Most subjects of human enquiry are supported by a generally acknowledged and respected theoretical framework which explains how things work and why they sometimes fail. The field of finance is poorly served in this regard, supported only by an academic theory that predicts the perfection of “efficient markets” while ignoring market imperfections.

As a result, investors and practitioners are left to fend for themselves drawing on convention, past experience and a theory they don’t believe in to inform their actions. It is hardly surprising that the finance industry is failing society with its periodic crashes, vast cost and unaccountability.

The theory developed at The Paul Woolley Centre, supported by empirical studies, represents a radically new approach that takes into account the principal-agent problems arising when asset owners delegate responsibility to asset managers. It shows that asset mispricing can occur despite all market participants acting prudently to maximize profits in light of the available information.

The new framework offers fuller and more convincing explanations for the principal forms of asset mispricing than have so far been presented in the academic or practitioner field. The implications extend to all market participants; both for private strategies and for the social ends of better functioning markets.

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Defensive diversification

By treating diversification as an unmitigated good, investors by and large ignore the damage that it does to returns. We would do well to channel Buffett who once remarked that “diversification is protection against ignorance; it makes little sense if you know what you’re doing.” The outcome of an obsession with benchmark-relative performance together with principal-agent problems is “defensive diversification”.

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Asset mispricing: the ignored externality

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. Asset owners should broaden their awareness of the externalities that arise from their investment approach.

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