Theories are designed to explain how the things work and to make predictions; that is as true for everything from nuclear physics to physical fitness.
It is more difficult to develop theories in the social sciences because of the unpredictability of human reactions.
In economics there are many theories but they often are bad at prediction, because there are so many diverse influences at work. It should be easier to formulate theories about the functioning of financial markets on the grounds that investors — who are predominantly professional — target the best available return and borrowers try to minimise cost: clear unambiguous objectives.
Academic finance has taken the principle of profit motivation on board and given us two main investment theories, dating back to the Sixties:
The Efficient Market Hypothesis (EMH), whose principle is investors won’t leave a fiver on the pavement; and The Capital Asset Pricing Model (CAPM), which says that the higher the risk, the higher the return.
Fund managers are ambivalent about the EMH, observing bubbles and crashes. But they seem content enough to use market indexes as benchmarks for active and passive investment. As for CAPM, it is a wonder it has survived the now ample evidence that high-risk stocks ultimately deliver lower returns than low-risk ones.
So professional investors have one theory, EMH, they don’t really believe in, and another, CAPM, that is at best unreliable. It leaves them relying on instinct, or simply going with the flow.
Hence the need for a better understanding of how finance works.
Dimitri Vayanos and Paul Woolley at the Centre for the Study of Capital Market Dysfunctionality at the London School of Economics have taken 12 years to come up with an alternative framework* which seems to do a better job of explaining the real world.
Their approach differs in one significant way from the standard model: they take into account that the ultimate asset owner now rarely invests directly himself but delegates responsibility to a professional manager.
This is where all the trouble starts. The manager has his own set of objectives and responsibilities and these may not always coincide with those of his clients. Moreover, the client is never quite certain of the manager’s competence and the manager for his part is keen to inspire confidence.
One way trustees of pension and other funds control delegated risk is to give the manager a benchmark, usually a market cap index, and instruct him not to stray too far from that.
Even if trustees do not do this, the manager is keen to keep shortfalls against the index or peer group returns to a minimum.
Vayanos and Woolley show this seemingly sensible practice is at the root of many flaws in present day financial markets. It works like this.
One sector of the market, say tech stocks, may start to do much better than many managers expected. To avoid a bad shortfall against the benchmark they are obliged to buy the very stocks they had earlier dismissed as expensive.
Their purchases and those of other managers chasing performance push the sector even higher.
The result is a bubble with high-risk stocks pushed to unrealistic levels that predicate sub-standard returns. Extreme versions of this occur infrequently, but the underlying pressures are constantly at work.
The research shows that the damage caused by these distortions extend beyond the stock markets. In particular, the focus on short-term price performance by investors causes corporate chiefs to do the same: promoting strategies that benefit their company’s share price often to the detriment of the long-term cashflow of the business.
The policy implications of this research are extensive and Woolley has now set up a company, Ricardo Research, to help disseminate the advice to large funds that can help them to handle delegation more effectively. The aim is to improve long-term returns while making markets more stable.
It seems to have taken a theory designed to explain imperfection to come up with a model of how to achieve, if not perfection, at least a better social outcome.
*Ricardo Research: A model of imperfection, ricardoresearch.com/idea/a-model-of-imperfection