefore, hedge fund managers face a moral hazard issue because they have an incentive to increase risk when their previous performance has been disappointing.
Therefore, characteristics that appear “investor friendly” on the surface can, in fact, lead to increased risk. In addition, the HWM provision increases the likelihood of a fund terminating its existence and creating a new fund when it is “out-of-the-money” in terms of incentive compensation.
Li Cai, Chris (Cheng) Jiang and Marat Molyboga contribute to the literature on the agency risks of hedge funds with their study, “The Moral Hazard Problem in Hedge Funds: A Study of Commodity Trading Advisors,” which was published in the Winter 2017 issue of The Journal of Portfolio Management. By focusing on CTAs, the authors were able to classify the funds as discretionary or systematic (where trading is based on algorithms, not opinions), an important distinction. Their study covered the period 1994 through 2014.
In other words, “discretionary managers who are underwater at midyear tend to increase their risk taking in the second half of the year.” Importantly, they found that “in most years, the impact on investors’ risk-adjusted performance has been negative, with investors getting exposed to greater risk without a corresponding increase in returns.” The impact of risk-shifting behavior was a 4.5% relative reduction in the Sharpe ratio.
Cai, Jiang and Molyboga explained that this is consistent with prior research that has found in negative market environments managers tend to be more concerned with career risk and thus engage in less risk-shifting. When fund mortality is high, survivorship is difficult and thus managerial career concern dominates. In contrast, when mortality is low and survivorship is easy, career concern is minimal.
These findings have important implications for investors. Not only do features of the hurdle rate and HWM provisions—which supposedly are designed to protect investors—create an increased moral hazard environment, they have negative impacts on risk-adjusted returns, at least for discretionary fund managers. If you happen to be considering a hedge fund, or, specifically, a CTA, at the very least, you should be aware of the moral hazards—hazards that can be avoided, or at least minimized, when choosing a fund that invests systematically.
They analyzed and contrasted the performance of systematic hedge funds, which use rules‐based strategies involving little or no daily intervention by humans, with the performance of discretionary hedge funds, which rely on human skills to interpret new information and make the day‐to‐day investment decisions. The study covered the period 1996 through 2014 and included data on more than 9,000 macro and equity hedge funds. To adjust returns for exposure to common factors, they used stock factors (beta, size, value and momentum) and bond factors (term and credit), as well as FX carry and volatility.
Investors have a clear preference for discretionary funds, given that they make up about 70% of the hedge fund universe and control approximately 75% of the assets under management. However, the authors found no evidence to support such a preference. For equity hedge funds, they found both that, after adjusting for exposure to well‐known risk factors, risk‐adjusted performances were similar and that for discretionary funds (in aggregate), more of the average return and volatility of returns can be explained by risk factors.
In their excellent book, “Quantitative Value,” Wes Gray and Tobias Carlisle provide further support for the power found in systematic, quantitative investing. They write that the objectiveness of the approach acts as a shield, protecting us against our own biases, while also acting as a sword, allowing us to exploit the cognitive biases of others.
To make this point, they presented the following example from Joel Greenblatt. Greenblatt’s firm, Gotham Capital, had compounded at a phenomenal rate of 40% annually, before fees, for the 10 years from Gotham’s formation in 1985 to its return of outside capital to investors in 1995.
As you can see, Vanguard’s systematic approach outperformed 79% of actively managed funds and DFA’s systematic approach outperformed 90%. Given that the largest cost of active management in taxable accounts typically is taxes, these figures likely understate the advantage of systematic approaches for taxable investors.
The aforementioned evidence should lead you to conclude that, when you invest, it should be with a fund that uses a systematic approach to gaining exposure to markets, asset classes or factors.