It’s that time of year. The time when all that politicking, manoeuvring and saving of face comes good…or bad. As Andrew Clavell at the Financial Crookery blog writes this week:
The phone rings, the foot soldier trots down to the honcho’s office, and, with a poker face worthy of Phil Ivey, hears about a dozen words and nods non-committally. A simple ceremony at the culmination of a year’s warfare.
But as bankers around the globe prepare themselves to receive “the number”, some look on in genuine despair, other inevitably through emerald eyes.
Raghuran Rajan, professor of finance at the Graduate School of Business at the University of Chicago, argues in the FT that compensation practises in the financial sector are deeply flawed - and probably contributed to the troubles in which we now find ourselves.
His argument is that managers of financial assets should be rewarded for the “value his abilities contribute to the investment process” - his alpha - rather than for bog-standard beta returns. But sources for alpha are rare, says Rajan, such as having truly special abilities in identifying undervalued assets; using activism to change the payout on an investment; or through the development of financial entrepreneurship or engineering.
Such abilities are rare. How then can untalented investment managers justify their pay? Unfortunately, all too often it is by creating fake alpha — appearing to create excess returns but in fact taking on hidden tail risks, which produce a steady positive return most of the time as compensation for a rare, very negative, return.
Those tail risks, in the case of the manager who bought AAA-rated tranches of CDOs or the management of Northern Rock, earned a premium in normal times for taking on beta risk that materialises only infrequently.
These premiums are not alpha, since they are wiped out when the risk materialises.
True alpha, says Rajan, can only be measured in the long term and with the benefit of hindsight.
Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.
So that deals with the investment management side. What now to do with the all those advisory types with a PhD in telling the client what they want to hear?
