Judging VC Skill: The Hardest Open Problem in Finance?

Byrne Hobart
12 min readFeb 18, 2020

One life skill working in finance teaches people is how to act disappointed, even insulted, at being offered an absurd amount of money for one year’s work. Every bonus season, analysts throughout the industry psych themselves up to be performatively bummed that The Number wasn’t even higher. This is not just about greed; it’s also a cultural performance that gives you camaraderie and job security. “If you’re not fighting me over thousands of dollars,” you boss might wonder, “are you really going to fight for me over millions?”

A negotiation like that doesn’t just happen because two people are fighting over a finite bonus pool. It also happens because nobody really knows what they’re worth. And this is in an industry where your only job is to make as much money you can without violating certain constraints (those constraints vary from hard rules like “Don’t break the law” or “Don’t violate your risk limits” to softer constraints like “If our firm’s founder gave a talk at Davos about the importance of beating climate change, don’t make us file a 13-F with a bunch of oil stocks.”)

In theory, it should be easy to figure out what to pay a portfolio manager: give them some capital, give them limits on how they can trade it, and pay them a percentage of what they make compared to some benchmark. Very simple. The benchmark represents beta, and everything not explained by the benchmark is alpha. But “give them capital and pay them a percentage” is an interesting construction. To the PM, it means their compensation is a call option. If your book is $100m and you’re paid 10% of your profits, you basically own a call option on the performance of a $10m portfolio. And everybody knows that you can raise the value of an option by raising either the expected value of the underlying asset or the volatility.

If you hire someone and one of their KPIs is “Surprise me!” then expect to be surprised.

Finance is full of arms races, and one of the fun ones is between a) compensation schemes, and b) clever ways to game these schemes. A smart PM who didn’t want to work too hard might realize that there are some well-known quantitative signals, like momentum and carry, that can be implemented pretty easily and that lead to decent long-term results. Or a PM might engage in factor timing. Whether you’re making the bet directly (as a quant) or indirectly (due to your personality type), if you were systematically betting on momentum and betting against…

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Byrne Hobart

I write about technology (more logos than techne) and economics. Newsletter: https://diff.substack.com/