Riding the Bubble with Convex Incentives.
Fernando Zapatero* (USC, Los Angeles, CA, US) and Juan Sotes-Paladino (University of Melbourne).
Several empirical studies contradict the efficient markets contention that sophisticated investors like hedge funds should underweight overvalued assets in their portfolios. We rationalize this evidence within a dynamic model that accounts for hedge fund convex incentive fees. In response to these incentives, risk-averse hedge fund managers with superior information can aggressively overweight an overvalued asset with positive risk premium to beat a risk-less benchmark, even when they expect overpricing to fall in the short term. To secure outperformance, managers tilt their portfolios towards the risk-less benchmark and hold too much of a negative risk premium asset. This distortion can increase with managers’ information advantage over other market participants. The optimal investment strategy of managers exacerbates equilibrium mispricing (both over- and undervaluation) with respect to the case of no convex incentives.