Practical analysis for investment professionals
23 April 2015

Asset Managers Pose Systemic Risk — It’s Time To Recognize It

Is printing money creating new systemic risks for the world economy?

As stock markets move to new highs, asset managers are booming, with vast inflows into bond and equity funds alike. The IMF has pointed out the potentially systemic risks created by concentrated pools of inflated and increasingly correlated assets. It is now time for regulators around the world to recognize the risks inherent in asset managers and funds that are too big to fail.

The financial crisis highlighted risks in banks and insurance, but other areas have been overlooked until now. Finally, the Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO) are beginning to recognize risks in the investment sector and are turning their attention to some of the largest managers. In Washington, D.C., this month, European Central Bank (ECB) vice president Vítor Constâncio warned of the build-up of leverage and the growing exposure to illiquid assets in the asset management sector. But there seems no hurry to plug the gaps.

More Urgency Is Needed

The risks in big bond, equity income, and emerging market funds must be addressed. Asset managers reject any suggestion that they might represent a threat to the financial system and are quick to point the finger at banks. But globally, the top 10 asset managers have a market share of almost 30% of their sector, much more than the top 10 banks represent in banking. Assets managed globally are estimated to exceed $80 trillion. Looking at it another way, BlackRock (the world’s largest asset manager) managed roughly $4.7 trillion in assets at the end of 2014, while the Industrial and Commercial Bank of China (the world’s largest bank) had “only” $3.28 trillion in assets on its balance sheet.

Quantitative easing (QE) has spurred growth in the investment sector since the crisis, contrasting with shrinkage in banking. Asset managers might not have leveraged balance sheets, but they are globally interconnected. The IMF noted this month that “correlations among major asset classes have risen markedly since 2010. Worryingly, concentration is not decreasing as the industry grows. Yet central banks seem unaware they might have exacerbated risks, creating asset bubbles with easy money policies. Why have regulators been slow to act?

Might the regulatory burden itself be a key driver of these concentration risks? The industry is being forced to improve its offerings for consumers, but there is little sign that competition itself is increasing. Cost and security seem to have become priorities for investors and their advisers, even above performance. Large funds offer apparent ease of dealing — in terms of investor subscriptions and redemptions — but underlying portfolio liquidity is likely to be deteriorating as they grow.

Undoubtedly financial advisers believe they are opting for safety. The virtuous cycle of success and fund growth gets regulatory encouragement. Many advisers find that larger funds reduce the compliance burden, in addition to being easier to explain to retail clients. Name recognition, perceived liquidity, and cost have become bigger factors than performance.

But in Aggregate, Systemic Risk May Be Growing

Overall stock market trading volumes are declining, with less capital now involved in market making. Big portfolio positions might be liquid enough for normal day-to-day dealing, but could be left stranded if investors make any significant rush for an exit. Regulation directs advisers to look at the apparent liquidity and security benefits of scale, but what is missing is a test of how this might work in a crisis.

New factors have been driving this fund concentration. Some star managers have attracted an enormous following, encouraged by the emphasis on brands and personality. The industry has always enjoyed good operating leverage, but strategy now seems focused almost entirely on scale. Scale offers great commercial advantage, with profitability improving as funds grow. Fortunately there are incentives for the best managers to limit fund growth to a level that still leaves opportunities for genuine performance.

But, increasing concentration points to the dominance of scale as a factor.

The recent acceleration in scale and concentration has, to date, seen only limited tests. Moves of star managers, such as Bill Gross, CFA, have triggered significant but orderly fund flows. Yet, it is possible in some less liquid asset classes — such as emerging markets and corporate bonds — for investor liquidity demands to exceed realistic liquidity in a sell-off. A fund’s scale can create an illusion of safety that may not be understood by private investors.

