Abstract
<h3>Practical Applications Summary</h3> Research shows that poorly performing hedge funds tend to engage in risk-shifting behavior—increasing volatility—to boost returns and, in turn, performance fees, especially when fee structures contain triggers such as high-water marks. In <b>The Moral Hazard Problem in Hedge Funds: <i>A Study of Commodity Trading Advisors</i></b>, <b>Li Cai</b>, <b>Chris (Cheng) Jiang</b>, and <b>Marat Molyboga</b> demonstrate that the market environment affects risk-shifting behavior among hedge funds—less risk-shifting behavior occurs in unfavorable market environments, and vice versa. The study also provides new evidence linking investment strategy and risk choices. The authors find that although risk-shifting behavior can increase fees for managers, it lowers investors9 risk-adjusted returns.
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