Managerial Incentives and the Risk-Taking Behavior of Hedge Fund Managers

Abstract

We use a binomial model to derive the optimal trading strategy for a hedge fund manager facing different constraints such as the possibility of the fund liquidation and a minimum net-of-fees return to deliver in order to meet investors expectations. Our model enables us to link the optimal trading strategy and the optimal volatility of the fund to the management and incentive fee rates, the minimum net-of-fees return required by investors, the size of the fund and the moneyness of the option-like contract held by the manager. We find that even if the optimal volatility of the fund increases when the option is out of the money, there is a certain point at which it starts to decrease; and this point can vary from one manager to another given that it is related to factors such as his ownership in the fund and his tolerance for risk. These results give further insights on why some empirical studies such as Brown, Goetzmann and Park (2001) and Clare and Motson (2008) fail to find a general trend in hedge fund managers risk-taking behavior when their option is out of the money.