Conditions for Survival: Changing Risk and the Performance of Hedge Fund Managers and CTAs

Investors in hedge funds and commodity trading advisors [CTA] are naturally concerned with risk as well as return. In this paper, we investigate whether hedge fund and CTA return variance depends upon whether the manager is doing well or poorly. Our results are consistent with the Brown, Harlow and Starks (1996) findings for mutual fund managers. We find that good performers in the first half of the year reduce the volatility of their portfolios, and poor performers increase volatility. These “variance strategies" depend upon the fund’s ranking relative to other funds. Interestingly enough, despite theoretical predictions, changes in risk are not conditional upon distance from the high water mark threshold, i.e. a ratcheting absolute manager benchmark. This result may be explained by the relative importance of fund termination. We analyze factors contributing to fund disappearance. Survival depends on both absolute and relative performance. Excess volatility can also lead to termination. Finally, other things equal, the younger a fund, the more likely it is to fail. Therefore our results strongly confirm an hypothesis of Fung and Hsieh (1997b) that reputation costs have a mitigating effect on the gambling incentives implied by the manager contract. Particularly for young funds, a volatility strategy that increases the value of a performance fee option may lead to the premature death of that option through termination of the fund. The finding that hedge fund and CTA volatility is conditional upon past performance has implications for investors, lenders and regulators.