Career Risk and Market Discipline in Asset Management
The compensation of employees in asset management is typically much higher than that of non-finance employees with similar education, and tends to be more unstable. In principle, the benefit of such a high compensation may be offset, at least partly, by the danger of possibly permanent career setbacks. The incentive problems in asset management obviously require leaving a considerable amount of risk on the shoulders of managers, especially those with the greatest decision-making power. Indeed, in this industry a substantial portion of compensation is performance-sensitive, with a fixed base salary supplemented by performance-related bonuses. However, the performance-based component is typically much more sensitive to upside than to downside risk.
Therefore, it is important to ask whether asset managers are exposed not just to the incentive mechanism of their compensation scheme, but also to the discipline imposed by the labor market, in the form of permanent career setbacks following underperformance. This is precisely the research question we address in this paper.
We focus on professionals working in hedge funds, as incentive concerns and their career implications can be expected to be particularly salient in this segment of asset management. We manually collected data on the careers and characteristics of 1,948 individuals who at some point worked in a hedge fund as low, middle or top manager in the investment company managing the fund. We find that upon being hired by a managing company, the professionals in our sample experience a significant acceleration of their career, but that entry into the hedge fund industry also exposes them to the danger of permanent setbacks upon the liquidation of the funds they work for.
In principle, such “scarring effects” may result either from a loss of reputation (“skill”) or from the accidental destruction of the managers’ human capital, owing, say, to overall adverse market trends in the relevant fund class or the whole market (“luck”). We label these two interpretations respectively as the “market discipline” and the “career risk” hypotheses. To discriminate between them, we test whether “scarring effects” are concentrated in funds that consistently underperformed their benchmark before liquidation. We find that high-ranking managers of funds liquidated after 2 years of average underperformance suffer job demotion entailing an average compensation loss that is $664,000 larger than if their fund had performed normally before liquidation. But where preceded by normal performance, fund liquidation is not associated with career setback or significant compensation loss.
On the whole, our results reveal a new facet of market discipline in asset management, operating via the managerial labor market. This labor market discipline is complementary to contractual incentives within the firm. The job market “stick” may indeed be a corrective to the tendency to motivate asset managers by generous “carrots”, i.e. performance-based remuneration that is far more sensitive to upside gain than to downside risk.