KEY POINTS:
At first glance one might think that a Centre for Capital Market Dysfunctionality has something to do with secret men's business. Fortunately that is not the case.
It is in fact a new investment research centre combining the talent and financial resources of one of the world's most
insightful fund managers with the business school of Imperial College, one of England's most prestigious universities.
Late last year Dr Paul Woolley, a finance professor and founder of fund manager Grantham Mayo Van Otterloo (GMO) Europe, donated £4 million ($10.8 million) to London University Imperial College to create the Centre for Capital Management Dysfunctionality.
The centre will look at how the workings of financial markets can cause less than optimal outcomes from the point of view of society in general.
While the corporate finance literature has looked at how problems arise when shareholders delegate decisions to boards of directors, there has been remarkably little research on the problems that arise when investors delegate decisions to asset managers.
For example, it is commonly assumed that comparing fund managers' performance with a stockmarket index generates herding by asset managers whereby many base their weightings in a stock on its relative size rather than their view of its attractiveness.
While this reduces a fund manager's risk of getting fired for performing badly, this behaviour also has important implications for asset price volatility and the efficiency of the wider economy.
Woolley asks how much do we really understand the behaviour that is induced and the costs it imposes? For example, back in 1999 everybody loved telecom stocks, enabling the European phone companies to raise huge amounts of capital from which they are now earning virtually no return.
Vodafone hit a high of £3.27 in 1999 to reach a weighting in the UK share index of 14.7 per cent and no one sold because it was going up. Eight years later it is trading around £1.50.
Directors can interpret a strong stock price as a consensus among shareholders that they are doing the right thing. Trouble is, blindly buying the index is not thinking, it is just following the herd.
At the inaugural conference of the centre at Imperial College in London last month, there were several presentations potentially of interest to retail investors.
One of these, Understanding Momentum, was a joint effort by the managing director of stockbrokerUBS and a professor of economics at Imperial College.
Momentum in a sharemarket context is the tendency for a share which has risen in value to keep on rising and, conversely, for a share which has fallen in value to keep on falling. The strategy of a momentum investor is thus to buy things which are rising in price and sell things which are falling.
No surprises then that momentum investing is one of the simplest trading techniques but, against the odds, this medium-term pricing anomaly does exist and hedge funds apparently make money from exploiting it.
The Understanding Momentum paper reported that there was no agreement among academics or investors why momentum investing works, only that momentum is most significant for a three to 12-month period. So momentum works but, Woolley asks, at what cost to society?
The stockmarket is supposed to allocate resources to the companies that can make the best use of it, not simply buy whatever's going up.
Momentum is in many ways the antithesis of value investing.
Value investors buy shares which look cheap, which means hunting for undervalued shares that are friendless and thus likely to have been trending downwards - the very stocks that a momentum investor might be selling.
Value investors like Woolley's GMO famously steered largely clear of technology shares in 1999-2000 just as the momentum investors were piling into them. As technology shares soared this gave rise to serious short-term underperformance and the firm lost 40 per cent of its mainly institutional business.
The outcome would have been more serious if the firm had not had a long-term practice of supplementing its predominant value style with a risk-reducing component of momentum strategy. Eventually the technology bubble collapsed, GMO was proved right and the clients returned.
Among other issues the centre will look at in the future is the impact of the cost structure of the asset management industry. Woolley says equity markets deliver a real return of around 5-6 per cent a year over time. The competition to gain incremental return over the index return is costing institutional investors around 1 to 1.5 percentage points a year on asset management plus trading costs. Private investor charges are twice this.
Fees on this latter scale bring equity returns back to a similar level as bonds but with much greater risk.
Excessive turnover of a fund's portfolio is another hidden cost, particularly for fund managers who favour momentum. Woolley reckons momentum strategies have an average portfolio turnover level four times that of a value strategy.
Pension funds in aggregate have liabilities 25 years into the future. They are having their assets exchanged with other pension funds 25 times over in a zero-sum game at a cost that represents a quarter of the value of the fund. Anyone who has invested in a savings plan for 10 years only to get their contributions back will know that that feels very dysfunctional.
The centre intends organising regular conferences, research and a website.
* Brent Sheather is a Whakatane investment adviser
