Abstract - Incentives and Endogenous Risk Taking: A Structural View of Hedge Funds Alphas

This paper studies the link between optimal portfolio choice when the manager is subject to non-linear performance incentives and ex-ante performance attribution measures. We study and compare structural versus reduced form measures of alpha and Sharpe ratios and document the existence of a significant bias in traditional reduced-form measures. The empirical estimation of the structural model allows us to use previously unexploited information about conditional second moments to draw inference about genuine risk-adjusted performance. Intuitively, the structural approach allows us to distinguish the effect of endogenous risk taking and skill from past fund performance, thus providing superior forecasts of hedge fund performance. We extend the work of Koijen (2010) on mutual funds by explicitly modeling hedge fund specific contractual features such as (i) incentive options, (ii) equity investor’s redemption options and (iii) primer broker contracts that together create option-like payoffs and affect a hedge fund’s risk taking. The optimal investment strategy derived from the model reveals that portfolio leverage depends on the distance to high-water mark. The call option creates an incentive to increase leverage while the put option reduces this incentive when distance to high-water mark is above a certain threshold. Out-of-sample, we show that portfolios formed using structural measures outperform portfolios based on reduced-form measures.

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