A. Pension Funds

Many defined contribution (DC) pension funds with rate of return guarantees tend to have similar benchmarks, thereby creating an incentive for herd behavior. Such behavior can have a spillover impact on capital markets through trading activities. According to the World Economic Forum (2011), these institutions “feel that their countercyclical role in the markets has begun to change as regulatory and accounting changes (e.g., mark-to-market accounting and strict solvency regimes) have forced institutions to be concerned with short-term changes in market prices. Therefore, the investment strategies and behaviors of these institutions have become more procyclical.”

OECD data shows a mixed picture of pension fund behavior in member countries. Some pension funds use portfolio rebalancing strategies, tempering both upward and downward movements in equity markets, which is beneficial to financial stability. Investment flow data shows that pension funds in several countries (e.g., Norway, Italy, Poland, and Turkey) acted in a countercyclical manner during 2008–09, engaging in large net equity purchases as markets tumbled and reducing the intensity of net purchases as markets recovered (OECD, 2010). On the other hand, pension funds in the United States (defined benefit funds), Portugal, and Spain were net sellers of equities, reflecting a move towards more conservative asset allocations (Figure 2).

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Net Purchases of Equities by Pension Funds in Selected Countries

(Annual change in percent)

Citation: IMF Working Papers 2013, 193; 10.5089/9781484336083.001.A001

Source: OECD Global Pension Statistics.

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B. Life Insurance Companies

Life insurance companies tend to have a long-term investment orientation, due to the long-term nature of their liabilities, and take limited investment risk.⁷ A relatively strong regulatory framework has contributed to maintaining life insurers’ conservative asset allocation (Rudolph, 2011). Nevertheless, risky activities grew in retirement savings products in some advanced economies during the past decade. Annuity products, offering return guarantees, increased substantially in the United States, reflecting in part marketing strategies designed to compete with other pension products like the 401(K).

Further, some insurance-dominated conglomerates conducted investment bank-like lending activities. The systemic relevance of these groups was magnified by activities that went beyond the traditional insurance business field. One prime example was the credit default swap (CDS) business conducted by AIG Financial Products, a non-insurance subsidiary of AIG. These companies were not immune to liquidity risk, especially when negative developments (e.g., a rating downgrade) triggered collateral calls or liquidity shocks rapidly led to increased claims over available liquidity. Under these circumstances, some life insurance companies turned to procyclical asset sales to mitigate the respective adverse effects on their balance sheets.

However, the evidence of life insurance companies’ procyclical behavior during the recent financial crisis is mixed. Rudolph (2011) found that U.S. life insurance companies’ asset allocations stayed remarkably steady through 2001–10, with only about 3 percent moving from equities to bonds (+ 2 percent) and cash (+ 1 percent) in 2007–08, although this may reflect valuation effects and was partially reversed in 2009 (Figure 3). On the other hand, Impavido and Tower (2009) found that life insurance companies contributed to the downward spiral during the equity markets’ fall in 2001–03 when they sold equities in an attempt to bolster their balance sheets that led to further declines in the market.⁸ According to the latter study, sales of equities and other financial instruments by this class of institutional investors have been more widespread in the recent financial crisis.

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U.S. Life Insurance Companies’ Asset Allocation

Citation: IMF Working Papers 2013, 193; 10.5089/9781484336083.001.A001

Source: Rudolph (2011).

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C. Endowment Funds

For many years before the crisis, wide portfolio diversification with a focus on alternative asset classes was a prevalent trend in endowment investing. Following Yale and Harvard and inspired by the pioneering work of Swensen (2009), many endowments allocated an increasing share of their portfolios into illiquid assets such as private equities, hedge funds, and real assets. However, the global financial crisis caused large losses and a shift of their strategies away from illiquid assets.

Asset allocation data from Harvard and Yale show that their overall strategic asset allocation has remained consistent with their long-term investment objectives (i.e., a stable allocation toward alternative assets). However, both endowment funds’ negative cash position during the pre-crisis period reversed after the crisis (Figure 4), which reflects renewed perceptions of the importance of a cash buffer. Harvard Management Company decreased its uncalled capital commitments by roughly US$3 billion and adjusted its strategy to secure more flexibility.⁹ In late 2009, Stanford Management Company tried to sell up to US$1 billion of its US$6 billion in illiquid investments. Although this sale plan was not implemented, it implicitly shows the endowment fund’s need for more liquidity and a portfolio adjustment.

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Harvard and Yale Endowment Fund Portfolios

(In percent of total assets)

Citation: IMF Working Papers 2013, 193; 10.5089/9781484336083.001.A001

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According to Preqin’s survey report in 2009, 57 percent of endowments had altered their private equity strategy through, for example, more stringent due diligence, reductions in commitments, and postponement of investments. Some endowments, despite their very long-term investment horizon, faced liquidity issues during the financial crisis. A Center for Social Philanthropy and Tellus Institute (2010) study of six university endowments found evidence of taking on excessive risks and investing in overcrowded asset classes prior to the crisis. The study argues that the funds played a role in magnifying certain systemic risks in the capital markets. The study reports that during the crisis “illiquidity in particular forced endowments to sell what few liquid holdings they had into tumbling markets, magnifying volatile price declines even further.”

