High-Water Marks: High Risk Appetites? Convex Compensation, Long Horizons, and Portfolio Choice
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)
Mark M. Westerfield
University of Washington
Journal of Finance, February 2009
We study the optimal portfolio choice of hedge fund managers who are compensated by high-water mark contracts. Surprisingly, we find that even risk-neutral managers will not place unboundedly large weights on the risky assets, despite the option-type features of the contract. Instead they will place a constant fraction of assets in a mean-variance efficient portfolio and the rest in the riskless asset, similar to investors with constant relative risk aversion. This result is a direct consequence of the indefinite horizon of the contract. We argue more generally that the risk-seeking incentives of option-type compensation contracts rely on the interaction of convex compensation and finite horizons, rather than on the convexity of the compensation scheme alone.
Number of Pages in PDF File: 49
Keywords: Performance evaluation, Hedge funds, Option-type compensation, High-water marks, Continuous time
JEL Classification: G11, G2
Date posted: December 17, 2008
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