Explaining Hedge Fund Investment Styles by Loss Aversion: A Rational Alternative

Abstract:     
Recent research reveals that hedge fund returns exhibit a range of different, possibly non-linear pay-off patterns. It is difficult to qualify all these patterns simultaneously as being rational in a traditional framework for optimal financial decision making. In this paper we present a simple model based on loss aversion that can accommodate for all of these pay-off structures in one unifying framework. We provide evidence that loss-aversion is a likely assumption for management as well as investor preferences. Following the current empirical literature, we solve a static asset allocation problem that includes a nonlinear instrument. We show analytically that four different pay-off functions may be rationally optimal. The key parameter in determining which of these four to choose in a specific setting, is the financial planner's surplus. The notion of surplus connects hedge fund manager's incentive schemes with the idea of mental accounting as proposed in recent behavioral finance research.

Keywords: hedge funds, performance measurement, loss aversion, behavioral finance

JEL Classifications: G11, G23

Working Paper Series