Asset Managers Under the MicroscopePartner and Head of Corporate and Institutional Banking and Wealth and Asset Management practices at Oliver Wyman Global Coordinator, Banks and Diversified Financials Research for Morgan Stanley
Since the financial crisis, governments have undertaken many initiatives intended to make banks safer, protect investors and stimulate the economy. These moves have presented new challenges for banks and asset managers. Stress tests, new liquidity rules, a growing focus on value for money and more intrusive regulation will require further adaptation that, over the long term, will cause a rethinking of operating models and a reshaped competitive landscape.
Many of these regulations have caused banks to pull back on their “market-making” role. As trading thins, the bond markets have become considerably less liquid, and new rules are likely to reduce liquidity even further. For investors, this poses the risk of greater volatility and the potential inability to liquidate positions in time without substantial price impact, especially during a downturn.
Asset managers are already reacting to reduced liquidity: Bond mutual funds are husbanding more cash, upgrading risk management processes and constructing portfolios across a larger number of securities. There is certainly more to do to upgrade liquidity risk management capabilities, but we believe regulators are overestimating the systemic risk of low liquidity of bond funds. The pressure to meet redemptions for the bond funds most vulnerable to runs (high-yield and emerging market) has roughly doubled since 2011, but we’ve found that markets have remained largely open during times of stress. Last year, we could not find examples of runs on the system for long-term mutual funds. Redemptions in the worst three months of the year were in line with the historical ranges, suggesting that asset managers are managing risks prudently and the risks are navigable.
The nature of the underlying investor base is the key for mutual funds. In the U.S., some two-thirds of mutual funds are held by tax-incentivized retail savers who invest for the long term and only switch from time to time. In Europe, data supports that those in pension tax wrappers also hold for far longer than those outside. Over time, policymakers should create predictive models for future redemptions that factor in patterns in investor behavior.
The bigger risk for asset managers stems from the potential new regulations on their conduct.
Here Come the Regulators
The bigger risk for asset managers stems from the potential new regulations on their conduct. Last year, fund managers (or their funds) escaped a designation of “systemically important financial institutions” that could have forced them to submit to a new regulatory regime imposed by the Financial Stability Board. But asset managers still are facing a new wave of scrutiny from regulators. Just a few examples:
- The UK’s Financial Conduct Authority has started a competitive review that will also consider “value for money” delivered by the industry.
- The European Securities and Markets Authority and other regulatory bodies are also increasing scrutiny of active managers who they believe are too closely following a benchmark.
The regulatory scrutiny also has a spillover effect, as investors take their cues from regulators’ concerns. We could see lawsuits over issues such as whether asset managers are fully informing investors about the liquidity or implied valuation risk of their products. The potentially bigger risk may emerge from spillover effects from prudential regulation such as the Securities and Exchange Commission’s draft on liquidity management. For example, we could see investors holding asset managers accountable for fully informing them about the liquidity or implied valuation risk of their products.
Value for Money?
In a zero-yield environment with ever more challenging liquidity risk and growing regulatory scrutiny, asset managers will increasingly have to prove that they are delivering “value.” In light of this, multi-asset products that combine several asset classes in a single product have thrived, and we expect them to continue doing so. At the same time, many managers have looked to build more comprehensive “solutions” capabilities with a focus on holistic advisory and not solely on product provision.
Moving from a product to a solutions provider, however, is a difficult path as this entails challenging questions around who owns client coverage (solutions team or the traditional product distribution channels), P&L, resourcing and pricing. Most importantly, it requires a shift in mindset from product, asset class and beating the benchmark toward a view of being a partner, looking at the portfolio level and meeting overall outcome objectives. While almost all managers have tried to build these broader “solutions” capabilities, we expect to see a clearer bifurcation over the next few years. Future leaders in this space will have to be fully committed, focusing their distribution model and product delivery/sourcing capabilities, as well as coverage efforts, on solutions whereas others will be pushed back to focus on delivering alpha or beta.
Moreover, many of the growth opportunities, we think, are likely to favor players that can meet end-investor liquidity demands or specialists such as alternative asset managers, whose longer lock-up periods, and thus ability to bridge the liquidity mismatch, should prosper in this environment.
The asset management industry overall has so far not been a source of systemic risk. The mutual fund industry, which rightly is at the core of the debate, only accounts for about 30 percent of total industry assets under management. This should give the industry some benefit of the doubt. It will be crucial for asset managers to articulate the case for value for money and careful liquidity management.
Most importantly, it will be critical for regulators to strike a balance between increasing scrutiny where it is due and supporting the industry in tackling the challenges of this liquidity conundrum. Policy makers and asset managers will jointly need to work on finding fund structures more appropriate for the new liquidity environment.