Author: Philip Edwards

Asset mispricing: the ignored externality

As part of the growing movement to recognise environmental, social and corporate governance (ESG) risks, the concept of externalities has become increasingly relevant. The English economist Arthur Pigou was one of the first to develop the idea of externalities in the early 20th century, pointing out that sparks from railway engines sometimes ignited nearby woodlands or farmland, destroying timber or crops. Because the owners of the land received no compensation for the damage caused, neither the railway companies nor their customers recognised the social costs associated with their transaction.

The externalities of greatest interest in contemporary discussion typically fall under the E, S and G headings. However, this leaves a critically important externality – that of asset mispricing – largely ignored. As well as polluted air, we have polluted asset prices. In this case, the offending parties are asset management strategies that are driven by prices rather than cashflows, contributing to destabilising positive feedback effects and chronic mispricing.

Adherents of efficient markets thinking will argue that the extent of asset mispricing is so small as to make any negative spillover effects trivial. But the existence of asset price bubbles, large and persistent profits to simple momentum strategies, and the inversion of risk and return across many asset classes (often described as the low volatility anomaly) completely undermines the picture of markets as more-or-less efficient.

If we instead accept that financial assets can be mispriced, and at times severely so, then it is worth considering what economic damage might result from this source. We can think about this at two levels: at the macro level of asset price bubbles and at the micro level of corporate decision-making.

Asset price bubbles are the ultimate manifestation of mispricing and are widely regarded as economically disruptive. However, the conventional wisdom in central banking – epitomised by the Greenspan doctrine – had been to use monetary policy to limit the damage after a collapse in asset prices, rather than attempting to head off the damage as a bubble inflates. This view remained intact in the aftermath of the Tech bubble of the late 90s, but was fundamentally challenged by the experience of the financial crisis. In a speech in 20091, Janet Yellen said that “not dealing with certain kinds of bubbles before they get big can have grave consequences. This lends more weight to arguments in favour of attempting to mitigate bubbles, especially when a credit boom is the driving factor.” It remains to be seen to what extent central bank policy will embrace this more interventionist mindset and how effective the approach will be.

While less obvious than asset price bubbles, the damage done by the impact of mispricing on corporate decision-making may be just as great. If prices do not reflect fundamental value, corporate executives are faced with a dilemma: do they maximise the share price in the short run or cashflows in the long run. In the presence of lucrative share option schemes, many choose the former. There has been much hand-wringing over the causes and effects of corporate short-termism, with the focus often on egregious compensation packages or the problems of quarterly earnings guidance. But the effects of asset mispricing on the private sector have received relatively little attention.

Asset owners have an opportunity to reduce both the macro and micro level social costs described above through their investment strategy choices. As we have argued elsewhere, investment decisions based on past price movements, as opposed to a thoughtful assessment of future cashflows, can cause asset prices to depart substantially from fair value. Common examples of price-only strategies include momentum and trend-following, tracking error constraints, and procyclical performance-chasing by both asset managers and asset owners. Performance-chasing is more a by-product of career risk considerations than an explicit strategy choice, but nonetheless deserves more attention than it typically receives. By identifying and removing such strategies from their portfolios, asset owners could help reduce the feedback effects that contribute to asset mispricing and thereby reduce the externalities that accompany it.

Amidst the broader shift in attitudes towards business – with a greater expectation that companies should behave in a socially responsible and sustainable way – investors need to be cognisant of the externalities that arise from their investment approach (and not just from the underlying companies they hold). Attention has so far been directed towards environmental and social issues, but over time, questions will increasingly be asked of the social utility of various aspects of finance – especially if financial market excesses contribute to an economic downturn in the years ahead. Asset owners and asset managers therefore have good reason, on both private and social grounds, to review the wider impact that their investment approach has on the world around them.

The transparency fallacy

“Sunlight is said to be the best of disinfectants; electric light the most efficient policeman”
-Louis Brandeis

The above quote is taken from Other People’s Money And How the Bankers Use It, a collection of essays published in 1914, criticising what Brandeis (later to become a Supreme Court Justice) saw as anti-competitive collusion between investment bankers and large corporations. Ever since, this expression has been used to support calls for greater transparency in everything from finance to politics and the media.

