If it takes a theory to beat a theory, then there may finally be an alternative to the Efficient Market Hypothesis (EMH) first proposed by Eugene Fama in the 1960s. Paul Woolley, formerly of GMO and the founder of The Paul Woolley Centre for the Study of Capital Market Dysfunctionality at the LSE has offered a model for financial markets which seems to fit better with the real world.
The two fundamental tenets of the EMH, in its hard form, are:
(1) Public information gets reflected in asset prices without delay
(2) In an efficient market, no arbitrage opportunities exist
If markets are efficient, then logically it follows that there are no bargains. Investors who believe in the EMH do not pay fund managers a fee to pick good stocks, because they do not think fund managers can find value.
Criticism of the EMH has been predominantly based on the real world experience of momentum and mispricing. Over short holding periods, there is some evidence of momentum in the stock market, while for longer holding periods mean reversion appears to be present.
Woolley’s contribution to the debate is to recognise that investors (“principals”) tend not to invest directly in securities but through “agents,” such as fund managers. It is the delegation by the Principals to the Agents that explains the mispricing in markets. Delegation creates an incentive problem insofar as Agents have more and better information than their Principals. Moreover, the interests and objectives of Agents frequently differ from those of their Principals. Principals cannot be certain of the competence or diligence of the Agents.
In his view, this model better explains real world observations. Rational profit-seeking by agents and the investors who appoint them gives rise to mispricing and volatility. Once momentum becomes embedded in markets, agents then logically respond by adopting strategies that are likely to reinforce the trends. This leads to under-and-over valuation of asset prices.
Woolley’s theory addresses the fact that markets are not always efficient and will exhibit mispricing. It is a small step further to argue that active managers can take advantage of periodic mispricing.