Emma Wall: Hello and welcome to Morningstar. I'm Emma Wall and here with me today is Paul Woolley from the London School of Economics to discuss how short termism creates anomalies in the market. Hello, Paul.
Paul Woolley: Hello.
Wall: So, I thought I'd start by asking you, what is momentum?
Woolley: Momentum in a word is trend following. It's buying stocks or bonds that are going up and holding them for a period. I mean it's a short-term strategy of buying what's going up or indeed selling what's going down, and then closing the position at the end of, say, two or three weeks or two or three months.
Wall: Because herding could have negative effect on investments, but momentum is a strategy that people use and then company gains out of it.
Woolley: Yes they can. Momentum means just following fund flows. It's got nothing to do. It takes no regard at all of the fundamental value of the business or if we're talking about equities it takes no account of the dividends, the earnings and so forth. It is simply following the momentum of funds the slushing across the markets constantly.
Wall: But it's one of the by-products of short termism isn't it, which we're becoming increasingly obsessed with as an investment market.
Woolley: I define short termism actually as being momentum and I identify long termism with actually investing on the basis of fundamental value, I mean that is a very important distinction think of I mean people who have been struggling for 40 years to nail the question of what is short termism. Well, if you identify it as being momentum following fund flows and investing on the basis of fundamental value, value investing if you like as being long-term.
Wall: How does this marry with the concept of the benchmark because you've just given the talk at Morningstar Investment Conference in Europe and you – benchmarks are one of the something that's quite close to Morningstar readers and they – I feel either increasingly obsessed with them to the detriment sometimes with that portfolio or frustrated with them and they would rather have their fund manager freed themselves from the shackles of the benchmark, but it does really drive performance, doesn't it at benchmark?
Woolley: First of all let's decide and benchmarks what benchmarks we're talking about. We're talking about a market cap based – the current market price based an index whether it's a national or global index. If you have that as a benchmark you're actually bear in mind just what we've been saying that prices are driven not just by the underlying value of securities but by fund flows moving.
Well similarly the benchmarks get distorted both the aggregate benchmark the value of the national index or indeed the valuation of individual parts of that whether it's industry or some segment of the market, like the high-tech in the tech bubble 15 years ago, I mean technology stocks got ridiculously overvalued and the index had 45% allocation that's ridiculously overvalued sector. So, the benchmarks get distorted and to chase benchmarks also you'll need to use momentum to chase that position. So, you're actually got a double whammy against you.
Wall: Is the answer then scrapping benchmarks all together?
Woolley: There will always be benchmarks in terms of indexes of what the markets doing, but it is best if you're a long term investor to focus on fundamental value as far as you can or to get your manager to focus on investing on the basis only of cash flows, because that is the only way that you win.
Momentum may win in the short run. It's like the hare and the tortoise, momentum may win in the short run, but unless you're extraordinarily lucky many, many times in a row over a long period, you will lose by using momentum and in fact, you provide the opportunity as momentum investors collectively provide the opportunities that the value investors exploit.
Wall: Paul, thank you very much.
Woolley: Fine.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
