Incentives and Risk Taking in Hedge Funds
Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); Mahidol University - College of Management
William T. Ziemba
University of British Columbia (UBC) - Sauder School of Business
Journal of Banking and Finance, Vol. 31, No. 11, 2007
We study how incentive fees and manager's own investment in the fund affect the investment strategy of hedge fund managers. We find that loss averse managers increase the risk of the fund's investment strategy with higher incentive fees. However, risk taking is greatly reduced if a substantial amount of the manager's own money (at least 30%) is in the fund. Using the Zurich hedge fund universe, we test the relation between risk taking and incentive fees empirically. Hedge funds with incentive fees have significantly lower mean returns (net of fees), while downside risk is positively related to the incentive fee level. Fund of funds charging large incentive fees achieve relatively high mean returns, but with significantly higher risk as well.
Keywords: Hedge funds, Incentive fees, Optimal portfolio choice
JEL Classification: G10, G29
Date posted: November 16, 2007
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