×

The incentives of hedge fund fees and high-water marks. (English) Zbl 1348.91254

Summary: Hedge fund managers receive a large fraction of their funds’ profits, paid when funds exceed their high-water marks. We study the incentives of such performance fees. A manager with long-horizon, constant investment opportunities and relative risk aversion, chooses a constant Merton portfolio. However, the effective risk aversion shrinks toward one in proportion to performance fees. Risk shifting implications are ambiguous and depend on the manager’s own risk aversion. Managers with equal investment opportunities but different performance fees and risk aversions may coexist in a competitive equilibrium. The resulting leverage increases with performance fees – a prediction that we confirm empirically.

MSC:

91G10 Portfolio theory
PDF BibTeX XML Cite
Full Text: DOI

References:

[1] Aragon, Tournament Behavior in Hedge Funds: High-Water Marks, Fund Liquidation, and Managerial Stake, Rev. Finan. Stud. 25 (3) pp 937– (2012)
[2] Aucamp, An Investment Strategy with Overshoot Rebates Which Minimizes the Time to Attain a Specified Goal, Manage. Sci. 23 (11) pp 1234– (1977) · Zbl 0369.90031
[3] Borodin, Handbook of Brownian Motion-Facts and Formulae (2002) · Zbl 1012.60003
[4] Breiman, Proceedings of the Fourth Berkeley Symposium on Mathematical Statistics and Probability pp 65– (1961)
[5] Browne, Reaching Goals by a Deadline: Digital Options and Continuous-Time Active Portfolio Management, Adv. Appl. Probab. 31 (2) pp 551– (1999) · Zbl 0963.91053
[6] Buraschi, SSRN eLibrary: 1785995 (2013)
[7] Carpenter, Does Option Compensation Increase Managerial Risk Appetite?, J. Finance 55 (5) pp 2311– (2000)
[8] Carraro, On Azéma-Yor Processes, Their Optimal Properties and the Bachelier-Drawdown Equation, Ann. Probab. 40 (1) pp 372– (2012) · Zbl 1239.60031
[9] Cherny, Finance Stoch (2013) · Zbl 1279.91144
[10] Cvitanic, On Portfolio Optimization Under Drawdown Constraints, IMA Lecture Notes in Mathematics & Applications 65 pp 77– (1995)
[11] Detemple, SSRN eLibrary: 1695866 (2010)
[12] Dumas, An Exact Solution to a Dynamic Portfolio Choice Problem Under Transactions Costs, J. Finance 46 (2) pp 577– (1991)
[13] Elie, Optimal Lifetime Consumption and Investment Under a Drawdown Constraint, Finance Stoch. 12 (3) pp 299– (2008) · Zbl 1164.91011
[14] Goetzmann, High-Water Marks and Hedge Fund Management Contracts, J. Finance 58 (4) pp 1685– (2003)
[15] Grossman, Optimal Dynamic Trading with Leverage Constraints, J. Finan. Quant. Anal. 27 (2) pp 151– (1992)
[16] Grossman, Optimal Investment Strategies for Controlling Drawdowns, Math. Finance 3 (3) pp 241– (1993) · Zbl 0884.90031
[17] Guasoni, SSRN eLibrary: 2134832 (2012)
[18] Heath, Minimizing or Maximizing the Expected Time to Reach Zero, SIAM J. Contl. Optim. 25 (1) pp 195– (1987) · Zbl 0613.93067
[19] Heath , D. W. Sudderth 1984 Continuous-Time Portfolio Management: Minimizing the Expected Time to Reach a Goal, Technical Report, Institute for Mathematics and Its Applications, University of Minnesota
[20] Janecek, Optimal Investment with High-Watermark Performance Fee, SAIM J. Control Optim. 50 (2) pp 790– (2012) · Zbl 1248.91092
[21] Kardaras, Minimizing the Expected Market Time to Reach a Certain Wealth Level, SIAM J. Finan. Math. 1 (1) pp 16– (2010) · Zbl 1198.60028
[22] Panageas, High-Water Marks: High Risk Appetites? Convex Compensation, Long Horizons, and Portfolio Choice, J. Finance 64 (1) pp 1– (2009)
[23] Ramadorai, The Secondary Market for Hedge Funds and the Closed Hedge Fund Premium, J. Finance 67 (2) pp 479– (2012)
[24] Revuz, Continuous Martingales and Brownian Motion (1999)
[25] Ross, Compensation, Incentives, and the Duality of Risk Aversion and Riskiness, J. Finance 59 (1) pp 207– (2004)
This reference list is based on information provided by the publisher or from digital mathematics libraries. Its items are heuristically matched to zbMATH identifiers and may contain data conversion errors. It attempts to reflect the references listed in the original paper as accurately as possible without claiming the completeness or perfect precision of the matching.