Much noise has been made recently about “fixing” the incentive structures that predominate in our financial markets. Never fear, there has been a lone voice of sanity crying in the wilderness, defending the way things have evolved in the markets, and to my mind, the way things probably have to be. I wish to stand with him and the doers, against the white-coated theorizers and commentators, and their vicious personal attacks on his friend in blogging, The Epicurean Dealmaker, stock symbol TED (who actually made the personal attacks first, but never mind, he’s a blogger). Having marshalled my thoughts, I do so here.
What are the carpers saying? Firstly that pay incentives are skewed to the short term, incentivising “traders” to take risky bets which look much less smart further out in time, like, say, CDOs. This is Martin Wolf’s major point, and I have some sympathy with it. Secondly, that traders should be paid for what they produce, not what the market makes you; they should be paid only for their “alpha-generation”. Instead a lot of investment returns are based on taking higher beta bets in rising markets. This is “fake alpha”. At some point those beta strategies — again, like leveraged CDO investing – will fail, and fail big, when the market drops. This is Professor Rajan’s substantial point, and is the one I have most trouble with. Both Wolf and Rajan suggest changes to compensation structures in financial markets: a realignment of incentives in favour of sustainable non-fake alpha-generation, compensation based on longer time periods (Wolf suggests a 12 years’ horizon) and “clawback” of escrowed compensation when things go wrong.
I have 3 problems with this:
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Traders find it very hard to distinguish between beta and alpha when they are trying to make money
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the concept of beta may even be unhelpful, a historical standard deviation-based measure with little predictive ability. This undermines the legitimacy of alpha
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we don’t really know what is beta and alpha in investment returns, and how much is plain luck. Luck should be compensated if it persists
One quick point needs to be made before we hit the jump. Martin Wolf said in one response to TED
“Academic” is often used as a term of abuse. But pretty well all the fundamental ideas in modern monetary and financial economics were invented by academics.
Not in my field, they haven’t. Pure academics in portfolio theory brought us the flawed Black Scholes Merton option pricing model, LTCM, and all the useless bits of the Capital Asset Pricing Model. Everything useful in portfolio theory has come from academic practitioners, people like Benjamin Graham and Philip Fisher, who took on risk and got their hands dirty in the market. Can anyone think of exceptions? And no, enforcing economic orthodoxy at the IMF for a bit doesn’t count as proper work. Continue reading
