Back in the Cretaceous Period, the heyday of the dinosaurs was well underway. These huge creatures ruled their world and surely expected to continue to do so for a long time. Bigger was truly better. Then, largely out of the blue, they were wiped out, perhaps as a result of a large meteor hitting the earth, perhaps not.
All we know for sure is that they disappeared.
Only the smallest animals that were the right size and could adapt faster, such as birds, survived. In the investment management world, firms with the largest amount of assets may be facing a similar fate as a momentous change in climate alters fundamentally the assumptions on which they have operated and have sought suitable and profitable fixed-income investments.
My argument is straightforward: that increasing regulation seems to be having the effect of reducing liquidity, and that in the new environment thus created, bigger, in terms of size of asset managers, may well no longer be better. A new breed of “right-size” investment manager, whose total of assets under management matches the opportunities available, is more likely to inherit the new financial world than the giants with which we became familiar in recent years.
The argument sounds simple, but the factors underlying what I call this climate change in the investment world represent a more complex set of knock-on effects, from regulation to liquidity, from liquidity to the available assets and, finally, to the optimum size and approach of those asset managers that will likely thrive in this new world.
To begin with regulation, the design of the new regulatory environment was borne out of the financial crisis and was seen as a way to make the financial system more secure and less likely to re-create the conditions that brought about the last crisis. But an unintended consequence of this is that we have lost the true economic valuation of an asset, a valuation independent of regulatory influence or central bank manipulation of the sort typified by “quantitative easing” programs.
Stated simply, valuations for assets that have a favorable regulatory status exceed those that do not. This needs to be properly accounted for when evaluating investment opportunities and making asset management decisions in the new, changed climate.
Furthermore, the downgrading in investment desirability of those assets with an unfavorable regulatory status reduces the available investment opportunities for asset managers seeking to create a diversified portfolio, the elements of which, are uncorrelated with each other - a portfolio, in other words, capable of generating above-average returns. This will have a serious impact on larger asset managers, but no manager will escape this challenge entirely.
Essentially, there has been an onslaught of regulation, and while each new rule can appear quite reasonable and rational in the wake of the financial crisis, this is having a significant and continuing impact on the banks in their role as providers of liquidity. Increased capital charges have caused banks to reduce their inventories, especially for credit instruments and high risk-weighted assets that are less liquid. Instead, inventory on balance sheets has been re-allocated to high quality liquid assets.
This impact on the providers of liquidity cannot fail to impact, in turn, the “consumers” of liquidity – the asset-management industry. A consequence of increasing regulations designed to make banks safer may well have been to increase the risk to non-bank financial institutions, especially those asset managers with exceedingly large AUM.
As a result, many investors have been forced to seek non-traditional sources of liquidity such as electronically traded funds and mutual funds. This liquidity risk transformation may prove illusory because if market conditions force a fast exit, in my opinion, these funds will surely and adversely impact the bonds that underlay the funds themselves.
This risk is exacerbated by the many open-ended funds that offer daily liquidity on what seems to be an underlying asset base that is becoming less liquid. For example, about two-thirds of European mutual funds are covered by the rules on “undertakings for collective investment in transferable securities”, which require that 90% of assets be held in liquid securities and that daily redemptions be offered.
The International Monetary Fund highlighted this risk to financial stability in a consultation with the US in July last year, in which it warned of a growing amount of liquidity and maturity transformations taking place through mutual funds and exchange-traded funds, especially those investing in credit instruments. The IMF added that it was concerned by a “decline in broker-dealer involvement in market making activity, potentially hampering the functioning of markets and price discovery at times of market stress”.
How to navigate this new landscape? Clearly, liquidity and regulatory risk factors have become features of the financial system that cannot be avoided. We believe, however, that they can be managed, but that you cannot manage what you cannot measure. As a result, my colleagues and I have developed several models to evaluate risks stemming from regulation and liquidity. This is achieved by recognizing that these risk factors show up as risk premia, thus, we have created tools to calculate this in our valuations and thus in our asset allocation decisions.
In the current investment climate, we believe that traditional fundamental valuations, based largely on econometric data, are an incomplete description of an asset's value. Since liquidity has become a larger risk factor, we believe an illiquidity premia should be calculated and incorporated into investment decisions. We use this approach across a spectrum of assets, including interest rate products.
I firmly believe that we are at the end of one era in investment management and the beginning of another. For years, many asset managers were able to transform themselves into giant behemoths by growing their assets under management. As long as the old climate of declining interest rates persisted, size was not a determining factor for performance. However, when the regulatory climate changes and when this change has the added impact of reducing market liquidity, then size does matter. Being too big is a severely limiting factor in terms of adapting to this change in climate.
We believe that the key to succeeding in the future is going to depend largely upon one's ability to interact with prevailing market liquidity conditions and to do so in a flexible manner.
For the moment, it may seem as if the giants of yesteryear are unassailable. In November last year, the Bank for International Settlements reported that the total of assets under management in the private sector has become increasingly concentrated in a few large market players, with the total net holdings of the 20 largest asset managers alone increasing by $4 trillion to $9.4 trillion between 2008 and 2012.
But doubtless, the dinosaurs looked enormously impressive right up to the moment that they vanished from the face of the earth. Ultimately, the Paleogene Period succeeded the Cretaceous and created the climate in which mammals could diversify and evolve.
We may be on the edge of a similar moment today for fixed-income investment, whereby the larger asset managers may be facing the bleak prospect of a smaller universe of opportunities. The “right-sized” and more nimble firms, those which can calculate the new risks and efficiently execute their strategies, are those that will potentially be able to thrive in this new world.
Jim Caron is a senior portfolio manager of fixed income at Morgan Stanley Investment Management.