D. Mutual Funds

Mutual funds have various investment objectives, but many invest for the medium to long term. Data on flows in and out of various mutual funds show that ample liquidity and low financial market volatility during the pre-crisis period increased investors’ risk tolerance and led to continuous inflows to mutual funds. However, Emerging Portfolio Fund Research (EPFR) Global data show that there was subsequently a clear pattern of rapid drawdowns from mutual funds, especially after the collapse of Lehman Brothers in September 2008 (Figure 5). Although, in principle, bond flows are more prone to destabilizing reversals than investments in equities, arguably because the stronger re-pricing of equities endogenously moderates outflow pressures, EPFR Global data show more volatility in equity funds than bond funds during this period. Possible explanations include fund managers’ difficulty in liquidating assets because of a liquidity dry-up in some bond market segments, asset switches within debt securities (e.g., a switch from high-yield corporate bonds to sovereign bonds), and client investors’ adoption of a hold-to-maturity approach in the face of market turmoil.¹⁰

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Net Inflows to Various Mutual Funds

(In billions of U.S. dollars)

Citation: IMF Working Papers 2013, 193; 10.5089/9781484336083.001.A001

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Raddatz and Schmukler (2011) analyzed micro-level data on mutual funds and found that both client investors and fund managers tend to show procyclical behavior, reducing their exposure to countries experiencing turmoil during bad times and increasing it when conditions improve. They conclude that capital flows from mutual funds did not seem to have a stabilizing role by, for example, generating large reallocations during the global financial crisis. Also, there is some evidence that a retrenchment of U.S. money-market mutual funds from European countries contributed to the rise in funding costs experienced by banks in the euro area in the fall of 2011 (Jenkins, 2011).

E. Sovereign Wealth Funds

The long-term investment strategy of non-budget stabilization SWFs enabled most of them to maintain their stance on asset allocations during the crisis. However, Miracky and Bortolotti (2009) describe how several SWFs decided to reduce exposures to, in particular, U.S. and U.K. banks in the second quarter of 2009. In retrospect, these SWFs may have liquidated part of their holdings at the worst possible moment and thus could have missed the subsequent (albeit temporary) recovery that followed. Although these SWFs were certainly countercyclical when they invested in bank stocks, the liquidations shortly afterward seemed to have been procyclical. Further, Bernstein, Lerner, and Schoar (2009) find that SWFs often pursue assets at home when domestic equity prices are already relatively higher and thus engage in “trend chasing.”

The crisis also brought significant changes in the implementation of SWFs’ stated strategies. Kunzel and others (2011) analyzed the asset allocation changes of a subset of SWFs and found evidence of some SWFs liquidating positions in an effort to support domestic economies or to increase the share of liquid instruments in their portfolios. Some SWFs, especially stabilization funds, have shown patterns of a flight to quality by increasing their exposure to high-quality sovereign assets, reflecting increased risk aversion. Measures to alleviate credit risk include a reduction of the portfolio allocated to bank deposits, early expiration of deposits, and shortening of the maximum maturity of deposits. They also adopted a more stringent process for the selection and approval of counterparties.

In other cases, assets from long-term SWFs were used to support domestic banks by providing liquidity to the banking system (by depositing their assets in domestic banks) and to help with bank recapitalization. For example, Ireland’s National Pensions Reserve Fund (NPRF) liquidated its assets in two tranches in 2011 to realize €10 billion cash, which was used to recapitalize the domestic banking sector (NPRF’s annual report for 2011). The Russian government used US$22 billion of the National Wealth Fund (NWF), whose mission is to co-finance the voluntary pension systems of the population, to support the domestic banking sector (Kazakevitch and Trishkina, 2010). While this behavior can be considered countercyclical, it does highlight the challenges in keeping to intended mandates during a crisis. Indeed, according to the International Forum of Sovereign Wealth Funds (IFSWF, 2011), some SWFs have experienced challenges in maintaining consistency between their investment policies and the underlying objectives of the fund, especially during periods of market turbulence (Figure 6). The debt crisis in the euro zone also posed a challenge to many SWFs in striking a reasonable balance between long-term investing and short-term flexibility (Park and van der Hoorn, 2012).

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Difficulties in Maintaining Consistency in Investment Policy

(Number of SWF respondents)

Citation: IMF Working Papers 2013, 193; 10.5089/9781484336083.001.A001

Source: IFSWF (2011).

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E. Central Banks (Reserve Managers)

Central banks hold official foreign exchange reserves for various reasons. These include “self-insurance” against financial shocks and sudden stops in accessing the international capital markets, and enhancement of the credibility of monetary policy. Thus, the primary objectives of reserve management are safety (i.e., preserving the value of the reserves) and a high degree of liquidity.

Prior to the crisis, as reserves grew rapidly, an increasingly larger share was invested with a more prominent return objective (sometimes separated in an “investment tranche” as opposed to a “liquidity tranche” with more traditional objectives). In particular, reserve managers started to take more credit risk to enhance investment returns. Borio, Galati, and Heath (2008) and Bakker and van Herpt (2007), among others, observe that central banks’ weight on the return objective has generally increased over time, for example, by showing a preference for asset-backed securities, increasingly using derivatives, and hiring more external managers. This trend was sharply reversed in the wake of the crisis. Pihlman and van der Hoorn (2010) find evidence of procyclical investment behavior by central bank reserve managers, who collectively pulled more than US$500 billion of deposits and other investments out of the banking sector between December 2007 and March 2009 (Figure 7).

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Composition of Global Reserves

Citation: IMF Working Papers 2013, 193; 10.5089/9781484336083.001.A001

Source: IMF Special Data Dissemination Standard (SDDS) data.

