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By Mark Jayne, Undergraduate, Department of Economics, lmjayne@ncsu.edu The agency problem between monetary funds, such as hedge and mutual funds, and their shareholders is a serious problem that deserves further analysis. To start, I have built a simple model to model the hedge fund vs. mutual fund situation. Assumptions of my basic model: We are looking at only one time period where investors may change their holdings once. The liquidity of the hedge funds and the mutual funds is the same. () is dependent on only. , the estimator for , is always right, i.e. = . Hedge fund managers obtain their pay solely through profits of the fund.
Based on these assumptions, we have the following consumption functions based off of the notation used in class. !"# = + !"# + + !"# ,
!"! = + + !"! ,
Where
is
the
salary
of
the
hedge/mutual
fund
manager
= !"! ,
(, )
is
a
function
that
converts
the
information
from
monitoring
into
net
money
flow
entering/exiting
from
the
fund,
Hedge
fund
manager,
and
Mutual
fund
manager.
Also,
!"(!) !"
> 0,
!" ! !"
< 0, and
managers will maximize their consumption, we set the derivatives equal to zero: !"# , = + !"# + !"# = 0 , = !"# !"# !"! , = + !"! = 0
, = !"! .
Since
the
negatives
make
the
right
side
terms
positive,
the
hedge
fund
situation
solves
the
agency
problem
better
unless
!"!
is
significantly
higher
than
!"#
(if
they
are
equal,
there
is
still
the
!"#
!" ! !"
Although this is a fairly sound argument as to why hedge funds are better able to solve the agency problem, there is a testing issue, as it is almost impossible to find data regarding hedge funds due to their private nature. This is why I shall focus my efforts on analyzing the relationship between mutual fund managers and their shareholders, and try to understand the motivations that are going on behind the scenes. First, I will make some new assumptions: 1. The expected gain per quarter in the market during all scenarios is 2%. 2. The rates of returns of the funds are normally distributed random variables ! ((2%, !"#$!%& )) and the variance term is under the control of the manager (i.e. it depends on how much risk he takes). Consider the following scenario. A potential shareholder is searching for a fund in which to invest. He finds five funds that are in his sector of interest, with corresponding past two quarter cumulative rates of return on their portfolios: 1. 2. 3. 4. 5. TownsBank10% Goldmen Slecks9.5% Bear Returns9% Liebalman Brothers5% Bankrock1%
and decides to invest in only one of them (which is not an unreasonable assumption, as many investors and pension plans tend to stay with one company, especially if they offer a diversified portfolio). Which one will he choose? Previous returns can be a foretelling of future returns (skill may move or skew the normal distribution in reality), and since these five funds are in the same sector, wayward market forces affect all of them similarly. He will try to maximize his possible return, and invest in TownsBank. Since mutual fund managers are incentivized only by cash flows in and out of their funds, this creates a contest (a tournament, per s) such that the mutual fund managers fight it out for the number one slot. Despite that Goldmen performed 17.5% better than Bankrock, they are both placed into the category of loser, as the rational investor will always go for TownsBank (all else equal, who wouldnt want that extra .5%?).
The
issue
that
I
will
discuss
in
this
paper
is,
what
will
the
losers
do
in
the
third
quarter?
For
instance,
what
will
Bankrock
do,
given
that
the
past
two
quarters
turned
out
the
way
that
they
did?
Bankrocks
manager
wants
to
be
the
winner
just
like
everyone
else,
but
he
is
very
far
behind
the
others.
He
has
to
take
measures
to
increase
his
current
returns
by
11%
(given
that
TownsBank
makes
the
expected
market
return
of
2%)
in
order
to
be
on
top.
Anyone
familiar
with
the
stock
market
knows
that
it
is
fairly
rare
for
people
to
make
a
return
of
11%
in
a
quarter.
However,
the
riskier
the
portfolio,
the
higher
the
chances
that
it
will
make
stellar
returns
(or
stellar
losses).
Therefore,
the
mutual
fund
manager
at
Bankrock
will
take
on
more
risk
in
hopes
to
gain
better
than
11%
and
be
the
winner
next
quarter.
Bankrock
is
already
on
the
bottom;
there
is
already
money
flowing
out
of
the
fund,
and
should
the
risky
venture
fail,
money
will
flow
out
of
the
fund
faster.
However,
if
the
venture
succeeds,
Bankrock
will
be
on
top,
and
not
only
will
money
stop
flowing
out
of
Bankrock,
money
will
flow
in,
and
the
gain
to
the
manager
from
this
change
will
significantly
eclipse
the
possible
loss
to
the
manager.
In
other
words,
we
will
create
three
possible
scenarios
(
is
for
expected
value):
Third
Quarter
Investment
High
Gain
Expected Gain/Loss
3!" = 2%
Bad Loss
This
is
the
possible
returns
for
the
investors/shareholders,
where
!"#$
is
the
change
in
the
return
because
of
the
risk.
