Dong He

Deputy Director

Monetary and Capital Markets Department

Global Financial Stability Report April 2015

Chapter 3

The Asset Management Industry and Financial Stability

Prepared by Hiroko Oura (team leader), Nicolas Arregui, Jonathan Beauchamp, Rina Bhattacharya, Antoine Bouveret, Cristina Cuervo, Pragyan Deb, Jennifer Elliott, Hibiki Ichiue, Bradley Jones, Yoon Kim, Joe Maloney, Win Monroe, Martin Saldias, Nico Valckx and Min-Jer Lee.

Motivation

• Rapid growth of the industry

• Growth of bond funds

• Movement into less-liquid assets (October 2014 GFSR)

• Retrenchment by banks from market making

Roadmap

• Industry Background

• Conceptual Risk Channels

• Empirical Analysis

• Policy Discussion and Recommendations

Structure of Asset Management Industry

Separate

account

36%

Open-end

mutual funds

41%

Closed-end

mutual funds

1%

Money market

funds

8%

Exchange-

traded funds

4%

Private equity

5%

Hedge funds

3%

Other

alternatives

2%

1. Asset Managers' Intermediation by Investment Vehicles

(Percent of $79 trillion total assets under management, end-2013)

Sources: BarclayHedge; European Fund and Asset Mangement Association; ETFGI; OECD; Preqin; Pension

and Investments Towers Watson; and IMF staff estimates.

Mutual Funds—domiciled in U.S. and Europe, but global investment

United States

49%

Japan

3%

Other

developed

9%

Brazil

3% China

2%

Other emerging

markets 4%

Luxembourg

10%

Ireland 5%

France 5%

United Kingdom

4%

Other

developed

Europe 7%

Developed

Europe 31%

Sources: European Fund and Asset Management Association; and IMF staff calculations.

Key Domiciles of Mutual Funds

(Mutual funds by domicile, percent of total assets under management,

end 2014)

Operation of a Fund

Key Known Risks

Known issues

• Hedge funds—leverage, insolvency, complexity

• MMF—constant net asset value NAV (= money-like liability), link to bank funding

…do not apply to MF, ETF

• Little borrowing

• Portfolio leverage capped

• No constant NAV

• Little insolvency risk: liabilities are “shares”—return and losses absorbed fully by investors

8

What are the risks from less leveraged “plain-vanilla” products?

9

Incentive

problems of

delegated

investment

Run risk

Price

externalities—

fire sales,

contagion,

volatility

Macro-

financial

consequences

First Mover Advantage •Liquidity mismatch

• Managers sell liquid assets first

• Some fund share pricing rules impose

cost of liquidity risk unfairly to second

movers

Information gap between managers

and investors

• Benchmark based evaluation

→Excessive risk taking

→Herding

• Brand name effects( Spillovers of

redemptions within fund family)

Does mutual fund investment matter for asset price dynamics? –Yes

• Do aggregate mutual fund flows affect aggregate price indices?

– Yes—for smaller, less liquid markets (EM assets, HY US corporate bonds) . Flows also help predict future returns first-mover advantage

– Less clear for U.S. equity, U.S. broad bond funds

• Concentrated holding by mutual fund—bad for bond spreads during 2008 crisis and 2013

10

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.1

0.5

0.9

1.4

2.0

2.6

3.2

3.8

4.4

5.1

5.7

6.4

7.1

7.9

9.1

10.6

12.1

14.0

17.0

37.4

Bonds Issued by Emerging Market and Developing Economies,

2013:Q1 and 2013:Q2

Concentration

Ch

an

ge in

cre

dit

sp

read

s, %

More concentration

What drives run risk? (1)

• Past returns and flight to quality

12

What drives run risk? (2)

• Some brand name effects, albeit weak

13

What can mitigate run risk ? (1) Holding cash in line with funds’ liquidity risk

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

Institutional Liquid subgroup Illiquid subgroup Flow Volatility

Sensitivity to a 1

standard

deviation increase

in volatility

Equity funds Bond funds

3. Differences in Cash Holdings across Funds

(In percent of total net assets)

Relatively less cash holdings compared to other funds

Relatively more cash holdings compared to other

funds

What can mitigate run risk? (2) Fees are effective in dampening redemptions

-35

-30

-25

-20

-15

-10

-5

0

5

2008 Equity Funds 2013 EM Bond Funds 2013 EM Equity

FundsCh

an

ge o

f avera

ge f

un

d f

low

s b

efo

re a

nd

du

rin

g

stre

ss e

pis

od

es,

in

perc

en

t o

f to

tal n

et

ass

ets

Stress episodes

Funds with low redemption fees

Funds with high redemption fees

3. Redemptions during Stress Times, by Redemption Fee Levels

Higher fees when investing in illiquid assets

… but fees have been declining

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Dec-

01

Jan

-03

Feb

-04

Mar-

05

Ap

r-06

May-0

7

Jun

-08

Jul-

09

Au

g-1

0

Sep

-11

Oct

-12

No

v-1

3

Feb

-02

Mar-

03

Ap

r-04

May-0

5

Jun

-06

Jul-

07

Au

g-0

8

Sep

-09

Oct

-10

No

v-1

1

Dec-

12

Jan

-14

Bonds Equity

Purchase Fee Redemption Fee

4. Trend of Mutal Fund Fees

(Simple average, in percent)

Does asset managers’ behavior amplify risks? (1) Incentives for excessive risk taking

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

-2.0 -1.7 -1.4 -1.1 -0.8 -0.5 -0.2 0.1 0.4 0.7 1.0 1.3 1.6 1.9 2.2 2.5

Mo

nth

ly fu

nd

flo

ws,

perc

en

t o

f to

tal n

et

ass

ets

Fund's monthly excess return over benchmark, in percent

Bond fund Equity fund

US Mutual Funds: "Convex" fund flow-performance relationship

Does asset managers’ behavior amplify risks? (2a) Herding

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

S&P 500 U.S. equity HG bond HY bond EM equity EM debt

End 2009 Mid 2014

1. Average Measure of Herding by Security Type

(Mean across securities, four-quarter average)

More herding

Retail funds herd more than institutional funds

Contribution to systemic risk (1) Investment focus seems matter relatively more than size

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

AE

Sovereign

bonds

AE Corp.

bonds

EM Bonds AE Equity EM Equity

1. Average Contribution to Systemic Risk, by

Investment Focus (in percent)

Contribution to systemic risk (2) Contribution not related to AMC’s size

Is current oversight framework sufficient to manage potential financial stability risks?--NO

• Focus on investor protection

• Regulation lacking specificity

– Liquidity requirements

– IOSCO principles—high-level principle-based requirements

• Hands-off supervision

– No international guidance on supervision

– Varying practices across jurisdictions

(One of the) Recommendations

Recommendations

• More “hands-on” microprudential supervision of risks

– Regulators’ own risk analysis, stress testing

– Better data (derivatives, securities lending)

• Incorporate macroprudential views (focus on systemic risk)

Recommendations

• Improve liquidity requirements

– Better definition of “liquid assets”

• Reduce first mover advantage

– (Minimum) redemption fees for funds investing in illiquid assets

– Adjust technical aspects of fund share pricing rules

End of presentation Thank you for your attention