Bank of England’s Andrew Haldane has summarized the rise and risks of asset management in a recent speech. As demographics and economic development propel the industry to ever higher assets under management, self-reinforcing correlated dynamics become a greater systemic concern. Market conventions, accounting practices, regulatory changes and structural changes in the industry all contribute to this risk.
“The age of asset management?”
Speech by Andrew G Haldane, Executive Director, Financial Stability, Bank of England, London, 4 April 2014
The below are excerpts from the speech. Cursive lines and emphasis have been added.
The rise of asset management
“Asset management is…an agency activity. Assets are managed on behalf of end-investors, whether institutional (such as pension funds and life insurance companies) or retail, the former typically through Separately Managed Accounts, the latter through Collective Investment Schemes.”
“The industry’s assets under management (AUM) are currently estimated at around USD87 trillion globally. This is…equal to around one year’s global GDP or around three quarters of the assets of the global banking industry. It has also grown fairly rapidly, with AUM roughly doubling over the past decade in dollar terms. The longer-term picture is more striking still. In the United States, AUM have risen almost fivefold relative to GDP since 1946, from around 50% of GDP to around 240% of GDP. In the United Kingdom this pattern has been replicated, but over a much shorter time period since around 1980.”
“The drivers of this growth are reasonably well-understood. The pool of prospective global savers has become larger, older and richer, each of which tends to be a boon for the asset management industry. Since 1950, average life expectancy has risen by nearly 50%, world population has risen by a factor of three and world GDP per capita has risen by a factor of nearly 40.”
“Looking forward, none of these global forces – population, ageing, incomes, wealth – are likely to go into reverse in the near future…the global asset management industry is likely to continue its upwards march, absolutely and relative to the economy. For example, PriceWaterhouseCoopers recently forecast that AUM would top USD100 trillion by 2020. Simply extrapolating GDP per capita trends forward…AUM could reach USD400 trillion by 2050. ”
The risks of rising asset management
“As an agency function, asset managers do not bear credit, market and liquidity risk on their portfolios. Fluctuations in asset values do not threaten the insolvency of an asset manager as they would a bank. Asset managers are, to a large extent, insolvency-remote. They are not, however, insolvency-immune. An individual manager or fund does face operational and reputational risk – for example, arising from a Maxwell Pensioners-sized fraud or an Arthur Andersen-shaped reputational hit. We have seen examples of this in the past – the large outflows from Gartmore’s funds following the departure of key staff prior to its acquisition by Henderson; or the outflows from Axa Rosenberg in 2011 following an alleged fraud.”
“Distress at an asset manager may aggravate frictions in financial markets, in particular frictions in market liquidity. One example would be an asset fire-sale. This might arise if assets from a failing fund were offloaded at a pace and scale that caused indigestion in the underlying market. .. This fire-sale friction might be fanned by the actions of investors or counterparties. Falling asset prices may be the prompt for withdrawal (in the case of open-ended funds) or sales (in the case of closed-end funds). In some respects, this would mimic a banking run, albeit operating through non-conventional channels.”
“In practice, such adverse financial market dynamics are more likely to arise from asset managers behaving in a correlated fashion. Academic and industry evidence points to at least three channels through which insurance companies and pension funds behaviour could generate pro-cyclicality…
- Market conventions have the potential to amplify pro-cyclical swings in asset prices and investor flows. For example, in market upswings fund managers are likely to try and juice-up returns by searching for yield in an attempt to outperform their benchmark. The reverse occurs in the downswing when there will be a quest for safety to boost relative return rankings.
- The 2000s saw the introduction of Financial Reporting Standard (FRS) 17 in the UK and Statement of Financial Accounting Standard (SFAS) 158 in the United States. This fundamentally changed companies’ accounting practices in respect of their pension obligations. In particular, companies were required to value pension assets at fair (that is, mark-to-market) values, with liabilities typically discounted using a corporate bond rate. Pension surpluses and deficits then needed to be recorded on balance sheet…. in a downswing, risky asset prices and safe rates tend to fall, raising measured deficits. Faced with this, pension funds will have an incentive to sell risky assets and purchase bonds to better match their assets and liabilities… A similar dynamic affects insurance companies.
- Risk-based regulatory rules can contribute further to these pro-cyclical tendencies. For example, consider a pension fund or insurance company operating close to its risk-based capital or funding requirement and whose bond portfolio is downgraded and suffers a drop in price. This has the effect of both reducing measured solvency due to marking to market and raising required risk-based capital requirements – a double whammy. In response to this, insurance companies and pension funds may have an incentive to sell their downgraded assets to de-risk their portfolio.”
Structural changes on the asset side
“As important as the absolute scale of the asset management sector is its composition. On the assets side, a number of important trends are at play…
- [There has been] rapid growth in specialist funds, often investing in less liquid asset classes. This is evident in the growth of so-called alternatives, such as hedge, private equity, real estate, infrastructure and commodity funds. These have risen from under USD2 trillion AUM in 2003 to over USD6 trillion by 2012, or from 5% to 10% of global AUM.
- A second striking feature has been the rise in the importance of passively managed funds, including Exchange Traded Funds (ETFs) and other index-tracking strategies. These passive or tracking funds have risen from USD2 trillion in 2003 to almost USD8 trillion by 2012, a rise in global market share from 5% to 13%. Within this, ETFs have been growing at an annual rate of around 30% for the past decade with AUM currently standing at USD2 trillion.”
“The shift towards illiquid assets heightens market risk for investors. And the move into passive and tracking strategies increases the potential for investor herding and correlated market movements.”
Structural changes on the liability side
“Turning to the liabilities side of the balance sheet, here again some important trends are at play…[There is a] progressively greater share of investment risk being put back to end-investors, with commensurately less being borne by intermediaries and companies. One clear example is found in the pensions industry, with the structural shift away from Defined Benefit (DB) and towards Defined Contribution (DC) pensions…The picture is similar on the life insurance side, with virtually all of the growth in UK life insurers’ balance sheets since the early part of this century coming from unit-linked products where the investment risk is borne by end investors.”
[…] Since the end of WWII, there have been a number of [nearly] structural developments (demographics boom, expansion of international trade, Eurodollar markets’ growth, price-competitive labour pools etc.) that have eventually bloated the financial industry. See here, here and here. Indeed, you can look at this development from various angles, but probably the one which stands out the most is the relative growth of AUMs of asset managers relative to GDP2. […]