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McCauley and Rigaudy (2011) document how exposure to government-sponsored enterprises (GSEs) was reduced and securities lending programs were scaled back. Reserve managers’ investment in assets under market pressure was also reduced when credit rating downgrades breached the minimum level for inclusion. The debt crisis in the euro area has also had a profound impact on the composition of reserves. Pringle and Carver (2012) find that central banks reduced their holdings of some euro area issuers’ debt or exposure to the euro more broadly. Currency composition data show that in the midst of the crisis the long-term trend of a decrease in the U.S. dollar share of global reserves came to a temporary end and flight to quality led to a short-term increase in the share of the dollar. More recently, reserve managers’ allocation to the euro has decreased since 2010, when sovereign risks in the euro zone periphery materialized, with the biggest “beneficiary” being the share of other currencies, which mainly consist of the Australian dollar and Canadian dollar (Figure 8).¹¹ Central banks’ holdings of gold have also changed. Since 1965, central banks had been net sellers of gold. This trend came to end during the global financial crisis when central banks turned into net buyers of gold. On average, the new buyers are willing to pay a significantly higher price than that prevailing at the beginning of the 2000s (Figure 9).

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Evolution of Currency Composition of Reserves

Citation: IMF Working Papers 2013, 193; 10.5089/9781484336083.001.A001

Source: IMF COFER.

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Evolution of Global Central Bank Gold Holdings

Citation: IMF Working Papers 2013, 193; 10.5089/9781484336083.001.A001

Source: World Gold Council.

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A. Underestimation of Liquidity Needs

Long-term investors sometimes face short-term liquidity needs. For example, central banks hold all or part of their foreign reserves in short-term liquid assets because reserves may need to be mobilized to provide necessary foreign currency (e.g., during a BoP crisis or for servicing external debt). Also, the open-ended structure of mutual funds means that client investors can redeem their shares on short notice, which leads fund managers to maintain a certain level of liquid assets rather than allocate all the fund’s assets to long-term securities.

Managing liquidity is an integral part of asset and liability management (ALM) modeling. Usually, liquidity needs can be anticipated and projected with reasonable accuracy (e.g., pension payments or life insurance claims). However, asymmetric assessment of liquidity risk could lead to procyclical behavior. In the pre-crisis period, there was considerable liquidity in the financial system, and competitive pressure led to an underestimation of required liquidity buffers. From an individual investor’s point of view, piling up sufficient cash can be a costly approach, lowering the asset manager’s short-term performance and sending a negative signal to clients about the manager’s capability. These constraints lead asset managers to underestimate liquidity buffer needs and allocate more to illiquid and risky assets. When favorable conditions are abruptly reversed and market funding conditions deteriorate, almost all investors are forced to sell investments quickly in order to raise cash. This brings serious disruption to long-term investors’ existing portfolios.

B. Difficulties in Assessing Market Risk and Macroeconomic Forecasting

In the wake of the crisis, macroeconomic, political, and financial sector risks increased significantly and have led to prolonged high volatility in the market (Figure 10).¹² Under the increased volatility and concerns about remaining risks, it has become more difficult for investors to make a clear distinction between temporary price fluctuations and more fundamental changes in risk. Moreover, materialization of many unprecedented and previously unthinkable scenarios (e.g., large global financial institutions’ failures, the euro area sovereign debt crisis, and the U.S. sovereign rating downgrade) have reshaped investor perceptions about safe assets and increased their concerns about tail risks.

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Evolution of VIX on S&P 500

Citation: IMF Working Papers 2013, 193; 10.5089/9781484336083.001.A001

Source: Bloomberg.

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Macroeconomic forecasting models have a poor track record in predicting the timing of recessions or turning points in the business cycle.¹³ The recent crisis also exposed the weaknesses in risk management systems and models. Traditional risk measurement methodologies (e.g., Value at Risk (VaR)) tend to underestimate underlying risks because an increase in asset prices often comes with lower volatility. With declines in estimated risk, investors have incentives to increase leverage or invest in illiquid assets. Once the economic or credit cycle reaches the peak, the subsequent decrease in asset prices results in greater asset price volatility.

A traditional risk measurement system does not see risks “through the cycle” and leaves investors vulnerable to rising risk premiums and higher volatility if market liquidity dries up. This causes greater investor losses than in normal credit cycles. Ang and Kjaer (2011) point out that California Public Employees’ Retirement System’s (CalPERS) internal control system did not work well when real estate markets surged during the 2000s, and their use of leverage peaked with the real estate market. Gorton and Ordoñez (2012) show that investors start to rigorously assess underlying default and liquidity risks only after financial distress materializes. As uncertainty increases substantially and issuers become more reluctant to provide information, investor analysis requires much greater efforts to gather adequate information, process complex data, and prepare for the risk of an unexpected event. In normal conditions, default risk of investment-grade issuers is considered remote and attracts insufficient attention (Economist, 2008).

C. Principal–Agent Problems and Manager Incentive Structures

Principal-agent problems occur at various levels in the investment management industry—between asset owner and asset manager and between internal manager and external manager, to name but a few. Principal-agent problems occur when the agent has better information than the principal, and the principal cannot fully monitor or control the actions of the agent (moral hazard). Benchmarks and annual performance targets are common instruments to address the latter issue, but they often lead to a focus on short-term returns and thus reduce the investment horizon of the manager.

