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Explaining Hedge Fund Investment Styles by Loss Aversion

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Author Info

  • Arjen Siegmann

    ()

  • Andr� Lucas

    ()
    (Faculty of Economics and Business Administration, Vrije Universiteit Amsterdam)

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 patternssimultaneously as being rational in a traditional framework for optimal financial decisionmaking. In this paper we present a simple model based on loss aversion that can accommodatefor all of these pay-off structures in one unifying framework. We provide evidence thatloss-aversion is a likely assumption for management as well as investor preferences.Following the current empirical literature, we solve a static asset allocation problem thatincludes a nonlinear instrument. We show analytically that four different pay-off functionsmay be rationally optimal. The key parameter in determining which of these four to choosein a specific setting, is the financial planner's surplus. The notion of surplus connectshedge fund manager's incentive schemes with the idea of mental accounting as proposed inrecent behavioral finance research.

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Bibliographic 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

Related research

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

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Cited by:
  1. Morton, David P. & Popova, Elmira & Popova, Ivilina, 2006. "Efficient fund of hedge funds construction under downside risk measures," Journal of Banking & Finance, Elsevier, Elsevier, vol. 30(2), pages 503-518, February.

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