The Moral Hazard Problem in Hedge Funds: A Study of Commodity Trading Advisors.

Posted: 5 Mar 2016 Last revised: 4 Feb 2017

See all articles by Li Cai

Li Cai

Illinois Institute of Technology - Stuart School of Business, IIT

Cheng Jiang

Illinois Institute of Technology, Stuart School of Business, Students

Marat Molyboga

Efficient Capital Management, LLC

Date Written: March 3, 2016

Abstract

The asymmetric nature of performance-based compensation in hedge funds introduces a moral hazard problem in which investors bear the negative consequences of fund managers' risk choices. We analyze whether risk shifting by a hedge fund manager is related to the manager's investment strategy and her survivorship concerns. Using gross fund return from 1994 to 2014, we find that the tendency to increase risk following poor performance is weak (strong) when there are strong (weak) managerial survivorship concerns. At the same time, risk shifting is significantly less prevalent when a manager utilizes algorithms, instead of discretion, in an investment strategy. We introduce a new model for estimating the economic impact of risk-shifting on hedge fund managers and investors. We estimate that fund managers generate an additional 0.25% per annum in fees that negatively impact investors' risk-adjusted returns.

Keywords: risk-shifting, hedge funds, Commodity Trading Advisors

Suggested Citation

Cai, Li and Jiang, Cheng and Molyboga, Marat, The Moral Hazard Problem in Hedge Funds: A Study of Commodity Trading Advisors. (March 3, 2016). Journal of Portfolio Management (2017), 43(2), pp. 77-89. Available at SSRN: https://ssrn.com/abstract=2741862

Li Cai (Contact Author)

Illinois Institute of Technology - Stuart School of Business, IIT ( email )

Chicago, IL 60661
United States

Cheng Jiang

Illinois Institute of Technology, Stuart School of Business, Students ( email )

10 West 35th Street, 18th Floor
Chicago, IL 60616
United States

Marat Molyboga

Efficient Capital Management, LLC ( email )

4355 Weaver Parkway
Warrenville, IL 60555
United States
6306576842 (Phone)

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