High-water mark (HWM) contracts are the predominant compensation structure for managers in the hedge fund industry. In the paper, Risk Choice under High-Water Marks, forthcoming in the Review of Financial Studies, I seek to understand the optimal dynamic risk-taking strategy of a hedge fund manager who is compensated under such a contract. This is both an interesting portfolio-choice question, and one with potentially important ramifications for the willingness of hedge funds to bear risk in their role as arbitrageurs and liquidity providers, especially in times of crises. High-water mark mechanisms are also implicit in other types of compensation structures, so insights from this question extend beyond hedge funds. An example is a corporate manager who is paid performance bonuses based on record earnings or stock price and whose choice of projects influences the firm’s level of risk.
Posts Tagged ‘Risk’
Our observations on the Federal Reserve’s final rule:
1. Delayed effective date and higher threshold: Foreign Banking Organizations (FBOs) eked out several small victories in the final rule—in particular, the July 2015 compliance date has been pushed to July 2016 and smaller FBOs (i.e., those with under $50 billion in US non-branch assets) are no longer required to form an Intermediate Holding Company (IHC). The changes reflect the Federal Reserve’s attempt to respond to FBOs’ concerns, especially that smaller FBOs did not pose as much risk to US financial stability.
Standard principal-agent theory prescribes that managers should not be compensated on exogenous risks, such as general market movements. Rather, firms should index pay and use contracts that filter exogenous risks (e.g., Holmstrom 1979, 1982; Diamond and Verrecchia 1982). This prescription is intuitive and agrees with common sense: CEOs should receive exceptional pay only for exceptional performance, and “rational” compensation practice should not permit CEOs to obtain windfall profits in rising stock markets. However, observed compensation contracts are typically not indexed. Specifically, stock options almost never tie the strike price of the option to an index that reflects market performance or the performance of peers. Commentators often cite this glaring difference between theory and practice as evidence for the inefficiency of executive compensation practice and, more generally, as evidence for major deficiencies of corporate governance in U.S. firms (e.g., Rappaport and Nodine 1999; Bertrand and Mullainathan 2001; Bebchuk and Fried 2004). This paper therefore contributes to the discussion about which compensation practices reveal deficiencies in the pay-setting process.
The hedge fund industry has grown tremendously over the last two decades. While this growth is due to a number of factors, one explanation is that its performance-based compensation system creates incentives for managers to generate alpha. This incentive system, however, could also motivate some managers to manipulate net asset values or commit outright fraud. Due to the light regulatory environment hedge funds operate in and their secretive nature, monitoring managers is generally difficult for investors and regulators.
In response, recent research has attempted to infer malfeasance directly from the distribution of hedge fund returns. In particular, the finding of a pervasive discontinuity in the distribution of net returns around zero has been interpreted as evidence that hedge fund managers systematically manipulate the reporting of NAVs to minimize the frequency of losses. This literature, however, has not recognized that performance fees distort the pattern of net returns.
In our paper, Are Hedge Fund Managers Systematically Misreporting? Or Not?, forthcoming in the Journal of Financial Economics, we show that inferring misreporting based on a kink at zero can be misleading when ignoring incentive fees. Because these fees are applied asymmetrically to positive and negative returns, the distribution of net returns should display a natural discontinuity around zero. In other words, there is a mechanical explanation for the observed kink in the distribution of net returns. We demonstrate this effect by showing that funds without incentive fees have no discontinuity at zero until we add hypothetical incentive fees to their returns.
The SEC’s recent decision to take disclosure of political activities off the SEC’s agenda is a policy mistake, as it ignores the best research on the point, described below, and perpetuates a key loophole in the investor-relevant disclosure rules, allowing large companies to omit material information about the politically inflected risks they run with other people’s money. It is also a political mistake, as it repudiates the 600,000+ investors who have written to the SEC personally to ask it to adopt a rule requiring such disclosure, and will let entrenched business interests focus their lobbying solely on watering down regulation mandated under the Dodd-Frank Act and the 2012 securities law statute, rather than having also to work to influence a disclosure regime.
It is a privilege to appear before a group that is so important to the strength and integrity of the fund industry. Independent directors have significant responsibilities, and it requires tremendous effort and time on your part to do your job well. I applaud your efforts to learn from the professionals who are participating in this conference. The insights of the panels you heard yesterday and this morning, and those you will hear after lunch will provide valuable information.
