Are too-big-to-fail money managers a risk to the global financial system?
The Bank of England’s financial stability watchdog, Andy Haldane, seems to think so. In a recent speech at the London Business School, he warned the crowd the mutual fund and asset management industries are increasingly “run-prone”—funds and firms are getting too big, owning too many assets, and if investors lose confidence in the managers and exit en masse, it could trigger huge asset fire sales, causing a vicious circle of failing funds and falling markets. If a fund were big enough, even something as innocuous as rebalancing could launch a panic!
He isn’t the only one saying this. In January, the global Financial Stability Board (FSB)—regulatory chiefs from around the world—released a consultation paper on identifying and regulating globally systemically important non-bank non-insurance financial institutions. Translated from Bureaucratese, that means too-big-to-fail investment firms. These are firms whose failure, regulators believe, “would cause significant disruption to the global financial system and economic activity”—liquidation of assets could “impact asset prices and thereby could significantly disrupt trading or funding in key financial markets, potentially provoking losses for other firms with similar holdings.”
Gee, who knew Bill Gross could destroy the world?
It’s all a bunch of nonsense—another misstep in the post-2008 regulatory adventures. Size doesn’t matter. Nor do fund flows.
Think about the implications of the FSB’s logic if it were indeed correct. Essentially, the bigger the fund, the more it would move the market—and, by extension, move itself. As funds attracted more clients, they’d buy more assets, pushing up the value of all their holdings, driving up their own returns, which would attract more clients, triggering more buying, attracting more clients and, well, you get the idea. The biggest funds would always perform best, continually get bigger and eventually there would be no one left.
Ridiculous, right? That’s not how markets work!
Yes, big trades impact prices in the very short term. It’s called friction. If a big fund makes a purchase, they might end up having to pay a little more. It’s a simple function of supply and demand. But it’s usually a blip—it doesn’t just stay elevated. Market forces take over, and they’re darned efficient. Maybe the incrementally higher price drives other owners to take some profits, increasing supply for sale. Or maybe other buyers just aren’t willing to pay the elevated price and drive it back down.
The same is true when big managers sell. If they try to offload a big chunk of stock, they might have to accept a bit less than the going market price. But that distortion, too, is frequently short-lived. Other buyers might see the lower price and jump at their chance to buy shares “on sale,” then drive the price back up as they compete for shares.
This all speaks to the key point overlooked by Haldane and the FSB: For every seller, there is a buyer. And vice versa. Let’s say you do get a “run” on a $100 billion equity fund (the likely too-big-to-fail threshold). For one, it would be unrealistic to assume every fund holder decides to liquidate at once—that didn’t even happen during the darkest days of the financial panic, when markets would fall -9% in a single day. Nor did it happen in the ’87 crash. (Which should be evidence alone the FSB’s thesis is flawed, but I digress.) But let’s say they lost 25% of assets under management in one day—$25 billion—and were forced to liquidate that much to meet redemptions. $25 billion is a lot, but average daily trading volume on the NYSE this year is $43.3 billion, and greater than $100 billion isn’t unusual—and on March 21, when daily volume hit its year-to-date high of $107 billion, the S&P 500 fell a paltry -0.29%. High volume doesn’t mean a big drop—it just means extra liquidity. Where prices go depends on demand.
Demand could very well be higher than the FSB assumes. It would be a fallacy to assume all those investors selling out would opt for cash. If they’ve simply lost confidence in the fund manager, not stocks, they might use the proceeds to buy stocks. They might buy another fund, whose manager would then go buy stocks—quite possibly the same ones the other fund manager sold. The market is a dynamic, wondrous thing with countless players both man and machine. Heck, those derided high-frequency trading platforms might just stand ready to buy shares a fund manager has to offload.
As for flight from big funds during a panic, that wouldn’t be any different from investors selling out of individual stocks, ETFs or smaller funds. Selling pressure is selling pressure, no matter where it comes from. Over $205 billion left equity funds from July through December 2008, according to the Investment Company Institute. The world didn’t end, and markets came back.
Incidentally, equity mutual funds also saw consistent net outflows in 2009, 2010, 2011 and 2012. Needless to say, fund flows don’t drive broad market performance.
Regulators, as usual, see it differently—while Haldane was skeptical over whether it was time to “actively intervene,” he did call asset management the “next frontier for macro-prudential policy,” and the FSB (also the geniuses behind Basel III banking regulations) seems to be heading in that direction. Who knows what they come up with. But slapping extra restrictions on large funds and managers isn’t necessarily a net benefit—it would likely make fund management costlier for investors, who already have protections against fund failure through SIPC coverage. Seems a needless price to pay, if you ask me.