Most institutional investors have long-dated obligations that extend decades into the future. Consistent with their long time-horizon and the need to deliver inflation-beating returns, such investors typically allocate the majority of their capital to public and private equity, real estate and infrastructure assets. Increasingly, such allocations are managed with environmental, social and governance (ESG) concerns to the fore. Indeed, some investors have gone further and now seek to align their investment strategy with the UN Sustainable Development Goals.

Paradoxically, the same investors will often use strategies that are inherently short-term in their approach. The most obvious example is the momentum strategy, which involves buying recent winners and avoiding recent losers. This is a high turnover strategy that has nothing to do with the productive allocation of capital. Moreover, the procyclical nature of the strategy means that it will tend to amplify trends, distort prices and, in the extreme, contribute to bubbles and crashes.

Out-and-out momentum strategies are just the tip of a large procyclical iceberg. The still widespread use of tracking error constraints forces managers to chase the fastest-performing segments of the market to avoid breaching their mandate guidelines. Even in the absence of such constraints, asset managers willingly chase trends in order to manage their own career risk. And performance-driven hire and fire decisions by asset owners further embed a procyclical bias within financial markets.

All this adds up to a situation in which large investors who claim to invest with a long horizon and who wish to be seen as champions of a socially responsible form of capitalism, are in fact contributing to dysfunctional capital markets in which short-termism dominates long-term thinking.

The social costs of asset mispricing and short-termism are less visible than the more widely discussed environmental and social externalities, but may be no less damaging.

Traditional finance theory suggests that in more-or-less efficient markets, a company’s share price is a fair reflection of the fundamental worth of the business. In this idealised world, there is no difference between actions that boost the share price and actions that deliver long-term value. However, in the presence of asset mispricing this no longer holds. As a result, it is possible – and often highly remunerative – for CEOs to engage in financial engineering rather than productivity-enhancing investment. An egregious and widespread example of this arises when share buybacks are used to mask the dilutive impact of stock-based compensation packages under the cover of “returning capital to shareholders”.

Procyclical dynamics also support a tendency towards monopoly: a rising share price confers greater market power on a company, enabling it to buy up competitors, often using their overvalued stock to fund the purchase. Asset owners that employ procyclical strategies are thereby facilitating a gradual shift towards a less competitive, less productive economy in which monopolistic corporations can engage in rent extraction on a vast scale.

Furthermore, procyclical strategies exert positive feedback effects on markets which help inflate asset price bubbles. When these bubbles eventually burst they often inflict significant and long-lasting damage on the economy, resulting in job losses and wage stagnation.

Public calls for institutional investors to recognise the impact of their investment approach have so far been limited to divestment campaigns focused on specific issues – most notably in relation to fossil fuel and tobacco holdings. However, as attention shifts towards broader issues such as excessive corporate power and rising inequality, it seems likely that asset owners will need to justify their investment strategy on much more fundamental grounds.

This would not require a huge leap from where we stand today. Savers and activists are already asking why their pension savings should support anti-social corporate activity. They might also ask why their savings should support anti-social investment strategies. Regulators across many markets have become increasingly assertive in encouraging funds to consider ESG issues. A natural extension of this – and one very much aligned with the underlying objectives of the sustainability movement – would be to ask large funds to consider the extent to which the strategies they employ contribute to market instability and capital misallocation.

Even in the absence of regulatory pressure, socially responsible asset owners will naturally want to understand the impact that their investment approach has on the wider world. This means going beyond the now commonplace integration of ESG considerations and the use of sustainability-themed strategies at the margin. Indeed, it demands that long-horizon investors avoid strategies that undermine the efficient working of capital markets and which consequently impose an unrecognised cost on wider society. If long-term capital was managed with a genuinely long-term mindset, the private and social benefits could be immense.

This article appeared in the Financial Times on 2 January 2020

People keep questioning the health of global capitalism. But the damage caused by dysfunctional stock markets is not receiving adequate attention. Fifty years on from the publication of a landmark paper propounding the efficient markets hypothesis — that investors respond rationally to publicly available information — it is time to look again.

Active investing comprises two main strategies. One is based on expectations of the cashflows each asset can generate. The other responds to short-term price movements and ignores fundamental value. Cashflow investing and price-only investing are implemented in a variety of ways, and together they represent the sum of investors’ actions in determining the prices of assets.

The efficient markets hypothesis takes account only of the first strategy, implying that prices reflect the consensus expectations of cashflow investors. Although modified and qualified over the years, the basic proposition remains unchanged.

But consider the evidence of trends and momentum, and bubbles and crashes. Market participants observe the impact of short-term fund flows and are ambivalent — at best — about the idea of markets being efficient. They know that a high proportion of stock market trades bear no relation to fundamental value and that few professional portfolios are actually invested exclusively for long-term cashflows.

Despite these reservations and for lack of an alternative, the efficient markets hypothesis continues to underpin some of the most important decisions taken by investors, from the largest institutional funds to the smallest private saver.

One prime example of the problem is the use of capitalisation-weighted indices as benchmarks for the composition of passive funds, and for the performance of active funds. The comparison of portfolio returns against index returns is deemed good practice, however short the period under review. But treating indices as the neutral default choice makes sense only if pricing is efficient.

For their part, policymakers assume that stock markets reflect the wisdom of crowds and have a hands-off attitude, confining themselves to picking up the pieces after each crash. They use mark-to-market rules in the regulation of financial institutions and approve products that improve liquidity or widen the range of choice. That is sensible in an efficient world, but not otherwise.

A better understanding is needed of why investors use these strategies and how this usage distorts prices. Research at the London School of Economics has focused on agency problems arising when asset owners and fund trustees delegate responsibility to external managers. The main concern here is that trustees are uncertain of the ability of their asset managers.

Accordingly, most trustees impose limits on how far returns should stray from the return of the benchmark index. Even when unconstrained, managers are keen not to let performance slip far below the index return lest their competence is questioned.

Benchmarking pressures come to the fore when prices in a sector, or a class of assets, move strongly ahead. Managers who had previously deemed a sector to be unattractive and had not participated in the rise are obliged to turn buyers at the higher price. That amplifies the initial rise to the point where the assets become high-risk and overpriced.

Below-index weights in stocks or sectors with rising prices have a greater, and potentially unlimited, impact on performance compared with overweight positions in those with falling prices. So the pressure to act is always stronger when markets are rising.

One price-only strategy spawns another, worsening the situation. Benchmarkers must act when prices pass a threshold — but momentum investors buy as soon as a trend becomes apparent. The latter are effectively exploiting benchmarkers who have no alternative but to pay the higher prices.

The outcome is a generalised bias to overvaluation. This analysis is consistent with the longstanding evidence that high-risk stocks have historically given a lower return than their low-risk counterparts.

The price-only strategies overlooked by the efficient markets hypothesis are creating systematic and chronic distortions that are too great to be countered by cashflow investors.

It is no surprise that a theory predicting efficiency cannot explain inefficiency, nor show investors how to act correctly in conditions of inefficiency. On the other hand, a theory of dysfunctional markets points to the source of trouble and can suggest solutions.

These include amending the terms of delegation from trustee to asset manager, so that the latter focuses solely on long-term cashflows, coupled with improved monitoring by trustees to ensure compliance. More efficient markets would deliver private gains for all except the mischief-making momentum players.

But the biggest prize would be the social benefits from a more efficient allocation of capital. That could provide a new lease of life for capitalism.