Abstract
According to Tobin’s (1958) two-fund separation theorem that underlies the Capital Asset Pricing Model, individual investors select their optimal portfolio by combining a cash position with the market portfolio. When applied to the fund industry, highly risk-averse investors can reach their desired risk level either by investing in defensive funds, or by buying and deleveraging more aggressive funds. The reverse is not true, because of the borrowing constraints that hold in a realistic setup. We conjecture that this leverage restriction distorts competition and enables high risk unconstrained investors, such as equity long/short hedge fund managers, to extract a rent through higher (management and performance) fees. With a sample of 1938 long/short equity hedge funds spanning a period of 15 years, we show that high-volatility funds deliver lower net-of-fees Sharpe ratios compared to their low-volatility peers. Combined with evidence that riskier funds also charge higher fees, these findings lend support to the “performance confiscation” hypothesis.
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