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Incentives and Endogenous Risk Taking: A Structural View on Hedge Fund Alphas
Author(s) -
BURASCHI ANDREA,
KOSOWSKI ROBERT,
SRITRAKUL WORRAWAT
Publication year - 2014
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/jofi.12167
Subject(s) - hedge fund , incentive , leverage (statistics) , performance fee , equity (law) , business , ex ante , alternative beta , fund of funds , actuarial science , financial economics , economics , finance , open end fund , microeconomics , fund administration , institutional investor , corporate governance , computer science , machine learning , political science , law , macroeconomics
Hedge fund managers are subject to several nonlinear incentives: performance fee options (call); equity investors' redemption options (put); and 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‐value from the high‐water mark. We study how these endogenous effects influence performance measures used in the literature. We show that reduced‐form measures that do not account for these features are subject to economically significant false discovery biases. The result is stronger for low‐quality funds. We propose an alternative structural methodology for conducting performance attribution in hedge funds.