Exposure limits are another common instrument but often are calibrated based on normal or stable market conditions, resulting in risk tolerance that can be overstated or short-sighted. With short-term performance targets and loose risk control systems, managers may have an incentive to increase investments in illiquid assets or use excessive leverage (e.g., the classic example of selling deep out-of-the-money options). This behavior leads to an excessive focus on short-term results at the expense of long-term benefits, reducing the incentive of managers to evaluate the long-term fundamental values of assets or potential losses under market volatility.¹⁴ More generally, although institutions may have long-term horizons, their asset managers may not necessarily have the same perspective owing to the nature of their compensation (e.g., annual bonuses based on one year’s performance).

Relative performance targets (index-based benchmarks or average returns in a peer group) stimulate herd behavior. This observation inspired the well-known model of Scharfstein and Stein (1990), who demonstrate that asset managers show herd behavior due to reputational concerns. As Trichet (2001) observed: “Some operators have come to the conclusion that it is better to be wrong along with everybody else, rather than take the risk of being right, or wrong, alone.” The negative impact of procyclical behavior can be more profound when the compensation structure is biased. Rajan (2005) argued that a biased compensation structure—more reward on the upside and less penalty on the downside—leads managers to invest in more risky assets, which may contribute to building asset bubbles. In the buildup of global imbalances, lenders offered risky loans but disregarded the long-term credit risks, because financial intermediaries created exotic products that generated large up-front payments (Bair, 2011).

D. Reporting and Disclosure Policies

Reporting requirements and disclosure policies affect investment behavior in two directions. On one hand, asset owners/boards of trustees who understand the investment objectives and benefits of long-term investing are more likely to allow asset managers to maintain existing asset allocations until asset values have recovered after a crisis. For example, Norway’s Government Pension Fund Global, though experiencing temporary large losses during the financial crisis, implemented its strategic allocation plan to increase the share of equities from 40 to 60 percent and expanded the benchmark portfolio to include small-cap companies. This implementation was backed by the asset owner’s clear understanding of investment philosophy and good communication with related stakeholders.

On the other hand, reporting requirements or disclosure policies may sometimes lead to procyclical behavior. Investor concerns about monthly or quarterly reports can make them adopt a shorter-term investment horizon than the period consistent with their original objectives. This could result in losing the opportunity to gain long-term investment premiums and increasing reinvestment risk. Jin (2005) argues that in the mutual fund industry disclosure of underperformance on a quarterly or annual basis puts fund managers at risk of being dismissed. New fund flows are sensitive to past performance, and fund outflows lead to the liquidation of assets. This implies that asset managers who focus on long-term performance may not see long-term gains realized.¹⁵

Even for institutional investors with explicit long-term mandates, disclosure requirements on a short-term basis tend to create implicit pressure. For example, if asset owners are tempted to publish information on good short-term performance or do not fully understand the linkages between investment objectives and their portfolios, they may encourage managers to add more risky assets even if an asset bubble is building up or to liquidate assets at the worst possible moment, adding to volatility in financial markets. This concern has led some SWFs (e.g., the Government of Singapore Investment Corporation (GIC) and the Abu Dhabi Investment Authority (ADIA)) to disclose only long-term performance in their annual reports.¹⁶ While reporting quarterly returns, Future Fund is also trying to educate its stakeholders on focusing on the longer-term returns. The headline risk (e.g., disclosing actual losses) seems to be an important consideration for sovereign investors who need to respond to the general public. This complexity also suggests that increasing attention should be given to finding a reasonable balance in information disclosure and frequency.

E. Regulation and Market Convention

Regulatory and accounting changes can force investors to become more short-term oriented and make them more vulnerable to market volatility. For example, strict mark-to-market valuation-based accounting rules or rigid capital requirements may constrain long-term investors’ ability to ride out short-term volatility.¹⁷ Asset valuations affect investors’ decision making process, because valuation affects financial statements and thereby investors’ risk tolerance. The World Economic Forum (2011) argues that mark-to-market accounting and pension regulations are pushing pension fund managers away from long-term investing, and Solvency II and other regulations will discourage life insurers from making longer-term investments.

Convention in the investment management community is also an important factor. For instance, the investment models used by many long-term institutional investors may be similar, which could be a factor contributing to herd behavior.¹⁸ Over-reliance on credit rating agencies can be a factor driving procyclicality as credit ratings are embedded in regulatory requirements and various financial contracts. Prudential regulation typically allows for less capital to be held against highly-rated bonds.¹⁹ Central banks use credit ratings to determine the eligibility of collateral for monetary policy operations. Bond portfolio manager performance is frequently benchmarked against standard indices that are composed on the basis of credit ratings.²⁰ A bond downgrade to below the investment-grade threshold often triggers immediate liquidation.

A. Implications for the Financial System

Various studies (e.g., Borio, Furfine, and Lowe, 2001; Joint FSF-CGFS Working Group, 2009) confirm that procyclical investing can be harmful for global financial stability. Although this is true for long-term as well as short-term investors, procyclical behavior by long-term investors is less expected by market participants, and the fact that they are also typically large can, therefore, cause more market disruptions. Procyclicality tends to overvalue short-term gains and put relatively less value on long-term projects. Specifically, during an upward phase of the cycle, assets can be allocated to investments with marginally positive or even negative net present value, mainly due to increased competition. In contrast, during a downturn even some investments with positive net present value cannot receive financing from investors, due to excessive risk aversion.

Further, procyclicality in asset allocation can make swings in financial asset value and economic activity more intense. From an individual investor’s point of view, procyclical behavior can be rational, especially if short-term constraints become binding or if the investor can exit earlier than others. However, the collective actions of many investors may lead to increased volatility of asset prices and instability of the financial system (Claessens, 2013). Figure 11 manifests to a large extent how procyclical behavior could have been reflected in the growth of global financial asset values since 2000. The value of various financial assets increased rapidly during the mid-2000s, but it contracted sharply in 2008, with the growth in recent years being moderate.

