Duration of poor performance and risk shifting by hedge fund managers

A typical hedge fund manager receives greater compensation after strong performance but does not lose compensation after weak performance, and therefore might take on more risk for the second half of the year after poor returns in the first half. We refer to this as “risk shifting.” However, continual risk shifting over a long period would likely make the fund too volatile to attract investors. We find that hedge funds with poor first-half-year performance do tend to increase risk during the second half-year. The effect is larger for funds that began the year “under water” and for smaller funds. The effect is smaller, however, if the poor performance lasts long.