How rational is the market?

This is one of a series of columns that were produced for Moneyweb Investor in which Stuart Theobald explores the intersection of philosophy of science and finance. This followed an earlier series for Business Day Investors Monthly on the same theme. This column was first published in April 2014.

A head-scratching battle rages among theorists of financial markets over how rational the market is. Rational expectations theory holds that prices reflect all available information about the future. Behaviourists, on the other hand, show how prices are influenced by our psychological foibles. The RE school responds that those foibles cancel each other out, so their theory is right over the long run. Behaviourists respond with Keynes’ famous remark that markets can remain irrational longer than you can remain solvent.

The truth is probably that both are right. The markets reflect the views of millions of agents, some of whom are rational and some of whom are not. But the one certain truth is that markets will be rocked by big surprises, and surprises are what make for crises. Both the rational expectations and behaviourists agree on that. So if we are to avoid crises, we should really focus on avoiding surprises.

The man responsible for financial stability at the Bank of England, Andrew Haldane, earlier this month outlined the case for one potential source of surprises: the asset management industry. Asset managers now look after more money than ever before in history, with global assets of $87-trillion, about the same as global GDP. The world’s largest asset manager, Black Rock, holds far more assets than the world’s largest bank, China’s ICBC. Asset manager clients are changing too, becoming older and wealthier, as retirement schemes have proliferated in the developed and developing world and the median age has drifted upward. By 2050, life expectancy will rise another 9%, the global population 30% and per capita GDP will triple. That means the assets managed by the industry will continue to rise dramatically, crossing $100trn by 2020 and possibly reaching $400trn by 2050. There is also a trend toward concentration, with the 20 biggest managers in the world managing about 40% of the assets, raising the question of whether we are creating funds that are too big to fail. The asset management industry is set to become vastly bigger than the banking industry, and we better spend some time figuring out the implications of that, lest it become the source of the next financial crisis like the banking industry was of the last.

This trend certainly holds in SA. Ten of our asset managers (Old Mutual, Sanlam, Investec, MMI, Coronation, Allan Gray, Stanlib, Investment Solutions, Prescient, Peregrine) rank among the 500 largest in the world, with assets of $861bn, about 1,3% of the total managed by those 500. That excludes the Public Investment Corporation, which manages R1.4trn and is the biggest asset manager in SA. But it is the international story that matters, as crises tend to be global, so it helps to focus on the global picture.

Just what surprises will this explosion in asset management bring? Part of the answer could lie in the investment strategies of those managers. There are some striking trends. One is the rapid growth of specialist funds pursuing alternative assets like private equity, real estate, commodities and all manner of things within hedge funds. “Alternatives” have risen from 5% to 10% of assets in the decade to 2012. There is also big growth in non-traditional markets like emerging market funds and high yield bonds, which has grown four times faster than traditional funds at 40% per year. Another trend is the rise of passively managed funds such as exchange-traded funds, particularly in the larger market cap segments of the equity market and sovereign bond market, which means fewer actively managed funds in those segments.

What’s the problem? So far we don’t know. But we do know that asset managers can and have caused problems, such as the collapse of Long Term Capital Management that had to be bailed out under US government supervision in 1998. An asset manager gets into distress if there is a run on it, much like a bank, because it cannot sell into illiquid markets without damaging the value of its assets. The structure of the industry looks like it could become pro-cyclical easily, with passive funds essentially forced to track the trend of selling, creating a dangerous feedback loop. Insurance funds and pension funds have to manage their risk to capital-related benchmarks, so they too could become sellers if the market becomes volatile. Even actively managed funds tend to be held against benchmarks, so managers are forced to sell or buy in tandem with the rest of the market.

The biggest fear is the concentration of so much in the hands of few firms. It makes it less plausible that foibles will average out, as the RE theorists argue, when there are so few agents in the market. And while we have been analysing banks for centuries, asset managers are a fairly new institutional type. We’re not quite sure how they will behave. It seems clear then that we have much homework to do to ensure that it is not the source of some future big surprise.