Christmas is here! Yes, it’s that time of year when we hedge fund managers reflect on the themes of charity, compassion, and, most important of all, free loot.
I look around the desks at Sopwith and I see men and women who can easily afford to buy anything they could reasonably desire. Yet every single one of them would rather receive a trinket worth a hundred bucks, no matter how useless a piece of junk it is, provided it’s free, than pay a hundred bucks out of their own pockets for something of actual utility. It’s a very curious phenomenon.
Mind you, there is no phenomenon so obscure, no tendency in human nature so venial, that our modern scientific society won’t take advantage of it. And by ‘modern scientific society’ I refer, of course, to our friends the investment banks.
That’s why at this time of year the offices of Sopwith Asset Management are flooded with greetings cards blazoned with messages of holiday cheer, peace on earth and goodwill to our fellow souls. And nestled underneath these cards are gift baskets packed with tons and tons of free loot.
My broker in Chicago fancies himself an amateur sommelier; he invariably sends me a case of fine wine. My salesman in London says he has an inside line at the distillery; he dispatches a bot or two of aged scotch. My man in Tokyo sends sake and the most exquisite floral displays. As for the New York crowd, they (true to form) outdo each other in sending me all of the above, and chocolates, and cigars, and caviar, and whatever else catches their eye.
It’s a profusion of presents, a glut of gifts, an oversupply of offerings. And to what purpose? Well, each of these bankers fondly imagines that come the New Year, when the time arrives for me to place my first trades of the season, I will remember their contribution with favor, and trade with them instead of with their hated rivals.
Note the economic calculations here. Even the most lavish of gift baskets won’t cost anywhere near as much as the commission from just one chunky trade. What’s more, trading commissions go directly into banker compensation; costs, on the other hand, are rarely subtracted directly from banker salaries. (The same logic, inverted, applies on our side of the equation: I pay broker commissions using my investors’ money, but get to drink the scotch myself).
Of course, the entire exercise is counterproductive, simply because everybody does it. If everybody sends a gift, then nobody stands out. So I end up trading with whoever offers me the best trade terms, expensive gifts be damned.
And the bankers know this. But they’re in a bind. If they, heaven forbid, choose not to bribe me any given Christmas, then they will stand out from the crowd, and I may choose to punish them by not trading with them. They can’t risk that, and so we settle into a happy (albeit unhealthy) equilibrium.
In any case I view the gift baskets as a sideshow. Because I never lose sight of what’s important – our real Christmas presents, and the ultimate in free loot: our annual bonuses. Merry Christmas, everyone!
Tuesday, December 29, 2009
Monday, December 14, 2009
The Risk Manager
I mentioned our risk manager in passing the other day. This wondrous individual deserves an entire post to himself; here goes.
Once upon a time, Sopwith did not have a full-time risk manager. I don’t know how the CEO managed to get away with this – presumably our initial investors were so taken in by our glamor that the idea that we could actually lose money never occurred to them – but it was never going to last. I still remember the day that the big boss walked up to my buddy Tim (our head of analytics) and asked him to be the risk manager.
Tim, being a smart guy, refused.
I, being a mere junior analyst at the time, was aghast.
Me: Tim, how could you refuse? Risk manager is an MD level job – that’s a major promotion!
Tim: Don’t kid yourself, sonny. Who makes the profits in this firm? The traders, that’s who. And who’s blamed for losses? The risk manager, that’s who. Even you should be able to figure out the power dynamics here. This ain’t no promotion, it’s a death sentence.
Me: But don’t you have the authority to cut trader positions? Surely that gives you power over them?
Tim: Yeah, but why would I ever cut anyone’s position?
Me: Errm, because it’s too risky?
Tim: Look. Where does my paycheck come from? From the profits that our trading team makes. What incentive do I have to limit these profits?
Me: But what if a trade goes sour and the fund goes bust? Wouldn’t you be out of a job?
Tim: Well, if I veto a bunch of trades and we just sit on our hands for a month or two, our investors will get impatient and pull their money, and I’ll be out of a job anyway.
Me: But surely investors should be smarter and more patient and more long term in their thinking?
Tim didn’t even bother replying to this, he just laughed derisively.
Me: Okay, never mind the investors. But couldn’t management do something to fix the incentives? Like maybe making your paycheck independent of the traders’ profits?
Tim: If they do that I’m quitting tomorrow. I didn’t join this business for charity, kiddo, I’m in it for the bonus pool.
