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Incentive Contracts and Hedge Fund Management

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  • Hodder, James E.
  • Jackwerth, Jens Carsten

Abstract

We investigate incentive effects of a typical hedge-fund contract for a manager with power utility. With a one-year horizon, she displays risk-taking that varies dramatically with fund value. We extend the model to multiple yearly evaluation periods and find her risk-taking is rapidly moderated if the fund performs reasonably well. The most realistic approach to modeling fund closure uses an endogenous shutdown barrier where the manager optimally chooses to shut down. The manager increases risk-taking as fund value approaches that barrier, and this boundary behavior persists strongly with multiyear horizons.

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Bibliographic Info

Article provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.

Volume (Year): 42 (2007)
Issue (Month): 04 (December)
Pages: 811-826

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Handle: RePEc:cup:jfinqa:v:42:y:2007:i:04:p:811-826_00

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References

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  1. Basak, Suleyman & Pavlova, Anna & Shapiro, Alex, 2005. "Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management," CEPR Discussion Papers 5006, C.E.P.R. Discussion Papers.
  2. Stephen A. Ross, 2004. "Compensation, Incentives, and the Duality of Risk Aversion and Riskiness," Journal of Finance, American Finance Association, vol. 59(1), pages 207-225, 02.
  3. Stavros Panageas & Mark M. Westerfield, 2009. "High-Water Marks: High Risk Appetites? Convex Compensation, Long Horizons, and Portfolio Choice," Journal of Finance, American Finance Association, vol. 64(1), pages 1-36, 02.
  4. Chevalier, Judith & Ellison, Glenn, 1997. "Risk Taking by Mutual Funds as a Response to Incentives," Journal of Political Economy, University of Chicago Press, vol. 105(6), pages 1167-1200, December.
  5. Lucian Arye Bebchuk & Jesse M. Fried, 2003. "Executive Compensation as an Agency Problem," Journal of Economic Perspectives, American Economic Association, vol. 17(3), pages 71-92, Summer.
  6. William N. Goetzmann & Jonathan E. Ingersoll & Stephen A. Ross, 2003. "High-Water Marks and Hedge Fund Management Contracts," Journal of Finance, American Finance Association, vol. 58(4), pages 1685-1718, 08.
  7. Suleyman Basak & Anna Pavlova & Alexander Shapiro, 2007. "Optimal Asset Allocation and Risk Shifting in Money Management," Review of Financial Studies, Society for Financial Studies, vol. 20(5), pages 1583-1621, 2007 21.
  8. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  9. Jennifer N. Carpenter, 2000. "Does Option Compensation Increase Managerial Risk Appetite?," Journal of Finance, American Finance Association, vol. 55(5), pages 2311-2331, October.
  10. Jennifer Carpenter, 1999. "Does Option Compensation Increase Managerial Risk Appetite?," New York University, Leonard N. Stern School Finance Department Working Paper Seires 99-076, New York University, Leonard N. Stern School of Business-.
  11. Fung, William & Hsieh, David A, 1997. "Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 275-302.
  12. William N. Goetzmann & Jonathan Ingersoll, Jr. & Stephen A. Ross, 1998. "High Water Marks," NBER Working Papers 6413, National Bureau of Economic Research, Inc.
  13. Bebchuk, Lucian A. & Fried, Jesse M., 2003. "Executive Compensation as an Agency Problem," Berkeley Olin Program in Law & Economics, Working Paper Series qt81q3136r, Berkeley Olin Program in Law & Economics.
  14. Fung, William & Hsieh, David A., 1999. "A primer on hedge funds," Journal of Empirical Finance, Elsevier, vol. 6(3), pages 309-331, September.
  15. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-57, August.
  16. Stephen J. Brown, 2001. "Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry," Journal of Finance, American Finance Association, vol. 56(5), pages 1869-1886, October.
  17. Basak, Suleyman & Shapiro, Alex & Teplá, Lucie, 2005. "Risk Management with Benchmarking," CEPR Discussion Papers 5187, C.E.P.R. Discussion Papers.
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Citations

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Cited by:
  1. Kolokolova, Olga, 2011. "Strategic behavior within families of hedge funds," Journal of Banking & Finance, Elsevier, vol. 35(7), pages 1645-1662, July.
  2. Lan, Yingcong & Wang, Neng & Yang, Jinqiang, 2013. "The economics of hedge funds," Journal of Financial Economics, Elsevier, vol. 110(2), pages 300-323.
  3. Jackwerth, Jens Carsten & Hodder, James E., 2008. "Managerial Responses to Incentives: Control of Firm Risk, Derivative Pricing Implications, and Outside Wealth Management," MPRA Paper 11643, University Library of Munich, Germany.
  4. Jens Carsten Jackwerth & James Hodder, 2005. "Employee Stock Options: Much More Valuable Than You Thought," Working Papers wp05-09, Warwick Business School, Finance Group.
  5. 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).
  6. Pablo Castañeda, 2006. "Portfolio Choice and Benchmarking: The Case of the Unemployment Insurance Fund in Chile," Working Papers 16, Superintendencia de Pensiones, revised May 2007.
  7. Basak, Suleyman & Pavlova, Anna & Shapiro, Alex, 2005. "Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management," CEPR Discussion Papers 5006, C.E.P.R. Discussion Papers.
  8. Franke, Günter & Krahnen, Jan Pieter, 2008. "The future of securitization," CFS Working Paper Series 2008/31, Center for Financial Studies (CFS).
  9. Hitoshi Matsushima, 2010. "Incentives in Hedge Funds," CIRJE F-Series CIRJE-F-714, CIRJE, Faculty of Economics, University of Tokyo.
  10. Gong Zhan, 2011. "Manager fee contracts and managerial incentives," Review of Derivatives Research, Springer, vol. 14(2), pages 205-239, July.
  11. 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.
  12. Suleyman Basak & Anna Pavlova & Alexander Shapiro, 2007. "Optimal Asset Allocation and Risk Shifting in Money Management," Review of Financial Studies, Society for Financial Studies, vol. 20(5), pages 1583-1621, 2007 21.
  13. Peyton Young & Dean P Foster, 2008. "The Hedge Fund Game," Economics Papers 2008-W01, Economics Group, Nuffield College, University of Oxford.

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