We’ll get to “antisocial” via a look at a chapter in The Future of Finance from the London School of Economics.
The chapter in question is “Why are financial markets so inefficient and exploitative?” by Paul Woolley. There are many things in this chapter with which I agree. There is roughly an equal number of things in the chapter with which I strongly disagree.
Implicit in the discussion is that bubbles and crashes are merely momentum with consequences.
A major component of the chapter holds that momentum arises from investors switching fund managers. The fund managers in ascendancy get more money and hence increase their positions, creating momentum. This has to be right.
The chapter implies that such momentum would barely exist without the intermediation of the fund managers. I’m not much of a historian, but I doubt that there were many tulip managers during the tulip mania. Though fund managers have less than a perfect record, it is my impression that individual investors are much more prone to chase winners. Do we have any data on this?
If people chase winning fund managers, why wouldn’t they chase winning assets as well?
Another more minor source of momentum discussed in the chapter is the imposition of (maximum) tracking error constraints:
The agent is obliged to close down risk by buying stocks that are rising and selling those that are falling, thereby amplifying the initial price moves.
This also sounds right to me. I have other arguments with tracking error constraints which are given, for example, in Changing fund management.
Another big theme of the chapter is that fund managers extract excessive rents from investors because of asymmetric information. I think that is only half right. It’s not that fund managers are hiding their performance from investors — they don’t know either. Knowledge (on both sides) can be improved by doing better performance measurement using random portfolios.
The author suggests that hedge funds should be hunted into extinction. This doesn’t make any sense to me. If we are to have active fund management, I don’t see what difference it makes who does it. If we are to have no active management, I don’t see much hope for the reasonably efficient allocation of capital.
Here are some assumptions:
- Big momentum (that is, a market crash) is bad.
- Small momentum increases volatility and hence is not desirable.
- Momentum strategies increase momentum (there is positive feedback).
Do we all believe each of these?
If I implement a momentum strategy, should you regard me as:
- Picking coins up off the ground
- Littering (acting conveniently for myself at the expense of others)