The big problem with big bonuses for hedge fund managers

Hedge fund managers chase big bonuses with the same enthusiasm as a labrador slobbering after a tennis ball, but the relentless pursuit of individual compensation is bad news for investors, employers and the hedge fund sector generally.

Portfolio managers and traders are more like to take “excessive” levels of risk in order to bolster their own pay, suggests a new piece of academic research from Chengdong Yin and Xiaoyan Zhang from the Krannert School of Management at Purdue University.

If a hedge fund manager is lagging his own high water mark – namely, the agreed minimum profit a fund has to reach before charging a fee – then portfolio managers are much more likely to increase their risks in order to hit the target and get paid. What’s more, the research suggests, even after they’ve exceeded this point, they’re likely to carry on taking bigger risks in order to maximise their bonus.

“The compensation structure for hedge fund managers is highly nonlinear and resembles a call option,” says the research. “Because the value of an option increases with uncertainty, hedge fund managers’ compensation structure encourages them to take more risk. Thus, it is reasonable for the public to worry that hedge funds may take excessive risk.”

There’s an obvious incentive here – bonuses comprise by far the largest proportion of hedge fund pay. A high-performing fund at a large hedge fund with more than $4bn in assets under management pays its portfolio managers a base salary of $275k and a bonus of $6.5m, according to figures from headhunters Glocap. Salaries for portfolio managers remain the same regardless of fund performance, its figures suggest, and even mediocre hedge fund managers can expect a bonus of $2.2m at a bigger firm.

The research also challenges previously held assumptions that hedge fund managers would take less risk if they were more likely to be fired for doing so, or don’t have many other employment options available. Hedge fund managers take the risk anyway, the research suggests.

If this seems like an obvious case of looking after their own back pocket, there’s another element that’s more worrying. When management fees become more important as part of the overall compensation structure, the research says that hedge fund managers are more likely to take fewer risks in order to protect assets under management and lock in what they have.

But the traditional 2 and 20 model – where hedge funds charge a 2% management fee and 20% of all profits – is dying. The majority of large hedge funds – such as Moore Capital Management and Brevan Howard – have cut management fees in the past six months after mediocre performance in an attempt stem an investor exodus. This is bad news.

“Our rational expectation is that without any management fee, hedge fund managers would surely be hungrier and take more risks but not necessarily deliver better style-adjusted returns,” says the research.

Contact: pclarke@efinancialcareers.com

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