Incentives and Endogenous Risk Taking: A Structural View of Hedge Funds Alphas

83 Pages Posted: 20 Mar 2011 Last revised: 28 May 2013

See all articles by Andrea Buraschi

Andrea Buraschi

Imperial College Business School; Centre for Economic Policy Research (CEPR)

Robert Kosowski

Imperial College Business School; CEPR (Centre for Economic Policy Research); University of Oxford, Oxford-Man Institute of Quantitative Finance; Unigestion UK

Worrawat Sritrakul

Imperial College Business School

Multiple version iconThere are 2 versions of this paper

Date Written: May 25, 2013

Abstract

Hedge fund managers are subject to several non-linear incentives: (a) performance fee options (call); (b) equity investor’s redemption options (put); (c) prime broker contracts allowing for forced deleverage (put). The interaction of these option-like incentives affects optimal leverage ex-ante, depending on the distance of fund’s value to high-water mark. We study how these endogenous effects influence traditional measures of risk-adjusted performance. We show that structural measure that account for these features are less subject to false discovery biases. The result is stronger for low quality funds. Finally, we show that out-of-sample portfolios based on structural dynamic measures dominate portfolios based on traditional reduced-form rules.

Keywords: Optimal portfolio choice, Euler equation, hedge fund performance

JEL Classification: D9, E4, G11, G14, G23

Suggested Citation

Buraschi, Andrea and Kosowski, Robert and Sritrakul, Worrawat, Incentives and Endogenous Risk Taking: A Structural View of Hedge Funds Alphas (May 25, 2013). AFA 2012 Chicago Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1785995 or http://dx.doi.org/10.2139/ssrn.1785995

Andrea Buraschi

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

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

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Robert Kosowski

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom
+442075943294 (Phone)

HOME PAGE: http://www3.imperial.ac.uk/people/r.kosowski

CEPR (Centre for Economic Policy Research) ( email )

London
United Kingdom

HOME PAGE: http://www.cepr.org/

University of Oxford, Oxford-Man Institute of Quantitative Finance ( email )

Eagle House
Walton Well Road
Oxford, Oxfordshire OX2 6ED
United Kingdom

Unigestion UK

4 Stratford Place
London, W1C1AT
United Kingdom

Worrawat Sritrakul (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

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