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Growth in Global Financial Assets

(In billions of U.S. dollars)

Citation: IMF Working Papers 2013, 193; 10.5089/9781484336083.001.A001

Source: Mckinsey Global Institute.

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Increased market volatility driven by procyclicality can, in turn, affect the real economy through supply and demand factors.²² Factors that encourage institutional investors to shorten their investment horizon often lead to a reduced supply of long-term funding, which raises costs for all borrowers. The quantification of these effects is complicated and must address the endogeneity of the problem. The causality from procyclical investing to instability works in both directions: investors respond to heightened volatility and by doing so they contribute to the problem. The challenge is to disentangle these mutually reinforcing processes.

One measure of the potential impact of procyclicality on financial stability is the magnitude of global investors’ flight to quality compared with selected indicators. We use the changes in foreign investors’ holding of U.S. treasury securities—still considered to be the safest assets in global markets—for quantifying investors’ overall collective behavior. The average monthly growth rate in foreign investor holdings of U.S. treasury securities was about 1.3 percent from 2002 to 2011. However, this growth rate recorded 4.2 percent and 6.4 percent in September and October 2008, respectively. These numbers are about two and three standard deviations from the average, respectively, and therefore the deviation can be used as a proxy to gauge the extent of non-U.S. investors’ procyclical behavior under extreme market volatility.

Figure 12 shows that foreign investors’ flight to quality reached almost US$220 billion during September–October 2008, an amount larger than the monthly trading volume of corporate bond markets in the United States and Japan. From a macroeconomic perspective, the amount of foreign investors’ flight to quality is the equivalent of 97 percent of 79 emerging economies’ average GDP and is 16 times larger than 70 low income countries’ (LICs) average GDP in 2008. The annual change in holdings of U.S. treasury bonds also shows foreign investors’ flight to quality behavior (Figure 13).

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Flight to Quality and Selected Indicators

(In billions of U.S. dollars)

Citation: IMF Working Papers 2013, 193; 10.5089/9781484336083.001.A001

Sources: U.S. Treasury, Treasury International Capital (TIC) data; Securities Industry and Financial Markets Association (SIFMA); Asias Bonds Online; and the IMF.

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Change in Treasury Securities Holdings (2008 vs. 2007)

(In billions of U.S. dollars)

Citation: IMF Working Papers 2013, 193; 10.5089/9781484336083.001.A001

Source: SIFMA.

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B. Implications for Individual Institutions

Long-term investors can reap the premium embedded in longer-dated assets or illiquid assets. Historically, asset classes associated with long-term investments have outperformed short-term assets, although long periods of underperformance also exist (Table 3). Further, it is widely accepted that an equity risk premium exists. Ilmanen (2011) has found the equity risk premium to be in the range of 300–800 basis points over long-term treasuries.

Table 3.

Historical Performance of Selected Assets

(Annualized returns, 1928–2011)

Source: Damodaran (2012).

Table 3.

Historical Performance of Selected Assets

(Annualized returns, 1928–2011)

	U.S. Stocks	Treasury Bills	Treasury Bonds
Mean	11.20%	3.66%	5.41%
Median	13.31%	3.20%	3.63%
Standard Deviation	20.11%	3.04%	7.78%

Source: Damodaran (2012).

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Table 3.

Historical Performance of Selected Assets

(Annualized returns, 1928–2011)

	U.S. Stocks	Treasury Bills	Treasury Bonds
Mean	11.20%	3.66%	5.41%
Median	13.31%	3.20%	3.63%
Standard Deviation	20.11%	3.04%	7.78%

Source: Damodaran (2012).

Procyclical behavior and interruption of long-term investment strategies may lead to worse performance in at least two ways. First, a shorter investment horizon leads to more frequent trading and, thus, higher transaction costs. The illiquidity of some asset classes in the portfolios of long-term investors compounds these costs, which can become a significant drag on performance. Barber and Odean (2000) found that between 1991 and 1996 the equity portfolio of households that traded most often, underperformed the average portfolio by 500 basis points annually. Compared with the most passive investor, the underperformance was even larger: approximately 650 basis points. Second, procyclicality can become a buy-high, sell-low strategy. Long-term investors take risks that are expected to materialize over very long horizons. When they do, investors lose on a marked-to-market basis. Reducing exposures in a crisis implies that losses are realized and therefore not recovered when markets turn. Evidence on poor timing decisions and missed recoveries is fragmented. Ang and Kjaer (2011) report, for example, that CalPERS bought high in real estate, as it implemented an aggressive expansion strategy shortly before the outbreak of the crisis. It then sold low, when the equity allocation was reduced in late 2008 in order to raise cash. Miracky and Bortolotti (2009) confirm that the latter was a widespread problem, as the first half of 2009 was marked by high SWF net divestments.

In the short run, investing procyclically can be profitable. Wermers (1999) found that stocks bought by investors qualified as herds outperformed those that they sold by an average of 4 percent in the following six months.²³ Sias (2004) found that institutional investors’ demand for a security in a quarter is positively correlated with their demand in the previous quarter. He attributes this to institutional investors following each other into and out of the same securities. In the longer run, however, a reversal is observed that dominates the short-run price dynamic. Gutierrez and Kelly (2009) report that this reversal takes place in the second year after herding, but that the magnitude depends on market conditions. They also found that institutional buys appear to be more informative than sells, as the former have a larger permanent impact on prices than the latter. Brown, Wei, and Wermers (2012) found that the reversal can be attributed to career-concerned fund managers responding to analyst revisions. Dasgupta, Prat, and Verardo (2011) note that the effect is concentrated among smaller stocks and that it is stronger for stocks with higher institutional ownership.

