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Risking or Derisking: How Management Fees Affect Hedge Fund Risk-Taking Choices

time:2023-02-21

Chengdong Yin, Xiaoyan Zhang

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This paper examines how hedge fund managers’ risk-taking behavior is influenced by their management fee structure. Unlike most studies that focus on incentive fees and high-water marks, this research highlights the role of management fees in shaping managers’ risk choices. The study uses a simple model to demonstrate that managers are less likely to take risks when their future management fees constitute a larger portion of their total compensation. This prediction is empirically tested using fund-level data from the Lipper TASS database (1994–2015). The findings show that when future management fees account for a higher percentage of compensation, hedge fund managers reduce their risk-taking. The sensitivity of risk reduction is more pronounced in funds with decreasing returns to scale.

The study also suggests that fund managers may lower risk-taking to increase the survival probability of their funds, ensuring they continue to receive management fees. The research shows that as the importance of future management fees grows, the likelihood of fund termination decreases. Moreover, larger funds and those employing capacity-constrained strategies exhibit a stronger reduction in risk-taking when future management fees increase.

This paper is the first to empirically test the impact of management fees on hedge fund managers' risk behavior, offering new insights into the role of management fees in determining managers’ risk preferences and providing a deeper understanding for investors of hedge fund managers’ risk-taking decisions.

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