Tuesday, October 11, 2011

Simple Theories of Hedge Fund Risk Taking

I've been on a several day rant about hedge fund age and size, all beginning with some miserable research by Pertrac.  (See here, here and here.)  In the last installment, I said I'd give a simple answer to the question: Why might risk taking by hedge fund managers fall, as the funds grow, or the fund ages?

For now, let's forget about survivorship bias.  I'll give two answers for the price of one.

Scenario One:

In the first post, I said it may be the case that someone starts a hedge fund because they have a good investment idea.  If the manager has success, he (yes, typically "he",) is now reasonable wealthy.  Taking 2% management fees and 20% performance fees on even a small portfolio with good returns makes a manager wealthy

If you are that manager, you now (a) no longer have a great idea (since yours worked!) and you have much more of your own money.  What do you do?  You diversify!  Only a fool invests in a single strategy that just had outstanding returns!

You look to other attractive strategies, probably several of them.  They may be almost as good as your first but probably not.  At least they likely they have reasonably low correlation amongst them.  That's good.  But, that means your risk drops.

Additionally, they will also be similar to what your competitors are doing.  That's not so good.  You now run a generic multi-strategy hedge fund like everyone else from your HBS class.  (Worse yet, you now manage a big staff, for which you have no skills.  Good luck trying to be Daniel Och.)

In any case, your new "used to be hot" single strategy fund is now a lower risk, multi-strategy, fund.

Scenario Two:

Money chases success.  In the academic world, the term is "performance-flow relationship"--assets flow to good performance.  In hedge fund parlance, "sophisticated investors" invest with "proven players".

The performance-flow relationship is not linear.  Exceptional performance leads to massive inflows.  Lousy performance does not lead to massive withdrawals.  In hedge fund parlance, "sophisticated investors" have "patience and staying power".

This means the payoff to superior performance looks like a call option.  But, the convexity of the call option deteriorates after a few years.  Without great early performance, you won't ever be a proven player.  If you are a proven player, you don't grow assets to the moon, sorry.

So, there you have it: Hedge fund manager risk taking will fall as funds age and grow.