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High-Water Marks: High Risk Appetites? Convex Compensation, Long Horizons, and Portfolio Choice

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  • STAVROS PANAGEAS
  • MARK M. WESTERFIELD

Abstract

We study the portfolio choice of hedge fund managers who are compensated by high-water mark contracts. We find that even risk-neutral managers do not place unbounded weights on risky assets, despite option-like contracts. Instead, they place a constant fraction of funds in a mean-variance efficient portfolio and the rest in the riskless asset, acting as would constant relative risk aversion (CRRA) investors. This result is a direct consequence of the in(de)finite horizon of the contract. We show that the risk-seeking incentives of option-like contracts rely on combining finite horizons and convex compensation schemes rather than on convexity alone. Copyright (c) 2009 The American Finance Association.

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File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1540-6261.2008.01427.x
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Bibliographic Info

Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 64 (2009)
Issue (Month): 1 (02)
Pages: 1-36

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Handle: RePEc:bla:jfinan:v:64:y:2009:i:1:p:1-36

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Cited by:
  1. Andrew J. Patton & Tarun Ramadorai, 2013. "On the High-Frequency Dynamics of Hedge Fund Risk Exposures," Journal of Finance, American Finance Association, vol. 68(2), pages 597-635, 04.
  2. Jorion, Philippe & Schwarz, Christopher, 2014. "Are hedge fund managers systematically misreporting? Or not?," Journal of Financial Economics, Elsevier, vol. 111(2), pages 311-327.
  3. Panageas, Stavros, 2010. "Bailouts, the incentive to manage risk, and financial crises," Journal of Financial Economics, Elsevier, vol. 95(3), pages 296-311, March.
  4. Patton, Andrew J & Ramadorai, Tarun, 2010. "On the Dynamics of Hedge Fund Risk Exposures," CEPR Discussion Papers 7780, C.E.P.R. Discussion Papers.
  5. Bliss, Richard T. & Potter, Mark E. & Schwarz, Christopher, 2012. "Decision making and risk aversion in the Cash Cab," Journal of Economic Behavior & Organization, Elsevier, vol. 84(1), pages 163-173.
  6. Gary Gorton & Ping He & Lixin Huang, 2010. "Security Price Informativeness with Delegated Traders," American Economic Journal: Microeconomics, American Economic Association, vol. 2(4), pages 137-70, November.
  7. Hodder, James E. & Jackwerth, Jens Carsten, 2007. "Incentive Contracts and Hedge Fund Management," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(04), pages 811-826, December.
  8. John Kambhu & Til Schuermann & Kevin J. Stiroh, 2007. "Hedge funds, financial intermediation, and systemic risk," Staff Reports 291, Federal Reserve Bank of New York.
  9. Paolo Guasoni & Gu Wang, 2012. "Hedge and Mutual Funds' Fees and the Separation of Private Investments," Papers 1208.4799, arXiv.org, revised Jan 2014.
  10. Agarwal, Vikas & Ray, Sugata, 2011. "Determinants and implications of fee changes in the hedge fund industry," CFR Working Papers 11-09, University of Cologne, Centre for Financial Research (CFR).
  11. Sheng, Jiliang & Wang, Jian & Wang, Xiaoting & Yang, Jun, 2014. "Asymmetric contracts, cash flows and risk taking of mutual funds," Economic Modelling, Elsevier, vol. 38(C), pages 435-442.
  12. Agarwal, Vikas & Daniel, Naveen D. & Naik, Narayan Y., 2009. "Role of managerial incentives and discretion in hedge fund performance," CFR Working Papers 04-04, University of Cologne, Centre for Financial Research (CFR).
  13. Stavros Panageas, 2009. "Bailouts, the Incentive to Manage Risk, and Financial Crises," NBER Working Papers 15058, National Bureau of Economic Research, Inc.
  14. Dandan Song & Jinqiang Yang & Zhaojun Yang, 2013. "High-Water Marks and Hedge Fund Management Contracts with Partial Information," Computational Economics, Society for Computational Economics, vol. 42(3), pages 327-350, October.
  15. Gong Zhan, 2011. "Manager fee contracts and managerial incentives," Review of Derivatives Research, Springer, vol. 14(2), pages 205-239, July.
  16. Serge Darolles & Christian Gouriéroux, 2013. "The Effects of Management and Provision Accounts on Hedge Fund Returns - Part I : The High Water Mark Scheme," Working Papers 2013-22, Centre de Recherche en Economie et Statistique.
  17. Maxim Bichuch & Stephan Sturm, 2011. "Portfolio Optimization under Convex Incentive Schemes," Papers 1109.2945, arXiv.org, revised Oct 2013.
  18. Rui de Figueiredo & Evan Rawley & Orie Shelef, 2014. "Bad Bets: Excessive Risk Taking, Convex Incentives, and Performance," Discussion Papers 13-002, Stanford Institute for Economic Policy Research.
  19. Aivaliotis, Georgios & Palczewski, Jan, 2014. "Investment strategies and compensation of a mean–variance optimizing fund manager," European Journal of Operational Research, Elsevier, vol. 234(2), pages 561-570.
  20. Morten Sorensen & Neng Wang & Jinqiang Yang, 2013. "Valuing Private Equity," NBER Working Papers 19612, National Bureau of Economic Research, Inc.

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