Beta Managers, Alpha Salaries

Most American investors figure that the gigantic salaries paid to top executives at the Wall Street megacompanies are justified. It's another facet of the American dream: To make it big, and make a big paycheck.

True, the man in the street suspects that paychecks of that magnitude are completely insane. But when viewed against corporate profits and the value the managers create for investors, one understands that a good CEO is worth every cent. Israeli investors also seem to have bought into that theory in recent years. If it works for America, why not here?

But last week that bastion of conservative capitalism, The Wall Street Journal, ran on its front page the headline: "Lost decade for U.S. stocks". In layman's terms, that means that the 500 biggest companies on Wall Street generated average nominal returns of 1.3% a year during the last 10 years. Deduct inflation and you realize that actually, you lost money on them. Compare that result with risk-free investment in low-yielding bonds and you realize that investors lost 4% to 5% a year. Now factor in the risk and you realize that investors actually lost 6% to 7% of their money each year.

The Wall Street Journal was purely technical in its analysis. You can do it too: Go online and extract long-term charts of indexes, or specific stocks. It's just that the U.S. financial press tends not to take the long-term view. That doesn't sell papers. Readers like articles about stock-market opportunities, about superstar executives, and mainly that in the long run stocks will generate fantastic returns. How fantastic? Enough to justify the salaries of the superstar executives. Get it?

But American sentiment about these fat-cat salaries seems to be changing. In March, Congress ordered some investment bankers to attend a special hearing on their pay. The bankers in question had been ousted from the likes of Merrill Lynch and Citigroup, which had lost tens of billions of dollars from bad investments in sophisticated financial instruments, such as ones based on subprime loans.

American and Israeli executives who treat themselves to gargantuan salaries should take a virtual mosey over to the Congress Web site and read the investment bankers' testimony. It might come in handy one day. We for one read the views of Citi's ex-chairman Charles Prince, who took home $40 million last year. He told Congress about his background, progress, the tremendous management ideas he brought to his company and about Citi's generosity to society under his rule, helping the unfortunate up and down the land. What he doesn't mention is his pay, the mechanism governing bonuses and options, his golden parachute, how his pay package was approved, the company's performance or that of its stock.

Prince had good reason. Citi's stock has gone back 10 years, dropping 60% in the last year. The bank's losses in 2007 and perhaps in the first half of 2008 as well wipe out much of a decade of profit, based on which Prince and the other royals received hundreds of millions of dollars in pay and bonuses.

What did he have to say to Congress? Beyond "it's the American way" and that's the price he commanded in the "executives market" and that most remuneration mechanisms are adjusted to short-term measurements - nothing.

A large part of executive pay in the U.S. is based on stock options, which is ostensibly a great way to link pay to long-term performance and create common interests between the executive and shareholders. That's in theory. In reality, stock options can turn bad managers into very rich bad managers if the stock market is bullish. They get to sell their options at a profit even if the company is doing dismally.

Secondly, when the share price falls far below the stock-option exercise price, most boards simply change the exercise price to the new low share price. That neuters the whole concept of reward and punishment.

Some managers take matters a step further by timing stock-option votes on the board of directors for the moment they announce something terrible, some crisis at the company. The share price tanks and they make money. (Of course, there are also the backdaters, who forge a date on a stock-option scheme to match a day the share price was particularly low.)

Cash bonuses, which seemingly link performance to pay more directly, can also result in inflated pay. What happens if after a bad year the company writes off profits of the previous year? Do the managers return bonuses for that year? They do not.

Do investors really understand that if a share price retreats 10 years while management helped itself to hundreds of millions of dollars during those 10 years - that is shareholder money that wound up in executive pockets?

They certainly do understand it. The problem is that many professional investors aren't investing their own money. In the same way the executives are managing somebody else's company, they're managing somebody else's money. Stock markets are not controlled by the little man, but by the big boys, the institutional investors, managing somebody else's money and charging management fees whether the market is taking off or tanking. Put otherwise, they take your money whether they've given you value or none at all.

Insiders refer to market returns as the market's "beta". Surplus returns over the market - meaning, your investment manager made better returns than passive investment in the benchmark index would have. It's called the market's "alpha". The problem is the plethora of managers who supply zero alpha yet charge management fees through the nose. No wonder the institutional managers don't hound executives to curtail their pay: They don't demand it of themselves. If pay and performance have become so dissociated, what does that say about the competitive market model? That it's bad.

But no better one has been found. Remember the alternative, that the government mediates between savings and investment rather than the market: The government would raise the money, allocate it and manage it. That is, you give your savings to the government and politicians and bureaucrats decide what to do with it. By nature, much of your money will wind up in the pockets of government darlings and some will be placed in bad investments that nobody vetted. Some will be used to finance bloated public mechanisms.

The government as solution isn't only 10 times worse than the free-market solution: It isn't possible in the era of the global economy. The question is what regulation (read, government intervention) could be instituted to improve market mechanisms. Possibly Israel's regulator will find solutions, but so far, none have been found in any place touched by the American model. At this stage, there is only one thing we can ask of all those alpha-paid managers supplying beta results: Stop selling stories about how you're worth every cent.