incentive contracts and hedge strongfund managementstrong - kit.pdf

Incentive Contracts and Hedge Fund Management by James E. Hodder and Jens Carsten Jackwerth May 23, 2005 C:\Research\Paper21 Hedge Fund\Paper17.doc James Hodder is from the University of Wisconsin-Madison, Finance Department, School of Business, 975 University Avenue, Madison, WI 53706, Tel: 608-262-8774, Fax: 608-265-4195, jhodder@bus.wisc.edu . Jens Jackwerth is from the University of Konstanz, Department of Economics, PO Box D-134, 78457 Konstanz, Germany, Tel.: +49-(0)7531-88-2196, Fax: +49-(0)7531-88-3120, jens.jackwerth@uni-konstanz.de . Incentive Contracts and Hedge Fund Management Abstract This paper investigates dynamically optimal risk-taking by an expected-utility maximizing manager of a hedge fund. We examine the effects of variations on a compensation structure that includes a percentage management fee, a performance incentive for exceeding a specified high- water mark, and managerial ownership of fund shares. In our basic model, there is an exogenous liquidation barrier where the fund is shut down due to poor performance. We also consider extensions where the manager can voluntarily choose to shut down the fund as well as to enhance the fund’s Sharpe Ratio through additional effort. We find managerial risk-taking which differs considerably from the optimal risk-taking for a fund investor with the same utility function. In some portions of the state space, the manager takes extreme risks. In another area, she pursues a lock-in style s