When Paul Woolley, academic-turned funds manager-turned academic, set up his research Centre in 2007, the two main associated universities, London School of Economics and University of Toulouse, didn’t like the name. But he insisted and now the Paul Woolley Centre for (the study of) Capital Market Dysfunctionality has a significant body of work in progress. GREG BRIGHT reports.
Paul Woolley, who was one of the founders of the European arm of the Boston-based global manager GMO, made a lot of money from funds management but the experience prompted him to question both the behaviour of managers and their value to society.
“I wasn’t a doom monger expecting a cataclysmic event,” he says of the Centre’s title. “But when I looked at how we, at GMO, exploited mispricing and contributed to it, I started to realise that this was not just inefficiency, it was dysfunctional.”Â
GMO had a valuation model but in order to remain in business the firm could not rely solely on that. It had to add momentum to the process. About 30 per cent of GMO portfolios were allocated to momentum stocks as an “insurance policy” and because clients expected tracking error within certain bands.
After two “glorious decades” of good returns to value investing, growth and momentum overtook it during the 1990s, such that at one point, Jeremy Grantham (the ‘G’ in GMO) declared that ‘value is dead’. And it was for a while, because the tech bubble kicked in. Despite the addition of momentum to its style, GMO lost more than 20 per cent against the index in 21 months.
But in March 2000 everything turned around. The bubble burst and value had another five glorious years. Woolley demonstrated his own market-timing skill and exited the firm to go back to academia.
“The tech bubble was a good laboratory experiment,” he said recently during the annual conference of the Centre at its third affiliated university, the University of Technology Sydney, where the Professor of Finance, Ron Bird, is also a former GMO manager.
Momentum is a high-turnover strategy. It works off the proven premise that stocks which have just risen in price are likely to keep on doing so, at least for an exploitable while. But this means, when blended with value investingÂ – picking stocks with low prices compared with various valuations of the underlying companiesÂ – a large part of the portfolio at any one time will be away from fair value.
“I thought this was dysfunctional,” Woolley says. “An obsession started to develop in my mind over momentum… It seemed to me that GMO had a good record, we were adding significant value across the board. The trouble was that clients came and went, usually at the wrong time. They turned up when we had done well and were just about to do badly…”Â
Woolley says that he had wanted Grantham, who remains the chief executive and CIO in Boston, to calculate a money-weighted return for clients. “But I never asked him,” he says. “I suspect it would not have been very good.”
The implication is that managers get most of the benefit from their outperformance rather than clients as a whole The agents do well but the end investor spends a lot of money playing a zero-sum game and suffering penalties through brokerage, fees and charges.
At the Centre, Woolley has written a paper with Dimitri Vayanos, Bruno Biais and others with the “innocent enough”Â title of: ‘Rents, Learning and Risk in the Financial Sector and Other Innovative Industries’. The paper contains a ticking bomb: it concludes that agents are in the best position to capture the bulk of returns in the economy.
“And momentum lies at the heart of the whole problem,” Woolley says.
While the Efficient Market Hypothesis has been largely discredited after recent bubbles and crashes, those who cling to its fragments should consider that it takes no account of the role of agents in funds management.
In his 2008 paper with Vayanos titled ‘An Institutional Theory of Momentum’ Woolley explains asset pricing in terms of a battle between momentum and value. (A version of the paper accessible to non-mathematicians is available on the CEPR Vox website.)
“Banks, brokers and fund managers dominate the pricing process,” Woolley says. “Our approach is to introduce delegation, whilst maintaining the assumption of rationality.”Â
He believes that rational explanations will always be preferable to those based on irrationality.
“We should be searching for a unified theory of finance to maintain a scientific approach.”
However, he adds that this is still compatible with having behaviouralist theories as an overlay.
Other work in the pipeline at the Centre include: exploring empirical implications of momentum theory; short-horizon investing versus long horizonÂ – private and social gains and losses; and implications for size of the financial sector.
It is possible that the large size of the finance sector is more a testament to its malfunctioning nature rather than its efficiency.
In 2007 Woolley wanted the Centre to pose the question: “Is society well served by the finance sector?” This seemed an odd question at the time. Not so odd today.