High-Water Marks: High Risk Appetites? Convex Compensation, Long Horizons, and Portfolio Choice

Abstract:     
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 in(de)finite 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.

Keywords: Performance Evaluation, Hedge funds, Option-Type Compensation, High-Water Marks, Continuous Time

JEL Classifications: G11, G2

Working Paper Series