Most of us have been brought up to believe that free markets combined with healthy competition deliver good outcomes. We also presume that what holds true in goods markets also applies in financial markets. The reality has made a mockery of this belief. Capital markets have come to resemble less the embodiment of efficiency, more a war zone. If foundations adopted investment policies more in line with this reality, they could secure better long-term returns on their own investments. At the same time, as large institutional investors, they could play a significant role in shaping the future of long-term investing and helping to bring stability to financial markets.
The standard paradigm for how financial markets work comes from the work of a group of Chicago economists who formalized the ‘efficient markets hypothesis’ in the 1970s. According to this theory, competition means prices are always ‘right’, capital markets are self-stabilizing, and no one can consistently earn excessive profits.
Everything we have observed in recent years has been the antithesis of the world described by this theory. Equity returns have been wretchedly low and volatile; bubbles, crashes and crises abound; and the return on fixed income has collapsed with no early prospect of improvement. Bankers have alternately made billions in profits and bonuses or come cap in hand to be rescued with bail-outs of even greater magnitude.
Because there has been no accepted alternative to the received wisdom, most of the policy actions and decisions of asset owners such as pension funds and charitable foundations are still based on the presumption of market efficiency. Sadly, new research shows that investing on the basis of a misunderstanding of how finance works leads to low and volatile returns and leaves asset owners vulnerable to exploitation by intermediaries.
The flaw in the efficient markets hypothesis is its failure to recognize that the bulk of asset owners (call them the principals) do not invest directly but delegate the task to agents, such as fund managers, banks and brokers. Delegation creates problems because agents have better information and different objectives from the principals, and the principals have difficulty learning whether agents are competent and diligent. In the case of foundations, the trustees are responsible for fulfilling the mission of the foundation while investment of assets is usually delegated to professional investment managers.