The most recent demands for greater transparency in the financial sector have arisen from work undertaken by the UK Competition & Markets Authority (CMA) as part of their Investment Consultants Market Investigation. Their final report highlighted a greater need for comparable performance information across the industry, especially in relation to fiduciary management offerings. The proposed solution – the Fiduciary Management Performance Standard – aims to allow trustees to compare the performance of different fiduciary offerings in a consistent fashion. The proposal enjoys widespread support, with a survey of trustees on the social media platform mallowstreet apparently showing 100% support for the idea.1

With modern computing power, demands for greater transparency are easily met by simply monitoring, measuring and publishing ever greater quantities of data. Indeed, measures and targets have come to dominate management practices across both the public and private sectors in many western economies. The New Labour UK governments of the late 1990s and early 2000s famously embodied this trend with centrally determined performance targets implemented across vast swathes of the public sector.

Unfortunately, this “measurement culture” created numerous unintended and damaging consequences. In particular, an excessive focus on targets and peer-group comparisons (usually in the form of league tables) led to participants gaming the system and engaging in performance-chasing behaviours in order to produce the “right numbers”.2 In hospitals, for example, there were reports of corridors being relabelled as “pre-admission units”, and wheels being removed from trolleys so they could be re-designated as beds. In schools, the intense media focus on league tables has resulted in widespread “teaching to the test” and a narrowing of the curriculum to focus solely on those subjects that count towards performance measures used in league tables. The problem is neatly captured in Goodhart’s Law: when a measure becomes a target, it ceases to be a good measure.

In asset management, the perils of a measurement culture are clear. Despite being regularly confronted with the warning that “past performance is not a guide to the future”, investors consistently display a performance-chasing bias – hiring outperforming managers and firing underperforming managers – that is ultimately wealth-destructive.3 The proposed Fiduciary Management Performance Standard risks introducing a new possibility for performance-chasing at the fiduciary manager level.

While the details are yet to be finalised, it is easy to foresee a world in which trustees are encouraged to regularly compare their scheme’s performance against similar schemes under the auspices of good governance. It doesn’t then require a huge leap of imagination to envisage trustees moving their business (and assets) away from fiduciary managers who have shown the weakest levels of performance in recent years, and towards those with the strongest performance. This will simply have the effect of amplifying existing trends within financial markets, with the best-performing asset classes and the best-performing managers seeing asset inflows (and vice versa).

Moreover, a highly publicised performance database will have an impact on fiduciary managers themselves. Just as asset managers respond to the threat of termination due to sustained underperformance by seeking to reduce their divergence from the benchmark (known as benchmark-hugging), so consultants and fiduciary managers are likely to limit the extent of their divergence from their peer group in order to avoid being seen as an eccentric outlier.

Rather than being a cure-all for the ills of the fiduciary management marketplace, directly comparable performance information is instead likely to exacerbate the problem of momentum-driven markets and their associated social costs.4 This is not to say that the way in which trustees select consultants and fiduciary managers cannot be improved – it surely can – but rather to argue that a performance database is likely to create more problems than it solves.

The fundamental problem identified in the CMA report is that of “low customer engagement”. In particular, the CMA found evidence that less engaged trustees end up paying higher fiduciary management and investment consulting fees. This is a highly intuitive finding; but providing lowly engaged buyers with a performance database that gives them a very easy (and supposedly diligent) way of making their decision is a recipe for simplistic backward-looking decision-making.

Improved decision-making will only follow from addressing the low engagement problem. On this point the CMA make some very sensible recommendations, such as mandatory tendering of fiduciary appointments and additional trustee guidance from The Pensions Regulator. Ultimately, what trustees need from a good consultant or fiduciary manager is a combination of integrity, expertise, humility, and an ability to listen and communicate well. None of these characteristics lend themselves to being easily measured and performance data will provide little or no indication as to whether a consultant has these qualities. Transparency can be valuable up to a point, but it is possible to have too much of a good thing.