The
return
(change
in
compensation)
for
the
fund
managers
third
quarter
looks
somewhat
different:
!"! , = + !!" The
only
change
in
his
monetary
income
(disregarding
()
for
a
moment)
comes
from
!" !,! !"
, which directly affected by the competition between funds, and, although they can
move together, the managers compensation is not directly linked to the returns of the shareholders. This is what creates the conflict of interest which leads to the excessive risk taking. Obviously, this is an issue for the shareholders, assuming that they are risk-averse. This risk taking will be much less of a problem in hedge funds, as fund managers tend to be risk-averse as well (they are people, after all), and the fact that they are slated to gain and lose with the shareholders makes it more likely that they will take a more conservative
approach. However, since the contest still applies in the hedge fund world, hedge fund managers will still behave in the same manner. Since the percent of gains that a hedge fund manager gets is dependent on the amount of money in the fund, there is still a strong incentive to be the best and attract large amounts of cash flow. In fact, if a specific hedge fund manager is not risk-averse, he will act in an even riskier manner than if he was managing a mutual fund, since he stands to gain so much more from being the best (hedge fund percentage gain fees can be 30% or more). This fact seems counterintuitive to my previous claim that hedge funds have more tools to solve the agency problem. However, the compensation setup still creates a slacking incentive on the part of the mutual fund manager; a fund manager who is not paid based on performance will be less likely to put the extra effort in to find hidden stock gems. Also, for mutual fund managers, there is a powerful incentive to work to find additional investors to invest in his fund (and thus contribute positively to money flow), and that takes away from the managers stock- hunting time. These facts, although not the topic of this paper, will severely eclipse the cost to investors from excess risk. bit: 1. 2. 3. 4. 5. Let us consider an additional competition scenario, where we change the numbers a Scenario 1 TownsBank10% Goldmen Slecks9.5% Bear Returns9% Liebalman Brothers5% Bankrock1% Scenario 2 TownsBank10% Goldmen Slecks4% Bear Returns3% Liebalman Brothers2% Bankrock1%
1. 2. 3. 4. 5.
In both scenarios, TownsBank has the lead, however there is a crucial difference; they are superstars in Scenario 2, beating the number 2 spot by 6%, however, their lead is sliced to only .5% in Scenario 1. This affords for very different behavior on the part of TownsBank. TownsBank knows that Goldmen will take on extra risk in both scenarios in order to become the winner; they have a much better chance of stealing the top spot in Scenario 1. Thus, TownsBanks manager fears for his winning position more than in Scenario 2, and consequently will take on more risk in Scenario 1 than in Scenario 2, even though his position and current rate of return is the same. Suppose Townsbank takes on no extra risk and thus gains his expected rate of return. Then in Scenario 1, TownsBank: 3!" = 2% = 2% + 10% = 12% Goldman Slecks: 3!" = 2% = 2% + 9.5% !"#$ In Scenario 2 TownsBank is the same, but Goldman Slecks: 3!" = 2% = 2% + 4% !"#$
As we can see, in order for Goldmen to beat TownsBank in Scenario 1, !"#$ > 0.5%, however in Scenario 2, !"#$ > 6% in order for this to happen. Clearly, TownsBanks manager feels much less pressure in Scenario 2, and will take less risky ventures in order to keep his top spot (he doesnt want to lose it all). The TownsBank manager will take as much risk as is necessary to optimize his chances of staying on top. As for testing my hypothesis that the real-world corollary to TownsBank will change his risky behavior based on the status of his followers, I propose obtaining data from multiple years (many, as this will be the n in the regression) and multiple sectors of mutual funds and separating them based on whether, during the second quarter, there is a clear winner in the rankings or not. Then, I propose analyzing the ANOVA of a regression (containing all relevant control variables, such as control for market volatility) to look at the variance of the change in returns to the third quarter for the one distinct winner case vs. the variance of the winners change in returns in the case where it is a close race. In conclusion, I have defined a model that tries to explain the relationship and the agency problem between mutual fund/hedge fund managers and their respective shareholders. Excessive risk taking is a serious issue that affects shareholder wellbeing, as most shareholders are risk averse and wish to minimize their risk exposure. The tournament situation, although able to incentivize managers to do a better job and gain a better return through working harder, is more apt to simply increase the amount of risky ventures by mutual fund managers, since their incentive structure dis-incentivizes working harder to gain better returns (i.e. change the expected value of the return, not just the variance). An extension of this tournament concept may also be applied to the situation where relatively new mutual fund managers are compared to those with longer track records, as one would expect the new managers to take larger risks in order to enhance their short track record (ones with the long track record would do this less, since they have a long track record to protect). This topic lends itself to for further study in another paper.