February 3, 2015 9:03 am
Reach for returns takes funds into the shadows
Asset managers delve deeper into shadow bank territory for returns
Using leverage, he argued, could allow investors to achieve the seemingly impossible; generate the kind of profits typical of stocks while enjoying the stability typical of bonds. Super hero-like indeed. But the strategy came with a significant catch: in order to juice up returns, fund managers needed to engage with the so-called shadow banking system.
Classic examples of such activities include financial institutions borrowing money by pawning their assets through ‘repo’ agreements or securities lending transactions, as well as using derivatives.
First, mutual funds have spent much of the 21st century fending off a two-pronged attack from hedge funds and exchange traded funds that have made hefty inroads into the asset management market.
As Mr Pozsar puts it: “These industry trends were the sources of a competitive push that drove the creep of leverage into the industry’s traditional, long-only, relative-return bond funds.”
In other words, as pension funds grapple with a classic case of asset-liability mismatch caused by high return expectations coupled with very low yields and growth, mutual funds have attempted to fill the gap by levering up their fixed income securities through traditional shadow banking methods.
The obvious solution — lowering the return expectations of investors such as pension funds — is far easier said than done. A much more palatable policy recommendation one could take away from the paper is that if regulators want to clamp down on shadow banking activities, they might do well to take a more holistic look at the environment that is fuelling them.
By seeking to leverage fixed income assets to offset the problems of relentlessly low yields, mutual funds are striving to become the super heroes that investors need at this particular moment in time — but they are having to lurk in the shadows to do so.