Banker's pay is deeply flawed (Financial Times) aka how to disguise beta as alpha.
In reality, there are only a few sources of alpha for investment managers. One of them comes from having truly special abilities in identifying undervalued financial assets. Warren Buffett, the US billionaire investor, certainly has it, yet this special ability is, by definition, rare.
A second source of alpha is from what one might call activism. This means using financial resources to create, or obtain control over, real assets and to use that control to change the payout obtained on the financial investment. A venture capitalist who transforms an inventor, a garage and an idea into a fully fledged, profitable and professionally managed corporation creates alpha.
A third source of alpha is financial entrepreneurship or engineering â€“ creating securities or cash flow streams that appeal to particular investors or tastes. As long as the investment manager does not create securities that exploit investor weaknesses or ignorance (and there is unfortunately too much of that), this sort of alpha is also beneficial, but it requires constant innovation.
Alpha is quite hard to generate since most ways of doing so depend on the investment manager possessing unique abilities â€“ to pick stocks, identify weaknesses in management and remedy them, or undertake financial innovation. Such abilities are rare. How then can untalented investment managers justify their pay? Unfortunately, all too often it is by creating fake alpha â€“ appearing to create excess returns but in fact taking on hidden tail risks, which produce a steady positive return most of the time as compensation for a rare, very negative, return.
What Does Goldman Know That We Don't? (Bloomberg) Michael Lewis on Goldman's big counterbet on subprime
Should banks take back their bonuses? (Dealbook)
Surging hotel prices worldwide (NY Times)