The momentum style of investing, employed to a certain extent by most equities managers, came in for a bout of criticism at the annual conference for the Paul Woolley Centre for Capital Markets Dysfunctionality in Sydney.

The impact of momentum on bubbles and the continued use of momentum to control business risk prompted the establishment of the research field by former funds manager Paul Woolley in 2007. The Centre includes faculties at the London School of Economics, the University of Toulouse and the University of Technology Sydney, which hosted last week’s conference.

 

Woolley told the audience of academics, fund investment staff and funds managers, that agents (such as managers) were in a position to capture the bulk of returns in the economy and that ‘momentum’ lay at the heart of the whole problem.

Professor Harrison Hong of Princeton University said that momentum was untethered to price.

“Momentum strategies accelerate the price reaction to news but a quicker reaction comes at a cost,” he said. “The later trend chasers get in at a price above the long-run equilibrium and further away from fair value.”

Hong argues that “IQ” is destabilising, in that the highly intelligent funds managers behave in a fashion which is less than optimal for investors and the market as a whole.

Recent examples include the “quant meltdown” of August 2007, the failure of Long Term Capital Management in 1998, the internet bubble and crash exacerbated by hedge funds and the current sub-prime-caused crisis.

“Bubbles and crises seem to be increasing in frequency with the smart guys involved being directly implicated,” he said.

High wages paid by managers and the ensuing competitive pressure pushes individual investment professionals towards strategies which yielded profits quickly.

“Increasing IQ can be destabilising because there’s a non-linear relationship with information efficiency.”

Hong asked whether the world needed as much speed and liquidity that the markets offered: “Would it have been horrible if the internet revolution had taken five years longer?”

Professor Ron Bird, who heads the UTS arm of the Centre, spoke to a related paper he was working on with Danny Yeung, also of UTS. The first preliminary draft is titled: ‘How Do Investors React Under Uncertainty’.

This involves, using Australian data, a re-examination of an overseas study which shows that the market responds to good and bad news differently when there is uncertainty – the negative reaction to bad news increases with uncertainty and the positive reaction to good news decreases.

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