Institutionalizing Countercyclical Investment: A Framework For Long-Term Asset Owners by IMF

Prepared by Bradley A. Jones

Abstract

Do portfolio shifts by the world’s largest asset owners respond procyclically to past returns, or countercyclically to valuations? And if countercyclical investment (with both market-stabilizing and return-generating properties) is a public and private good, how might asset owners be empowered to do more of it? These two questions motivate this study. Based on analysis of representative portfolios (totaling $24 trillion) for a range of asset owners (central banks, pension funds, insurers and endowments), portfolio changes typically appear procyclical. In response, I suggest a framework aimed at jointly bolstering long-term returns and financial stability should: (i) embed governance practices to mitigate ‘multi-year return chasing;’ (ii) rebalance to benchmarks with factor exposures best suited to long-term investors; (iii) minimize principal-agent frictions; (iv) calibrate risk management to minimize long-term shortfall risk (not short-term price volatility); and (v) ensure regulatory conventions do not amplify procyclicality at the worst possible times.

Institutionalizing Countercyclical Investment: A Framework For Long-Term Asset Owners – Introduction

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“It is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.” – John Maynard Keynes, 1936

To the extent that the willingness to bear risk diminishes in periods of stress and increases in upturns, procyclical investment can amplify market movements and contribute to feedback loops that are potentially detrimental to financial stability and long-term economic growth. The Financial Stability Forum (2009, p. 8-10) notes that “mutually reinforcing interactions … between the financial and real sectors of the economy … tend to amplify business cycle fluctuations and cause or exacerbate financial instability.” The Bank of England (hereafter, BoE, 2014, p. 4) suggests that procyclicality “can decrease the resilience of the financial system and thereby potentially contribute to serious interruptions in the vital functions which the financial system as a whole performs in the economy.” Industry forums have pointed to the pernicious impact of “quarterly capitalism,” arguing that “the relentless focus on short-term performance and hypersensitivity to the current news cycle … undermines corporate investment, holds back economic growth, and lowers returns for savers” (Focusing Capital on the Long-term Initiative, hereafter FCLTI, 2015, p. 3).

The World Economic Forum (2011, p. 9) cite three constituencies that stand to benefit from a greater emphasis on long-term countercyclical investment: 2 asset owners who might enjoy better returns by accessing risk premiums the rest of the market eschew; corporations who can more easily obtain financing for strategic initiatives with large upfront costs but significant long-term payoffs (i.e. infrastructure); and broader society by mitigating the volatility and dislocations wrought by boom-bust asset cycles. Narrowing the focus to the implications of the advancing tide of “short-termism” among large asset owners and corporations, Barton and Wiseman (2014) contend:

“Too many of these major players are not taking a long-term approach. They are failing to engage with corporate leaders to shape the economy’s long-range course. They are using short-term investment strategies designed to track closely with benchmark indices. And they are letting their investment consultants pick external asset managers who focus mostly on short-term returns. To put it bluntly, they are not acting like asset owners. The result has been … herd behavior, excess volatility and bubbles. This in turn results in corporate boards and management making suboptimal decisions for creating long-term value.”

Dampening procyclicality in the banking sector has emerged as a key area of focus for policy makers in recent years, 3 but the issue of procyclicality, as it relates to institutional investors, has received much less attention. Related analysis has tended to concentrate almost exclusively on asset managers rather than underlying asset owners and the consultants who advise them (see for example, Financial Stability Oversight Council, 2013; Feroli and others, 2014; IMF, 2015; Financial Stability Board, 2015). As Papaioannou and others (2013, p. 5) acknowledge, “global and national financial sector regulation and supervision have yet to play a significant role in restraining such risks to the global financial system.” In the context of financial stability, the paucity of attention paid to institutional (non-bank) asset owners—a group including pension funds, insurers, sovereign wealth funds, central banks, and endowments—is somewhat surprising given: asset owners have at their disposal a pool of assets larger than banks, and the gap is widening; only 25 to 35 percent of financial (excluding real estate) wealth worldwide is estimated to be managed via asset management firms—the majority is invested directly by asset owners themselves (McKinsey & Company, 2013; Jones, 2015; IMF, 2015); and large strategic shifts in capital over multi-year periods are the purview of asset owners and the consultants advising them, not asset managers.

Indeed, often lost in the discussion of financial stability risks posed by asset managers is that most have limited input (especially relative to consultants) in the strategic asset allocation of asset owners. Much of the asset management industry is dedicated to providing implementation services, that is, vehicles through which institutional asset owners express their investment objectives formulated by investment committees pursuant with board directives (see Box 1). Funds in which asset managers are afforded considerable discretion over allocations to asset classes and geographies represent a minority of invested assets. In the open-end mutual fund industry for instance, which oversees almost eighty percent of worldwide assets invested through collective investment schemes,6 asset managers typically have discretion over tactical adjustments vis-à-vis pre-set benchmarks pertaining to a single asset class and region. These tactical deviations are usually constrained by pre-agreed limits (‘tracking error’).  It would therefore seem “inappropriate and ineffective for asset managers to be viewed as responsible for actions that are essentially just the passing through of end-investor decisions” (Elliott, 2014, p. 1). Furthermore, to the extent that asset managers amplify procyclicality in their tactical decisions, it can often be a response to the (short-term) performance appraisal terms imposed on them by asset owners and their consultants. Because asset owners and their consultants have imperfect knowledge about the ability of investment agents (as managers operate in a high-noise, low-signal environment which makes it difficult to distinguish skill from luck), they may interpret a period of underperformance vis-à-vis peers or a momentum-biased capitalization-weighted benchmark as a sign of manager incompetence: as the underperformance grows, principals are likely to conclude their agents are unskilled and thus terminate them in favor of outperforming peers holding securities with strong momentum. In short, distinguishing the actions of asset owners and asset managers is important to the formation of policies designed to ameliorate risks to economic and financial stability stemming from procyclical investment behavior.

countercyclical investment
Countercyclical Investment

The relatively small literature on asset owner investment characteristics has often had a qualitative and anecdotal flavor, concentrated on high frequency money flows around specific events (i.e. crises). Papaioannou and others (2013) and Ang and Kjaer (2011) discuss selected examples of herding behavior by asset owners during the global financial crisis. Pihlman and van der Hoorn (2010) find central bank reserve managers to have pulled more than US$500 billion of deposits from the banking sector between December 2007 and March 2009, thus putting strain on major central banks at the worst possible time. BoE (2014) qualitatively infer procyclical investment among life insurers in the U.S., UK and France. Ang and Kjaer (2011, p. 94) broadly suggest that while “long-horizon investors have an edge … unfortunately, the two biggest mistakes of long-horizon investors—procyclical investments and misalignments between asset owners and managers—negate the long-horizon advantage.”

countercyclical investment

countercyclical investment
Countercyclical Investment

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