Explaining hedge fund investment styles by loss aversion: A rational alternative

Recent research reveals that hedge fund returns exhibit a range of different, possibly non-linear pay-off patterns. It is difficult to qualify all these patterns simultaneously as being rational in a traditional framework for optimal financial decision making. In this paper we present a simple model based on loss aversion that can accommodate for all of these pay-off structures in one unifying framework. We provide evidence that loss-aversion is a likely assumption for management as well as investor preferences. Following the current empirical literature, we solve a static asset allocation problem that includes a nonlinear instrument. We show analytically that four different pay-off functions may be rationally optimal. The key parameter in determining which of these four to choose in a specific setting, is the financial planner’s surplus. The notion of surplus connects hedge fund manager’s incentive schemes with the idea of mental accounting as proposed in recent behavioral finance research.