Does the Primacy of Asset Management Signal the End of Value Creation?

Wow. The Age of Asset Management. It sounds so portentous, so serious. It's not quite as iconic as the Age of Exploration, or even the Age of Aquarius, but hey,  if you're in the asset management business, it must be nice to know that your work is worthy of Age-ism.

What this appears to mean is that the global economy is, belatedly, pulling itself out of the recession in which it has been mired since Justin Bieber was a new discovery. As a result, assets are being created, financial assets in particular, and somebody has to manage them. Which sounds like good news for the financial services industry and a warning to hold onto your wallet for everyone else.

There is lots of data to support this asset creation story as the following article explains. But the trend also raises an unsettling question about what all this asset management talk really means. Because as we have seen for the past few years, corporations and the banks that used to fund them have been loath to actually do what they were originally designed for: invest and lend. Businesses are notably leery about actually committing themselves to anything to which a guarantee is not attached. And financial institutions seem happier managing money than putting it to work the old-fashioned way by assuming some limited risk on the growth of the economy. There is also the looming question of impatience: the inclination to move money funds so quickly that notions like long-term and short-term seem archaic in the face of high speed algorithmic trading done by bots rather than investors.

This reluctance to do something more productive than manage other people's money will, eventually, come back to haunt everyone involved through lower returns and subpar growth. But the presumable thinking appears to be that a way will be found to manage for that. JL

Dan McCrum reports in the Financial Times:

Financial capital, even among long-term institutional investors, has become restless at just the time the economy requires patience
Andrew Haldane has declared the age of asset management upon us, but we suspect champagne corks will not be popping at BlackRock et al.
The title for the speech by the executive director for Financial Stability at the Bank of England appended a crucial question mark, and it turns out that the central bankers are only just starting to get heads around an entirely different set of too-big-to-fail problems to those of the banks. The good news is that asset management is going to be huge — spectacularly, monumentally more huge that it is now.
Current assets under management worldwide are in the region of $87tn, one year of global GDP or about three-quarters of the assets held by banks.
These will rise as the world gets richer. Case in point is the US:

Extrapolate the following chart forward to 2050 and assets under management number will be $400tn (although we were into the realm of numbers too big to take in at $87tn, really).

We are also nowhere near peak-Piketty.

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. There is a strong cross-country correlation between GDP per capita and AUM relative to GDP (Chart 3).
Accompanying this has been a sharp rise in the ratio of global wealth to income. Among Western economies, this ratio has roughly doubled since 1950 from around 200-300% of GDP to around 400-600% of GDP (Piketty (2014)). Among other things, this has been attributed to post-war capital market liberalisation causing an upward shift in asset prices.

But the bad news is that regulators need to think about what that means for markets and the financial system.
For one, concentration is actually higher in asset management than banking, when it comes to the top ten share of assets, although the banks are generally bigger than the asset managers. (Deutsche Bank appears in both lists.)

Too big to fail, perhaps, but in a different way to the banks. Solvency of the asset managers isn’t really the problem — little leverage, third party ownership of the assets — but pro-cyclic behaviour, herding and short termism may be.
Part of that is regulatory, solvency requirements for pensions and life insurers for instance. But we also think the investment consultants who steer vast amounts of pension cash around are going to get a lot more scrutiny.

The use by asset holders of a small pool of consultancies for investment advice may also generate correlated investment strategies. And the use of short-term performance mandates for fund managers is also likely to amplify pro-cyclical swings in asset allocation and asset prices.

Also, job risk for trustees and staff at pension funds, who have an incentive to pay to get their hands held by investment consultants and to not take risks when things are going well.
Haldane argues that long term capital such as pension funds is supposed to act as an anti-cyclical force, taking risk when its price is cheap — for instance buying stocks in a crisis.
The evidence, however, reveals the opposite happening.
The bank looked at the portfolios of over 2000 corporate pension funds between 2006 and 2012, splitting them into the strong and weak on the basis of funding levels.

Both the strongest and the weakest pension funds began the period with a similar equity allocation. As equity prices started to fall in 2008, however, the allocations of strongest and weakest funds diverged sharply. The strongest pension funds reduced significantly their allocation, effectively cutting it in half, while weak funds maintained or increased their allocation. By the end of the period, the strongest funds had half the equity allocation of the weakest.

At one level, these portfolio reallocations made sense — the strongest protecting their surpluses by de-risking, the weakest trying to close their deficits by re-risking. Yet, from a longer-term or societal perspective, these reallocations are troubling. To cushion the risk cycle, we would wish to see stronger long-term investors purchasing risk when it was cheap. That would benefit both investors and the economy. Capital that can afford to be patient should be patient.
But those funds with the strongest shoulders appear instead to have ducked for cover, while the weakest appear to have engaged in a gamble for resurrection. In the longer-term, this type of behaviour is likely to worsen returns to investors. It will also amplify cycles in the financial system and economy by draining risk-taking when it is already weak. Patient capital ought to part of the solution to the long-term financing puzzle. In practice, it may have been part of the problem.

Meanwhile, the pro-cyclicality of investors is also a concern — rushing for the exits in times of trouble, piling on risk in a boom. That is market psychology, but also the consequence of benchmarking: taking on more or less risk than whatever you are trying to beat at different times.
Add to that increasing use of indexes in illiquid markets, and…

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 (Chen et al (2010)). This could itself induce a further round of asset fire sales in an amplifying loop.

Now, that is not, necessarily, the fault of asset managers. But regulators are going to go where their money is and, if the five year debate over regulating money market funds is anything to go by, this sentence will be sending chills through the industry, after Haldane said that capital requirements are the wrong approach to too-big-to-fail…

Tools which act on liquidity risk – minimum liquid asset requirements, restrictions or gates on liability redemptions – may be more suitable.

The regulatory fallout from the crisis continues. Asset managers did not cause the crisis, but as their age begins they are far from covered in glory.

Financial capital, even among long-term institutional investors, has become restless at just the time the economy requires patience