The Financial Crisis of 2007-09 “...appears to have had an enduring effect on investor behavior. We find structural breaks in investor behavior after the global financial crisis.”

So says the IMF in its Global Financial Stability Report for 2011 released last week.

The Report confirms many of the investment trends illustrated in the year’s better investment consultant surveys (i.e. Towers Watson, Cliffwater, Casey Quirk), but does not really add very much to what we already know.

The IMF’s analysis is built upon data sets maintained by the OECD and Emerging Portfolio Fund Research together with its own Survey on Global Asset Allocation conducted earlier this year. While the IMF’s findings are original, and worthy of attention, they suffer from a paucity of data collection at the international level - a fact the IMF itself acknowledges.

Chapter 2 of the Report is the relevant one for investors/ asset managers, it is entitled: “Long-term Investors and Their Asset Allocation: Where Are They Now?”; and it runs to some 47 pages in length.

The Report puts total assets under management (AUM) in the 17 OECD countries at about $60 trillion or 143% of GDP (year-end 2009). Breaking the data down:
  • The U.S. accounts for about half of all AUM but this is trending lower
  • Japan’s share of the total has declined from 23% in 1995 to 14% at year end 2009
  • The share managed by investment funds has increased significantly (from 29% to 40% over the same period) at the expense of global pension and insurance companies
  • US investors’ exposure to equities has declined (54% to 44% of )
  • Asset allocations differ significantly by country
The Report finds that the Financial Crisis or, Second Great Contraction as Carmen Reinhart and Kenneth Rogoff prefer to call it, led to investors pulling back in both equity and bond investments (with one notable exception: increased equity flows into Latin America).

Further, there is a strong correlation between expectations of long-term growth in specific markets and capital flows to them, but almost no connection to interest rate differentials. This trend is behind the continuing capital flows into emerging market equities (and increasingly into locally denominated EM bonds).

Investors are clearly moving heavily into (longer duration) fixed income securities at the expense of domestic equities. While the IMF’s analysis acknowledges the growing interest in tail-risk hedging and ‘risk-budgeting’, it does not detect the strong move by investors into alternatives (hedge funds, private equity, commodities and real estate). This may be a result of the broad Solvency II driven sell-down by continental European insurers.

The IMF’s Report also provides support for those who advocate that institutions with defined liabilities (like ‘defined benefit’ pension plans) should manage their portfolios more closely in line with their actuarial liabilities (i.e present value of future retirement benefits). The data show a clear trend towards duration matching by institutional investors.

The global equity market crash and bond market rout of 2007-08 has left deep scars in the psyche of real money investors (pension funds, insurance companies etc). This is leading to the partial dismantlement of Modern Portfolio Theory and ‘style bucket’ investing, and the gradual adoption of ‘risk-budgeting’.

This means investors are increasingly looking at the overall risk profile of their portfolios rather than thinking about risk in terms of individual asset classes (equities, bonds, real estate etc) and making asset allocation decisions accordingly.

While the Financial Crisis seems to have prompted investors to consider taking a more holistic approach to asset allocation, regulators risk strangling this more nuanced approach to asset allocation and risk management.

The insurance industry in Europe is expecting much higher capital charges for holding alternatives investments under Solvency II. If the IMF’s Report has one flaw, it is the way it uncritically assumes that alternatives are inherently riskier than long-only equities and bonds. It is this sort of loose thinking that perpetuates the very mistakes being made by regulators around the world.

The ‘structural breaks’ in investor behavior prompted by the Financial Crisis offer a narrow window for the industry to recalibrate its approach to asset allocation along risk-budgeting lines. Let’s hope that regulators don’t shut the window before the shift towards more robust risk management becomes second nature.