September 2, 2014    3 minute read

Investment Management: Systemic Risk

   September 2, 2014    3 minute read

Investment Management: Systemic Risk

Do fund managers pose a systemic risk to the world’s financial system? Regulators around the world, including the Bank of England and the U.S. Treasury Department have been asking themselves the same question, and the answer is YES.

In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the entire system. In the wake of the 2008 crisis, regulators are understandably looking at areas they haven‘t examined before.The systemic risk might not be as great as many might think. Avi Nachmany head of research for Strategic Insight in New York has an interesting view on this matter. Strategic Insight produced this fascinating chart which shows us how investors in mutual funds have behaved over the last twenty years, comparing that to how the portfolio managers themselves behave. We are living in this semi-permanent state of investment anxiety and fortunately we have an opportunity to look at 50 years of history and identify the times of crisis.

This chart is a good example. Let’s focus on the period of October 2008 when portfolio managers and investors were facing a challenging period. The average mutual fund has 4 or 5 percent in cash over that period. Historically, during the financial crisis and market bubbles, portfolio managers served as a buffer against investor anxiety, rather than an amplifier which they might do if they were leveraged or if they had to make forced sales.

There have been some important changes to the way the fund management industry is structured over the past few years – most importantly the introduction and growth of ETFs. If we take a look at the next chart provided by the Strategic Insight in New York, it clearly shows flows in and out of actively managed mutual funds compared to ETFs and Index Funds outside the U.S. I sometimes like to refer to the emerging markets as emerging wealth regions. The question as an investor is what do you do and how do you think about wealth creation over a long period of time? The emerging markets are seen as a perfect place for core long-term strategic asset allocation.

Looking at the same exercise but this time by analysing the emerging market fund flows from inside the U.S. Here we can see the ETF money, which is impatient most likely to head out swiftly in reverse, and the actively managed money following a relatively calm pattern. That is where actively managed funds in emerging markets are now used as a core long-term strategic asset allocation.

I believe that there are many more questions to be answered about the systemic risk that fund managers cause, but, provided there is no leverage involved, they do not appear to have stoked the great systemic risk that we have encountered in the last twenty years.

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