Hedge Fund Payoffs and Loss Aversion

Abstract:     
For an agent with loss averse preferences we derive the optimal payoffs with one option. A total of four different payoffs are found to be optimal, depending on the strike price of the option and whether the initial position of the agent is one of surplus or shortfall. Our results have implications for the hedge fund industry, where funds typically display nonlinear payoffs. Manager compensation typically includes a high-water mark for the incentive fee, which is a likely candidate for the reference point in loss averse preferences. The shape of the optimal payoffs for an initial shortfall position corresponds either to a short put or short straddle. This can be related to managers that are below their customary return, suggesting that investment strategies creating a short put payoff like those followed by LTCM might be driven by loss averse preferences. Furthermore, the steepness of the payoffs under loss aversion increases in the difference to an initial reference point, which corresponds to hedge funds increasing their risk when performance falls further behind.

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

Working Paper Series