Probing a far from efficient market By Philip Coggan Financial Times: August 14 2006
As snappy titles go, the Paul Woolley Centre for Capital Market Dysfunctionality hardly rolls off the tongue. But the new research centre, which combines one of the UK's most thoughtful fund managers with the expanding Tanaka business school unit of Imperial College, London, will be hoping to produce some incisive comment on financial markets. Mr Woolley made his name at the European unit of GMO, the Boston-based fund manager with a reputation for long-term value bets. A former academic, Mr Woolley produced a stream of papers while at GMO covering issues such as index-tracking and the misallocation of capital and the poor returns achieved by those who backed corporate rights issues. Imperial has been reaching business for about 50 years but the unit has really taken off only after the arrival of Richard Sykes, formerly of Glaxo Wellcome, as chairman, and a donation by a former PhD student turned entrepreneur, Gary Tanaka. The school specialises in three areas, risk and quantitative finance, innovation and entrepreneurship and health care management. The new centre, founded with the help of a £4m donation from Mr Woolley, will look at how sub-optimal outcomes (from the point of view of the economy, or society in general) can arise from the working of markets, even when individuals are acting rationally. Imperial says that a lot of academic work has been done on the agency-principal problems that arise when shareholders delegate management decisions to boards of directors, but much less attention has been paid to the problems that arise when investors delegate decisions to fund managers. As an example, Mr Woolley cites figures showing that the typical equity portfolio turns over its portfolio once every year. This means that a pension fund with liabilities stretching 25 years into the future will exchange its shares 25 times with other pension funds over the life of its portfolio with zero collective gain but at a sizeable cost, probably equating to around a quarter of the future value of the fund. Another problem is that equity markets typically return around 5-6 per cent in real terms per year. Private clients pay around 2-3 per cent to get access to active equity management, and thus pay fees that swallow up around a third of their return. In turn, that raises the issue of why financial services companies account for such a large proportion of corporate profits, when their function is largely that of an intermediary. Mr Woolley suggests that "there seems to be a grotesque misallocation of resources involved here". Academics focused for a long time on the efficient market hypothesis, which suggests that market prices reflect all available information. But over the last 10 years or so, a lot of attention has been paid to market anomalies such as seasonal variations (the January effect), the long-term outperformance of value stocks and the existence of bubbles such as dotcom mania. One school of thought, known as behavioural finance, has argued that investors are not perfectly rational beings and that their psychological biases, such as loss aversion, mean prices can depart from fair value. But Mr Woolley thinks the departures from the theoretical world are more profound than can be explained by the behaviouralists. He says: "It seems there are features in the functioning of secondary capital markets that invalidate Adam Smith's dictum that if every entrepreneur pursues his own self interest, this will lead to the highest level of utility for all." The research centre will employ a small staff of academics and administrators and will, Imperial hopes, act as a beacon for the rest of the finance faculty. The aim will be to produce research papers, hold conferences and a best of breed website. 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