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

49 Pages Posted: 17 Dec 2008  

Stavros Panageas

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Mark M. Westerfield

University of Washington

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 indefinite 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

Panageas, Stavros and Westerfield, Mark M., High-Water Marks: High Risk Appetites? Convex Compensation, Long Horizons, and Portfolio Choice (August 2007). Journal of Finance, February 2009. Available at SSRN: https://ssrn.com/abstract=1316667

Stavros Panageas (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Mark M. Westerfield

University of Washington ( email )

Box 353200
Seattle, WA 98195
United States

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

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