2012-12: Incentive Thresholds, Risk-Taking, and Performance. Evidence from Hedge Funds

Managerial incentives induce risk-taking as well as effort. Theoretical research has long considered risk-taking a potential side effect of incentives, but empirical investigation is limited. This paper uses exogenous variation in hedge fund manager's incentives to examine both performance and risk-taking. I find, consistent with theory, that being farther below a key incentive threshold increases risk-taking and decreases performance. On average, a manager's risk-taking increases 50% and their performance falls 2.1 percentage points when he is below the incentive threshold. I also show, consistent with the theoretical predictions, risk-taking behavior is non-monotonic; very distant managers take less risk and perform better than less distant managers. Further, I examine the role of organizational features in impacting the responsiveness to explicit incentives and the mechanisms managers use to increase risk. My results highlight the importance of risk-taking in response to incentives designed to induce effort and inform empirical research, contract design, practitioners, and policy makers. The results also show that moral hazard, not just selection, is an important determination of manager performance.