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THE INCENTIVES OF HEDGE FUND FEES AND HIGH‐WATER MARKS
Author(s) -
Guasoni Paolo,
Obłój Jan
Publication year - 2016
Publication title -
mathematical finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.98
H-Index - 81
eISSN - 1467-9965
pISSN - 0960-1627
DOI - 10.1111/mafi.12057
Subject(s) - hedge fund , incentive , performance fee , risk aversion (psychology) , leverage (statistics) , portfolio , fund of funds , economics , business , actuarial science , microeconomics , finance , financial economics , fund administration , expected utility hypothesis , machine learning , computer science
Hedge fund managers receive a large fraction of their funds' profits, paid when funds exceed their high‐water marks. We study the incentives of such performance fees. A manager with long‐horizon, constant investment opportunities and relative risk aversion, chooses a constant Merton portfolio. However, the effective risk aversion shrinks toward one in proportion to performance fees. Risk shifting implications are ambiguous and depend on the manager's own risk aversion. Managers with equal investment opportunities but different performance fees and risk aversions may coexist in a competitive equilibrium. The resulting leverage increases with performance fees—a prediction that we confirm empirically.