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Incentives and Risk Taking in Hedge Funds

Posted: 16 Nov 2007  

Roy Kouwenberg

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); Mahidol University - College of Management

William T. Ziemba

University of British Columbia (UBC) - Sauder School of Business

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Abstract

We study how incentive fees and manager's own investment in the fund affect the investment strategy of hedge fund managers. We find that loss averse managers increase the risk of the fund's investment strategy with higher incentive fees. However, risk taking is greatly reduced if a substantial amount of the manager's own money (at least 30%) is in the fund. Using the Zurich hedge fund universe, we test the relation between risk taking and incentive fees empirically. Hedge funds with incentive fees have significantly lower mean returns (net of fees), while downside risk is positively related to the incentive fee level. Fund of funds charging large incentive fees achieve relatively high mean returns, but with significantly higher risk as well.

Keywords: Hedge funds, Incentive fees, Optimal portfolio choice

JEL Classification: G10, G29

Suggested Citation

Kouwenberg, Roy and Ziemba, William T., Incentives and Risk Taking in Hedge Funds. Journal of Banking and Finance, Vol. 31, No. 11, 2007. Available at SSRN: https://ssrn.com/abstract=1030288

Roy R. P. Kouwenberg

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

HOME PAGE: http://people.few.eur.nl/kouwenberg

Mahidol University - College of Management ( email )

69 Vipawadee Rangsit Road
Bangkok, 10400
Thailand

HOME PAGE: http://www.cmmu.mahidol.ac.th/main/faculty/aroy.asp

William T. Ziemba (Contact Author)

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada
604-261-1343 (Phone)
604-263-9572 (Fax)

HOME PAGE: http://williamtziemba.com

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