Are Money Managers Lemmings?
It was once widely believed that the rise of professional investors would make financial markets less prone to manias, panics and crashes. Lately, the opposite belief has begun to take hold. Take it from the International Monetary Fund’s Bradley Jones:
It should perhaps serve as a shot across the bow that the rise of the institutional investment management industry -- populated with what are presumably the most sophisticated, well resourced and rational speculators in the world -- has coincided with three of history’s largest bubbles in the last twenty five years: the Japanese Heisei bubble of the late 1980s, the global equity bubble of the late 1990s, and the structured credit bubble of the mid 2000s.
That’s from a working paper, titled “Asset Bubbles: Re-thinking Policy for the Age of Asset Management,” that’s been making the rounds during the past few weeks. It’s part of a burgeoning new official literature on the problems with asset managers. There’s “Asset Management and Financial Stability,” published in 2013 by the U.S. Treasury Department’s Office of Financial Research. There’s a 2014 speech -- “The Age of Asset Management?” -- by the Bank of England’s great thought-provoker, Andy Haldane. There were also a few fretful pages on the “ascent of the asset management sector” in the 2014 annual report of the Bank for International Settlements, the international club for central bankers. And in March the Financial Stability Board, the international club for the people at central banks who care about financial regulation, and the International Organization of Securities Commissions together issued a set of proposed “Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions.”
It is as if, Steve Johnson recently wrote in the Financial Times, global financial regulators were running some sort of contest.
The winners will be those who can sound the scariest warnings about the damage the ever-expanding asset management industry could be set to inflict on humanity.
The main problem with asset managers, one learns from reading (or, in a couple of cases, skimming) these papers and reports, is that they behave too much like other asset managers. That is, they “herd” -- buying into particular securities or asset classes mainly because lots of other asset managers are doing it. In the process, they make market highs go higher and market lows go lower.
This acknowledgement that professional investors don’t automatically drive prices toward something close to their correct levels is a welcome shift in economic consensus. In the 1960s and 1970s, empirical evidence that financial market prices moved very quickly to reflect new information led most people in academic finance and many in economics to conclude that the prices were thus in some fundamental way right. By the 1980s this view was beginning to lose adherents in academia, but it continued to inform financial regulation, monetary policy and other pursuits up to the financial crisis of 2008.
Now, as the IMF’s Jones explains in his entertaining and informative paper, there’s a growing body of theory and evidence that the incentives faced by professional money managers push them to run with the herd and inflate bubbles rather than making their own decisions and betting that bubbles will deflate. These incentives aren’t new. “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally,” wrote John Maynard Keynes in 1936, assessing the state of professional investing at the time. What’s different is that professional money managers now control a much bigger share of the world's financial assets than they did in the 1930s, and that the pressure they face to behave conventionally (that is, buy the same things everybody else is buying) is so explicit. The performance of active managers is now measured against the benchmarks of conventionality known as market indexes, while index funds and most exchange-traded funds are conventional by design.
What if anything should regulators do about this? The notion that some asset managers are so big that they should be designated as “systemically important” -- regulatorspeak for too big to fail -- seems pretty silly, given that, as the FSB/IOSCO report acknowledges, “asset managers tend to have small balance sheets and the forced liquidation of their own assets would not generally create market disruptions.” There was a time (1998) when a hedge fund could pile on enough debt that its failure endangered the global financial system, but that doesn’t seem to be the case now, and the giant asset managers such as BlackRock and Vanguard that regulators are concerned about aren’t really leveraged at all.
A more promising approach might be to look at the ways in which regulators have been pressuring asset managers to behave conventionally, and maybe dial some of them back a bit. In his speech, the Bank of England’s Haldane mentions risk-based capital rules and mark-to-market accounting as forces that have driven pension funds and insurance companies to buy and sell assets in a procyclical, boom-and-bust way. I also get the sense that, in the U.S. at least, any asset management approach that isn’t built around low-cost index funds is being subjected to increasing scrutiny from regulators and the courts.
Still, I’m having trouble imagining how we could get to a world where asset managers felt encouraged to follow the path less traveled. Better to acknowledge that there will inevitably be asset bubbles and busts, and figure out how to keep them from doing too much damage.
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