Chapter 12 for the 21st century

Chapter 12 of Keynes’s masterpiece The General Theory of Employment, Interest and Money has long been recognised as a brilliant articulation of the tendency towards short-termism in financial markets, containing some of the most widely quoted passages in all of finance and economics. However, the problems that Keynes highlighted have proved stubbornly resistant to change and it is striking that the short-termism he described has, if anything, intensified over the 80 years since his account.

Chapter 12 provides the first clear analysis of the dysfunctionality of capital markets, where Keynes explicitly highlights the social costs of highly liquid financial markets. In many ways, the work undertaken at the Paul Woolley Centre for the Study of Capital Market Dysfunctionality has formalised and extended the ideas first discussed by Keynes in the 1930s. By creating Ricardo Research we hope to build on this work in order to effect change through the behaviour of large asset owners. In this short article, we outline some of the parallels between the ideas contained in Chapter 12 and the research that motivates our work at Ricardo.

The importance of asset prices

Keynes was acutely aware of the role that asset prices play in acting as a signal to corporations and entrepreneurs in the real economy:

“the daily revaluations of the Stock Exchange … inevitably exert a decisive influence on the rate of current investment. For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem like an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit.”

Keynes asserts here that asset prices play a crucial role in determining whether potentially profitable projects are ignored or wasteful projects are funded. It follows that asset prices are central to the efficient functioning of the economy and if the pricing process is corrupted this can have damaging economic and social consequences. It is therefore essential to look in detail at how asset prices are determined and under what conditions severe asset mispricing might arise.

Long-term investors and game-players

In Chapter 12, Keynes lamented that an increasing proportion of equity was:

“owned by persons who … have no special knowledge of the circumstances, either actual or prospective, of the business in question”.

The problem Keynes is pointing to here is that when an increasing proportion of equity investors have no special knowledge of the businesses in which they invest, there is no reason to expect market prices to be a fair reflection of company fundamentals. Furthermore, we should expect markets to be more volatile than would otherwise be the case, “since there will be no strong roots of conviction to hold it steady”.

He goes on to say that:

“it makes a vast difference to an investment market whether or not they [long-term investors] predominate in their influence over the game-players.”

Keynes’s game-players “are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’, but with what the market will value it at … three months or a year hence.” In other words, they are focused on anticipating short-term market movements rather than assessing long-term value. We believe that the weight of money engaged in momentum and performance-chasing behaviours has created a situation in which “game-players” now almost certainly predominate in their influence over long-term investors, contributing to the dysfunctionality of financial markets.

Keynes also reminds us not to rely on “expert professionals” to help bring prices towards fair value:

“the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.”

The outcome – famously described in Keynes’s beauty contest metaphor – is a situation in which investors focus their efforts on second-guessing each other rather than making independent judgements about long-term value.

Building on his earlier reference to “game-players”, Keynes develops an important distinction between two approaches to investing. The first involves making an assessment of the fair value of a business based on a thoughtful analysis of the company’s long-term cashflow generation prospects – what Keynes calls “enterprise” and we, at Ricardo Research, refer to as “cashflow investing”. The second approach is based on an extrapolation of past price movements – often described as a momentum or trend-following strategy – what Keynes calls “speculation” and which we refer to as “price-only investing”.

In practice, most strategies are a combination of the two approaches (some intentionally, others inadvertently), but we argue that incentive structures create a bias towards price-only behaviours that amplify trends in markets and carry prices away from fair value.

Succeeding unconventionally

Turning to the plight of the long-term investor, Keynes is at his most pessimistic:

“Investment based on genuine long-term expectation is so difficult today as to be scarcely practicable.”

The situation has not improved since Keynes wrote these words and one shudders to think what he would have made of high frequency trading and trend-following strategies. He continues:

“it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.”

Here Keynes presciently highlights the challenge that institutional investors face when adopting a long-horizon approach. The increasingly regulated and litigious environment for fiduciaries has only intensified the risk of criticism (or worse), creating a barrier to the adoption of strategies that run the risk of looking ill-judged in the short run. Keynes adds an insightful footnote relating to performance monitoring processes:

“The practice, usually considered prudent, by which an investment trust or an insurance office frequently calculates not only the income from its investment portfolio but also its capital valuation in the market, may also tend to direct too much attention to short-term fluctuations in the latter.”

