Dean P. Foster and H. Peyton Young
We show that it is very difficult to devise performance contracts that reward portfolio managers who generate excess returns while screening out managers who cannot generate such returns. Theoretical bounds are derived on the amount of fee manipulation that is possible under various performance contracts. We show that recent proposals to reform compensation practices, such as postponing bonuses and instituting clawback provisions, will not eliminate opportunities to game the system unless accompanied by transparency in managers’ positions and strategies. Indeed there exists no compensation mechanism that separates skilled from unskilled managers solely on the basis of their returns histories.
...MUCH MORE (49 page PDF)
HT: Marginal Revolution
See also the earlier discussion by the same authors on some of the topics in the above paper that we linked to via Knowledge@Wharton in 2008,
It's easy for an unscrupulous hedge fund manager to make himself look better than he is, as Foster and Young demonstrate in their paper. "We show, in particular, that managers can mimic exceptional performance records with high probability (and thereby earn large fees) without delivering exceptional performance."...
One of my personal favorites, "The optimal design of Ponzi schemes in finite economies" should have won either a Nobel prize or the more prestigious John Bates Clark Medal.
(just kidding Sveriges Riksbank and Swedish Royal Academy, you have a really nice prize)