Dysfunctionality studies coming together ‘like magic’

Paul Woolley
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 (Pictured: Paul Woolley)

The study of capital market dysfunctionality, which former fund manager Paul Woolley embarked on in 2007, investing £5 million (A$9.25 million) of his own money to establish three study centres around the world, is turning out to be a unified body of theory.

Woolley addressed the eighth annual conference organized by University of Technology, Sydney on behalf of the Paul Woolley Centre last week. UTS will carry the “Paul Woolley” name at its centre for another two years as it brings in alternative funding for its part in ongoing research.

Woolley said that he set up the centre to try to get a better understanding of how the system worked because he did not think prevailing finance theory was adequate. He thought he would find sectors of dysfunctionality but gradually realized, two or three years into the project, that they were interconnected. “It all fits together like magic,” he told the conference. The two other centres – at the London School of Economics and Toulouse University – have been focusing on theory, he said, “which might sound indulgent”.

“For the most part asset owners don’t invest directly and yet intermediaries are left out of asset-pricing theory. So we have been trying to put the intermediary into the theory. The main problem is that the principal doesn’t know whether the agent is competent or diligent. So, we’ve been studying delegation.”

The prevailing theory agrees on three main anomalies: momentum; short-termism; and high-risk stocks delivering lower returns than low-risk stocks, which Woolley described as “the biggest indictment” on theory.

“At the LSE we thought if we could explain momentum we would get an idea of where we were going. We think it’s because the principal doesn’t know whether the agent is competent… If you can explain momentum you can explain value/growth, under and over-reactions and commercial risk – about a dozen anomalies.”

Woolley maintained a traditionalist approach to the research, assuming rationality despite behaviouralist theories and evidence.

A subsequent study looked at management contracts, which on the surface seemed optimal in curtailing the agents through the use of benchmarks. “That’s fine and dandy in terms of agency friction but it gives rise to the inversion of risk and return,” he said.

This was because the one thing the agent wanted was to ensure there was no underperformance in the short run. This prompts the agent to overweight higher-volatility stocks. The risk-adjusted return of low-risk stocks in global markets is about four times higher than high-risk stocks.

“So, prices are being influenced by the contracts,” Woolley said. An irony is that most principals know that markets are inefficient and appoint agents to exploit that but they use tools – such as various risk measures, benchmarks and diversification tactics – which are predicated on markets being efficient.

Professor Ron Bird, who set up the UTS leg of the Paul Woolley Centre and continues to convene the annual conference, pointed out that at the second conference, in 2008, Professor Ian Harper, now of Access Economics, called for a new inquiry into Australia’s financial system.

Bird made a joint submission with Jack Gray, part-time academic, director of Brookvine, and, like Bird and Woolley, a former fund manager at GMO, to the current Murray Inquiry into the Financial System. In that the two argued that at some point there was a negative impact on GDP from having a larger financial system. This was something the inquiry should look at.

Bird said that Ross Gittins, economics editor of the Sydney Morning Herald, who reported on the submission, expressed the opinion that the inquiry was unlikely to adopt their recommendation.

But there was at least one paragraph in the whole of the interim report, Bird said, that noted the view but said the inquiry would be concentrating on efficiency rather than the size of the system and economic growth.

Bird thanked the sponsors of the conference: the Centre for International Finance and Regulation (CIFR) and the Reserve Bank, as well as the Paul Woolley Charitable Trust, along with UTS for the continuation of their support for studies in the field.

David Gallagher, chief executive of CIFR, said his organization was interested in hearing more ideas about cutting-edge research that it could work with. It had a dozen projects relating to superannuation which it funded. This was the biggest segment of 53 projects funded to date.

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