Creating Fake Alpha

Monday, April 28, 2008 | 08:00 PM

Saturday's discussion about the UBS report, including the post on banker's compensation, led to some intriguing email from people who must remain nameless because of their professional affiliations.

Included amongst the feedback was the phrase "Creating Fake Alpha," which I had first read in John Cassidy's Portfolio column earlier this month, titled The Banker's Bailout:

"Then there is the central and controversial issue of how to pay people who work for financial firms. In blowup after blowup, compensation schemes based on short-term performance have encouraged traders, division heads, and C.E.O.’s to act recklessly.

In the typical case, a trader or executive places a bet that pays off immediately—or soon enough to increase the individual’s bonus or stock-options value—but exposes the firm to long-term dangers.

Examples include Merrill’s decision to step up its production of mortgage securities just as the outlook for the real estate market darkened and Bear’s refusal to keep an adequate reserve of cash on hand. Earlier this year, Raghuram Rajan, a former chief economist at the International Monetary Fund, referred to such behavior as “creating fake alpha—appearing to create excess returns but in fact taking on hidden risks.”

One possible solution to this is to "force traders and senior executives to take a more long-term view." And the way you accomplish that is simple: Pay the traders and risk managers in stock or options that don’t vest for five or 10 years.

Perhaps when we look back at this era from a future vantage point, we will see that this was the last great era of finance (see today's WSJ: Is Finance's Economic Role Ebbing?).

I wonder if the bankers and financial engineers responsible for creating the subprime meltdown and the credit crunch may have finally killed the goose that laid the golden eggs . . .   


What say ye?


UBS $37B Write Down, Part II: Compensation

Analyzing Bear Stearns' Bailout
John Cassidy
Portfolio, Apr 14 2008

Is Finance's Economic Role Ebbing?
Sector May Make Up Smaller Part of GDP as Jobs Are Being Cut
WSJ, April 28, 2008

Switching boats in midstream to ride out credit storm
John Dizard
FT, August 14 2007 03:00

Bankers’ pay is deeply flawed   
Raghuram Rajan
FT, January 8 2008 18:04

Monday, April 28, 2008 | 08:00 PM | Permalink | Comments (35) | TrackBack (1) add to | digg digg this! | technorati add to technorati | email email this post



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» Creating Fake Alpha from Adventure of Strategy
One of my favourite economist blogs, The Big Picture, has a post titled Creating Fake Alpha, that highlights once again a malady that western business just doesn't seem to be able to rid itself of. Namely, the inability to... [Read More]

Tracked on Apr 29, 2008 12:01:43 AM


To be held responsible for one's actions has become an arcane concept, especially in light of taking risks with other people's money. Wouldn't that fallacy create 'moral hazard' at the individual financial institution level?

Posted by: John R | Apr 28, 2008 8:24:53 PM

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