Risk Choice Under High-Water Marks

Abstract

I provide a closed-form solution to the optimal dynamic risk choice of a fund man- ager who is compensated under a high-water mark contract. The manager's optimal risk choice varies with the distance between the fund's asset value and its high-water mark. Negative returns increase the manager's eective risk aversion (`de-leveraging') when the value of his outside option is low, termination is `strict', or management fees are high, and decrease his eective risk aversion (`gambling') otherwise. I show that in the absence of limits on risk taking, it is never optimal for a manager to walk away. When there are risk limits, walk-away can be optimal following losses.