The Journal of Finance

High‐Water Marks: High Risk Appetites? Convex Compensation, Long Horizons, and Portfolio Choice

Published: 01/23/2009   |   DOI: 10.1111/j.1540-6261.2008.01427.x

STAVROS PANAGEAS, MARK M. WESTERFIELD

We study the portfolio choice of hedge fund managers who are compensated by high‐water mark contracts. We find that even risk‐neutral managers do not place unbounded weights on risky assets, despite option‐like contracts. Instead, they place a constant fraction of funds in a mean‐variance efficient portfolio and the rest in the riskless asset, acting as would constant relative risk aversion (CRRA) investors. This result is a direct consequence of the in(de)finite horizon of the contract. We show that the risk‐seeking incentives of option‐like contracts rely on combining finite horizons and convex compensation schemes rather than on convexity alone.

Capital Commitment

Published: 08/27/2024   |   DOI: 10.1111/jofi.13382

ELISE GOURIER, LUDOVIC PHALIPPOU, MARK M. WESTERFIELD

Twelve trillion dollars are allocated to private market funds that require outside investors to commit to transferring capital on demand. We show within a novel dynamic portfolio allocation model that ex‐ante commitment has large effects on investors' portfolios and welfare, and we quantify those effects. Investors are underallocated to private market funds and are willing to pay a larger premium to adjust the quantity committed than to eliminate other frictions, like timing uncertainty and limited tradability. Perhaps counterintuitively, commitment risk premiums increase with secondary market liquidity, and they do not disappear when investments are spread over many funds.

Looking for Someone to Blame: Delegation, Cognitive Dissonance, and the Disposition Effect

Published: 08/06/2015   |   DOI: 10.1111/jofi.12311

TOM Y. CHANG, DAVID H. SOLOMON, MARK M. WESTERFIELD

We analyze brokerage data and an experiment to test a cognitive dissonance based theory of trading: investors avoid realizing losses because they dislike admitting that past purchases were mistakes, but delegation reverses this effect by allowing the investor to blame the manager instead. Using individual trading data, we show that the disposition effect—the propensity to realize past gains more than past losses—applies only to nondelegated assets like individual stocks; delegated assets, like mutual funds, exhibit a robust reverse‐disposition effect. In an experiment, we show that increasing investors' cognitive dissonance results in both a larger disposition effect in stocks and a larger reverse‐disposition effect in funds. Additionally, increasing the salience of delegation increases the reverse‐disposition effect in funds. Cognitive dissonance provides a unified explanation for apparently contradictory investor behavior across asset classes and has implications for personal investment decisions, mutual fund management, and intermediation.

The Price Impact and Survival of Irrational Traders

Published: 01/20/2006   |   DOI: 10.1111/j.1540-6261.2006.00834.x

LEONID KOGAN, STEPHEN A. ROSS, JIANG WANG, MARK M. WESTERFIELD

Milton Friedman argued that irrational traders will consistently lose money, will not survive, and, therefore, cannot influence long‐run asset prices. Since his work, survival and price impact have been assumed to be the same. In this paper, we demonstrate that survival and price impact are two independent concepts. The price impact of irrational traders does not rely on their long‐run survival, and they can have a significant impact on asset prices even when their wealth becomes negligible. We also show that irrational traders' portfolio policies can deviate from their limits long after the price process approaches its long‐run limit.