Creating Fake Alpha
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 balance the need for short term rewards required to attract and retain talent, with managing the risks that rewarding short term profits at the expense of long term performance entails. A quote (of a quote, as it happens, but rather click through The Big Picture to get to it) :
"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.”
Anything new here? Of course not. If you'd like to see how many times this particular bit of history has repeated itself, read Alex Berenson and Mark Cuban's 2004 book The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America, which was about Enron and WorldCom (and before.) The tune changes but the song remains the same. If people are paid for short term results rather than long term performance, then human nature being what it is, at least some of them will "create fake alpha" to pad their pockets, at the expense of the firm's risk profile.
I wonder what the next cataclysmic corporate disaster to bring this issue to the fore again will be .....