Me: What a bizarre situation. But surely this is not a problem unique to us. How do other hedge funds solve it?
Tim: Well, most other hedge funds insist that their traders invest their own money in the fund, so that they’ll be less likely to take wild gambles. But can you see the big guy [our CEO] doing that?
Me: No, I guess not. He’s too smart and too rich to fall for that.
Tim: Precisely.
Me: So what are you going to do? What’s Sopwith going to do?
Tim: I dunno. Not my problem, kiddo.
It was a poser all right. But I should have had more faith in our senior staff. Not for the first time, they came up with a solution to the problem of risk management that was utterly original, and just a wee bit insane.
If incentives were a problem, they reasoned, then why not hire a risk manager who would be immune to these incentives? By happy coincidence, our CEO knew just the man: a professor of finance who was independently wealthy, a figure of immense culture and sophistication, who could be guaranteed not to kowtow to the traders for a few measly millions in bonus money.
Professor Fortescue was as impressive as heck. He had a first-class academic pedigree, with multiple Ivy League degrees and a tenured chair at a top university. His research in finance theory had yielded several seminal papers, and various bulge bracket investment banks and blue chip hedge funds paid him hefty consulting fees to sit on their boards.
But all of that was irrelevant. All that we cared about was the fact that he was rich. Not fabulously so, but rich enough to not really care about his annual bonus. It looked like our incentive problem was solved.
Unfortunately, it was solved a little too well. Professor Fortescue was so immune to the lure of money that he felt no particular obligation to work for it. He accepted the job at Sopwith out of loyalty to our CEO, but his heart was never in it. He would wander into the office at noon, read a couple of papers, shoot the breeze with various colleagues, then head out again no later than 3 pm. A good life; if I hadn’t already had my heart set on being a trader, Professor Fortescue would have been my idol.
Oh, and the crowning irony? Our investors were beside themselves with excitement at the thought that this famous academic would be risk-managing our fund. If only they knew!
Once upon a time, Sopwith did not have a full-time risk manager. I don’t know how the CEO managed to get away with this – presumably our initial investors were so taken in by our glamor that the idea that we could actually lose money never occurred to them – but it was never going to last. I still remember the day that the big boss walked up to my buddy Tim (our head of analytics) and asked him to be the risk manager.
Tim, being a smart guy, refused.
I, being a mere junior analyst at the time, was aghast.
Me: Tim, how could you refuse? Risk manager is an MD level job – that’s a major promotion!
Tim: Don’t kid yourself, sonny. Who makes the profits in this firm? The traders, that’s who. And who’s blamed for losses? The risk manager, that’s who. Even you should be able to figure out the power dynamics here. This ain’t no promotion, it’s a death sentence.
Me: But don’t you have the authority to cut trader positions? Surely that gives you power over them?
Tim: Yeah, but why would I ever cut anyone’s position?
Me: Errm, because it’s too risky?
Tim: Look. Where does my paycheck come from? From the profits that our trading team makes. What incentive do I have to limit these profits?
Me: But what if a trade goes sour and the fund goes bust? Wouldn’t you be out of a job?
Tim: Well, if I veto a bunch of trades and we just sit on our hands for a month or two, our investors will get impatient and pull their money, and I’ll be out of a job anyway.
Me: But surely investors should be smarter and more patient and more long term in their thinking?
Tim didn’t even bother replying to this, he just laughed derisively.
Me: Okay, never mind the investors. But couldn’t management do something to fix the incentives? Like maybe making your paycheck independent of the traders’ profits?
Tim: If they do that I’m quitting tomorrow. I didn’t join this business for charity, kiddo, I’m in it for the bonus pool.
Me: What a bizarre situation. But surely this is not a problem unique to us. How do other hedge funds solve it?
Tim: Well, most other hedge funds insist that their traders invest their own money in the fund, so that they’ll be less likely to take wild gambles. But can you see the big guy [our CEO] doing that?
Me: No, I guess not. He’s too smart and too rich to fall for that.
Tim: Precisely.
Me: So what are you going to do? What’s Sopwith going to do?
Tim: I dunno. Not my problem, kiddo.
It was a poser all right. But I should have had more faith in our senior staff. Not for the first time, they came up with a solution to the problem of risk management that was utterly original, and just a wee bit insane.
