Risks are growing in big equity and bond funds

Money printing and the current stockmarket boom are increasing systemic risk, pushing problems into new areas. Now the questions is; are some asset managers too big to fail? The financial crisis highlighted risks in banks and insurance, but other areas have been overlooked. Finally, regulators are beginning to recognise risks in the investment sector, and are turning their attention to some of the largest managers. But there seems no hurry to plug the gaps. More urgency is needed, and the risks in big bond, equity income and emerging market funds must be addressed.

Asset managers reject any suggestion they might represent a threat to the financial system, and are quick to point the finger at banks. But globally, the top ten asset managers have a market share of almost 30% of their sector, much more than the top ten banks represent in banking. Assets managed globally are estimated to exceed $80 trillion, and the world’s largest investment manager is bigger than the world’s biggest bank.

Quantitative easing has spurred growth in the investment sector since the crisis, contrasting with shrinkage in banking. Asset managers might not have leveraged balance sheets, but they are globally interconnected. Worryingly, concentration is not reducing as the industry grows. Yet, central banks seem unware they might have exacerbated risks, creating asset bubbles with easy money policies. Why have regulators been slow to act?

Might the regulatory burden itself be a key driver of these concentration risks? The industry is being forced to improve its offering for consumers, but there is little sign that competition itself is increasing. Cost and security have become priorities for investors and their advisers, even above performance. Large funds offer apparent ease of dealing – in terms of investor subscriptions and redemptions – but underlying portfolio liquidity is likely to be deteriorating as they grow.

Undoubtedly financial advisers believe they are opting for safety. The virtuous cycle of success and fund growth gets regulatory encouragement. Many advisers find that larger funds reduce the compliance burden, in addition to being easier to explain to retail clients. Name recognition, perceived liquidity, and cost have become bigger factors than performance. But in aggregate, systemic risk may be growing.

Overall stockmarket trading volumes are declining, with less capital now involved in market making. Big portfolio positions might be liquid enough for normal day-to-day dealing, but left stranded in any significant rush by investors for an exit. Regulation directs advisers to look at the apparent liquidity and security benefits of scale, but what is missing is a test of how this might work in a crisis.

New factors have been driving this fund concentration. Some star managers have attracted an enormous following, encouraged by the emphasis on brands and personality. The industry has always enjoyed good operating leverage, but strategy now seems focused almost entirely on scale. Scale offers great commercial advantage, with profitability improving as funds grow. Fortunately, there are incentives for the best managers to limit fund growth to a level that still leaves opportunity for genuine performance. But, increasing concentration points to the dominance of scale as a factor.

The recent acceleration in scale and concentration has to date seen only limited tests. Moves of star managers such as Bill Gross and Neil Woodford, have triggered significant but orderly fund flows. Yet, it is possible in some less liquid asset classes – such as emerging markets and corporate bonds – for investor liquidity demand in a sell-off to exceed realistic liquidity. The fund’s scale can create an illusion of safety that may not be understood by private investors.The regulatory problem is that managers are required only to test liquidity on open-ended funds at the margin – whether subscriptions and redemptions over a period of weeks should be at bid or offer prices. They must consider whether fund inflows or outflows might compromise fairness for ongoing fund investors. And, if mutual funds are very small, managers must consider an orderly plan for protecting residual investors and ensuring orderly liquidation.

But, while regulators worry about investors in small funds, there is no symmetry in the treatment of the biggest funds. Managers are not required to demonstrate the implications of a significant withdrawal; how they might achieve price discovery and liquidity. If the only plan is gating investors, the systemic risk could simply be pushed elsewhere. Investors would scramble for liquidity in other assets if their largest investments were locked-in for a period.

The Financial Stability Board (FSB), chaired by Bank of England Governor Mark Carney, recently warned that it would move to address any too-big-to-fail problems among entities that are neither banks nor insurers. But, it is still consulting and has not yet spelled out what new rules are needed. There is an urgent need for research and analysis to develop a working definition of systemic risk. And, it would be best if this were harmonised globally so that global asset managers know where they stand.

Together, the FSB and International Organisation of Securities Commissions aim to look at the potential for size, complexity and interconnectedness to impact the wider financial system through disorderly failure. The new consultation will likely focus on managers with assets under management exceeding $1 trillion and funds of over $100 billion, but it is easy to see that smaller funds than this could raise systemic issues. The asset managers likely to be affected have not yet been named, and this consultation will continue till May 29.

But this approach may not capture risks to individual national or regional finances. If concentration might be a risk globally in asset managers, the risk to individual exchanges and asset classes should surely also be looked at. National regulators should ask managers to be more explicit in explaining the risks of scale to investors. More detailed attention to funds below $100 billion that might dominate their asset classes is needed.

A version of this article was published in CFA Enterprising Investor on April 23rd 2015 and as an Op-Ed in Financial News on April 13th 2015.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. I have no business relationship with any company mentioned in this article. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

Image credit; Creative Commons some rights reserved.

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