Herding and Pro-Cyclicality – The Antidote

Andrew Haldane, Executive Director, Financial Stability at the Bank of England, and one of our favourite iconoclasts, recently gave a speech entitled “The Age of Asset Management?” (http://www.bankofengland.co.uk/publications/Documents/speeches/2014/speech723.pdf), which is worth reading in its entirety.

It contains a number of interesting and thought-provoking observations; but the one that particularly caught our eye was how the behaviour of asset managers, and of those who appoint them as their agents, may have a greater influence on the pricing of risk than often considered in a world in which rounding up “the usual suspects” generally means taking a bank or banks behind the woodshed for a good, old-fashioned, regulatory beating.

Bankers are not the only ones who have a herding instinct. Fund and investment managers do too, because self-interest means that they are loth to make themselves vulnerable to significant underperformance against the benchmarks or indices against which those who appoint them tend to judge them. It truly is the unusual and the brave who are willing to take the career risk of sticking to their convictions and pursuing a consistent, rational, risk-adjusted investment thesis. Too many fund managers are “dedicated followers of fashion”, which results in a form of pro-cyclicality in which many try to invest in the same asset class at the same time.

The reason for asset managers’ increasing influence is largely a matter of scale; because the largest, such as Blackrock, control more assets than the largest global banks and (re)insurance companies. Almost all of this may be managed on an agency basis, but the flows of funds that these firms have to invest will only continue to increase, with the result that how, why and for how long they invest will have a material influence in all major asset classes; while, if they light upon a “faddish” sector they are capable of completely distorting pricing versus risk and volatility. One only has to observe the relentless grinding down of so-called “hi-yield” spreads to historic lows over Treasuries, coupled with the regulatory impact of reducing dealers’ willingness to hold inventories, to realize that at some point, when sentiment and risk appetite change, many are likely to be trampled upon in the rush for the exits.

This is why, at Awbury, we are particularly fond of those managers who operate in asset classes such as private equity, where skill, knowledge, length of experience, market presence, relationships and patience are traits which tend to result in superior risk-adjusted long-term performance; and where adding our ability to structure complementary insurance solutions leads to an outcome which is mutually beneficial to the managers, and those banks and (re)insurance companies with whom we partner; and where the interests of all parties are aligned.

-The Awbury Team

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