A recent paper (available here on SSRN) by Andrew Clare and Nick Motson, entitled "Locking in the gains or putting it all on black - An investigation into the risk-taking behaviour of hedge fund managers" explores the issue of whether or not hedge fund managers are adjusting the risk of their funds based on two factors - how the fund is performing compared to its peers, and whether or not the fund is currently above its high water mark, at which point the manager could capture performance fees (HT to a recent Hedge Fund Review article).
The authors find evidence that hedge fund managers do in fact adjust the risk profiles of their funds in response to their relative performance with peers: managers that are performing poorly will increase their risk profiles, while those doing well relative to their peers will do just the opposite and reduce the risk level of the fund. While in some ways this makes perfect sense, it does suggest that hedge funds on average are less worried about targeting absolute returns, the very reason some investors allocate capital to such funds.
The researchers also considered the implied "moneyness" of the manager's performance option to examine the behavior of managers when the fund is above its high water mark. In a sense, the compensation structure for hedge fund managers has option-like characteristics. As the fund performs above its high water mark, the performance option becomes in-the-money.
Clare and Motson showed that managers with an incentive option well in-the-money will decrease the risk profile of their fund, possibly trying to lock-in value, especially towards the end of the calendar year. On the other hand, the managers of under-performing funds with options out-of-the-money do not seem to take on additional risk in an attempt to get the fund whole. The authors believe this behavior may be due more to a fear of liquidation from investors if the added risk ends up producing further losses. Preservation of capital (and the 2% fee on top of such capital) seems to be more of a driving factor than taking a shot at trying to capture performance fees. Given that many managers have a significant stake of their own wealth in the funds is also no doubt impacting any extra risk that the managers are willing to take.
So what does this imply for the markets? One could argue that during bullish years (or at least positive return periods), investors in both over- and under-performing funds may see the returns of their funds revert to the mean as we get closer to the end of the calendar year, with the under-performing funds possibly experiencing additional volatility as they try to chase the returns of their peers. On the other hand, when the market is down, both over- and under-performing funds, especially those with less of a likelihood of hitting their high water marks, are likely to maintain or scale-back risk in an effort to maintain capital during difficult downturns. Whether one can, or wants to trade on this behavior is another question.