Incentives and Endogenous Risk Taking: A Structural View on Hedge Fund Alphas

Hedge fund managers are subject to several nonlinear incentives: performance fee options (call); equity investors' redemption options (put); and 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-value from the high-water mark. We study how these endogenous effects influence performance measures used in the literature. We show that reduced-form measures that do not account for these features are subject to economically significant false discovery biases. The result is stronger for low-quality funds. We propose an alternative structural methodology for conducting performance attribution in hedge funds.