Anthony Hilton, Evening Standard, reports on a recent study offering an insight into how the world of intermediaries operates
Paul Wooley used to be a money manager – and a very good one, too – but decided later in life to try to make the City a saner place. So he became an academic and provided the funds specifically to study dysfunctionality in financial markets. He has been in his element in recent years when many of the things he warned might happen have happened. And he has just contributed to a major work by the London School of Economics on how the financial system might be reformed.
Of particular interest to pension schemes is Mr Wooley’s explanation of why equity returns have been so poor and volatility so high. His key insight is to observe that the efficient market hypothesis takes no account of the role of intermediaries. It assumes that agents behave exactly like principals so their interventions have no effect on the underlying prices of securities. But if you observe how agents actually behave – how they have their own businesses to run, backs to cover and profits to maximise – it is immediately obvious that they do not behave exactly as if they were handling their own money.
This key difference in behaviour is like going through the back of the wardrobe in the children’s story The Lion, The Witch and the Wardrobe. You enter a whole different world.
If the interests of agents are not totally aligned with those of their clients then it follows that their actions do have an impact on prices.
At its simplest it explains why fund managers will follow the herd even when they believe the herd is wrong because being caught out with all the others minimises their business risk. “No one could have foreseen this outcome” they all bleat in unison. This in turn opens the door to the idea that the flow of funds directed by agents can create a momentum in markets and it is this momentum rather than fair value which drives share prices for much of the time.
Mr Wooley talks about rent capture and how it becomes the main preoccupation of agents. Rent capture is, of course, the polite economist’s term for ripping off the clients and he says that the success of intermediaries in getting more than their fair share of the available profits in the economy can in time bleed the economy dry. Thus the reason why equities have failed to give pension schemes the returns they need to justify the risk is that the money which should properly have accrued to the pension schemes has instead over the years been creamed off by the agents.
If the problem is ever to be solved, Mr Wooley says, then the people running pension schemes have to change the rules to tilt things back in their favour.
As a first step, he says they should introduce a 30% rule which says that no portfolio should turn over more than 30% a year – in effect giving an average holding of just over three years for each security. This, he has calculated, would deliver an increase in the average annual return of funds of 2% –3%. Currently average turnover is in excess of 100% and with dealing costs and charges of 1%, this by itself reduces the value of a fund by a quarter over 25 years. To hammer home the point, he suggests that pension schemes which trade in excess of 30% should lose their tax exempt status.
Second, he says the trustees should emphasise dividends rather than capital growth as historically 90% of the long term return on equities comes from dividends.
Third, pension schemes should have no truck with alternative investments – hedge funds where the charges are so high only the managers can expect to make money or in commodities which offer no income and which can complicate inflation targeting because investment flows exaggerate the underlying price movements.
It is hard to believe many schemes will follow what Mr Wooley says because, as he points out, trustees and investment committees are themselves increasingly behaving like agents.
Anthony Hilton is financial editor, Evening Standard;
Author: Anthony HiltonAnthony Hilton – 61, won the 2007 "Decade of Excellence Award," for business and financial journalism given annually by the World Press Awards in competition with a short list of writers from Fortune,