1. Discussion of Effort, Risk and Walkaway under High Water Mark Contracts by Indraneel Chakraborty and Sugata Ray
Roy Kouwenberg Mahidol University, Bangkok Erasmus University Rotterdam

2. Summary Theoretical model of hedge fund management and investment.
Incentive fees, with high water mark (HWM)
Risk and effort chosen by the fund manager
Investors capable of withdrawing funds (“walk-away”).
Numerical solution of the model. Key results:
As the fund value drops further below the HWM:
Manager increases variance of returns
Expected returns for investors decrease (lower effort/alpha)
Investors more likely to withdraw funds

3. Summary
Calabration of model parameters using the CISDM hedge fund database.
Empirical investigation using the CISDM database
Effect of a fund’s required return to reach HWM on:
Risk taking (+)
Expected returns (−)
Probability of a fund dropping from the CISDM database (+)
Numerical welfare analysis of modifying the fee contract, using the calibrated model.

4. Discussion Overall, interesting work! Main comment: paper too long
67 pages
17 tables (!)
10 figures
Result: focus and contribution become less clear
Where lies the contribution: theory, empirical results, or calibration of the model (welfare analysis)?
Suggestion: pick one or two areas to focus on.

5. Discussion of theoretical model
Some assumptions of the theoretical model:
Manager can increase alpha through extra effort, but this is costly (utility loss)
No uncertainty about alpha; completely under control of manager
Manager has no money in the fund
No incentive alignment (no loss of reputation either).
Assumption of a uniform portfolio return distribution
Infinite period model: investor keeps a constant dollar amount of money in the fund (rebalancing)
Investor anticipates the manager’s optimal effort and risk
Numerical solutions only

6. Discussion of theoretical model
The model assumes that the investor anticipates the manager’s optimal effort (alpha) and risk level at the beginning of the period. The investor will withdraw all money when the expected fund return is negative.
Comparison to practice
Investor have very little information about a hedge fund’s investment strategy and true alpha
Investors face lock-up periods
Hedge generate returns through beta exposure
Who walks away: the manager or the investor?

7. Discussion of empirical analysis
Some comments on empirical results:
Brown, Goetzmann and Park (2001, p1870): “we find little or no evidence that poor performers […] increase volatility to meet their high water mark.” Comparison?
Relation between required return to reach HMW and future fund returns: adjust the returns for risk (volatility) and try to explain alpha (proxy for effort)
Hedge funds report their returns to the database voluntarily: when a fund drops out of the database, we actually don’t know why.
=> Paper interprets this as a “walk-away by investors”

8. Interpretation of empirical results
Hedge funds compete for alpha: as more money flows into a strategy or anomaly, alphas will decrease and the high water mark (+hurdle rate) becomes more difficult to beat with same level of risk.
Is the required return to reach the HWM in the paper’s empirical analysis perhaps a proxy for excessive fund flows and over-crowding of a strategy?
Higher fund flows => lower future excess returns, higher risk taking, higher probability of dropping out?
Control for fund flows?