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

49 Pages Posted: 12 Nov 2004

See all articles by Mark M. Westerfield

Mark M. Westerfield

University of Washington

Stavros Panageas

University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: August 2007

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 Classification: G11, G2

Suggested Citation

Westerfield, Mark M. and Panageas, Stavros, High-Water Marks: High Risk Appetites? Convex Compensation, Long Horizons, and Portfolio Choice (August 2007). Available at SSRN: https://ssrn.com/abstract=1010846 or http://dx.doi.org/10.2139/ssrn.1010846

Mark M. Westerfield

University of Washington ( email )

Box 353200
Seattle, WA 98195
United States

HOME PAGE: http://www.markwesterfield.com

Stavros Panageas (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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