Paul Woolley insists that he is pro market forces; he is not some sort of Trotskyite. A cursory glance at some of the research work he is either doing or financing might prompt scepticism. But this urbane Londoner who established the top-shelf GMO quant shop in Europe is mainly concerned about inefficiencies and mispricing. And maybe greed. Greg Bright spoke with him about his latest research.
Paul Woolley’s most recent research paper, which he presented at the famous Marathon Club in London in January, struck a chord given the events of the financial crisis and, more importantly, its probable causes.
The Marathon Club is a collaboration of financial institutions which promotes research and advice for pension funds. It is, as you might expect, a rather conservative organisation.
Woolley’s research though, like other papers from him or researchers attached to the three universities funded by the Paul Woolley Centre for Capital Market Dysfunctionality, has a tendency to question the status quo to put it mildly.
The latest paper, entitled “Rent Capture Through Financial Innovation”, looks at the impact of new investment products and who tends to benefit from them. Given the contribution to the financial crisis made by the enthusiastic sales of CDOs and the like, an examination of who benefited from them is sure to provoke interest.
Not only is it the agents, such as investment banks and fund managers, who benefit most from innovative products, but also the adoption by pension funds of these products and their spread, with increasing “rents” extracted by their promoters, may also be a lead indicator of crisis.
Woolley says: “Financial agents are in a position to capture the bulk of the gains of the financial economy.”
He says that the paradigm of efficient markets, the study of which dates back to the 1950s, has ignored the agency problem in pricing and rent capture.
“Pension funds are the custodians of social wealth,” he says. “I’m not an optimist about the success of more regulation but what better way to address the problem than to get the funds to act in a way which is privately beneficial (to them and their members) and which is also socially beneficial.”
Woolley believes that any initiative to resolve the dysfunctionality of global finance should come from “giant” funds worldwide.
“They need to revise their strategies and contracts and to exercise their ownership rights,” he says.
By countering the power of agents, they will help stabilise markets.
Agents introduce a “moral hazard”, which could be reduced by pension funds co-operating more with each other, and merging into larger funds where possible, and not trying to beat each other on short-term performance.
The main source of market mispricing is momentum, Woolley believes. Momentum investing causes share market bubbles which have a major impact on society through the misdirection of resources. Most fund managers include at least an element of momentum investing in their processes to ensure they don’t stray too far from the overall market.
Momentum in pricing encourages agents to use trending rather than long-term value in their style.
And performance fees, which are designed to align the interests of agent and client better, actually increase the moral hazard and shrink the investment time horizon.
Woolley believes that with a new framework for the operation of pension funds- where they better flexed their muscle – returns could double from an average of about 4 per cent a year to about 8 per cent over the long term.