The aim of this paper is to analyse and explain the relationship between the age of a hedge fund manager and risk-taking behaviour, and the impact of this relationship on hedge fund returns. The risk-taking behaviour is studied in the light of agency costs and career concerns.

          In the hedge fund industry, agency costs for hedge fund managers are specific in that they are lower relative to those of other money managers. Several explanations can be put forward: the reporting of holdings and returns is not mandatory, compensation is mainly based on profits, hedge fund managers invest their personal assets in their funds and the lock-up periods allow long-term strategies to be conducted.

          Career concerns in the hedge fund industry are also unique in that they change over time. This is due to the sources of the manager’s compensation - the assets under management and the returns. Young managers generally have a lower level of assets under management than older managers. Consequently, they take more risk to obtain good returns, while the large size of the fund provides older managers with their compensation. As a result, the risk level diminishes as the hedge fund manager's age rises. Moreover, statistics show that failed hedge fund managers rarely start a new hedge fund, and if they move into the mutual fund industry, for example, this is associated with a pay cut. The amount of the pay cut is more significant for older hedge fund managers, and it is thus an incentive for them to mitigate their risk-taking behavior. A final explanation for the lower level of risk taken by an older hedge fund manager is the large amount of personal assets invested in the fund.

          On the assumption of low agency costs and increasing career concerns over time, the author characterizes the risk-taking behavior through increasing risk aversion.

          The database used, provided by TASS, covers the period from January 1994 to December 2000. To be included in the sample, 24 months of consecutive returns and at least USD 5 million in assets are required. The data is dropped for the initial incubation period for each fund. It results in a sample containing 982 funds.

          Three risk measures are used: the standard deviation of a portfolio’s return, a tracking error deviation measured relative to a fund of funds index and a beta deviation. While the standard deviation is an absolute measure (it does not provide a comparison with the risk of the benchmark), the other two are relative risk measures. The author defines the tracking error deviation as a measure of how much a manager’s tracking error (i.e. the volatility in returns not explained by market volatility) differs from that of the average manager in the same style category. Beta deviation is the difference between the fund’s beta on the fund of funds index (i.e. each individual fund’s time-series coefficient obtained from a regression of the fund’s returns on the fund of funds index) and the average beta on the fund of funds index for all other funds in the same style category.

          In addition, three performance measures are used: the return in excess of a risk-free rate, a return adjusted for the exposure to a number of passive indices, and a return adjusted for the exposure to a number of hedge fund indices.

          Several regressions are conducted to study the relationship between returns and age, with one of the three performance measures as a dependent variable. In the first set of regressions, the independent variables are the manager characteristics and the fund characteristics. In the second set of regressions a control for market exposure is added, through passive market indices, while hedge fund market indices are added to the third set of regressions. As far as the manager tenure is concerned, the first set of regressions shows that each additional year of experience is associated with a statistically significant decrease in the annual returns of about -0.8%. The manager's age is also a significant and negative explanatory variable. The inclusion of the control for market exposure allows the R² to be improved, and the relationship between manager tenure and returns maintains a coefficient of -0.7%.

          Focusing on the relationship between manager tenure and risk-taking behavior, one of the three selected risk measures is taken as the dependent variable, and the independent variables are the manager tenure, the size of the fund, and the interaction between tenure and size. It appears that an increase in manager tenure, fund size or tenure/size interaction engenders less risky behavior.

          The author also analyses the relationship between risk-taking behavior and career concerns, by using a time-varying proportional hazards model. It permits the conditional probability of failure upon not having failed in a prior period to be calculated, and it avoids the sample-selection bias. The defined model compares the explanatory variables of a hedge fund that fails to the explanatory variables on the set of hedge funds that could have failed during the period but did not. If there is a difference, it exhibits coefficients significantly different from zero. It appears that good performance is negatively related to failure, and all three risk measures are positively related to failure.

          The last relationship studied is between the risk-taking behavior and the returns. Regressions are conducted with the annual return (less a risk-free rate) as the dependent variable, and the manager tenure, the fund characteristics and one of the three risk measures as independent variables. According to the results, each of the three risk measures is negatively related to the annual returns.