Fund management reform will help avert groupthink

November 24, 2013 7:04 pm

Fund management reform will help avert groupthink

By John Authers

Can globalised capital markets co-exist with democracy and the nation state? It is reasonable now to fear that the answer is “no,” and that means that reforming the investment industry should be a far higher priority than it is. Markets and democracy have much in common. Just as Winston Churchill said democracy was the worst form of government apart from all the others that had been tried, so markets may well be the worst way to allocate capital and set prices – apart from all the others.They can also act as a positive discipline on governments. To cite perhaps the most famous example, George Soros’ attack on the pound sterling in 1992 led to a humiliation for the UK’s government of the day. But it was driven by Mr Soros’ belief that the UK was trying to hold the pound unsustainably high. Once the pound was allowed to find its true level, and interest rates fell, the UK embarked on a decade-long economic boom.

Problems arise when markets, or the investors who drive them, fail to attempt to reconcile prices with economic fundamentals. This is not because of any conspiracy. Rather, the nature of investment, now driven by institutions investing others’ money, and not by individuals investing their own, has created systematic distortions.

This is a recent phenomenon. As recently as 1985, global mutual funds held barely a trillion dollars in assets; now this figure has reached $35tn. Institutions now control most of the New York Stock Exchange by market capitalisation; 50 years ago, they barely held 10 per cent of stocks, in a market that was controlled by individuals. And most new investment is now done passively – accepting prices as they are offered, and making no attempt to make contrarian bets. In these circumstances, groupthink abounds. Such a market will inevitably be driven by the priorities of institutions, rather than necessarily the interests of their clients.

Those distortions, to cite Mr Soros again, are a problem because markets can be reflexive. Rather than accept an external reality, they create their own reality, which affects economic fundamentals.

This gets in the way of democratic policy-setting by nation states, and creates a powerful incentive to experiment with an economic system other than markets.

There are several examples of reflexive markets over the last five years. In 2008, investors bought oil as a hedge against the credit crisis in the US, and the recession and low interest rates it would bring in its wake. This pushed up oil prices, creating an inflation shock when the world should have been worrying about deflation. The spike in oil prices even prodded the European Central Bank into the fatefully wrong decision to raise interest rates, barely two months before the Lehman Brothers bankruptcy.

In the same era, the “carry trade” – the practice of borrowing in currencies with low interest rates and parking funds in higher-yielding currencies, and pocketing the difference – distorted currencies. Most notoriously, it pushed the yen to unfeasibly low levels, as traders borrowed it, while forcing up currencies backed by commodities – such as the Brazilian real. Indeed, during the crisis year of 2008, the real correlated almost perfectly with the Vix index of perceived volatility in the US stockmarket, meaning that it was moving mostly in response to shifts of sentiment in the west. This made life harder for policy makers in Brazil. Small wonder they would complain of “currency wars”.

Or a final example, look at the sell-off in the currencies of several large emerging markets earlier this year, after the Federal Reserve began threatening to “taper off” its purchases of bonds – an episode known as “taper talk”. The way funds ran swiftly for the exit made life difficult for policy makers in countries like India – and also for the Fed, which eventually abandoned its tapering plans.

None of this is an argument for using some system other than the market to distribute economic goods. But it would be perfectly understandable for governments in developing countries who find their economic policy dominated by the priorities of a few fund managers to try to do something different.

This would not end well. To avert such an outcome, governments should look closer at the causes of market problems. That means tighter regulations of banks, but also looking at the incentives that are created by the ways fund managers are paid. It means limiting the size of financial institutions. And it needs the investment industry itself to find ways to restructure its companies and its products.

Without more urgency on this, what now appears a largely technical financial problem, caused by the unintended consequences of the huge growth of the fund management industry, could yet drive a broader political move away from market economics.