High-Water Marks: High Risk Appetites? Convex C

Abstract: We study the portfolio choice of hedge fund managers who are compensated by high-water mark contracts. We find that even risk-neutral managers do nt place unbounded weights on risky assets, despite option-like contracts. Instead, they place a constant fraction of funds in a mean-variance efficient portfolio and the rest in the riskless asset, acting as would constant relative risk aversion (CRRA) investors. This result is a direct consequence of the in(de)finite horizon of the contract. We show that the risk-seeking incentives of option-like contracts rely on combining finite horizons and convex compensation schemes rather than on convexity alone.

Author(s): STAVROS PANAGEAS and MARK M. WESTERFIELD

High-Water Marks_High Risk Appetites.PDF