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High-water marks: high risk appetites? convex compensation, long horizons, and portfolio choice

Panageas, Stavros and Westerfield, Mark M. (2009) High-water marks: high risk appetites? convex compensation, long horizons, and portfolio choice. The Journal of Finance, 64 (1). pp. 1-36. ISSN 0022-1082

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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 not 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.

Item Type: Article
Official URL: http://www.afajof.org/journal/browse.asp
Additional Information: © 2009 The American Finance Association
Library of Congress subject classification: H Social Sciences > HG Finance
Sets: Departments > Finance
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Date Deposited: 26 Jun 2012 09:34
URL: http://eprints.lse.ac.uk/44490/

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