On Tournament Behavior in Hedge Funds: High Water Marks, Managerial Horizon, and the Backfilling Bias

52 Pages Posted: 18 Mar 2009 Last revised: 27 Mar 2010

See all articles by George O. Aragon

George O. Aragon

Arizona State University (ASU) - Finance Department

Vikram K. Nanda

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics

Multiple version iconThere are 2 versions of this paper

Date Written: November 2, 2009

Abstract

We analyze the risk choices by hedge funds that perform poorly, relative to other funds and in absolute terms - and test predictions on the extent to which these decisions are related to the fund's incentive contract, investment horizon and dissemination of performance information. We find that tournament behavior is more prevalent in the (backfilled) period when funds may be at an incubation stage, before they start voluntarily reporting to a database. Excluding backfilled data, we find that variance shifts depend on absolute rather than relative fund performance. Consistent with theoretical arguments, the propensity for losing funds to increase risk is significantly weaker among those that tie the manager's incentive pay to the fund's high-water mark - suggesting a possible benefit from such incentive structures - and among funds that face little immediate risk of closure. Overall, the combination of factors such as reporting performance to a database, high-water mark provisions, and low risk of fund closure appear to make poorly performing funds more conservative with regard to risk-shifting.

Keywords: hedge funds, tournaments, risk-taking, backfilling, high-water marks

JEL Classification: G11, G12

Suggested Citation

Aragon, George O. and Nanda, Vikram K., On Tournament Behavior in Hedge Funds: High Water Marks, Managerial Horizon, and the Backfilling Bias (November 2, 2009). Available at SSRN: https://ssrn.com/abstract=1361846 or http://dx.doi.org/10.2139/ssrn.1361846

George O. Aragon

Arizona State University (ASU) - Finance Department ( email )

W. P. Carey School of Business
PO Box 873906
Tempe, AZ 85287-3906
United States

Vikram K. Nanda (Contact Author)

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics ( email )

2601 North Floyd Road
P.O. Box 830688
Richardson, TX 75083
United States

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