This issue also has close linkages with investors’ original objectives and interests. For example, assets in SWFs should contribute to smoothing shocks from cyclical movements of commodity prices, meeting long-term pension liabilities, and securing adequate resources for future generations. For SWFs with longer investment horizons, fire sales of assets are likely to realize losses and jeopardize the original rationale for the SWF. Central bank reserve managers’ procyclical behavior (e.g., pulling out deposits from the banking sector) during the crisis could help them avoid large losses—at least temporarily. However, their collective actions contribute to a more prolonged freeze of the global funding markets to which private sector participants need to regain access. This will ultimately require central banks’ to take offsetting policy measures that can lead to more financial costs and a burden on their own balance sheets.

A. Investment Strategies and Strategic Asset Allocation

SAA is fundamental to ensuring sustainable long-term investing and minimizing procyclicality. The first step in the SAA process is to determine the objectives and liabilities of a long-term investor, which, in turn, determines the investment horizon. An accurate estimate of the true investment horizon reduces the probability that a significant share of assets will need to be sold unexpectedly or at short notice in response to movements in benchmark indices. For example, pension funds should focus on beneficiaries’ retirement horizon and risk tolerance in constructing their products, and all factors, including liabilities, benefit payments, operating expenses, and employer and member contributions, should be taken into account in determining the appropriate asset allocation mix.

A well-defined ALM approach is needed to derive the SAA of a long-term investor. An ALM approach aims at matching assets and liabilities, so that a long-term investor can invest in assets that mature when cash is needed, thus minimizing financial risks and avoiding procyclical behavior. Ideally, long-term investors could invest most of their assets in illiquid securities or loans. However, uncertainty about financial market conditions may imply that a long-term investor needs to hold liquid assets as well, as a buffer to accommodate potential liquidity needs (see Appendix: bullet 1.d.). For example, CalPERS allocates the majority of its assets to growth-oriented assets, but also maintains a certain amount of income-generating and liquid assets (Figure 14).

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CalPERS’ Strategic Asset Allocation

Citation: IMF Working Papers 2013, 193; 10.5089/9781484336083.001.A001

Source: CalPERS.

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In designing an SAA, institutional investors should be especially careful with credit-related instruments. The recent crisis suggests that complex credit risk dynamics in securitized products were at the center of both the risk transfer and the accompanying buildup of leveraged positions that turned out to be unsustainable. Valuation of such complex instruments is often difficult, in particular at times of market distress. When investors include illiquid assets in their portfolio, they should ensure that there are sufficient risk premiums or protection clauses, which may be difficult for many complex instruments.

A risk factor-based approach could be one of the methods to complement the traditional asset class-based SAA (see Appendix: bullet 1.f.). This methodology focuses on underlying risks embedded in assets rather than simple diversification across different assets. Ang, Goetzmann, and Schaefer (2009) argue that a risk factor focus allows a better understanding of risk-return trade-off. This approach is appropriate for long-term investors, since a deeper understanding of how each risk factor evolves in a different horizon could help build a more robust portfolio that helps asset owners avoid having to change their strategy in an inconsistent way. The Alaska Permanent Fund Corporation has adopted a risk factor-based approach and decided to group its investments by risk and return profiles (Figure 15), with a view to assessing risk in areas beyond volatility, such as liquidity risk, currency risk, and company exposure.²⁴

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Alaska Permanent Fund Corporation’s SAA by Asset Class and Risk Factor

Citation: IMF Working Papers 2013, 193; 10.5089/9781484336083.001.A001

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Operational procedures should be well-defined in designing and implementing SAA. Key considerations include the following: (i) the investment objectives and time horizon should be in line with the asset owner’s objectives; (ii) risk tolerance should be established to clearly delineate the amount of absolute and relative risk that asset managers can utilize to achieve the investment objectives; (iii) the risk-bearing capacity of an institution and managers should be assessed before a formal risk tolerance limit is established; (iv) the SAA should encapsulate the spectrum of investment risks that the fund is designed to take; (v) the SAA should reflect the changing nature of each risk factor among eligible assets; (vi) the unique characteristics of each risk factor should be reviewed in choosing an appropriate mix of assets;²⁵ and (vii) the constituent asset classes should be subject to separate decisions on how they should be managed.

B. Portfolio Rebalancing

Portfolio rebalancing creates investment discipline and can help avoid procyclical behavior or even make behavior countercyclical.²⁶ The SAA is implemented via a benchmark or target allocation to which the actual asset allocation needs to be rebalanced periodically to keep risk exposures constant (see Appendix: bullet 2.b.). Rebalancing involves selling assets that have risen in price and buying those that have declined, thus preventing a single asset class from dominating the portfolio if its value keeps rising. Rebalancing also helps to avoid herd behavior. If asset prices mean-revert, then rebalancing benefits from buy low-sell high dynamics, which increase returns over the long run. Norway’s Government Pension Fund Global provides a prime example of an institutionalized rebalancing framework. The ministry of finance has set rules for full rebalancing back to the strategic weights. These specify the maximum permitted deviation between the weights in the actual benchmark portfolio and the strategic benchmark portfolio before the fund must be rebalanced.

