Incentives and Endogenous Risk Taking: A Structural View of Hedge Funds Alphas
The University of Chicago; Imperial College Business School; Centre for Economic Policy Research (CEPR)
Imperial College Business School; University of Oxford, Oxford-Man Institute of Quantitative Finance
Imperial College Business School
December 10, 2011
AFA 2012 Chicago Meetings Paper
This paper studies the link between optimal portfolio choice when the manager is subject to non-linear performance incentives and ex-ante performance attribution measures. We study and compare structural versus reduced form measures of alpha and Sharpe ratios and document the existence of a signiﬁcant bias in traditional reduced-form measures. The empirical estimation of the structural model allows us to use previously unexploited information about conditional second moments to draw inference about genuine risk-adjusted performance. Intuitively, the structural approach allows us to distinguish the eﬀect of endogenous risk taking and skill from past fund performance, thus providing superior forecasts of hedge fund performance. We extend the work of Koijen (2010) on mutual funds by explicitly modeling hedge fund speciﬁc contractual features such as (i) incentive options, (ii) equity investor’s redemption options and (iii) primer broker contracts that together create option-like payoﬀs and aﬀect a hedge fund’s risk taking. The optimal investment strategy derived from the model reveals that portfolio leverage depends on the distance to high-water mark. The call option creates an incentive to increase leverage while the put option reduces this incentive when distance to high-water mark is above a certain threshold. Out-of-sample, we show that portfolios formed using structural measures outperform portfolios based on reduced-form measures.
Number of Pages in PDF File: 65
Keywords: Optimal portfolio choice, Euler equation, hedge fund performance
JEL Classification: D9, E4, G11, G14, G23working papers series
Date posted: March 20, 2011 ; Last revised: March 24, 2012
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