[We analyze whether risk shifting by a hedge fund manager is related to the manager's incentive contract, personal capital stake, and the risk of fund closure. We find that the propensity to increase risk following poor performance is significantly weaker when incentive pay is tied to the fund's high-water mark and when funds face little immediate risk of liquidation. Risk shifting is also less prevalent when a manager has a significant amount of personal capital invested in the fund. Overall, high-water mark provisions, managerial stake, and low risk of fund closure appear to make a hedge fund manager more conservative with regard to risk shifting.]

We analyze whether risk shifting by a hedge fund manager is related to the manager's incentive contract, personal capital stake, and the risk of fund closure. We find that the propensity to increase risk following poor performance is significantly weaker when incentive pay is tied to the fund's high-water mark and when funds face little immediate risk of liquidation. Risk shifting is also less prevalent when a manager has a significant amount of personal capital invested in the fund. Overall, high-water mark provisions, managerial stake, and low risk of fund closure appear to make a hedge fund manager more conservative with regard to risk shifting. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

We find that capital flows to hedge funds in different countries are influenced by the strength and the enforcement of investor protection laws. Hedge funds located in weak investor protection countries exhibit greater sensitivity of investor outflow to poor performance, relative to funds in countries with strong protection. Furthermore, weak investor protection is associated with fund managers engaging in greater returns management. Our findings suggest that in countries with weaker investor protection, poor fund performance exposes investors to a greater risk of fraud and legal jeopardy, thus triggering a larger outflow of capital.

Stocks expected to be sold by distressed mega hedge funds (MHFs) face anticipatory institutional selling and increased short interest. However, no evidence of anticipatory trading is found in stocks held by nondistressed MHFs, distressed non-MHFs, or stocks confidentially held by distressed MHFs, suggesting that public portfolio disclosure by large and closely followed distressed investors, and not common investment signals, drives anticipatory trading. Distressed MHFs with greater exposure to such anticipatory trading suffer 2.21% lower style-adjusted returns. Stocks subject to anticipatory trading experience negative abnormal returns followed by reversals, indicating the price destabilizing effect of anticipatory trading.