Picture: THINKSTOCK
Picture: THINKSTOCK

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THE past year has not been a happy one for value managers who invest on the basis of fundamentals, while momentum traders who chase short-term trends have been making hay. Yet, there is a conundrum about precisely where their profits come from — or rather, at whose expense. Value managers have no interest in buying the momentum folk out of their overvalued stocks. So, who is on the wrong side of what, in the short run, is a winning trade for the momentum brigade?

Dimitri Vayanos and Paul Woolley of the London School of Economics offer a convincing answer in a new paper.* The victims are fund managers whose portfolios are benchmarked against market indices. This is paradoxical. The purpose of benchmarking is partly to manage the conflicts of interest whereby professional managers (agents) invest money on behalf of asset owners (principals).

With constraints on the margin by which returns may diverge from those on the index, the practice is meant to limit the damage that can be done. Yet, there are serious unintended consequences.

To comply with tracking constraints, a manager has to control how far the composition of the portfolio departs from the index. It is crucial to be most vigilant towards underweight positions in securities with large weights in the index, especially those with volatile and rising prices.

Vayanos and Woolley point out that if a security doubles in price and the investor is half-weight, the mismatch doubles, whereas if the investor is double-weighted and the price halves, the mismatch halves. So, underweight positions in large, risky securities have the greatest potential to cause the manager trouble.

The models used by Vayanos and Woolley show how benchmarking pressures distort prices. If, for example, a positive earnings shock for a security causes prices to rise to a higher valuation, managers who are underweight will find their mismatch has increased and be obliged to make additional purchases to satisfy their tracking constraint.

There is no corresponding pressure on managers with overweight positions because they have gained a contribution to their target return and are unlikely to have breached the tracking error on the upside. The initial price rise is thus amplified, making these stocks both more expensive and more volatile.

The outcome is that high-risk stocks are driven up and their future returns down, while low-risk stocks are pushed down and their prospective returns up. In effect, benchmarked funds are captive buyers of securities with rising prices, and momentum traders are exploiting that predictability. The irony is pension fund trustees have been appointing one set of managers to exploit another set also in their pay.

When a majority of trades bears no relation to fundamental worth and is focused instead on window-dressing and gaming, mispricing is inevitable. Momentum traders and benchmarkers focus on current price and valuation to the exclusion of what matters for pension fund beneficiaries — long-term earnings and dividends. The focus on fund flows rather than cash flows leads to secular overvaluation, argues the paper, and explains the inversion of the relationship between risk and return, whereby high-volatility securities and asset classes offer lower returns than low-volatility ones.

It follows that capital is being misallocated, and it is also clear transaction costs in capital markets are unduly high, as momentum trading involves high trading volumes, which is one of several reasons value investing tends to outperform momentum in the long run.

Vayanos and Woolley suggest a radical revision of the contracts that trustees write with fund managers. They have thrown down a hugely important challenge to trustees and their investment consultants. Financial Times

*Curse of the Benchmarks, LSE Financial Markets Group discussion paper number 747