Rebalancing rules can be further improved by incorporating forward-looking risk and return measures. Traditional rebalancing is based on realized (ex post) returns and fixed weights for asset classes or risk factors. A long-term investor can benefit from time-varying risk premiums, for instance by increasing the allocation to asset classes or risk factors beyond the normal level when risk premiums are unusually high. These more sophisticated rebalancing rules require adequate forward-looking, risk-adjusted valuation models.

C. Risk Management

The global financial crisis brought important challenges for risk management. First, because of the magnitude and breadth of the shock, correlations between the returns of almost all asset classes increased, and thus the benefits of diversification failed to protect asset values. Second, many investors failed to anticipate the contagion to economic growth and risky assets throughout the world. Third, it was difficult to assess liquidity risks, because this depends to a large extent on macroeconomic factors and tail events rather than asset composition itself. Fourth, traditional models assume that distributions of losses are not correlated over time, but sizable losses at one moment led to a severe lack of liquidity and confidence, which resulted in larger losses in the following periods.

Learning from the recent crisis, institutional investors can strengthen their risk management in several ways:

D. Governance

Investment policies must be anchored with and understood by the owners/boards of trustees, who should feel comfortable with the risks taken also in “bad times.” Investment decisions, including allowing deviations from the benchmark (in the case of active management), are typically taken by the manager.²⁸ Active portfolio management can bring financial and non-financial benefits, but it is hard to align the incentives for portfolio managers (as agents) with the long-term objectives of the fund owners (as principals). Through active management, portfolio managers aim to outperform a benchmark over a given horizon. This horizon is, by construction, shorter than the horizon of the fund itself. Active management creates incentives for short-term profit seeking and, potentially, less aversion to short-term loss. Although active positions tend to be relatively small when compared with overall SAA decisions, collectively they may contribute to procyclical volatility in the market. The optimal degree of active management depends, however, on the size of the fund and the markets in which it operates (Malkiel, 2003).

Further, empirical evidence in favor of the financial benefits of active management is limited at best. Ang and others (2009) and Ibbotson and Kaplan (2000) found that the contribution of active management to the overall return that is genuinely idiosyncratic is very small. The reported risk reduction that took place during the crisis was, in many cases, a timing decision, as investors returned to the market when the “worst” of the crisis appeared to them to be over. However, market timing can be very risky and often tends to be costly. Active management can be profitable in less efficient markets where arbitrage opportunities remain, but, because of the lower liquidity, procyclical investment behavior can be disruptive. Nevertheless, financial markets still need some active managers, as not all portfolios can be managed passively. A certain share needs to be managed actively to ensure liquidity and price discovery in the markets. Very large investors may not be able to manage their portfolios in a totally passive manner for this reason.

Owners/boards of trustees of long-term funds could design active/tactical management mandates to be countercyclical (i.e., allow explicitly for exploiting the periods of illiquidity or dislocations in the market to provide liquidity and buy long-term assets cheaper at a time of (temporary) market dislocation). The Future Fund (2012) for example, as one of the lessons learned from the crisis, explicitly recognizes the option value of cash: “With the benefit of operating the portfolio for the past few years, recognition of the value of having the ‘dry powder’ to respond opportunistically to attractive investments has grown.”

Whether or not to allow active management by managers and the exact nature of these mandates is a key decision to manage the risk of procyclical behavior. It is important that incentives for the manager are compatible with those of the owner, so that the manager does not inappropriately adjust risks if that is not in the long-term interest of the owner. This can be achieved, for example, by giving shares to managers or requiring them to invest in the fund, so that they become owners as well, perhaps with a lock-up period for personal investments (see Appendix: bullet 4.c.). Extending the performance measurement period for multiple years (e.g., an annual bonus on the basis of rolling medium- to longer-term performance) should be encouraged, rather than using short-term performance-based targets. The OECD (2013) supports the view that the performance of fund managers should be evaluated over a period of several years, taking into account ALM objectives and the level of implied risk. Some institutional investors (e.g., SWFs) have adopted performance measurement policies to discourage short-termism and foster long-term orientation in investing (Table 4).

Table 4.

Performance Measurement System of Selected Investors

Sources: Annual reports of individual SWFs.

Table 4.

Performance Measurement System of Selected Investors

Fund	Performance Measurement or Compensation
CalPERS	In 2009, CalPERS sent a memo to its hedge fund partners suggesting improvements in governance, including manager compensation. Some of the suggestions included: The imposition of cash-type hurdle rates or a lower performance fee over a zero hurdle. A structure where performance fees “vest” and are crystallized fractionally over a set number of years. A rolling performance fee structure, perhaps over three or four years. A requirement that managers reinvest a given percentage of performance fees in the fund.
GIC (Singapore)	The primary metric for evaluating GIC’s investment performance is the rolling 20-year real rate of return. It takes a long-term view when assessing external managers by evaluating a steady application of their investment philosophy and process throughout market cycles.
Government Pension Fund Global (Norway)	Performance-based pay is calculated on the basis of the performance of the fund, with the group and individuals measured against set targets over a period of at least two years. Half of the accrued performance-based pay shall be paid the year after it was accrued, while half shall be held back and paid over the following three years.
Future Fund (Australia)	The Board interprets the requirement to achieve a return of at least CPI + 4.5 percent per annum over the long term as meaning over rolling 10-year periods. The Board explicitly rejects the concept of peer risk (the risk of underperforming other institutional investors over the short term) as being inconsistent with the mission and mandate of the Future Fund.
Alberta Heritage Savings Trust Fund (Canada)	The Fund’s performance is measured on one-year performance numbers and on a five-year annualized rolling basis. The Fund has a long-term goal to achieve a return of the Canadian CPI + 4.5 percent. The policy target is set to meet this goal over the long term.

