Institutional asset management seems to be in structural ascent, due mainly to demographic developments. The importance of asset managers for global financial conditions is now comparable in importance to the regulated banking system. Asset managers bear much less leverage than banks, but the sheer size of their asset holdings and their vital role for market liquidity and leverage in the shadow banking system has created substantial vulnerabilities. There is evidence that institutional asset managers and their clients can be the source of self-reinforcing market momentum.

Institutional asset management

Size and trend

The largest holders of marketable securities in the financial system are so-called “real money” investment managers with longer-term horizons, such as mutual funds, pension funds, insurances, and sovereign wealth funds. Other funds have carved out niches for special purposes. Altogether, the role of professional asset management has been growing in past decades with total assets now close to USD90 trillion, roughly equal in size to global GDP. Asset managers are a major contributor to money creation in the shadow banking system and provider of liquidity in many securities and derivative markets.

The expansion of institutional investment is being propelled by the demographic development of the world. Population aging is bringing the median age of the world population closer to the point of maximum saving, resulting in a growing savings glut (view post here). As a result, the importance of asset management for global liquidity (defined as ease of financing) is increasing relative to the regulated banking system, in particular through greater presence in bond markets (view post here).

A subset of investment funds have thrived in recent years as a consequence of the secular downward trend in interest rates and fixed income term premia. This includes fixed income, credit, risk parity and trend-following funds. A stable or rising yield environment could disrupt or even reverse this expansion. The threat is obvious for fixed income and risk parity strategies, but similarly serious for trend following. Trend followers have historically not just benefited from rising bond prices, but also from the sizable carry of long duration positions and the diversification value of long duration positions in the deflationary crises of the past 20 years. The latter two tailwinds could turn into headwinds in a rising interest rate environment (forthcoming post).

“Distress at an asset manager may aggravate frictions in financial markets, in particular frictions in market liquidity.”

Andrew Haldane, Chief Economist, Bank of England, 2014

Systemic importance

With rising assets under management, inefficiencies and self-reinforcing correlated behavior become a greater systemic concern. Market conventions, accounting practices, and regulatory changes in the industry all contribute to such inefficiencies (view post here). For example there is evidence that insurance regulation, such as the EU’s Solvency II framework, creates a bias against asset with high market risk and daily volatility, such as equity (view post here). Simultaneously, this regulation favors holdings with lower mark-to-market volatility but serious medium-term shortfall risk, such as government bonds or high-grade credit.

In sharp contrast to banks, asset managers use very little leverage. In particular, outside hedge funds and private equity funds, leverage is typically less than 2% of assets under management. However, asset managers can use some debt financing to enhance returns, either through outright borrowing or through derivatives (synthetic leverage). They tend to do so in a pro-cyclical fashion (see section below). Considering the huge volume of assets, changes in buy-side leverage can still have a significant impact on financial conditions, particularly in areas where funds carry more leverage, such as in emerging markets (view post here).

“Open-end funds are exposed to redemption risk because investors have the ability to redeem their shares (usually on a daily basis) while funds have increasingly been investing in relatively illiquid securities.”

IMF Global Financial Stability Report, April 2015

The issue of “pro-cyclicality”

Also, there is reason and evidence for asset managers to be pro-cyclical in their investment style, particularly in crises. This appears to occur through several channels:

  • Institutional investors rely on stability of funding and market liquidity. Since asset managers themselves are an increasingly dominant provider of liquidity in securities and derivatives markets and – indirectly – a provider of funding for outright or synthetic leverage (view post here), negative shocks can trigger a self-feeding dynamics, with multiple rounds of liquidity pressure.
  • End-investors of U.S. mutual funds have an incentive to rush for redemption in serious market downturns, since liquidation costs will have to be borne disproportionately by those that stay invested (view post here). Analogously, asset managers globally have a tendency to hoard cash in market downturns, in order to prepare for redemptions and protects against disproportionate fires sale costs in markets with precarious liquidity (view post here).
  • Institutional investors often bias portfolios to the highest-risk securities within the confines of prescribed risk metrics in order to improve formal track records (view post here). More generally, theoretical models suggests that investment managers that maximize assets-under management have an incentive to enhance their risk-adjusted returns in normal times (when there are inflows) at the expense of larger drawdowns in crisis times (view post here).
  • Risk management systems struggle with the estimation of tail risk and statistical models are usually thrown into disarray during financial turmoil (view post here).
  • Investment managers follow short-term performance targets and can be compromised by human stress response (view post here).
  • Regulations and conventions typically encourage herding (view post here), particularly when portfolio managers are measured against benchmarks and peers, and are risk averse in respect to relative performance (view post here). Indeed, the common practice of benchmarking forces many investment managers to chase overvalued and volatile assets to contain the risk of underperforming benchmarks with an unacceptable margin. This can lead to market inefficiency, perverse relations between risk and returns and predictable flows in the market than can be exploited by momentum traders (view post here).
  • Real money funds can become a catalyst of market sell offs because they are averse to significant under-performance versus peers or benchmarks (view post here).

Thus unsurprisingly there is empirical evidence of funds re-allocating according to market conditions, chasing assets with high returns in boom times and reverting to low-risk securities in times of uncertainty (view post here).  Negative momentum that results from investment management can be reinforced by redemptions. Moreover, the impact of flows on prices is likely becoming stronger. In the fixed-income space, torrid growth in the size of funds has in recent years has been in stark contrast with weakening market intermediation (“market making”) by banks. This has largely been the consequence of regulatory reforms and increases the risk of severe market dislocations if and when accommodative monetary policy is to be rolled back.

“There is evidence that buy-side investor flows may amplify shocks in fixed income funds rather than dampen them. The evidence is that investors partially sell when the prices fall.”

Feroli, Kashyap, Schoneholtz and Shin, 2014

Sovereign wealth funds

While the overwhelming majority of financial assets is owned and managed by private investors, sovereign investors have grown to become important players in international capital markets. Sovereign wealth funds (SWFs) hold some USD3.6 trn in assets while international foreign exchange reserves amount to USD10 trn. SWFs are usually divided into five types: stabilization funds, saving funds, development funds, pension reserve funds and FX reserve investment funds (view post here).

Taken together, the value of assets in SWFs and foreign exchange reserves is equal to about one-fourth of the assets under management of private institutional investors. Importantly, sovereign wealth funds’ investment objectives are politically mandated and depend upon the purpose of the fund and political influence. Their operations are typically linked to public finances (through their funding and withdrawal rules), and monetary policy and exchange rate management. Hence they can introduce distortions in global markets.