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Explaining Hedge Fund Investment Styles by Loss Aversion

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Author Info
Arjen Siegmann ()
André Lucas () (Faculty of Economics and Business Administration, Vrije Universiteit Amsterdam)

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Abstract

Recent research reveals that hedge fund returns exhibit a range of different, possibly non-linear pay-off patterns. It is difficult to qualify all these patterns simultaneously as being rational in a traditional framework for optimal financial decision making. In this paper we present a simple model based on loss aversion that can accommodate for all of these pay-off structures in one unifying framework. We provide evidence that loss-aversion is a likely assumption for management as well as investor preferences. Following the current empirical literature, we solve a static asset allocation problem that includes a nonlinear instrument. We show analytically that four different pay-off functions may be rationally optimal. The key parameter in determining which of these four to choose in a specific setting, is the financial planner's surplus. The notion of surplus connects hedge fund manager's incentive schemes with the idea of mental accounting as proposed in recent behavioral finance research.

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Publisher Info
Paper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 02-046/2.

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Date of creation: 17 May 2002
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Handle: RePEc:dgr:uvatin:20020046

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Web page: http://www.tinbergen.nl/

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Related research
Keywords: hedge funds; performance measurement; loss aversion; behavioral finance;

Other versions of this item:

Find related papers by JEL classification:
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G23 - Financial Economics - - Financial Institutions and Services - - - Pension Funds; Other Private Financial Institutions

This paper has been announced in the following NEP Reports:

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