Risk-Taking and Managerial Incentives: Seasoned versus New Funds of Funds

Abstract

While the hedge funds industry has grown rapidly during the past decade, a lack of transparency, a need for professionally conducted due diligence, and the inaccessibility of closed funds to new investors led to a significant growth in funds of funds-i.e., funds that invest in multiple individual hedge funds. This article investigates the performance, managerial incentive, and risk taking behavior for new versus more seasoned funds of funds. The results show no differential in risk-adjusted performance. However, junior funds are shown to have more risk aversion, evidenced by less total risk taking, less systematic risk, and more diversity in investment. The article argues that this is consistent with the "herding" theory in mutual funds proposed by Chevalier and Ellison [1997] as well as the empirical evidence for overconfidence in financial managers by Ben-David, Graham, and Harvey [2006]. After two to three years, the difference in risk taking disappears and the junior funds behave much more like their seasoned counterparts.