The principal-agent problem in fund management

Before diving head long into the new year I wanted to point out a a paper that came out last month.  A paper by Paul Woolley and Dimitri Vayanos at the London School of Economics entitled “Taming the finance monster” attracted a fair bit of attention. In it they take to task the owners of capital for essentially putting up with the ongoing shenanigans of fund managers on their behalf. In addition to taking to task efficient markets they try to tackle the principal-agent problem in fund management.

This is surely an overlooked topic in finance. The separation of actual fund management from capital owners presents all sorts of issues. One could argue that market failures, broadly defined, occur because of the mismatch in incentives for the parties. Woolley and Vayanos write:

Agents have learnt that financial markets do not function like goods markets, and that the usual laws of competition do not apply under asymmetric information. Moral hazard, complexity and opacity all help them capture rents. They also benefit from mispricing, volatility and the proliferation of products. The costs and fees of intermediation go hand in hand with pricing inefficiencies in contributing to the erosion of the returns on savings.

As noted earlier the paper attracted a number of pieces in the UK. While their call to a return to long term, fundamental investing sounds good in theory there seems to be a fair amount of skepticism about the likely uptake of the author’s recommendation both for investors and regulators alike. In any event, the principal-agent issue in finance is overlooked one. The paper is worth a look if for no other reason to remind ourselves of it.

Items that mention the Woolley and Vayanos paper:

Market failure.  (Buttonwood’s notebook)

Tackling the two-headed monster of efficient markets theory and the principal-agent problem.  (FT Alphaville)

Time to stop the addiction to momentum trading.  (FT)

Big is not always beautiful.  (Economist)

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