Global financial regulators appear to be engaged in their own private game.
The winners will be those who can sound the scariest warnings about the damage the ever-expanding asset management industry could be set to inflict on humanity. Their prize will be raising their own prominence by extending their regulatory reach.
The Financial Stability Board, the International Organization of Securities Commissions, the US Financial Stability Oversight Council, the International Monetary Fund and the Bank for International Settlements are the early leaders, courtesy of dark warnings about the havoc fund managers and investors are set to wreak.
Their concerns boil down the threat of destabilising runs in the asset classes tainted by the presence of asset managers.
Investors are procyclical they say, and are likely to rush en masse for the exits when prices start falling. The biggest managers are now “ systemically important” they say: a handful of managers controlling mind-bogglingly large sums now hold the fate of entire asset classes in their hands.
This is all made worse by a desiccation of liquidity, they say, particularly in the fixed income world where market makers now hold little inventory, and in emerging markets, which are, of course, “vulnerable”, an adjective already shaping up to be one of the most overused of the 21st century.
These may be perfectly valid concerns. But in their overexcited urge to point fingers of blame, have regulators ever stopped to assess their own role in this mess?
Just why are mutual funds susceptible to runs? Because investors are promised same-day liquidity, the ability to redeem at the drop of a hat, even if the underlying assets are not, in fact, particularly liquid. This situation is magnified in the world of exchange traded funds, which offer liquidity by the millisecond.
But such structures are not the only ones capable of being dreamt up by the human race. Indeed, some alternative beasts already walk among us. They go by the Latin name iuxtaque clausis fiscus, and are (slightly) more commonly known as the (lesser spotted) closed-ended fund.
The beauty of the closed-end fund is that although investors can sell out any time, they can only sell to other investors. Such funds thus have so-called “permanent capital”, although, in reality, shareholders retain the right to wind them up.
If there is a run on, say, emerging market debt, open-ended funds would be forced to sell their assets, potentially at fire-sale prices. This would push prices lower still, possibly triggering yet more selling and creating serious dislocations for countries and companies needing to roll over debt.
In contrast, closed-ended funds would not need to sell any assets at all. Some investors might choose to sell, and the price they receive may be below the market price of the underlying securities. But there would be no fire sale of assets and far less risk of triggering a systemic crisis.
At present, the small size of the closed-ended fund sector means it struggles to even be a footnote in the debate. In the US the sector has $289bn of assets, 1.8 per cent of the $15.7tn held in open-ended mutual funds. In the UK, closed-ended investment trusts have assets of £126m, 2.1 per cent of the £6tn run by UK-based managers.
One might think regulators worried about the risk of destabilising runs might be keen to encourage their spread. Unfortunately, if one thought so, one would be wrong, particularly in Europe.
EU regulators have seen fit to lump even the most plain vanilla, equity-based UK investment trusts in with the private equity and hedge funds covered by the Alternative Investment Fund Managers Directive, simply because they are not Ucits vehicles. This has raised costs, “to little discernible benefit to shareholders”, as one trust eloquently put it.
Now, under Mifid II, investment trusts (but not open-ended funds) will be deemed “complex products”, meaning execution-only investors will need to complete an “appropriateness test” before being allowed to invest.
This measure, due to come into force in January 2017, will erect a barrier to the sale of investment trusts via online platforms, again to little discernible benefit. It has been labelled “absurd” by James Budden, marketing director of Baillie Gifford, the fund house.
Given the regulatory panic over the possible fallout from open-ended funds, A move to further marginalise one obvious partial solution to regulators’ fears could equally be described as “absurd”.
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