(September 12, 2013) — As investors try to avoid volatility their activity may be actually creating it, the International Monetary Fund (IMF) has said in a report.
The organisation has identified certain “herding” behaviours that are characteristic of many types of institutional investors and examined their effect on the wider financial markets.
“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 paper said. It found the result of these effects is complicated. The link between procyclical investing and instability works in both directions: investors react to heightened volatility and make the problem worse.
The IMF found five main reasons for this herding by the world’s largest—and supposedly longest-term—investors: underestimation of liquidity needs; difficulties in assessing market risk and macroeconomic forecasting; principal-agent problems and managers’ incentive structure; reporting and disclosure policies; and regulations and market convention.
As short-term behaviour is less expected from these large institutions than it would be from individual investors and other market participants, when they act in this way—and being the size they are—markets become disrupted, the IMF said.
These actions may also hurt their investment returns, rather than protect them, the report claimed.
“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.”
The paper outlined and gave examples of each type of institutional investor’s behaviour during the crisis and makes a series of recommendations to help prevent it occurring.
“This mainly entails a combination of a more forward-looking strategic asset allocation, portfolio rebalancing, sophisticated risk management, appropriate incentive structures for portfolio managers, and sound governance.”
The IMF stresses that there is no “one-size-fits-all” approach, but the strategic framework should be tailored to fit each individual investor.
To read the full paper, entitled “Procyclical Behavior of Institutional Investors During the Recent Financial Crisis: Causes, Impacts, and Challenges”, click here.
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