Institutional funds - the main channel for market turbulence

by Chakravarthi Raghavan

GENEVA: There has been an explosive growth in institutional investors and the global value of assets managed by them, and while they probably are not the primary cause of market turbulence, they are the main channels by which the changing moods of investors are transmitted to the markets, according to the Bank for International Settlements (BIS).

In the US and Europe, equity prices continued to rise sharply last year, and reached new highs in April 1998 - going hand in hand with periodic surges of uncertainty. Thus, while stocks fell sharply in the autumn of 1997, in response to the crisis in South-East Asia, they soon resumed their growth.

The strength and breadth of the bull-market run in the US and Europe showed asset-price gains almost everywhere, despite divergences in cyclical positions and projections.

Referring to the various explanations for the rise in asset prices, and analyzing the various explanations and evidence backing them, BIS concludes that the current high valuations could be viewed as having more to do with declining returns on substitute assets, such as bonds, rather than with changes in attitudes towards risk.

Professional asset management

The growth of the professional asset management industry has been a key feature of the structural changes in the international financial system, a development with implications for many different aspects of the financial landscape - market turnover, securities issuance, international capital flows, market stability, industrial organization and corporate governance.

A wide variety of institutional investors, with professional asset managers, has emerged - pension funds, insurance companies (life and non-life), and investment companies (of all kinds).

In 1995, the assets managed by them in North America, Europe and Japan totalled $20.949 trillion, and this exceeded aggregate GDP for the industrial countries concerned. And the uneven distribution of these assets across countries is indicative of the considerable scope for growth, particularly in continental Europe.

At the core of the asset management relationship is a pool of assets, the returns on which are shared by the principal owners of these assets and the professionals managing the portfolios on behalf of the owners.

While the distinction often drawn between the institutional investors and proprietary trading desks of financial and non- financial companies is arbitrary, the asset-allocation decisions of institutional investors are likely to have greater bearing on longer-term asset-price cycles than proprietary desk activities, which are of a short-term, speculative nature.

Also, the incentive structure characterizing the delegated portfolio management framework can itself give rise to distinct patterns of investment behaviour impacting on market stability.

Analyzing the various institutional investors and the range of their activities, BIS says that equity holdings generally tend to be more diversified internationally than holdings of fixed-income securities. The share of foreign assets is highest in pension-fund portfolios, while insurance companies tend to be the least geographically diversified group. While the share of emerging-market investments has been increasing in recent years, international holdings by institutional investors from industrial countries tend to be concentrated in securities from the same group of countries.

But despite their recent growth, international investments represent a much smaller share of institutional-investor portfolios than one might have expected on the basis of the relative capitalization of national markets. The bias towards domestic securities appears too strong to be explained by the obvious barriers to foreign investment - higher transaction and information costs, exchange rate risks, as well as legal, regulatory and tax considerations. But the current diversification levels are less puzzling if one takes into account the structure of the liabilities of the investors.

There is also an asymmetry between investor and recipient perceptions, especially in emerging economies. The high concentration of institutional assets in some of the most financially developed countries contrasts with the relatively small size of many recipient markets. This asymmetry, coupled with ebbs and flows characterizing portfolio investments in emerging economies, highlights the potential for instability. A marginal portfolio adjustment for the investor may easily amount to a first-order event for the recipient.

Volatility of institutional funds

A shift of 1%in equity holdings by an institutional investor in one of the G-7 countries away from domestic equity would be slightly more than a 1% share of total market capitalization, but would constitute the equivalent of 27% of market capitalization in emerging Asian economies, and over 66% of Latin American equity markets.

There is now a growing share of savings channelled through institutional investors. On the one hand, both motives and attitude towards risk can vary substantially across different types of institutional investors, and the continuing growth of investor types will promote diversity of financial market players.

However, the risk and reward structure embedded in a delegated portfolio management relationship could impair the ability or willingness of managers to take contrarian positions, thus reinforcing a herd-like type of behaviour.

And while there is a greater variety of individual actor preferences and views that can find direct expression in asset-allocation decisions, the dynamics of delegated portfolio management relationship may discourage diversity - due to the frequent evaluation of money managers' investment performance against market benchmarks. And the managers' incentive to follow each other's trading strategies is strengthened when evaluation is performed against a peer universe. Under-performance along with the rest of the group will be less damaging than the risk of being singled out when a contrarian bet proves disappointing.

Analyzing the response of institutional investors to the events of 1997, and based on pension-fund data available from the Netherlands, UK and USA, BIS reports that fund managers had embarked on a reduction of their exposure to Asia as early as the last quarter of 1996, possibly responding to the emerging signs of strain.

While the withdrawal may reflect a retreat from an originally overweight exposure, it is consistent with survey evidence of declining market enthusiasm for the region for a number of months prior to the outbreak of the crisis in July.

The behaviour of these managers, BIS adds, contrasts sharply with that of banks, which apparently continued to increase their exposure to Asian borrowers until the second quarter of 1997.

