Archive for December 5th, 2008
Hedge Funds, Panic, Sledges, Nedges and Executive Compensation
A Variety of Risk & Incentive Ideas All in One Post!
There is an article in The Wall Street Journal today entitled, Citadel’s Losses Add to Mr. Griffin’s Pain.
We’re rather indifferent to Mr. Griffin’s pain as we’re sure that he is to ours, but that’s not why we are writing.
We mention the article because it relates to earlier postings and provides an idea for executive compensation that we haven’t seen discussed before.
Markets, Crises, Nedges and Sledges. It’s often the case that relatively the good performers or safer investments suffer unjustifiably along with bad performers or losers in market downturns, crises, and panics. We italicized “unjustifiably” because we doubt that such a notion applies to market economics. However, such events can transpire for a number of reasons.
As we mentioned on Tuesday in Taking the Fun(ds) out of Hedge Funds, better performers may suffer – if there is such a notion in markets – when poorly incentivized investors sell those securities at small gains or small losses rather than recognize large losses on terrible performers.
Also, as Richard Bookstaber nicely describes in the excellent A Demon of Our Own Design there may be runs on high quality assets if market participants know that distressed sellers hold those assets. Mr. Bookstaber provides a few examples, including the run on Brazilian bonds during the Asian Crisis (in 1997), and Long-Term Capital Management’s (LTCM’s) massive problems due to the fact that it was publicly announced that Travelers was ending proprietary, fixed-income trading at Salomon Smith Barney in July, 1998.1
In addition, these market dynamics are why we often refer to hedges as nedges (near hedges) or sledges (somewhat like hedges). Pedge or predge for “probabilistic hedge” also captures this notion that things aren’t as secure, locked-down, and predictable as they might at times seem.
In stressed times, there are few proper – i.e., risk-free – hedges. Instead, it becomes quite possible to lose on both sides of trade. One of the main, exacerbating problems is the fact that during calm times, traders and analysts receive evidence that allows them to overestimate the validity or predictability of the interactions of the various parts. So, for those folks, “hedging” day-to-day profits and activities during calm times, especially in “cost-effective” ways, leaves them exposed to the rarer, but far more damaging large events.2
High-water Marks and Executive Compensation. The article on Citadel briefly mentions high-water marks that relate to asset values and compensation for fund managers. That means that if a (hedge) fund generates loses, it must recoup those losses before the fund manager can earn a performance bonus – usually 20% of gains.
We’d like to see corporations implement similar, equity-related compensation schemes for their senior managers and boards.
A quick search of the web turns up others offering the same recommendation, but our brief search identified no firms that have incorporated such a schedule into their executive compensation plans.
We could see where it would be difficult to show that such a policy is optimal in a mathematical agency model, but that’s due to computational constraints that force such models to be stark. The basic reason that such a policy would be suboptimal in a mathematical model is that there would likely be a wide range of preliminary outcomes where it would be difficult to motivate the person to continue to work, and given that, the initial risk premium would have to be large to ensure that the agent would participate.3
However, in real life, such a policy would seem very compelling and would likely be less demotivating to other employees, and that should be worth something. In fact, maybe even more than the direct effect on management, and that’s one of the benefits that would be difficult to formally model without a substantial loss of elegance or the elimination of solvability.
Now, perhaps we’re also drawn to the idea because we’ve seen any number of managements paid for substantial improvements in share prices that turn out to be nothing more than the right-side of an upward facing parabola. The same management team was also in place during the left-side decline, too. Of course, we’re willing to sarcastically admit that down times can’t be avoided as they’re always due to general economic conditions, whereas the upsides are solely due management’s actions and prowess. Yeah, we doubt that you’re buying it, either.
As always, we might update the post as we think about it a bit more.
Footnotes:
- It is absolutely shameful that Bookstaber’s book, published in 2007, has not received more attention during our continuing crises in late 2008. As usual, the folks who would benefit the most for it, are least likely to read it. Perhaps that’s why we have these problems and they repeat. ↩
- We wouldn’t doubt that despite the past year or so, there are still folks who would dismiss our criticism. They would fancy themselves as “scientists,” but won’t let data (empirical evidence) get in the way of their models. We have a half-finished, aged post on the topic that remains in our draft queue. ↩
- Of course, even that degree of speculation on our part, implicitly assumes a multitude of economic and mathematical assumptions. ↩
