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

Hedge fund managers are subject to several non-linear incentives: (a) performance fee options (call); (b) equity investor's redemption options (put); (c) prime broker contracts allowing for forced deleverage (put). The interaction of these option-like incentives affects optimal leverage ex-ante, depending on the distance of fund's value to high-water mark. We study how these endogenous effects influence traditional measures of risk-adjusted performance. We show that structural measure that account for these features are less subject to false discovery biases. The result is stronger for low quality funds. Finally, we show that out-of-sample portfolios based on structural dynamic measures dominate portfolios based on traditional reduced-form rules