The importance of mutual funds in the lives of American investors is clear. Mutual funds hold close to $14 trillion of the hard earned savings of over 53 million American households. The majority of Americans access the markets through mutual funds. They invest in funds, and hope their investments will grow, for many reasons—to make a down payment on a house, to save for a college education, and ultimately to pay for a retirement.
Many academic researchers, policy makers, and other practitioners have concluded that fair value accounting can lead to suboptimal real decisions by firms, particularly financial institutions, and result in negative consequences for the financial system. This conclusion is sustained by the belief that fair value accounting was a major factor contributing to the 2008-2009 financial crisis by causing financial institutions to recognize excessive losses, which in turn caused excessive sales of assets and repayment of debt, thereby leading to procyclical accounting leverage. Leverage is procyclical when it decreases during economic downturns and increases during economic upturns. In our paper, Does Fair Value Accounting Contribute to Procyclical Leverage?, which was recently made publicly available on SSRN, we examine whether there exists any link between fair value accounting and procyclical accounting leverage.
To address this question, we develop a model of commercial bank actions taken in response to economic gains and losses on their assets throughout the economic cycle to meet regulatory leverage requirements. We focus on commercial banks because of the central role they play in the financial system and the allegation that their actions in response to fair value losses contributed to the financial crisis. Our model and empirical tests based on the model establish that procyclical accounting leverage for commercial banks only arises because of differences between regulatory and accounting leverage, and not because of fair value accounting.
Every firm is exposed to business risks, including the possibilities of large, adverse shocks to cash flows. Potential sources for such shocks abound—examples include disruptive product innovations, the relaxation of international trade barriers, and changes in government regulations. In our paper, CEO Compensation and Corporate Risk: Evidence from a Natural Experiment, forthcoming in the Journal of Accounting and Economics, we examine (1) how boards adjust CEOs’ exposure to their firms’ risk after the risk of such shocks increase and (2) how incentives given by the CEOs’ pre-existing portfolios of stock and options affect their firms’ response to this risk. Specifically, we study what happens when a firm learns that it is exposing workers to carcinogens, which increase the risks of significant corporate legal liability and costly workplace regulations.
The results presented in this paper suggest that corporate boards respond quickly to changes in their firms’ business risk by adjusting the structure of CEOs’ compensation, but that the changes only slowly impact the overall portfolio incentives CEOs face. After the unexpected increase in left-tail risk, corporate boards reduce CEOs exposure to their firms’ risk; the sensitivities of the flow of managers’ annual compensation to stock price movements and to return volatility decrease. Various factors likely contribute to the board’s decision, including CEOs’ reduced willingness to accept a large exposure to their firms’ risk and the decline in shareholders’ desired investment after left-tail risk increases. Indeed, managers act to further reduce their exposure to the firm’s risk by exercising more options than do managers of unexposed firms. These changes, however, only slowly move CEOs’ overall exposure to their firm’s risk because the magnitude of their pre-existing portfolios continues to influence their financial exposure to the firm.
Today [Oct. 23, 2013], the Commission is proposing new rules to implement Title III of the JOBS Act, which exempts qualifying crowdfunding transactions from the registration and prospectus delivery requirements of the Securities Act. The new Regulation Crowdfunding is expected to be used primarily by small companies. As is well known, although personal savings is the largest source of capital for most start-ups, external financing is very important to many small and medium-sized businesses. Unfortunately, as is also well known, many small businesses have difficulty finding external capital. It is worth noting that the need for outside investment is even greater among minority entrepreneurs, who tend to have lower personal wealth than their non-minority counterparts.
Supporters of crowdfunding believe that it may offer a potential solution to the small business funding problem. Observers point to the success of existing crowdfunding services around the world, which raised almost $2.7 billion in 2012, an increase of more than 80% from the prior year.
It is an honor to be with you today [Oct. 15, 2013]. The National Association of Corporate Directors has long played an important leadership role providing the insight and guidance that board members need to enhance shareholder value and effectively confront the various business challenges their companies face. The NACD has also been a very important partner to the SEC—providing valuable input on a number of our rulemaking efforts that affect companies and their boards of directors.
As members of boards of directors, each of you has an incredibly important job. You are fiduciaries and tasked with the oversight of company management—which requires a tremendous amount of time, knowledge and dedication. As a former director, I know all-too-well the heavy responsibility you have and the hard and time-consuming work involved to do the job properly.
One aspect of the job, which has taken on increasing importance in the last several years, is the role that you play in shareholder engagement and ensuring that management is considering the needs of investors in connection with the information that is provided to them.