It’s long past time for professional investors to set aside the efficient market hypothesis (EMH) as the basis of most asset management strategies, according to Paul Woolley, a senior fellow at the London School of Economic and Political Science. Noting that earlier, on the first day of the Sixth Annual European Investment Conference, keynote speaker Martin Wheatley had discussed ethics, trust, and governance, Woolley dismissed those issues as secondary to the primary problem — the intellectual framework in which finance is conducted. “I blame the academic theory of efficient markets for the successive crises we’ve had,” Woolley said.
The EMH, he said, assumes that competition results in asset prices that reflect fair value and self-stabilizing capital markets, allowing no room for excess returns for intermediaries. Further, it does not address what Woolley called the “three perversities of investing”: momentum, short-termism, and risk-return inversion. The way forward, according to Woolley, is an asset pricing model that recognizes that investors delegate to agents, and these intermediaries have different degrees of competence and different objectives. This leads to asset mispricing and “rent capture” by agents.
Woolley explained asset pricing as the result of the forces of momentum investing and fair value, or fundamental, investing, noting that most active management represents a combination of the two styles. Woolley sees fund managers following momentum-based strategies in order to improve short-term performance and capture incentive fees. Tight tracking errors, mark-to-market valuation for regulators, and herding are additional explanations for the popularity of momentum. Yet, Woolley said, fund managers’ adherence to tight tracking errors around market capitalization-weighted benchmarks often end up pushing them into high-risk, overpriced securities. Instead, he suggested, benchmarks should be based on underlying fund flows, or GDP plus inflation.
Momentum, Woolley concluded, is a losing strategy for long-term investors. Investors are better served by focusing on long-term fair value investing and adopting investment strategies and incentives that similarly induce a long-term perspective. These could include a limit on portfolio turnover and longer-term performance targets. Finally, Woolley suggested that a move away from the EMH as a guiding investment theory might result in social gains that come with more stable financial markets.
Watch Woolley’s full presentation below.
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