Do Hedge Funds Conduct Mid-Year Risk Shifting?

Hedge fund managers with asymmetric performance-based compensation packages have the incentive to increase the risk taking of their funds in response to poor performance. Based on regression analysis of data from a panel of dollar-based hedge funds from 1994-2008, we find evidence that they do just that. Using fund return volatility for our risk measure, we find that a hedge fund with net asset value (NAV) below its previous high-water mark (out of the money) in the first half of the year tends to have higher volatility of monthly returns in the second half of the year. A hedge fund with NAV above its high-water mark (in the money) in the first half of the year tends to have lower volatility of monthly returns in the second half of the year. Our findings are robust for various ways to estimate high-water mark and after controlling for back-fill bias. Using common risk factors that can explain how hedge funds generate their returns to show that out-of-money funds display a shift of risk exposures: they increase exposure to the equity market and decrease exposure to the bond market. Our findings are robust to various ways to estimate risk exposures and high-water mark. Combining the above, hedge funds do conduct mid-year risk shifting. Out-of-money funds increase exposure to equity and decrease exposure to credit markets. Fund characteristics are also shown to play a role in mid-year risk shifting: large and illiquid funds charging lower performance fees are less involved in shifting volatility with out-of-money compensation option. On the other hand, illiquid funds are more likely to increase exposure to the equity market when they are out of money. We also explore the interactions between performance and fund characteristics and how they relate to the mid-year risk shifting behavior to achieve a multi-dimensional view.