Further investigation is needed, BIS says, as to whether this demonstrates greater insight on the part of pension-fund managers, or the unwillingness of banks to withdraw precipitately lest it damage customer relationships.

Also unclear is the extent to which banks' investment decisions were influenced by safety-net guarantees for interbank counterparties or the anticipation of intervention by the international financial community in the event of a crisis.

Nevertheless, these two types of institutions behaved differently.

Role of hedge funds

And while hedge funds have acquired notoriety because of their aggressive investment practices and the relative secrecy of their activities, and despite oft-cited anecdotal reports, BIS says there is "little concrete evidence that hedge funds as a group were heavily involved in triggering or even intensifying the series of South-East Asian currency depreciations."

BIS notes the absence of publicly available figures on hedge-fund positions, but, on the basis of statistical estimations, concludes that the hedge funds had considerable exposure to Asia at the beginning of 1997, but that these long positions were substantially reduced a few months before the crisis, while positions were built up in Latin America. Also, says BIS, there appears to be no statistical evidence that "these funds as a group had extensive short positions against Asian currencies at any time during or after the summer of 1997".

But while some of the anecdotal reports referred to by BIS, and public charges about the speculative activities of specific hedge funds, have come from high-ranking personalities like Malaysian Prime Minister Mahathir Mohamad, the contrary conclusions of BIS are related to such funds "as a group", and not to any individual fund or funds.

The behaviour of pension and hedge fund managers before, during and after the crisis in Asia, contrasts with that of investors in US mutual funds in emerging markets.

The investors' shift away from Asian and towards Latin American funds that started in early 1997 intensified during the summer months after the first episodes of depreciation, and then turned into a generalized retrenchment from both regions during the autumn, as the turbulence continued and its resonance was felt in the equity markets of industrial economies. This is in contrast to their behaviour at the outbreak of the Mexican crisis when the flow towards Asian emerging- market funds was only momentarily interrupted.

Comparing these with the response to the October 1997 market break, BIS notes that the institutional investors' responses are not necessarily uniform across industries or in different situations.

However, independently of when different types of investors started reducing their exposure to South-East Asia, the region experienced a generalized withdrawal of funds by both bank and non-bank institutions during the second half of 1997, illustrating how highly-correlated strategies across different players may contribute to an aggravation of asset-price movements.

These behavioural characteristics of institutional investors, therefore, will be an increasingly important determinant of domestic and institutional financial market conditions, "and the implications for financial stability warrant serious consideration."

Emerging trends

A growing appetite for liquid, transferable securities that offer diversification possibilities is a natural consequence of the rapid growth of institutional investment. But there has been a marked downward trend in the supply of such staples of pension and mutual fund portfolios as industrial-country government bonds and publicly listed equities.

Net equity issues have been on the decline in the US for over four years, under the influence of a wave of mergers and acquisitions. Unlike in the late 1980s, these have not been financed by bonds and corporate share buybacks aimed at increasing shareholder returns.

Also, efforts at fiscal consolidation throughout the industrial world imply a decline in the supply of equities and government bonds, and this demand has to be satisfied by other asset classes.

This is likely to give impetus to the markets for securitized debt, private equity, emerging-market securities and other alternative forms of investment. It is also likely to encourage the further development of synthetic securities which replicate the risk/return characteristics of government paper through the use of structured derivatives.

There is evidence that during the past few years, alternative investments like leveraged buyout funds, international private equity and venture capital have made considerable inroads into institutional- investor portfolios - with commitments standing at about $70 billion for US and Canadian pension funds.

There is also a consolidation trend across the entire financial services sector, with implications for the industrial organization of the asset- management sector and its relationship with other types of financial institutions. Asset-management conglomerates are constantly growing in size, naturally or by acquisitions. There have also been some well- publicized cases of consolidation in the insurance industry.

Other structural events include liberalization of the Japanese financial services market, the creation of a single currency market in Europe, and the trend towards mergers or strategic alliances between banks and asset-management companies.

"These developments," says BIS, "raise questions about whether current regulatory structures, which remain fragmented along industry and national lines, are adequately suited to an emerging financial landscape where borders are becoming increasingly blurred."

"Does the growth of institutional investors contribute to financial instability?"

"The answer is probably not, as the primary cause of market turbulence, but, by virtue of the size of their portfolios, they are usually the main channel through which the changing moods of investors are transmitted to financial markets."

The forces that could "potentially induce institutional investors to engage in behaviour that might at times amplify asset price dynamics require further study."

"There is need for those responsible for safeguarding financial stability at both the national and international level to understand the way various types of investors behave and react to market conditions. In an increasingly liberalized financial market place of global proportions, understanding and managing market dynamics and their associated risks is the best insurance against excessive volatility that leads to costly crises." (Third World Economics No. 187/188, 16 June-15 July 1998)

The above article was originally published in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.