The regulatory problem is that managers are typically required only to test liquidity on open-ended funds at the margin — whether subscriptions and redemptions over a period of weeks should be at bid or offer prices. They must consider whether fund inflows or outflows might compromise fairness for ongoing fund investors. And, if mutual funds are very small, managers must consider an orderly plan for protecting residual investors and ensuring orderly liquidation.

No Symmetry

While regulators worry about investors in small funds, there is no symmetry in the approach to the risks of the largest funds. Managers should be required to demonstrate the implications of a significant withdrawal: how they might achieve price discovery and liquidity. If their only plan is gating investors, the systemic risk could simply be pushed elsewhere. Investors would scramble for liquidity in other assets if their largest investments were locked-in for a period.

The FSB, chaired by Governor Mark Carney of the Bank of England, recently warned that it would move to address any too-big-to-fail problems among entities that are neither banks nor insurers. But it is still consulting and has not yet spelled out what new rules are necessary. There is an urgent need for research and analysis to develop a working definition of systemic risk. And, it would be best if this were harmonized globally so that global asset managers know where they stand.

Together, the FSB and IOSCO aim to look at the potential for size, complexity, and interconnectedness to impact the wider financial system through disorderly failure. The new consultation will likely focus on managers with AUM exceeding $1 trillion and funds of over $100 billion, but it is easy to see that smaller funds than this could raise systemic issues, particularly when considering that some may employ leverage. The asset managers likely to be affected have not yet been named, and this consultation will continue until 29 May 2015.

This approach may not capture risks to individual national or regional finances. If concentration might be a risk globally in asset managers, the risk to individual exchanges and asset classes should surely also be looked at. National regulators should ask managers to be more explicit in explaining the risks of scale to investors. More detailed attention to funds below $100 billion that might dominate their asset classes is needed. And a broader set of policy tools is necessary to address the risks stemming from financial firms at large.

It is time for regulators to move from their narrow focus on banks and insurers to recognize wider systemic risk.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Colin McLean, FSIP

Colin McLean, FSIP, is founder and CEO at SVM Asset Management, an independent Edinburgh-based fund management group. He is a member of CFA Institute and was elected to the Board of Governors in 2012. McLean is a fellow of the Institute and Faculty of Actuaries and a chartered fellow of the Chartered Institute for Securities & Investment. In 2012, McLean was appointed an honorary professor at Heriot-Watt University, lecturing in behavioral finance. He is a regular contributor to financial publications and has been a guest on Bloomberg TV & Radio, CNBC, BBC TV and Radio. McLean is also a frequent conference speaker on investment, hedge funds and behavioral finance.

7 thoughts on “Asset Managers Pose Systemic Risk — It’s Time To Recognize It”

  1. Scott D. Knapp, CFA says:

    I’m amazed that this is still a debate. Sadly, there are plenty in positions of great influence who are more interested in protecting the asset management industry than investors and society at large. Keep sounding the alarm!

  2. Stuart Roseman, Esq. says:

    It sounds like what you’re suggesting is basically Basel III for asset managers. Which, on its surface, makes some sense. But I want to address a couple of small points here. First, beyond the stress-testing itself, how would you restrict the illiquidity in any given fund or group of funds? At what level? And could you really require anything more than, say, the SEC would, in terms of the emphasis on reporting and transparency over actual limits on what can be held in a fund’s portfolio?

    What I’m driving at is, it is likely to be extremely difficult to implement regulations enforcing specific liquidity ratios to be held by all funds at all times. What would these look like? Specific position limits in particular security types? I don’t think that would be likely to fly. If you cap, for example, a fund’s or group of funds’ position in corporate bonds, that would have the effect of essentially destroying the market for those bonds as oversupply drives prices underground, which would have the further unpleasant effect of severely limiting corporate debt financing.

    The risk has to flow somewhere. And there are only two places it can go. Investors or those trying to raise capital.

    There is no such thing as a risk-free investment. While I totally agree with the idea of stress-testing, and of improved transparency and reporting, I don’t think position limits or trading caps or strict adherence to preset liquidity ratios are workable solutions.

