The mystifying immortality of efficient markets theory

A few weeks ago, I wrote a blog post in which I criticised the PLSA’s guide to Patient Capital. A shorter version of the post was published in the FT. Between them, they generated quite a bit of feedback.

Some can be easily dismissed (someone accused us of being ‘jealous’ of private equity fees – talk about getting things back to front) but one point, in particular, got me thinking. In a thoughtful response, the manager of a large UK DB pension fund pointed out that the missing part of my argument was the inherent value of the lower volatility of unlisted equity vis-à-vis listed. In a world of pension solvency rules and funding plans this matters (notwithstanding that this lower volatility is neither real nor a good measure of risk). 


Unlisted equity is only revalued occasionally, and usually on some reasonably sensible assessment of how the business is progressing. Listed equity, on the other hand, suffers the effects of short-term market speculators who create share price volatility as they seek to out-speculate each other. So, despite the large chunk of private equity returns which go to the managers, the proposition of equity-type returns at low volatility is all but irresistible.


It's hard to see from first principles how private equity should be inherently more or less risky than listed equity. It will surely vary from company to company in either case. Studies show that returns from private equity are not in the long run significantly distinguishable (before fees!!) from listed small-cap equity. That said, one study in 2018 (Doskeland and Stromberg) showed that debt/enterprise ratios in Leveraged Buy-Outs are roughly twice those in public companies matched for industry and country – so the theoretical volatility of the equity slice in private equity is actually higher. 

The logical conclusion is that the existence and easy availability of secondary markets to anyone who wants to trade (speculate) on them has actually become damaging to the financial system.

The real question though is whether private equity volatility is artificially low, listed equity volatility too high, or both. There are many studies in this area going back to, for example, Shiller (1981) and French and Roll (1986) which show that public stock price volatility is way higher than is justified by fundamentals. The problem here is, therefore, at least in part, not that private equity understates risk through infrequent valuations, but that listed equity overstates it. And regulators (who, knowingly or unknowingly base their approach on observably wrong Efficient Markets Theory) misguidedly incorporate share price volatility as an input in calculating solvency risk for pension funds. This forces pension funds to reduce their listed equity allocations to well below the level that is justified by underlying economic reality.


This is not just some theoretical observation. It reduces the supply of risk capital to companies, creates a misalignment of time horizons between company management and end investors, and is likely a contributor to lacklustre productivity growth. The logical conclusion is that the existence and easy availability of secondary markets to anyone who wants to trade (speculate) on them has actually become damaging to the financial system. Is there a quick fix for this? Well, one way to do it would be to make it much more difficult to speculate. Of course we’re not advocating that stock markets should only open once every five years (they do actually serve a liquidity function), but as a thought experiment, what if our pension fund clients were able to value their portfolios on that basis? Surely it would be better than the current Alice-in-Wonderland approach of using an artificially created non-fundamental measure of risk to drive damaging real-world behaviour? 

Stuart Dunbar


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