Monetary Sugar Daddy

I started in the asset management industry in 1993. Since then, industry assets under management (AUM) have grown from slightly under $4 trillion to over $17 trillion at the end of 2013 (source: Yahoo Finance). AUM has grown consistently, except for declines in 2002 ($6.6 trillion in AUM) and 2008 ($10.4 trillion in AUM). The 2002 decline was bailed out by Alan Greenspan and 1% rates (low rates for a “considerable period”). Of course Greenspan’s easy monetary policies created a housing bubble (thank you Easy Al – we sold our house in FL near the peak) and the eventual bust, which caused the industry’s AUM decline in 2008. During this industry recession, Bernanke came to the rescue and outdid Greenspan. The Bernanke Fed lowered rates to 0% and printed trillions of dollars to purchase mortgage debt and U.S. Treasuries, creating massive asset inflation. Asset gatherers and the investment management industry rejoiced – long live the Fed!

The asset management industry has often relied on and appreciated the Federal Reserve’s heavy hand in financial markets. Monetary policy under Greenspan, Bernanke, and Yellen has increased in its influence each market cycle and has helped put a floor under the industry’s AUM and revenue. Initially the Fed’s backstop of the financial markets was called the Greenspan put, but now it’s safe to insert any global central banker. It has been a wonderful relationship and business model for the investment management industry. Even if an asset management business didn’t grow its customer base, it could increase fees and revenues by simply riding the wave of easy money policies and the resulting asset inflation.

Despite record high stock prices and record low bond yields, the easy ride for asset managers appears to be coming to an end, as the industry is now under threat of a structural shift. As most know, the investment management industry is undergoing a major shift away from active to passive management strategies. According to a recent Bloomberg article, “Vanguard managed more than $3.5 trillion globally as of April 30,” with “$148 billion in flows in the first six months of 2016.” The shift to passively managed strategies isn’t new news. However, I believe a major cause is underappreciated.

While many market participants will point to the lower fees as the catalyst for the growth in passively managed funds, I believe aggressive, asymmetrical, and relentless monetary policy has also contributed. Since central banker “emergency” intervention began in 2008, EVERY decline in asset prices has been reversed with central banker policy response — real and verbal. In effect, one of the most important aspects of free markets, the pricing and respect for risk, has been temporarily suspended. Central bankers have replaced free markets with markets that are perceived to only go one direction (up).  Investors are being conditioned and rewarded to believe this time actually is different. If investors believe central bankers can set asset prices and control risk (or at least the perception of risk), it’s understandable they’ll flock into index funds and ride the central banker’s wave of easy money in a low fee vehicle.

Unlike private bank balance sheets that were the foundation of the credit bubble of 2003-2008, current asset bubbles are supported by unlimited central banker purchasing power – their balance sheets, in theory, can expand indefinitely. The perception that central banker resources are unlimited provides investors with a feeling that they can always rely on central bankers to maintain financial stability (stable to rising prices); further reducing investor need for risk management, and in turn reducing investor demand for active management.

Ironically, the investment management industry needs its sugar daddy, the central bankers, to fail and fail miserably. The industry needs to prove active management works and its fees are justified. In a market without properly priced risk and without genuine opportunity, it is difficult to generate sustainable absolute returns and achieve investment objectives (for example, how does a bond fund with an income objective provide sufficient income in a no yield world?). In addition to threatening the business models of banks (flat yield curve), insurance and pension plans (insufficient yields relative to obligations), I believe it’s safe to add the asset management industry to the list of industries the central bankers have inadvertently put at risk.