  3. John Fletcher says:

    Many inaccuracies in this article. You can’t compare apples with oranges. A bank is not a fair comparison to make against an asset manager. As they play different roles with the financial system. As a result, have different degrees of risk. Risk itself is not one dimensional. The idea of reducing systemic risk is simply fantasy. One simply shifts risk to different areas within the system. Yes asset managers’ balance sheets have low leverage. However, the risk of interconnectedness as a result of QE is false. This was present before QE and made apparent since the “big bang deregulation ” and abolition of the Glass-Steagall Act. Is illiquidity a bad thing when investing in a particular fund (mandate dependent)? You would expect to be compensated for this illiquidity. Furthermore, bond investing and equity investing are two very things in terms of risk. You speak of symmetry but bond investing by nature is asymmetric, as the downside outweighs the upside potential. It is not the job of an asset manager to provide liquidity per se. It should however be the managers responsibility to educate investors of the risks of investing in a particular fund. The exit of Bill Gross did have a short term impact on TIPS and MBS. If there was another liquidity crisis, cross-asset correlations would turn positive anyway. I do agree that central banks have exacerbated systemic by hiding the true leverage within the system and driving up asset prices (note no bubbles as there is no mania). So while “printing” money does create new risks, such as model risk relating to RWAs and leverage ratios to name a few, you cannot assume they are systemic. Particularly as you point out there is no “one size fits all” definition of systemic risk. Let us not forget that increased regulation has lead to more concentration of risk and reduced liquidity.

    1. John —

      Many thanks for weighing in, though I’m not sure I follow your line of argumentation. Are you suggesting that, since asset managers are different from banks, they do not deserve regulatory scrutiny? Surely even if activity is different the sheer magnitude of asset size warrants a look, even if regulation takes a different shape. At the risk of being too direct (and with apologies for same) you have thoughtful observations here, but the editor in me is unsure what the thrust of your argument is and would love to hear it.

      How would you phrase your take on this subject in no more than five sentences?

      Cheers, and thanks for reading!


      1. Scott D. Knapp says:


        You beat me to the punch. Asset managers pose different risks versus banks, but that doesn’t mean those risks aren’t systemic in nature.

        I think a good starting point would be to agree that an asset manager’s products should never be more liquid than high percentage of their underlying holdings (not sure what “high percentage” means, but it could be modeled).

        In my opinion, markets could be in for a rude awakening when fixed income sectors fall under duress and holders of bond ETFs head for the door in droves. Could that be a replay of the subprime crisis? I don’t know, but it is at least a theoretical possibility.

        1. Scott —

          Thanks for weighing in. My take is that it’s tough to make statements like “always” or “never,” though I’d be unlikely to invest in a fund with a significant liquidity mismatch. I’d be even more unlikely to manage one. How can you be a thoughtful investor when someone else controls your time horizon?

          I’m not sure what the right regulatory take is — that’s another side of the organisation’s specialty — but I know the IMF is taking a hard look at it. Hopefully they come up with a good solution. I’m glad it’s not my problem to solve!

          All best and thanks for reading —


          1. John Fletcher says:

            @ William

            Many thanks for your input. While regulation is needed, including asset managers, it is about effective rather than the volume of regulation. The burden of regulation is clear post-crisis and a structural change is still on-going. As such it is more the unintended consquences of regulation that is an issue. Unfortunately as with anything there is no crystal ball. Therefore, regulation should be “fine tuned” (Alan Greenspan).

            In my opinion event-driven funds are evidence of the need of illquidity. This is due to trade positioning and the damage to the fund in the event of heavy redemptions.

            On a lighter note, @Scott I do also think something is on the horizon. As the recent oil crash gives a signal of things to come. Wouldn’t be surprised on another US equity crash in 2 years. Once we begin to see more a recovery in cyclicals. However, I think any crash would be a black swan event similar to the Swiss Franc event.

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