{"id":1073,"date":"2026-09-14T23:08:23","date_gmt":"2026-09-14T23:08:23","guid":{"rendered":"https:\/\/david.bookstaber.com\/?p=1073"},"modified":"2026-09-15T16:35:10","modified_gmt":"2026-09-15T16:35:10","slug":"moral-hazard-in-asset-management","status":"publish","type":"post","link":"https:\/\/david.bookstaber.com\/?p=1073","title":{"rendered":"Moral Hazard in Asset Management"},"content":{"rendered":"\n

Compiled from posts I first published in 2006 and 2007.<\/em><\/p>\n\n\n\n

There is a moral hazard for investment managers to take big risks: They are gambling with other people’s money. Fund managers share proportionately in the profits when they succeed, but do not share directly in the losses when they fail.<\/p>\n\n\n\n

For example, active mutual fund managers are generally benchmarked to an index of the security types they hold. They “succeed” to the degree that they outperform the benchmark. Success attracts more money, which brings in more management fees that flow to the managers’ pockets. Failure to beat the index tends to result in attrition of assets under management. But in the worst case a manager doesn’t lose money the way investors lose theirs. Thus, the incentives for a new manager who wants to make a fortune, but who doesn’t have any special ability to beat the market<\/a>, is to take a gamble by building a portfolio that is riskier than the index.1<\/a><\/sup><\/p>\n\n\n\n

Suppose the manager has “won” the gamble and thereby attracted more capital. If the manager becomes complacent with the higher fees generated by that capital he might stop gambling. In that case, the investors who expected him to beat the index will just be owning the index \u2013 but will be paying excess management fees because their lucky manager has a “proven record” of beating the index. And that’s actually the better scenario: If the manager continues to gamble he will eventually lose (i.e., underperform the index), and the losses will be greater in dollar terms because the manager was gambling with more capital than before.<\/p>\n\n\n\n

Hedge Funds Amplify the Hazard<\/h3>\n\n\n\n

Hedge funds exacerbate this hazard because they can take enormous risks, and the payoffs to managers from big wins are realized quickly. One would hope that after a hedge fund manager blows up with an unjustified gamble that would be the end of his career. An October 2006 Wall Street Journal article revealed that such a hope may be in vain:<\/p>\n\n\n\n

\n

Brian Hunter, the natural-gas trader behind last month’s massive losses at hedge fund Amaranth Advisors, is exploring whether to get back in the game, people familiar with his plans say. … Amaranth, based in Greenwich, Conn., is liquidating, after Mr. Hunter’s bad bets triggered roughly $6.4 billion in losses, or 70% of its assets.<\/p>\n<\/blockquote>\n\n\n\n

In 2005, Hunter personally banked roughly $75MM in performance fees for making enormous gambles with other people’s money. The next year he lost more than half his investors’ money and bankrupted his employer. Not only did he keep his fees on the prior year’s performance, but apparently there are still people out there who want him to gamble with their money.<\/p>\n\n\n\n

\n

Betting on fallen hedge-fund stars isn’t all that uncommon. John Meriwether, who led Long-Term Capital Management until its 1998 implosion, now runs another hedge fund.<\/p>\n<\/blockquote>\n\n\n\n

The Status Quo<\/h3>\n\n\n\n

A common hedge fund structure pays managers a 2% management fee and, on top of that, 20% of profits. This emphasis on performance incentives is a hallmark of the industry. But the incentive is almost always implemented with a peculiar feature: The fund manager gets to lock in performance fees at the end of each calendar year. He keeps the rewards for a positive year even if he subsequently loses money for investors.<\/p>\n\n\n\n

This fee structure creates perverse incentives. Because the manager shares directly in the upside, but risks nothing material on the downside, he has every reason to take excessive risks. The annual lock-in produces a behavior known as the Wealth Effect: Managers who have accumulated large profits tend to reduce risk towards the end of a calendar year in order to protect their impending payout. Managers who are underwater tend to “double-down” and take more risk, in hopes of recovering and turning a profit they can harvest at year end. In each case the manager’s incentives are not aligned with those of the investors, who expect a manager to steadily follow his advertised strategy and risk profile regardless of how much has been made or where they are in the calendar.<\/p>\n\n\n\n

A common patch for this problem is to establish a “high-water mark” so that managers do not earn any incentives until they have entirely recouped losses. The perverse result of this is that as soon as their performance falls too much they tend to close up shop rather than stay in the game to recoup their investors’ losses. After all, there is no performance fee paid for recovering losses. Sometimes it is easier to start a new fund where they once again immediately share in profits. (This tendency for losers to quit has resulted in a notoriously large “performance selection bias” in the hedge fund industry.)<\/p>\n\n\n\n

