Many practitioners in financial markets and nearly all academics live in a constant state of denial. They believe markets are efficient. This creed is the cornerstone of Modern Portfolio Theory, CAPM and the Black-Scholes options pricing model. Yet, the idea that participants in markets act rationally with regard to returns and risk and that therefore assets are priced correctly and prices are constantly adjusting to new information is plainly, empirically, wrong. The 1987 crash, the dotcom boom and bust, the manifest mispricing of credit (in part a by-product of the biggest bubble in house prices ever seen) are just four examples from recent times of inefficient markets.
The role of financial institutions in setting asset prices has largely been ignored in the academic literature. But these institutional investors now dominate share ownership across the world. The big are also getting bigger. Between 1980 and 2000, the biggest 100 US mutual fund managers more than doubled their market share from 19% to 40%.
This is important because agents have very different motivations to principals. The dotcom bubble is a good example of what this means in practice. Many fund management firms abandoned long cherished value-oriented investment processes and joined the party, loading up on hot tech stocks. By 2000, Vodafone was 14% of the FTSE 100, but they carried on buying. When Baltimore Technologies (delisted in 2005) and eight other companies replaced big groups such as Scottish & Newcastle, Imperial Tobacco and Thames Water in the FTSE in March 2000, nine firms with aggregate annual profits of £500 million were apparently rationally valued more highly than companies that had generated profits of £3.73 billion.
This seemingly bizarre behaviour by some of the highest-paid and brightest people on the planet was probably not motivated by a fundamental investment belief that "this time it’s different". The biggest driver was probably business risk. Jeremy Grantham, the founder of Boston money manager GMO, eschewed the technology, media and telecoms hype. His reward was the mass defection of clients. Assets under management shrunk from $31 billion in mid-1998 to $20 billion in 2001. When the TMT bubble imploded, those who had dismissed Grantham as a curmudgeon hailed him as a seer.
GMO (now running $120 billion) was able to stand apart from the herd because of the convictions of Grantham and its independence. Fund managers who are part of larger financial conglomerates probably find it much harder to take such a risk, as do those who are publicly quoted and accountable to shareholders. The 35% decline in assets under management that GMO suffered for sticking to its beliefs also represented a sharp decline in revenues, something that owners and shareholders find unpalatable and managers therefore try to avoid at all costs.
Individuals within firms are also rewarded for following what their peers are doing. If your benchmark is the FTSE 100 and Vodafone is 14% of the index, not owning it represents a huge, career-threatening, risk. Mutual fund managers are probably even more susceptible to herding behaviour. Securing a coveted four- or five-star rating is basically about relative performance. Those funds then receive the biggest marketing budgets and get a disproportionate share of inflows. Growing assets under management means more fees for the firm and a potentially bigger bonus for the manager.
Herd behaviour may be becoming more common because of the bigger role played by agents in financial markets. This in turn might help explain how bubbles are formed. What is absolutely clear is that institutional investors do affect asset prices. Not only is there an emerging body of academic literature to support this, common sense dictates that they must.
State Street Global Markets has been studying the aggregate flows (net buys minus net sells) of institutional investors across asset classes for seven years and has historical information dating back more than a decade. Flows can be thought of as the revealed preferences of institutional investors. They are a quantitatively rigorous way of measuring how a relatively homogenous group of investors are interacting with financial markets.
The present picture is not a pretty one. Across developed equity markets, flows have collapsed. In early summer, institutional investors reacted to fears over inflation by aggressively buying equities and selling government bonds. Now the spectre haunting markets is economic growth, or rather the lack thereof. Investors are selling equities and buying government bonds. This shift in asset allocation is consistent with both growth fears and rising risk aversion.
Aristotle proved 2,400 years ago that the world was a sphere. Flat-earthers are rightly derided. A doctrinaire belief in efficient markets is equally irrational. Markets regularly stray far from fundamental value and the behaviour of agents can make these shifts self-reinforcing. Following the money can solve a large part of the asset price puzzle. At the moment, institutional investors are firmly on the sidelines. Those hoping that equity markets will bounce seem likely to be disappointed.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own