Bankers pay is deeply flawed

The typical manager of financial assets generates returns based on the systematic risk he takes – the so-called beta risk – and the value his abilities contribute to the investment process – his so-called alpha. Shareholders in asset management firms, such as commercial banks, investment banks and private equity or insurance companies are unlikely to pay the manager much for returns from beta risk. What the shareholder will really pay for is if the manager beats the S&P 500 index regularly, that is, generates excess returns while not taking more risks. Hence they will pay for 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. 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 third source of alpha is financial entrepreneurship or engineering – creating securities or cash flow streams that appeal to particular investors or tastes.

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