Andrew Clavell at Financial Crookery posted a great piece collecting many bloggers thoughts (and adding his own) on Wall Street Compensation. He focuses on the question of whether Wall Street is paid based on actual alpha or some perversion of beta that is sold as alpha. He writes,
A significant reason why the brightest still clamour to sign up at these banks, and why investment bank traders desire to run hedge funds is precisely because their pay is a non-recourse strip of yearly call options on market beta and talent alpha. Come on, we all know this, surely. The unwritten rule is that this cliquet option can be abruptly terminated; then you are on your own.
While I think this is an excellent point, I think the factor behind compensation is simple in theory, but somewhat more complex to ponder. I believe Wall Street is one enormous Las Vegas, full of casinos and gamblers who get paid based on how much they can put the odds in their favor.
In The Way of the Turtle by Curtis Faith, he writes about how he made more money than anyone else in his class, using the same capital, the same rules, and following the same ten commodities because of one reason, he had an edge. His edge was his ability to follow the rules. He goes on to encourage the reader to discover the edge he or she has and learn to profit from it - drawing on the fact that a casino doesn't care if some high roller takes it for $2 million in craps in three nights in a row because they know they have an edge in simple odds and that high roller's success is simply drawdown.
To cite another, more obscure source, my high school history teacher told me once, "You have discovered early in life what most don't ever realize. You don't have to give 100% to be successful, you just have to do 1% more than the majority of people." It was a great complement and I took it to heart and believe it to be true. Essentially, trading and compensation is a zero sum game, where the majority of people are average and if you can gain an edge over most people, and recognize that edge, you will win out over time, taking money from the mediocre. Most people have some considerable edge in something, those who are (financially) successful recognize it and those who are not successful never realize it.
In our Wall Street Casino Model, it is important to first find out who is the house and who is the gambler. The sell side, for the most part, is the House, the casino, and market participants, or the buy side, is the gambling public. Historically, the sell side has had an enormous informational edge that has enabled them to take money from the buy side in general and make it the houses money. This led to another enormous edge - wealth itself. It is no secret that its much easier to make money if you have money. A casino with little capital could get bankrupted by a high roller going on a lucky streak, but one with plenty of capital will realize their edge. Along with wealth usually comes another edge - access to a network of other wealthy people. Investment Bankers and many brokers are compensated so highly because they realize that edge. Some blue-blood from Connecticut who may be dumb as a brick and lazy could easily be the highest compensated investment banker because he knows many wealthy people who own companies, have capital, and would make great clients for an Investment Bank.
Traders on the sell side have historically been compensated based on taking as little risk as possible in executing orders and distributing deals so that they profit from marketmaking, and manage the risks of the deals they have bought up. It is part sales and part risk management - hence "Sales and Trading". They are compensated based on Beta of their respective area. When Equity Bankers do well, Equity Traders do well, and so on. In their casino, they are essentially the dealers (hence "broker-dealers") and responsible for running the table games for the buy side without allowing for anyone to break the house and eliminating their edge.
The brokers have historically been the marketers for the casinos. They are paid based on the amount of people they can get in to play, what types of gamblers they get in, and how they can sway them to one game over another. They historically either people with a network of very wealthy people, and/or very persistent and savvy salespeople, who are able to convince a gambler with the odds stacked against them that they can win. Their edge derives nothing outperformance of investments, but underperformance may begin to erode away at their edge.
On the buy-side, money managers have been paid to try to gain an edge on the sell-side, as well as other managers. They mostly play an enormous game of poker against other buy side managers. In poker, the house has no edge, but just takes a rake. The investors in the fund pay managers because of the edge, or perceived edge the managers have - either their ability to outperform the individual investor or their ability to market themselves as better than the others. Think of the situation like the World Series of Poker. It is filled with a few different types of players. There are those who qualified based on winning multiple online tournaments and are usually superior players. There are those players who get bankrolled to play and get a share of the winnings and are also very good. And, there are those who can afford the $25,000 fee themselves and try to beat the other two types of players. The buy side is one big and ongoing poker match. All these players have an edge over the average poker player, but when competing against each other, their respective edges worsen and it becomes much more random - hence a full time sports agent winning. The buy side is paid based on skill or perceived skill in gaining an edge over other buy siders. In aggregate they have been historically overpaid - unless of course they get a collective edge over the house.
The advent of the internet and financial media as well as regulatory shifts has changed the landscape however, shifting the informational edge to the benefit of the buy-side. In turn, the sell side as a whole is no longer paid for it. You only have to look at sell-side research to see this. They were paid based on their perceived informational edge and manipulated by the investment banking. Once this edge is gone, they are not worth as much, since research is not really too exclusive. This has caused a shift towards capital and advice. Lending and financing has become a big business as has advising on deals, and or investments. As the internet spawned tons of discount brokerages who have an edge over the wirehouse brokers because they don't have to really pay brokers to bring in clients, nor research arms and bankers, and had very low overhead. They use the internet as the main marketing tool and provide cheaper, and arguably better, third party research. This along with the rise of ETF's has also hurt mutual fund money managers on the buy-side. Since investors are now privy to much more information, mutual fund managers no longer have the perceived edge of skill, scale, or access to information that they once did. In turn they have suffered. Those with actual skill have seen their compensation go down because they are in an industry saturated by people without skill - who are now being paid for something different. They instead flocked to more boutique managment firms and/or hedge funds - leaving lower paid, less skilled employees at the major fund families. Also, Big Investment Banks, facing a smaller retail market, are less able to underwrite deals and unable to exercise any informational and capital edge they may have.
