One way trustees of pension and other funds control delegated risk is to give the manager a benchmark, usually a market cap index, and instruct him not to stray too far from that.
Even if trustees do not do this, the manager is keen to keep shortfalls against the index or peer group returns to a minimum.
Vayanos and Woolley show this seemingly sensible practice is at the root of many flaws in present day financial markets. It works like this.
One sector of the market, say tech stocks, may start to do much better than many managers expected. To avoid a bad shortfall against the benchmark they are obliged to buy the very stocks they had earlier dismissed as expensive.
Their purchases and those of other managers chasing performance push the sector even higher.
The result is a bubble with high-risk stocks pushed to unrealistic levels that predicate sub-standard returns. Extreme versions of this occur infrequently, but the underlying pressures are constantly at work.
The research shows that the damage caused by these distortions extend beyond the stock markets. In particular, the focus on short-term price performance by investors causes corporate chiefs to do the same: promoting strategies that benefit their company’s share price often to the detriment of the long-term cashflow of the business.
The policy implications of this research are extensive and Woolley has now set up a company, Ricardo Research, to help disseminate the advice to large funds that can help them to handle delegation more effectively. The aim is to improve long-term returns while making markets more stable.
It seems to have taken a theory designed to explain imperfection to come up with a model of how to achieve, if not perfection, at least a better social outcome.
*Ricardo Research: A model of imperfection, ricardoresearch.com/idea/a-model-of-imperfection