Research undertaken at the PW Centre formalises this argument by establishing a clear link between the constraints and incentives faced by asset owners and asset managers, and the momentum and performance-chasing dynamics that result.1 Investors that “direct too much attention to short-term fluctuations” – both asset owners and asset managers focusing on short-term benchmark-relative performance – create destabilising market dynamics and impose a social cost in the form of market crashes and lower returns to the end-saver. Keynes’s widely quoted remark that “it is better for reputation to fail conventionally than to succeed unconventionally” maps neatly to our distinction between short-term performance-chasing (failing conventionally) and long-term cashflow investing (succeeding unconventionally).

Getting back to social purpose

The balance between short-term and long-term investors has a significant influence on the social utility of financial markets. With price-only activities – such as momentum and performance-chasing – now arguably the dominant influence on markets, the resulting mispricing and volatility acts as a costly externality on society. As Keynes put it:

“When the capital development of a country becomes the by-product of a casino, the job is likely to be ill-done.”

Shifting the balance in favour of long-term investors will not be easy, but we are optimistic that by working together, asset owners and the asset management community can foster a healthier and more socially useful financial system. We hope that by directing attention towards the underlying drivers of market dysfunctionality – including misaligned incentives, benchmarking and performance-chasing – we can stimulate a debate that promotes both the private and social interests of the end-saver.

Welcome to Ricardo Research

We are pleased to announce the launch of Ricardo Research – an investment advisory business with a mission to transform the way that investors think about financial markets, with the ultimate goal of fostering a more socially useful financial system.

The launch of Ricardo Research is the culmination of a journey that began in 2007, when Paul Woolley founded The Centre for the Study of Capital Market Dysfunctionality at the London School of Economics. The Centre’s aim was, and remains, to develop a coherent framework to explain the real-world behaviour of financial markets, with a particular focus on their imperfections and social costs. In contrast to the efficient markets paradigm, with its idealised picture of perfect markets, the Centre focuses on the causes and consequences of chronic asset mispricing.

The new framework identifies delegation, by asset owners to asset managers, as a critical element in the generation of market dysfunctionality. By focusing on the agency issues that exist within the financial system, the research develops a more realistic understanding of capital markets that is consistent with empirical evidence. Where proponents of efficient markets see “anomalies” – the value and momentum premia and the low volatility anomaly – we see the essential characteristics of market behaviour with a clear explanation in delegation and misaligned incentives.

The research developed at the Centre has far-reaching implications for asset owners, who we see as the key agents of change in their role as stewards of large pools of capital. Ricardo Research will translate the research findings of the Centre into practical advice for large institutional investors – especially those with a long time-horizon and who are conscious of the social impact of their investment choices. The grounding of our advice in a robust body of theory differentiates us from mainstream investment consultants, who inevitably rely on an ad hoc mix of convention, experience, and a defunct theory to guide their advice and decisions.

There will be a free flow of ideas between the Paul Woolley Centre at the LSE and Ricardo Research, with Dimitri (Professor of Finance and Director of the Centre) sitting on the Board of Ricardo Research and playing an active role in the development of our ideas. We are particularly excited by the combination of practitioner and academic input into the idea generation process at Ricardo.

As part of our launch, we have posted three papers under the Ideas section of our website – we hope they provide food for thought and stimulate debate.

  • In A Model of Imperfection we outline the main elements of the framework developed at the PW Centre with a focus on benchmarking and momentum as the key drivers of market dysfunctionality.
  • Stabilising and Destabilising Strategies distinguishes between different strategy types on the basis of their impact on market stability. We argue that destabilising strategies impose a largely unrecognised negative externality on society.
  • A Precondition for Sustainability argues that without addressing the underlying barriers to long-term behaviour within financial markets, calls for asset managers and companies to adopt sustainable strategies are likely to fail.

We look forward to engaging in an active conversation with trustees, CIOs, asset managers and other interested parties as we seek to challenge the prevailing wisdom. Please get in touch if you would like to be part of the conversation!