Risk-Taking of Hedge Funds: Empirical Evidence vs. Theoretical Modeling

When an investor delegates portfolio management to a hedge fund manager, whose risk-taking preference governs? Single-period models with option-like incentives suggest stark variation in risk-taking across fund value and time as fund managers maximize their own well-being. Empirical validation is hard to come by, as each hedge fund traces out only a few points on that risk-taking surface. Cross-sectional pooling of normalized returns allows precise estimation of the normalized risk-taking surface. In fact, it is almost flat with some increased risk-taking at very low fund values. A multi-year model is consistent with these findings.