Sources: Annual reports of individual SWFs.

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Table 4.

Performance Measurement System of Selected Investors

Fund	Performance Measurement or Compensation
CalPERS	In 2009, CalPERS sent a memo to its hedge fund partners suggesting improvements in governance, including manager compensation. Some of the suggestions included: The imposition of cash-type hurdle rates or a lower performance fee over a zero hurdle. A structure where performance fees “vest” and are crystallized fractionally over a set number of years. A rolling performance fee structure, perhaps over three or four years. A requirement that managers reinvest a given percentage of performance fees in the fund.
GIC (Singapore)	The primary metric for evaluating GIC’s investment performance is the rolling 20-year real rate of return. It takes a long-term view when assessing external managers by evaluating a steady application of their investment philosophy and process throughout market cycles.
Government Pension Fund Global (Norway)	Performance-based pay is calculated on the basis of the performance of the fund, with the group and individuals measured against set targets over a period of at least two years. Half of the accrued performance-based pay shall be paid the year after it was accrued, while half shall be held back and paid over the following three years.
Future Fund (Australia)	The Board interprets the requirement to achieve a return of at least CPI + 4.5 percent per annum over the long term as meaning over rolling 10-year periods. The Board explicitly rejects the concept of peer risk (the risk of underperforming other institutional investors over the short term) as being inconsistent with the mission and mandate of the Future Fund.
Alberta Heritage Savings Trust Fund (Canada)	The Fund’s performance is measured on one-year performance numbers and on a five-year annualized rolling basis. The Fund has a long-term goal to achieve a return of the Canadian CPI + 4.5 percent. The policy target is set to meet this goal over the long term.

Sources: Annual reports of individual SWFs.

Governance relating to the risk control framework, which aims to ensure that the actual portfolio stays relatively close to the strategic asset allocation and that action is taken when risk exceeds predefined ceilings, could also restrain procyclical investment behavior. Asset owners/boards of trustees should have a firm understanding of how asset allocation creates risks, what risk factors are behind each asset class, and how managers’ risk taking is compensated in terms of expected return (see Appendix: bullet 4.e.). To this end, managers should have frequent communication with asset owners by providing adequate information about the portfolio construction process. Ang and others (2009) argue that Norway’s Pension Fund Global could have reduced its losses in 2008, if key risk factor exposures in the pre-crisis period had been better communicated and the asset owner had had a good understanding of the potential drawdown of these factors. Finally, the risk from procyclical behavior should be considered when owners make important decisions on the investment framework and compensation system.

E. National and International Policymakers’ Role

Since the global financial crisis, many countries and international institutions have made extensive efforts to strengthen regulation and supervision with the purpose of enhancing financial stability. One of the many objectives is to reduce excessive risk taking and prevent procyclical behavior. In the banking sector, the countercyclical capital buffer under the Basel III framework intends to promote the buildup of capital in good times, which can be drawn down in periods of stress. A similar measure (Solvency II) was introduced in the European insurance sector.

There has been relatively little discussion of how to promote institutional investors’ role in avoiding procyclical behavior and providing stable long-term capital. On the contrary, some regulatory measures can bring unintended costs or discourage long-term investment activities. For instance, a strict mark-to-market rule may lead long-term investors to focus on short-term gains or losses in asset values, rather than their investments’ long-term valuations, making it difficult to properly match their long-term liabilities with long-term assets. Adding an ALM perspective to regulatory issues may help strike the right balance between reducing short-term vulnerability and promoting long-term investment. For example, regulators could apply a differentiated approach to investors depending on their liability structures (e.g., banks: short-term liabilities, pension funds: long-term liabilities).

Institutional investors’ increased presence in the global capital markets has also raised concerns about the implications of their potential procyclical investment activities, especially with regard to the recent huge capital flows across countries. A surge in capital inflows or outflows can pose challenges to policymakers: the former can create financial market volatility, asset bubbles, and rapid exchange rate appreciation, while the latter can lead to currency collapse, the loss of foreign reserves, and disruption in financial markets. Responding to these problems, some authorities have introduced capital flow management (CFM) measures. These measures can be necessary when a country has specific external vulnerabilities, but they need to be balanced with benefits in long-term cross-border investments. Thus, policymakers’ flexible approach to different types of investments (e.g., in terms of maturity or sector) could promote long-term investment while reducing procyclicality in capital flows.

The issue of procyclical investment behavior was debated in a working group (WG) of central banks and other official institutions that revised the IMF’s Guidelines on Foreign Exchange Reserve Management (2013). However, the members of the WG refrained from concluding that financial stability should be explicitly stated as one objective of the mandates of reserve managers as this could be in conflict with their fiduciary duties to protect the safety of foreign reserves, thus providing motivation for further research in this area. Also, the OECD Task Force on Institutional Investors and Long-Term Financing (2013) recently released, “Draft High-Level Principles of Long-Term Investment Financing by Institutional Investors,” which aim to help policymakers design a policy and regulatory framework that encourages institutional investors to act in line with their longer-term investment horizon, thereby enhancing their capacity to provide a stable source of capital for the economy and facilitating the flow of capital into long-term investments.