UK – A flawed understanding of finance combined with problems between savers and the professionals who invest for them are destroying capitalism, according to academics at the London School of Economics (LSE).

A team there has developed an alternative model of finance that recognises how individual savers delegate investment responsibility and sets out to explain mispricing, momentum, bubbles and crashes.

Paul Woolley, chairman at the LSE’s Paul Woolley Centre for the study of Capital Market Dysfunctionality, said: “Principal-agent problems and a flawed theory and understanding of finance are bringing capitalism to its knees.”
Addressing the issue of sustainable investment, he told an event hosted by Prince Charles at St James’s Palace that momentum investing had become dominant over fundamental investing, both for short-term gain and short-term risk reduction.

He argued that this type of investing had been the main cause of bubbles and crashes.  

“The choice between these two strategies, rather than the length of holding period, is the key to understanding short-termism,” he said.

The aims of the sustainability movement cannot flourish when investors disregard fundamental value, he said.

While the finance sector is fuelled by capital provided by savers, it is savings institutions such as pension funds that set the terms for how that capital is allocated, he added.

“Immediately, there is a problem,” he said.  “Astonishingly, the bulk of investing by pension funds and other savings institutions is now conducted without reference to fundamental value.”

He pointed out that pension funds used academic finance theory to select benchmarks, control risk, choose strategies and write contracts with managers, but claimed that theory assumed investors invested directly in securities.

Woolley said his centre was developing an alternative model of finance by recognising that individual savers delegate responsibility for investing to others.

Delegation creates principal-agent problems, he said, with the agents having better information and different objectives, and the principals being unsure about the competence and diligence of the agents.

“The new theory explains mispricing, momentum, bubbles and crashes and other long-standing puzzles, such as value and growth, under- and over-reaction and why, perversely, high-risk stocks offer a lower return than low-risk stocks,” he said.

He said it allowed investors to compare risk-adjusted returns for different strategies and implementations, adding that, so far, this had only been possible empirically.

The model showed that momentum could only be justified for investors with short horizons, and that fundamental investing won out in both the medium and long run.

Woolley also argued the work had significant policy implications.

“It shows that almost everything practitioners and policymakers are currently doing is diametrically wrong and both privately and socially damaging,” he said.

Funds adopting these strategies will be rewarded with higher medium- and long-run returns, irrespective of what other funds are doing, he claimed.