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!