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

Stavros Panageas and Mark M. Westerfield
Journal of Finance 2009, 64(1): 1-36
Lead Article

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Summary

With an indefinite horizon, convex compensation (e.g., high-water marks and other “option-like” contracts) does not generate unbounded risk-taking. In a simple portfolio choice model, we show that risk-neutral managers act as CRRA investors.

Abstract

We study the optimal portfolio choice of hedge fund managers who are compensated by high-water mark contracts. Surprisingly, we find that even risk-neutral managers will not place unboundedly large weights on the risky assets, despite the option-type features of the contract. Instead they will place a constant fraction of assets in a mean-variance efficient portfolio and the rest in the riskless asset, similar to investors with constant relative risk aversion. This result is a direct consequence of the in(de)finite horizon of the contract. We argue more generally that the risk-seeking incentives of option-type compensation contracts rely on the interaction of convex compensation and finite horizons, rather than on the convexity of the compensation scheme alone.

Cite as

Panageas, Stavros, and Mark M. Westerfield. 2009. “High-Water Marks: High Risk Appetites? Convex Compensation, Long Horizons, and Portfolio Choice.” Journal of Finance 64(1): 1–36. https://doi.org/10.1111/j.1540-6261.2008.01427.x

BibTeX

@article{PanageasWesterfield2009,
  author  = {Panageas, Stavros and Westerfield, Mark M.},
  title   = {High-Water Marks: High Risk Appetites? Convex Compensation, Long Horizons, and Portfolio Choice},
  journal = {Journal of Finance},
  year    = {2009},
  volume  = {64},
  number  = {1},
  pages   = {1--36},
  doi     = {10.1111/j.1540-6261.2008.01427.x},
  url     = {https://doi.org/10.1111/j.1540-6261.2008.01427.x}
}

The PDF posted here is the authors’ manuscript (August 2007 draft). The version of record is available from the journal at the DOI above. Updated October 5, 2026.