Explaining Hedge Fund Investment Styles by Loss Aversion: A Rational Alternative

25 Pages Posted: 11 Mar 2002  

Arjen Siegmann

VU University Amsterdam

Andre Lucas

VU University Amsterdam - Faculty of Economics and Business; Tinbergen Institute

Date Written: May 7, 2002

Abstract

Recent research reveals that hedge fund returns exhibit a range of different, possibly non-linear pay-off patterns. It is difficult to qualify all these patterns simultaneously as being rational in a traditional framework for optimal financial decision making. In this paper we present a simple model based on loss aversion that can accommodate for all of these pay-off structures in one unifying framework. We provide evidence that loss-aversion is a likely assumption for management as well as investor preferences. Following the current empirical literature, we solve a static asset allocation problem that includes a nonlinear instrument. We show analytically that four different pay-off functions may be rationally optimal. The key parameter in determining which of these four to choose in a specific setting, is the financial planner's surplus. The notion of surplus connects hedge fund manager's incentive schemes with the idea of mental accounting as proposed in recent behavioral finance research.

Keywords: hedge funds, performance measurement, loss aversion, behavioral finance

JEL Classification: G11, G23

Suggested Citation

Siegmann, Arjen and Lucas, Andre, Explaining Hedge Fund Investment Styles by Loss Aversion: A Rational Alternative (May 7, 2002). Available at SSRN: https://ssrn.com/abstract=302289 or http://dx.doi.org/10.2139/ssrn.302289

Arjen Siegmann (Contact Author)

VU University Amsterdam ( email )

De Boelelaan 1105
Dept. of Finance
Amsterdam, NOT IN US OR CANADA 1081 HV
Netherlands
+31205986581 (Phone)

HOME PAGE: http://personal.vu.nl/a.h.siegmann

Andre Lucas

VU University Amsterdam - Faculty of Economics and Business ( email )

De Boelelaan 1105
Amsterdam, 1081 HV
Netherlands
+31 20 598 6039 (Phone)
+31 20 598 6020 (Fax)

HOME PAGE: http://www.feweb.vu.nl

Tinbergen Institute

Roetersstraat 31
Amsterdam, 1018 WB
Netherlands

HOME PAGE: http://www.tinbergen.nl

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