Risk Aversion and Incentive Fee

By: Amarendra Bhushan Dhiraj
Submitted: 2007-01-17 16:17:16
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Risk averse means being willing to pay money to avoid playing a risky game, even when the expected value of the game is in your favor.

Let's find out how risk averse you are. If you are a student, I'm guessing that ?20,000 is a lot of money for you. A gift of ?20,000 would make your life noticeably easier. Losing ?20,000 would make your life noticeably harder. If you're a well-paid executive or CEO (Ha! Ha!), multiply my dollar numbers by ten, or a hundred.

Risk aversion is a concept in economics, finance, and psychology explaining the behaviour of consumers and investors under uncertainty. Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain with a more certain but possibly lower expected payoff. The inverse of a person's risk aversion is sometimes called their risk tolerance.

A person is given the choice between a bet of either receiving ?200 or nothing, both with a probability of 50%, or instead, a certain (100% probability) payment. Now he is risk averse if he would rather accept a payoff of less than ?1000 (for example, ?80) with probability 100% than the bet, risk neutral if he was indifferent between the bet and a certain ?100 payment, risk-loving (risk-proclive) if it required that the payment be more than ?100 (for example, ?120) to induce him to take the certain option over the bet.

The average payoff of the bet, the expected value would be ?100. The certain amount accepted instead of the bet is called the certainty equivalent, the difference between it and the expected value is called the risk premium.

I strongly believe that for companies, whether in the technology sector or otherwise, to enjoy long term growth and success, a model that includes taking calculated risks is a must. In my opinion, about 10% of projects that a company pursues should be in the risky category. If a company is satisfied in organic growth, sitting back and doing the same thing again and again will probably suffice to a point, but for real growth risks must be taken and a culture of innovation must be encouraged and nourished. Too many companies either get complacent or are unwilling to upset the status quo.

If that had been the case, Wipro would still be the Vegetable Products Ltd and not one of the leading providers of IT services in the world. Dell’s model of direct-to-consumer sales would not have seen the light of day if Michael Dell had not taken the risk. Ideas and concepts are not very useful if nothing is done about them. This does not mean that every potential risky project should get the green light, or that every vegetable oil company would prosper by pursuing IT services. This does not suggest that risks should be random. In most cases that would be foolhardy and counterproductive. Great leaders are those that learn to evaluate risks, and can identify the right ones often enough. Managers and executives would do well to look at the kinds of risk some of the greats have taken and learn from them. IT is a high-risk profession, yet some organizations are reluctant to assume reasonable levels of IT risk. When an organization is too cautious in dealing with the issue of risk, it may fail to gain all the potential benefits of information technology.

The global market sell-off has been partially blamed on hedge funds. Some argue, like the IMF chief economist in Monetary Policy and Incentives that incentive fees induce hedge funds into taking more risk and that this is the cause of recent volatility.

This is just plain wrong. Incentive fees incentives hedge funds to MANAGE risk NOT to take risk. The two months (so far) bear market is due to the overconfidence of the long only crowd, central bank actions and geopolitical affects on commodity prices. Hedge funds, if anything, dampen down volatility and market panic. Were it not for hedge funds covering shorts and buying cheap, temporarily under priced securities the sell off would be much worse. The performance fee forces managers to be risk averse. Like most real hedge fund managers, I loathe risk and hedge everything I can; I profit from volatility but I certainly don't cause it. Some of my strategies rely on buying in down markets and selling in up markets, while traditional investors do the complete opposite.

Some say incentive fees are unfair because the manager shares in the profits but not in the loses. NO WAY. Real hedge fund managers ALWAYS keep their own money in their fund. A negative year for a fund almost guarantees the defections of key staff and many investors, thereby threatening, often fatally, the fund's franchise. The manager shares in the downside just as much as the upside so the incentive fee acts nothing likes a call option payoff profile. A hedge fund MUST make money every year to be viable as an ongoing business.

People in glass houses should not throw stones. Along with its equally incompetent sister, the World Bank, the IMF sadly demonstrates the vast gap between performance AND incentives in its own pitiful operations. IMF staff is paid high salaries and live in big Washington DC houses, nicely alleviating their own poverty while reducing the wealth of their unfortunate clients. IMF teams fly first class into impoverished countries, hang out in 5 star hotels with the local despot's cousins (finance ministers and business "leaders") and explain to their former, local citizen college buddies from Macroeconomics 101, about how their "reforms" and austerity measures will help the "common" people. A financial package is arranged, which often ends up in the offshore bank accounts of the elite and/or further wrecks the economy/the environment/the lives of normal people. Nice job IMF. Nice incentives.

Hedge funds efficiently allocate capital to where it can best be utilized. The bureaucrat economists of the IMF and World Bank have spent the last 50 years inefficiently abusing capital and making poor people, poorer. Let's benchmark their salaries to the income of those in the poorest 20% in client countries. It's their job to alleviate poverty so let's INCENTIVIZE them to start actually doing it.

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