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.