Financial reform has a heads up in the U.S., ostensibly aimed at ensuring that investment banks should never again force governments to the debt wall through imprudent loans to improvident borrowers with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act. (Good luck on that one! Long-Term Capital Management didn’t require a government bailout – but only because the New York Fed knocked some heads together. Had LTCM not been wound down in orderly fashion, who knows what the alternative history would have been – whether Bear Stearns, among others, would have been around to start the next round of financial crises.)
What works in America is getting a jaundiced view overseas, starting with a new book. “The Future of Finance: And the theory that underpins it,” published by the London School of Economics and Political Science, includes a chapter by Paul Woolley, former IMF official, investment banker and asset manager and now a fellow at the eponymously named Paul Woolley Centre for the Study of Capital Market Dysfunctionality. Summing up the current impasse, he writes: “Prevailing theory asserts that asset prices are informationally efficient and that capital markets are self-correcting. It also treats the finance sector as an efficient passthrough, ignoring the role played by financial intermediaries in both asset pricing and the macro-economy.”
Those intermediaries, he argues, through the principal-agent relationship, occult the markets. Principals may have an interest in efficient markets, but agents have their own interests which tend to compensation, among others.
“Some economists still cling to the conviction that recent events have simply been the lively interplay of broadly efficient markets and see no cause to abandon the prevailing theories,” Woolley adds. “Other commentators, including a number of leading economists, have proclaimed the death of mainstream finance theory and all that goes with it, especially the efficient market hypothesis, rational expectations and mathematical modelling.”
He contends, instead, that the key issue is “to recognise that investors do not invest directly in securities but through agents such as fund managers. Agents have better information and different objectives than their customers (principals) and this asymmetry is shown as the source of inefficiency – mispricing, bubbles and crashes.”
His solution is for the largest pension fund managers – the “Giants” – to adopt a set of 10 policies:
- Adopt long-term investment approach based on future dividend flows, rather than momentum -based strategies that rely on short-run price changes
- Cap annual turnover of portfolios at 30%
- Understand that all tools now used to manage risk and return are based on the discredited theory of efficient markets
- Adopt stable benchmarks for performance (GDP growth plus a risk premium)
- Do not pay performance fees
- Do not engage in alternative investments
- Insist on total transparency by managers of their strategies, costs, leverage and trading
- Do not sanction the purchase of “structured”, untraded or synthetic products
- Work with other shareholders and policy-makers to secure full transparency of banking and financial service costs borne by companies in which the Giant funds invest
- Provide full disclosure to all stakeholders and for public scrutiny of each fund’s compliance with these policies.
“Each fund that adopted these changes could expect an increase in annual return of around 1-1.5%, as well as lower volatility of return. The improvement would come from lower levels of trading and brokerage, lower management charges and, importantly, from focussing on fair value investing and not engaging in trend-following strategies. The gains would accrue regardless of what other funds were doing,” he argues.
Worth a look. After all, Woolley was once a director at Baring Brothers, a firm now deceased for fairly mundane reasons — namely a trader who swung for the fences.