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.
Momentum
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.
Excessive rent
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.
Antisocial
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)
Picking coins up off the ground? You left out the part about the steamroller bearing down. If there really are coins in front of the steamroller, picking them up is a public service in the same way that old duffers prospecting with metal detectors perform a public service by putting their finds back into circulation.
To the extent any strategy works, the strategist is being compensated for performing a service. To the extent it fails, he’s wasting public resources as well as his own. I think–I could be wrong. Good questions!
By the way, what better way could there possibly be for someone with “asymmetric information” to publish it than through buying and selling? That’s what prices are for, to transmit information. They do it much more emphatically than words.
I tend to agree. Competitive businesses end up providing a service that barely makes a profit relative to the costs of provision. Minimizing the costs of provision flows through to the consumer of the service. Anyone who is making a living with asymmetric information in markets is creating much more value then they are extracting, via prices more accurate given what’s knowable than they would be without their actions. This benefits the market participants hugely more than the provider, because the accuracy of prices affects all transactions, not just the provider’s. Regarding the waste of public resources, I doubt it. Those who are unprofitable leave quickly, and the noise and losses of fresh upstarts destined to fail probably reaches a steady state which supports, e.g., ongoing incremental computer sales. This seems to me to be an excellent outcome, where asymmetric players net of losing ones provide a large benefit at a small cost, and one of the costs is the infrastructure that supports the losers. And the losers are a necessary part of the overall productive enterprise, some of them succeed and do it better. It’s a good use of the technology business in support of a net win to society. What social loss?