If incentives were a problem, they reasoned, then why not hire a risk manager who would be immune to these incentives? By happy coincidence, our CEO knew just the man: a professor of finance who was independently wealthy, a figure of immense culture and sophistication, who could be guaranteed not to kowtow to the traders for a few measly millions in bonus money.
Professor Fortescue was as impressive as heck. He had a first-class academic pedigree, with multiple Ivy League degrees and a tenured chair at a top university. His research in finance theory had yielded several seminal papers, and various bulge bracket investment banks and blue chip hedge funds paid him hefty consulting fees to sit on their boards.
But all of that was irrelevant. All that we cared about was the fact that he was rich. Not fabulously so, but rich enough to not really care about his annual bonus. It looked like our incentive problem was solved.
Unfortunately, it was solved a little too well. Professor Fortescue was so immune to the lure of money that he felt no particular obligation to work for it. He accepted the job at Sopwith out of loyalty to our CEO, but his heart was never in it. He would wander into the office at noon, read a couple of papers, shoot the breeze with various colleagues, then head out again no later than 3 pm. A good life; if I hadn’t already had my heart set on being a trader, Professor Fortescue would have been my idol.
Oh, and the crowning irony? Our investors were beside themselves with excitement at the thought that this famous academic would be risk-managing our fund. If only they knew!
Tuesday, December 8, 2009
Power Corrupts
They say that power corrupts, and that absolute power corrupts absolutely. Nowhere have I seen the truth of this maxim confirmed so utterly as in the saga (ongoing) of Jimmy the Kid.
Jimmy used to be such a nice young boy. Friendly, willing, open, and keen; hardworking and honest; your typical freshly-scrubbed graduate. True, he was not overly blessed with intelligence, but let’s face it, intelligence is a highly overrated commodity. It’s certainly no prerequisite for success, and left to his own devices, Jimmy would have been successful. He would have settled into a career of undistinguished but happy mediocrity at some middling investment bank, with all the trappings: wife, kids, two cars, a cat and a dog. Membership at the country club and vacations in Europe.
But he was promoted before his time, and that was his ruin.
It’s no secret that the finance industry is in a bubble. All around Wall Street there are 20-some year olds with no qualifications beyond bespoke suits and limitless self-confidence, raking in the big bucks. The flow of easy money means that anyone who is not actually comatose is guaranteed a multi-million dollar pay check; you just have to be in the game and success is assured. Never before have so many Ferraris been bought by so many people for so little work.
A few of these prodigies recognize that they’re just lucky to be in the right place at the right time, and they live their lives accordingly. But the vast majority are not so introspective. Most Wall Street employees feel divinely entitled to the richesse that accrues to them; it’s only what they deserve, after all.
Jimmy is at the extreme end of this spectrum. He considers his early promotion to be incontrovertible proof of his exceptional talent. And since he must have been doing something right to get promoted, he sees no need to change. To his incompetence he has added arrogance, stubbornness, and an utter lack of self-awareness.
Yes, the experiment of promoting Jimmy the Kid to management has exceeded my wildest expectations.
Jimmy used to be such a nice young boy. Friendly, willing, open, and keen; hardworking and honest; your typical freshly-scrubbed graduate. True, he was not overly blessed with intelligence, but let’s face it, intelligence is a highly overrated commodity. It’s certainly no prerequisite for success, and left to his own devices, Jimmy would have been successful. He would have settled into a career of undistinguished but happy mediocrity at some middling investment bank, with all the trappings: wife, kids, two cars, a cat and a dog. Membership at the country club and vacations in Europe.
But he was promoted before his time, and that was his ruin.
It’s no secret that the finance industry is in a bubble. All around Wall Street there are 20-some year olds with no qualifications beyond bespoke suits and limitless self-confidence, raking in the big bucks. The flow of easy money means that anyone who is not actually comatose is guaranteed a multi-million dollar pay check; you just have to be in the game and success is assured. Never before have so many Ferraris been bought by so many people for so little work.
A few of these prodigies recognize that they’re just lucky to be in the right place at the right time, and they live their lives accordingly. But the vast majority are not so introspective. Most Wall Street employees feel divinely entitled to the richesse that accrues to them; it’s only what they deserve, after all.
Jimmy is at the extreme end of this spectrum. He considers his early promotion to be incontrovertible proof of his exceptional talent. And since he must have been doing something right to get promoted, he sees no need to change. To his incompetence he has added arrogance, stubbornness, and an utter lack of self-awareness.
Yes, the experiment of promoting Jimmy the Kid to management has exceeded my wildest expectations.
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