A Fix<\/h3>\n\n\n\n

The industry is ripe for an evolution in incentive structures: It is obvious that this needs to involve delayed vesting of performance fees. Performance fees should be kept in escrow with a vesting period much longer than one calendar year. (Just as the exact performance share varies from fund to fund, the vesting period could vary. A reasonable vesting period would be something like five years.)<\/p>\n\n\n\n

So long as investor money is at risk, performance fees should be at risk. Granted, fund managers have to feed their families, so they would lock in their fees gradually over the vesting period. But delayed vesting will keep their skin in the game even if they have a big drawdown.<\/p>\n\n\n\n

To see how this would ameliorate the hazards inherent in the current incentive structure, imagine a hedge fund named Zamaranth funded by two equal investors, A and B. During 2005 Zamaranth doubles its investors’ money, and the manager gets $100 million in incentive fees \u2013 escrowed, vesting over five years. Beginning 2006 the manager is earning $1.67 million each month from escrow \u2013 an ample payout from his stellar performance. If investor A cashes out, that money is no longer at risk and the manager immediately banks the escrowed fees: $50 million. A few months later, Zamaranth’s remaining positions collapse, losing all of the value they accumulated during 2005. Investor B, having lost all his gains, recoups all of the performance money remaining in escrow. The Zamaranth manager took a big risk, and he shared in the consequences. But he is still incentivized to work for his investor, because he is not “below water,” so any profits he earns will immediately accumulate in his escrow account.<\/p>\n\n\n\n

20 years later<\/h3>\n\n\n\n

Europe pushed in this direction: The Alternative Investment Fund Managers Directive (AIFMD, 2013) effectively required at least 40% of performance fees to vest over at least 3 years. In the U.S., the closest such rule is Dodd-Frank Section 956, but it has not been put into effect.<\/p>\n\n\n

  1. The mechanics of this gamble can vary in complexity. One simple approach: Hold every security in the index except for the lowest-risk ones. This modified portfolio will sometimes beat the index and sometimes underperform it \u2013 nobody knows in advance which, and even after the fact virtually nobody can tell whether the difference was due to skill or luck. \u21a9\ufe0e<\/a><\/li><\/ol>","protected":false},"excerpt":{"rendered":"

    Managers share the upside and not the downside. An argument about incentive design in asset management, first published in 2006 and 2007.<\/p>\n","protected":false},"author":1,"featured_media":1076,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"inline_featured_image":false,"_jetpack_newsletter_access":"","_jetpack_dont_email_post_to_subs":false,"_jetpack_newsletter_tier_id":0,"_jetpack_memberships_contains_paywalled_content":false,"_jetpack_feature_clip_id":0,"_jetpack_memberships_contains_paid_content":false,"footnotes":"[{\"content\":\"The mechanics of this gamble can vary in complexity. One simple approach: Hold every security in the index except for the lowest-risk ones. This modified portfolio will sometimes beat the index and sometimes underperform it \u2013 nobody knows in advance which, and even after the fact virtually nobody can tell whether the difference was due to skill or luck.\",\"id\":\"e1446c9c-3f2b-4141-98b3-8f02d181820f\"}]","jetpack_publicize_message":"","jetpack_publicize_feature_enabled":true,"jetpack_social_post_already_shared":true,"jetpack_social_options":{"image_generator_settings":{"template":"highway","default_image_id":0,"font":"","enabled":false},"version":2},"jetpack_post_was_ever_published":false},"categories":[15],"tags":[],"class_list":["post-1073","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-finance","post-archive"],"jetpack_publicize_connections":[],"jetpack_sharing_enabled":true,"jetpack_featured_media_url":"https:\/\/david.bookstaber.com\/WP\/wp-content\/uploads\/2026\/09\/asymmetric-incentives-asset-management-scaled.jpg","_links":{"self":[{"href":"https:\/\/david.bookstaber.com\/index.php?rest_route=\/wp\/v2\/posts\/1073","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/david.bookstaber.com\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/david.bookstaber.com\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/david.bookstaber.com\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/david.bookstaber.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=1073"}],"version-history":[{"count":5,"href":"https:\/\/david.bookstaber.com\/index.php?rest_route=\/wp\/v2\/posts\/1073\/revisions"}],"predecessor-version":[{"id":1090,"href":"https:\/\/david.bookstaber.com\/index.php?rest_route=\/wp\/v2\/posts\/1073\/revisions\/1090"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/david.bookstaber.com\/index.php?rest_route=\/wp\/v2\/media\/1076"}],"wp:attachment":[{"href":"https:\/\/david.bookstaber.com\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=1073"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/david.bookstaber.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=1073"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/david.bookstaber.com\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=1073"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}