“Nickels vs. Black Swans: Reputation, Trading Strategies, and Asset Prices” by Yale professor Hongjun Yan and his doctoral student Steven Malliaris, looks at how hedge fund managers’ concerns about their reputations affect their investment strategies.

The paper explains why “nickel” strategies are popular, even when they offer low expected returns. Nickel strategies are those that earn small positive returns most of the time but occasionally suffer huge losses; black swan strategies are the opposite, generating small losses most of the time but occasionally leading to spectacular loss-erasing profits.  In a rough estimate, Yan and Malliaris found that approximately 40% of hedge fund assets are invested in nickel strategies, while only 0.6% are in black swan strategies.

“Reputation concerns are essential to understanding the hedge fund industry,” says Yan. “The industry has been growing tremendously in the last twenty years. Many believe hedge funds are playing an important role in the current financial crisis.  To fully appreciate the impact of this industry on the overall economy, one has to understand the reputation concerns.”

Yan and Malliaris modeled how sophisticated investors form perceptions about a manager’s ability, the strategy choices the manager makes in response based on reputation concerns, and the interaction between the two. The authors explain that investors infer a manager’s ability from his performance and update their beliefs after investment returns are realized. When investors see a loss, they may downgrade the manager’s ability and fire him by taking their money out of the fund—a costly blow to his reputation and ability to attract new clients and capital.

As a consequence, a fund manager is likely to forgo even profitable black swan strategies since he is likely to incur a series of losses and be fired before the large but infrequent profits arrive. A nickel strategy that offers reliable returns over a number of years allows the manager to build a solid track record.

According to Yan and Malliaris, reputation concern is stronger among managers with more modest reputations, who may be fired after a few losses, than those with high reputations. If the average manager is reluctant to pursue profitable black swan strategies, then reputation concerns can have a significant impact on manager performance.

This result also suggests that, after decades of growth, the overall return from the hedge fund industry is likely to be less impressive going forward, as it is likely that more managers with modest reputations have joined the industry. “Managers with less convincing track records are more likely to forgo more profitable opportunities to avoid risking their careers. The main job of those money managers is to find the money to manage and keep their clients. This naturally would take a toll on their performance,” says Yan.

Another finding in their analysis is that the interaction between investors’ perceptions of their managers’ ability and managers’ responses can lead to multiple self-fulfilling equilibria: the market can be stable in two totally different situations. Once the market shifts from one to the other, however, it can create fragility in the economy.

In one equilibrium, investors may believe that a strategy is popular among talented managers and thus those investors will be more tolerant of managers who use that strategy; poor performance will not be attributed to managers’ ability.  This makes the strategy attractive to managers, and, in some economic environments, may make this belief self-fulfilling.  In the other equilibrium, investors may become very intolerant to that strategy and make managers cautious in taking the strategy. This helps explain the rise and fall of many hedge fund strategies. For example, the convertible bond arbitrage strategy was extremely popular until early 2004.  After 2004, however, more than half of the asset under management, about $20 billion, fleeted away in a few quarters, even though the opportunity appeared to be even better.

Yan and Malliaris explain that hedge fund managers have no incentive to change their strategy unless investors change their perceptions, and vice versa. Due to this coordination problem, the economy may get stuck in the equilibrium where managers tend to avoid certain strategies despite their higher profitability, or the other equilibrium where managers all want to jump onto the bandwagon and invest in the popular strategies.  This implies slow moving capital, that is, when profitable opportunities arise, they may not be able to attract capital right away, leaving opportunities unexploited for an extended period of time.

Once the coordination problem breaks, however, there may be a shock as the economy switches to the other equilibrium, resulting in large amounts of capital being moved around very quickly. This drastic capital relocation can lead to significant changes in asset prices, even without news on the fundamentals.

Despite the importance of reputation concerns, it appears to be an understudied topic, according to Yan. “For example, we don’t even know how hedge fund managers are affected after big losses. From newspapers, one might have the impression that a manager can easily restart another hedge fund after blowing up his current one. But those headlines are usually about the cases for high profile managers. In an ongoing research project, we look at this issue more systematically and find that it is very hard for an average manager to restart after a failure.”