Incentives and Endogenous Risk Taking: A Structural View on Hedge Fund Alphas

Hedge fund managers are subject to several nonlinear incentives: performance fee options (call); equity investors' redemption options (put); and prime broker contracts allowing for forced deleverage (put). The interaction of these option-like incentives affects optimal leverage ex ante, dependi...

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Bibliographic Details
Published in:The Journal of finance (New York) 2014-12, Vol.69 (6), p.2819-2870
Main Authors: BURASCHI, ANDREA, KOSOWSKI, ROBERT, SRITRAKUL, WORRAWAT
Format: Article
Language:English
Subjects:
Asset management
Capital market
Economic incentives
Economic performance
Fees
Financial investments
Financial portfolios
Hedge funds
Investment advisors
Investment funds
Investment policy
Investment strategies
Leverage
Methodology
Portfolio management
Put & call options
Risk aversion
Risk management
Risk taking
Risk theory
Studies
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Summary:Hedge fund managers are subject to several nonlinear incentives: performance fee options (call); equity investors' redemption options (put); and prime broker contracts allowing for forced deleverage (put). The interaction of these option-like incentives affects optimal leverage ex ante, depending on the distance of fund-value from the high-water mark. We study how these endogenous effects influence performance measures used in the literature. We show that reduced-form measures that do not account for these features are subject to economically significant false discovery biases. The result is stronger for low-quality funds. We propose an alternative structural methodology for conducting performance attribution in hedge funds.
ISSN:0022-1082
1540-6261
DOI:10.1111/jofi.12167