This shift in informational advantage has caused the house to have a much smaller edge, where skilled gamblers can actually gain an edge over the house - like card counters in blackjack. It has in turn,caused the house to change which games it offers, focusing more on its access to capital, than its research and execution - focusing on Investment Banking, Private Equity, and most importantly dedicating itself to those clients who will buy up its deals - hedge funds. It has also caused them to employ gamblers themselves to go play at other casinos and try to gain an edge over other gamblers through their expansion of internal hedge funds and prop desks.
Let's look how this new reality has affected various areas:
Brokerage
Retail brokerage is focused much more on the higher net worth individual as they are now Wealth Managers and Financial Advisors and are paid based on their advice on a fee basis rather than commission. They are much more relationship driven rather than transaction driven. This is a service that is more readily utilized by the wealthier investor. This is why these days, retail brokers are getting paid less overall, but the big producers with all the relationships are paid very well because they have the clients the firm wants. Those that invest in hedge funds and money managers who in turn buy up their deals. This is also why there is a mad grab for assets with banks paying 2x 12 month trailing gross (very big premium) just to come over.
Investment Bankers
Investment Bankers are still paid well, but the business is different than it was before. It has become much more focused on M&A and PE rather than IPO's, as well as debt over equity offerings. They are forced to sell more to other companies and the institutional clients than to their retail clients. Hedge funds readily buy up deals most likely in exchange for influence with their research arm and information on upcoming deals. It, in turn, has become more of a retail business where they have the incentive to just do as many deals as possible without regard to risk. This has perpetuated an enormous premium for someone with a huge rolodex, which is the capital lifeblood of the business, as well for entry level overachievers who have an edge in the fact that they always do 110% and are willing to work 80 hours a week, to crank out the material the associates and partners need to win business. They are the labor. They get paid well for their edge, but are very easily replaceable - except for those with connections - they do however have an edge none the less, but on an hourly basis they are compensated not all that much more than someone who works two 40 hours/week middle office jobs for $40,000 a year.
Traders
Sell side traders are either paid based on the deal flow to the buy-side - mostly hedge funds. Mortgage Traders, Fixed Income, and Structured Products guys have gotten paid the best because thats where the Investment Bank has made their money. They are given an edge either for their sales prowess, or their ability to manage their risks. They are able to follow the rules, take risk, and remain calm - not easy to do. They have been paid relatively well as they are now responsible of maintaining or gaining any edge they have over the hedge funds, which are more successful gamblers than their mutual fund counterparts. Prop side traders are paid the most for this edge.
Hedge Funds
On the buy side, hedge funds are professional gamblers who always try to beat the house. They benefit from a few edges. They have the ability to go short and invest in markets that the rest of the gamblers can not. In the enormous poker game, they have the ability to see the river and the rest of the market only the flop and the turn. They also are out to outsmart the house, either by gaining an edge over traders or over bankers, but the most edge they have is over the public in the fact that their positions are not transparent. They are basically playing a game of poker where they can see everyone else's cards, but on one can see theirs. They are paid a great deal of money for this edge - hence why they are compensated so well. They are also enormous sources of capital. Whereas the mutual funds used to basically transfer money from the buy-side to the sell-side, buy simply buying what the sell side was selling (ie playing in the casino), they are becoming the casino in some cases. They are basically doing the equivalent of setting up their own poker game, playing at the table with other people and still taking a rake. This increasingly gives them an edge over the house, because they can be both at the same time. This is why sell side banks have stepped into prop trading and investment banking - the only trouble is they have to report their earnings. They have many edges over the house and are paid considerably for these edges - although the entrance of many other funds has hurt their collective edge
On the whole, in the global casino, the odds have turned from the house to the gambler, enabling those who can actually gain an edge (achieve alpha) to get compensated very well, and those who can not to gravitate towards mediocrity. I think the current problem with the financials and the exodus from the sell-side to the buy-side the past few years shows how this shift in "edge" has caused a change in compensation and migration of talent. A money manager in a mutual fund that has lagged the S&P 500 in this day and age doesn't get paid based on his perceived ability to beat a benchmark, but the preference someone has over letting him go to the casino rather than going himself. This has caused closet indexing as mutual funds becomes a business that is compensated on something different. Those who have an actual edge in the casino have gone to the buy side instead. These types of shifts have occurred throughout Wall Street. Someone who complains that they are underpaid just doesn't understand what they are being paid for and what their role is in the casino. In the Wall Street is not the smartest or the hardest working that gets paid the most, but the person who can turn the odds the most in his employers favor - whether employed by the house or a gambler.
Great Post. I would also suggest readers to be careful and think carefully before taking on any additional credit and if consolidating, remember not to run up those store and credit cards again.
A secured loan did help me get back on my feet but I am overpaying each month so I don’t pay as much interest in the long term. Also means I will be debt free sooner!
Posted by: Homeowner Loans | January 22, 2008 at 05:24 AM
I am trying to get back on my feet and I was wondering whether investing in penny stock to get started would be wise decision. What do you think?
Posted by: Stock Investor | September 19, 2009 at 08:29 AM