How to stop the bogus bonus

26th November, 2011

Successful oversight is going to require more transparency about what trades are being made. But transparency is a scarce commodity

It used to be so easy to “earn” a performance bonus in financial services. Step one: agree a contract whereby you are paid if you exceed a modest benchmark with the funds you are managing. Step two: borrow money and invest it in risky assets. Step three: profit! Step three does not follow automatically, of course, if the risky asset does not pay off. But from the point of view of the fund manager and his bonus, it’s a case of “heads I win, tails the investor loses”.

It’s fairly trivial to show that such bonus schemes, if implemented naively, offer disproportionately larger bonuses for ever larger risks. We might hope that investors are too sophisticated to fall for such obvious tricks. Yet Dean Foster, a statistician at the University of Pennsylvania, and Peyton Young, of Oxford University and the Brookings Institution, were warning in the early days of the financial crisis that fund managers could hide risks in far more sophisticated ways.

The problem is, as Foster and Young show, that it is possible for an unskilled fund manager to mimic a genuinely skilled one, in the same way that an insect might mimic a leaf, or a harmless creature mimic a poisonous one.

This mimicry, too, involves three steps: first, invest all your funds in whatever benchmark you need to beat, whether it’s treasury bills or a stock market index; second, make a bet that some unlikely event will not come to pass using the invested funds as security; finally, boast of benchmark beating returns, because you’ve delivered the benchmark plus the additional money from winning the bet. Collect your performance fee. (In the unlikely event that you lost the bet and with it all your investors’ cash, simply cough awkwardly and look at your shoes.)

Rather disturbingly, Foster and Young have proved that if investors can only examine your investment returns and know nothing about your investment strategy, as a fund manager you can always make your numbers look good by taking on small risks of very bad outcomes.

These are the “black swans” made famous by Nassim Taleb: low probability, high-impact events, except that these particular swans are genetically engineered – deliberately manufactured and then hidden away, to escape at unwelcome moments.

The solution seems obvious: pay performance bonuses with a lag, perhaps in company stock, or allow “clawback” – in effect, a financial penalty rather than a bonus – if those pesky black swans do appear. But in a recent presentation, Peyton Young explained that none of these approaches really do much to help. It’s true that deferred bonuses can help evaluate performance itself over a long term, but the mimic strategies will remain available. The mimic can, for example, make a huge bet and then simply go quiet if the bet pays off, making safe, neutral investments until the bonus comes due.

Regulators, investors and senior management simply cannot judge traders and fund managers on the basis of their performance alone, no matter how good it looks – the black swans can always be bred and hidden.

Successful oversight is going to require more transparency about what trades are actually being made. And in many parts of the financial services industry, transparency is a scarce commodity.

Kweku Adoboli, the former UBS employee charged with fraud and false accounting, worked on a “Delta One” desk – and the whole point of Delta One trading is to replicate a certain pattern of returns through trading strategies that need not be disclosed.

The folly of “rewarding A while hoping for B” is – thanks to a famous article by Steven Kerr – now well known. But what about “rewarding A” without realising that in fact you are being given “C” in disguise?

Payment by results is an attractive idea, but in a world where black swans can be deliberately manufactured, results can be treacherous.

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