“For their part, principals cannot be certain of the competence or diligence of the agents. Introducing agents (into the academic research on capital market behaviour) brings greater realism to asset-pricing models and, more importantly, gives a far better understanding of how capital markets function.” In Woolley’s own research, he has maintained the traditional assumption of fully rational behaviour by all participants. He admits that if he introduced elements of behavioural finance, where it is shown participants do not always behave rationally, the results would be even more complex. Financial intermediaries also have an added ability to capture what the economists call ‘rents’. Woolley says: “If a funds manager spots an investment opportunity with a known and certain pay-off, he can finance it directly from his own or borrowed funds and enjoy the full gain for himself. His client might like to participate and would be prepared to pay close to the full value of the gain in fees for the privilege.

The client would be in pocket so long as the investment, net of fees, gave him a return above the riskless rate. But whether he borrows the funds or raises them from the client, the fund manager captures the bulk of the gain thanks to his superior knowledge of available opportunities.” Another common theme in the centre’s research is the impact of momentum investing on markets and client returns. When momentum, which leads to mispricing of assets and can create bubbles, is combined with agent rent capture, they create a “perfect storm”. The technology bubble of the late 1990s is a good example of the impact of momentum. Tech stocks received an initial boost from fanciful expectations of future profits from technological progress, and primarily from the internet. Meanwhile, funds invested in the less-glamorous value sectors languished, prompting investors to lose confidence in their managers and switch to newly successful growth managers, which in turn boosted prices further. Some value managers even altered their style to include growth to avoid being fired.

The trend accelerates in an environment when investors’ horizons are shortened, notwithstanding the fundamental liability profiles of pension funds. Woolley says that the length of time investors hold securities – portfolio turnover – is a good indicator of short-termism, which he believes has been a feature of capital markets for the past two decades. “Turnover on the major equity exchanges is now running at 150 per cent per annum of aggregate market capitalisation, which implies average holding periods of eight months. The growth in trading of derivatives, most of which have maturities of less than a year, is also symptomatic of shortening horizons,” he says. “Fund managers have a choice between investing based on fair value and momentum investing, or some combination of the two. Those who are impatient for results or who have no ability or desire to undertake the hard work of fundamental analysis to find cheap stocks, will use momentum. “In fact, over the short run, momentum is usually the best bet. There is a self-fulfilling element here because the more investors use a momentum strategy the more likely it will work. “Momentum trading and the distortions to which it gives rise are part and parcel of the trend towards the increasing short-termism and high trading volumes in finance. Both have their origins in principal/ agent problems and both contribute to the loss of social utility.”

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