It’s rational behavior: Investors eagerly reward asset managers for generating outsize returns. Although they do yank out some of their money when returns turn to losses, the punishment isn’t proportional to those earlier rewards. An analyst at the European Central Bank argues that this behavior creates risks for the entire financial system that need to be addressed.
Managers don’t feel the complete burden of a high-risk investment in a bearish market, according to the paper titled “Are Fund Managers Rewarded for Taking Cyclical Risks?” by Ellen Ryan, a financial stability expert at the ECB, published this month. The paper is part of a larger series.
During periods of market exuberance — when investors are enthusiastic about market performance and the sentiment is reflected in asset prices — investors are inclined to take more risk. This heightened appetite can result in “excessively” dampened market risk premia — the compensation due to investors for assuming the risk.
During bullish times, funds buy higher-risk investments in hopes of generating higher returns. But buying assets at higher prices also pushes down a fund’s potential return — a lower risk premium.
If amplified investor risk appetite leads to lowered risk premia when markets are strong, a volatile turn in the markets can sharply reverse this trend. When markets take a sudden hit or turn bearish, investors scramble to drain their high-risk investments, but, because of managers’ high levels of risk-taking during the good times, they don’t have enough cash to reimburse investors. Ryan calls this trend among managers “cyclical risk-taking.”
“This trend can then reverse sharply when a crisis hits and as the fund sector is faced [with] rising investor redemptions,” Ryan wrote. “The fund sector’s procyclicality can be amplified further where pre-crisis risk-taking has left funds with insufficient liquidity to meet redemptions. These dynamics were recently observed during the crisis period which followed the outbreak of the coronavirus pandemic in March 2020.”
The paper looks at the incentives for managers to take these risks in the first place.
One motivation is the flow-performance relationship, meaning investors are more likely to put money into a fund that has had strong performance. Asset managers earn money from fees, not returns. The better their fund’s performance, the more investors they’ll attract and the more money they’ll make.
That means the flow-performance relationship is an “implicit incentive contract” for the asset manager. It also may result in managers that are more inclined to make high-risk investments, which can generate outsize returns in good market environments.
This is true across all asset classes, Ryan found.
When performance falters, the relationship breaks down.
“...[As a result,] fund managers may not fully take into account the downside risks to their investments, as the flow response to this outcome is weaker,” Ryan wrote. “In this sense the flow-performance relationship can reward truly ‘excess’ risk taking, where an investment’s return does not necessarily have to compensate for associated risk.”
The flow-performance relationship isn’t the only reason managers engage in cyclical risk-taking. Managers also invest in securities that are “cyclical in nature,” meaning the assets generate high returns when the market is strong and low returns when it falls.
If there’s a positive relationship between inflows and strong performance, then there should be a positive relationship between outflows and weak performance — In fact, there is, but it’s weaker. For example, the paper found that performance relative to peers plays a greater role in determining the funds that receive inflows during bullish periods. Investors don’t rely as heavily on peer comparisons during stressed market environments.
“This type of behavior among investors can be intuitively interpreted as follows: During good times investors choose high-performing funds because they believe the manager has ‘hot hands’ or is highly skilled,” Ryan wrote. “During a crisis outflows are in large part driven by the wider shock, with performance relative to peers playing a lesser role.”
This dynamic perpetuates cyclical risk-taking, because it rewards managers well with large inflows as investments outperform in a strong market but does not inflict “equivalent punishment” when the investment underperforms in a bad market environment.
“As such, managers do not need to fully internalize the effect of a crisis on their portfolio and in flow terms will always benefit from leaning into (and possibly amplifying) an asset price boom,” Ryan wrote.
The paper also noted that investors have a stronger response to good performance achieved through cyclical risk taking than to bad performance. In short, managers are being over-rewarded and under-punished for taking cyclical risks with investor capital.
“This suggests that market discipline, as imposed by funds’ investors, may not be sufficient to ensure prudential behaviour among fund managers,” Ryan wrote.
The paper is an explicit call for regulatory intervention, warning that the behavior and misaligned incentives may eventually lead to systemic risk — the possibility that one market crisis could cause the whole system to collapse.
