It used to be so easy to “earn” a performance bonus in financial services. Step one: agree a contract whereby you are paid if you exceed a modest benchmark with the funds you are managing. Step two: borrow money and invest it in risky assets. Step three: profit! Step three does not follow automatically, of course, if the risky asset does not pay off. But from the point of view of the fund manager and his bonus, it’s a case of “heads I win, tails the investor loses”.
It’s fairly trivial to show that such bonus schemes, if implemented naively, offer disproportionately larger bonuses for ever larger risks. We might hope that investors are too sophisticated to fall for such obvious tricks. Yet Dean Foster, a statistician at the University of Pennsylvania, and Peyton Young, of Oxford University and the Brookings Institution, were warning in the early days of the financial crisis that fund managers could hide risks in far more sophisticated ways.
The problem is, as Foster and Young show, that it is possible for an unskilled fund manager to mimic a genuinely skilled one, in the same way that an insect might mimic a leaf, or a harmless creature mimic a poisonous one.