Hedge Fund Manager-Investor Conflicts of Interest: A Numerical Analysis with Loss-Aversion

Abstract

This thesis investigates the dynamically optimal risk-taking by a loss-averse hedge fund manager who also takes the possibility of fund liquidation into account. To achieve this, a custom version of the Prospect Theory utility-function is deployed. Furthermore, the effects yielded by different variations of the standard hedge fund contract on managerial incentives are examined. With a single-period horizon, the manager portrays complex risk-taking that varies considerably with fund value and time. In some regions of the state space, the manager pursues excessively high risk-levels relative to those a loss-averse investor. The incentive fee option is found to be the main source of the resulting conflict of interest between manager and investor. Conversely, managerial fund share is identified as a powerful tool of interest alignment. I also extend the manager's horizon to stretch over multiple evaluation periods, and find that overall managerial risk-taking is a decreasing function of the horizon. Finally, the cost of hedge fund investing is assessed, with particular focus attributed to incentive fees.