Risk shifting is one of the most widely taught ideas in finance and can occur, for instance, when firms face financial distress. When a company is about to go broke, it might be tempted to take on risky projects that promise high returns. Shareholders reap the benefits of this gamble if the projects succeed, but otherwise creditors bear the loss. In this case, shareholders are essentially taking a bet with the creditors' money.
This situation arises whenever the expected payoffs of managers' investment choices allow them to cash in on the upside, but avoid being penalized for the downside. Compensation contracts for managers are sometimes structured in a way that generates such lopsided payoffs. Stock options, for example, give managers an incentive to take more risks to increase the options' value, while the worst that can happen is that options become worthless but managers still receive their base pay. In the mutual fund industry, fund managers may take excessive risks to manipulate their results, knowing that investors tend to flock to funds with good results, but do not quickly withdraw from poorly performing funds.
But while such uneven payoffs can encourage risk shifting, a study titled, "High-Water Marks: High Risk Appetites? Convex Compensation, Long Horizons, and Portfolio Choice," by Chicago Booth professor Stavros Panageas and Mark M. Westerfield of the University of Southern California, argues that the implicit or explicit length of a contract is an important factor that can either exacerbate or mitigate this behavior.
A fund manager who is hired to work for an investor for only one period would have an incentive to choose a risky strategy in hopes of getting a higher payoff at the end of the contract. A failed bet would come at the expense of the investor, not the manager. However, the possibility of working for an investor for a long time could lead to a moderation of the incentive to shift risks. "The concern is not so much that managers get paid for gains and are not penalized for losses," says Panageas. "The real issue is whether managers have a long-term horizon."
The High-Water Mark Contract
To illustrate how the incentive to shift risks depends on both the distorted nature of the payoffs and the finite horizon of a contract, the authors analyze a specific type of compensation agreement commonly used in the hedge fund industry—the high-water mark contract.
Each year, hedge fund managers typically receive a fraction of the fund's returns in excess of a threshold called the high-water mark. The high-water mark is the highest value attained by the fund. If, for example, the high-water mark is $100 million and the fund's value rises to $120 million at the end of the year, the hedge fund manager collects a fraction—typically 20 percent— of the $20 million profit. In the following year, the threshold for earning performance fees rises to $120 million. If, on the other hand, the fund's value falls to $80 million, then the high-water mark stays at $100 million the following year. This mechanism ensures that a manager gets a performance fee only when investors make a profit, and requires that the manager make up for earlier losses before becoming eligible for a bonus.
The contract is similar to an option—a financial instrument that gives the buyer the right to purchase a security, such as a stock, at an agreed-upon "strike price" on a specified date. The high-water mark corresponds to the strike price. When the fund's value increases, the hedge fund manager gets paid and the strike price is set at a new, higher level; but, when the fund loses money, the strike price remains unchanged and the manager retains the implied option at the old strike price.
Because of its option-like features, a high-water mark contract would seem susceptible to problems of risk shifting. A fund manager can increase the volatility of the fund, which in turn increases the value of the contract and the possibility of gaining a lot with little to lose.
However, options and high-water mark contracts differ in one important way, say Panageas and Westerfield. Unlike options, most contracts between hedge fund managers and investors do not have a specified termination date. In fact, the high-water contract mark could be thought of as a sequence of options with a changing strike price. Thus, when the hedge fund's value declines in one period, the value of all implied future options declines as well. In other words, the farther away the manager is from the high-water mark the harder it will be to cross it.
Shift or Shirk?
A bolder portfolio consisting of risky assets improves a hedge fund manager's chances of exceeding the high-water mark, but it also increases the likelihood that the fund's value will take a hit. When the value of the fund falls, the opportunity to earn a bonus in the future diminishes because the high-water mark remains unchanged. Thus, when deciding which assets to invest in and how much risk to take, fund managers face a trade-off between the possibility of a short-term gain if they choose risky assets and the longer run benefits of staying close to the high-water mark.
This argument illustrates that incentives to shift risks are not caused by the distorted nature of the payoffs alone. If the high-water mark contract was a "one-shot" game, then fund managers would not care how far they land from the high-water mark; they would simply go for broke by taking an aggressive bet on the stock market. But because fund managers would like to continue their relationship with clients and at the same time increase their chances of earning a handsome bonus, they are unlikely to pursue an aggressive strategy that would take them too far from the mark.
Because of fund managers' long-term interests, the expected payoffs of the high-water mark contract become less lopsided— managers are rewarded for gains as well as penalized for losses. "This leads to an alignment of incentives between the manager and investor on how much risk to take," says Panageas. Indeed, the authors show that hedge fund managers who maximize their compensation over a long investment horizon would choose a portfolio of assets similar to a risk-averse investor. That is, they are unlikely to make highly risky bets.
Thus, the best way for investors to get fund managers to work hard for them and avoid unnecessary risks is to somehow bind the manager to the relationship for a long time. Measuring the performance of managers based on a long-term average, and not just on how they performed today, is one way to mitigate risk shifting, says Panageas. The incentives generated by a contract should try to keep the manager focused on the long-term gains.
While high-water mark contracts in principle have no end date, in reality nobody can stop a manager from walking away from a fund. For instance, if a fund is valued significantly below the high-water mark, possibly because of a bad shock such as a recession, the managers would be more inclined to terminate the contract because they have little hope of earning a performance fee in the future. In fact, a study that analyzed the results of Panageas and Westerfield's paper found evidence of risk shifting among managers with assets that are worth much less than the high-water mark. But the study also found that fund managers with assets valued just slightly below the threshold tend to be conservative in their investment choices, just as Panageas and Westerfield predicted.
"High-Water Marks: High Risk Appetites? Convex Compensation, Long Horizons, and Portfolio Choice." Stavros Panageas and Mark M. Westerfield. Journal of Finance, February 2009.