The most recent issue of the Quarterly Journal of Economics has an interesting article by Dean Foster and Peyton Young on the gaming of compensation schemes by portfolio managers. They demonstrate that any compensation scheme based exclusively on performance, without conditioning on any information about the actual underlying investment strategy, can be gamed. It’s not enough to reward performance alone. What’s necessary is transparency in managers’ positions and strategies. Then it’s possible to structure a viable compensation contract.
In an earlier post we emphasized that good governance of risk managers at non-financial companies requires making distinctions between types of strategies. The Foster/Young results, while developed for investment managers, have relevance for corporate risk managers, too. Only by scrutinizing risk managers’ positions and strategies can the company incentivize the right kind of hedging.