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Dwindling Risk, Passive Capture and Market Mood Swings

 5 min read / 

If one were to look up frequently used synonyms for the word risk, you might be a little surprised to find how bias the results are. Danger, hazard and liability all seem to pop up more often than not. The odd tails of opportunity arise in the side alleys of any research undertaken. Yet any breath of fresh air is blocked by general antipathy towards risk.

Inherent Risk

Risk is embedded in humanity’s DNA and has allowed everyday decisions to become as complex as they are. Thousands of years ago the power of risk enabled one caveman to acknowledge an opportunity and become risk-taking. The risk-taking caveman found food in a brutal environment and survived, whilst the risk-averse cavemen starved to death. It would not be without merit to say that risk has become a dirty word. Yet some could argue it always has been. During boom years there is a sense of excitement around risk, whilst hostility usually takes over during the troubled times.

Yet it seems investors have grown tired of these continuous mood swings and instead opted for a more stable distaste for risk. Indexes have turned their back on the rulebook. Equity tracker funds have changed investment philosophy all over the globe. Investors have become more interested in protecting their wealth and looking for arbitrage opportunities, than searching for abnormally high market returns.

Fund investing suits this philosophy, yet it also distorts investments and what capitalism is ought to look like. As more capital flows
into funds, the price of securities ceases to act as a gauge of a firm’s underlying performances. The irony is that although investors are turning away from abnormal returns for safer investments, they are in fact creating an environment where abnormal returns could eventually flourish, due to a misallocation of capital.

Future Value Expectation Driving Investment

Companies attracting fund investment (to mimic index movements) are receiving enormous price momentum, despite no new information
about the company available to investors. Future values are overtaking present values as the rule of thumb. The bad turns to ugly when one comes to realize that capitalism could be defeating capitalism. The concentration of the passive fund market is dominated by very few asset management giants. This could create a very moral problem, or depending on which side of the fence one is on, a profitable opportunity.

Whole industries are at risk of being concentrated in the hands of a handful of powerful passive investment managers. Ultimately, the corporate governance standard is finding it now has only a few more moves left to make, as asset managers come closer to an inevitable check-mate. What follows, is the inescapable loss of competitive forces. Capitalism is thus losing its most dynamic facet. Money management giants are using their economies of scale to create an ‘umbrella sector’, in which there are significant interests in the big players of the industry.

Airlines and Banks

The US airline industry is within striking distance of passive annexation. Airfares have been creeping up as of recent, owed mostly
to a mellow competitive environment. The US banking sector seems to have a similar fate, with most of the sector predominantly owned by very few asset management firms.

Yet it could end up being the weight AMFs have over index compositions, that creates the most intrigue. If asset predators captured sizable swaths of the capital markets, they are likely to be a prominent force when it comes to deciding what companies should be included in the benchmarks.

This excessive concentration of power led Blackrock to back mainland Chinese shares to be implemented within the MSCI benchmark last year. Miraculously, in May this year, MSCI announced it was to add 234 Chinese mainland shares to its flagship index. It is unclear how much influence Blackrock had over the agreement. what is clear, is that money management giants are happy to show global markets how much oligopolistic leverage they really have.

Complacent Capitalism

It is too soon to call the matter a threat, yet to ignore it would ultimately leave the door open to markets acquiring an obvious flaw,
should security markets be disproportionality controlled by a few AMFs. Popular efficient market models will be at risk of ceasing to work effectively.

If companies with large presences in the most popular indexes draw more capital irrespective of their underlying book performance, there could be a risk that they become complacent in the ways they are meant to benefit the economy.

Facebook leads the offenders with its critical mass and miss use of data that has come to light this year. The social monopoly’s share price has stubbornly refused to react. Fund managers are looking for long-term gains and seem dogmatic in their approach, even in defiance of the present market environment. Passive investing is creating a major flaw in the global economic climate. Low volatility and relatively stable price growth have produced a market blueprint that hides its vulnerabilities.

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