REACH FOR RETURNS TAKES FUNDS INTO THE SHADOWS / THE FINANCIAL TIMES COMMENT & ANALYSIS

Markets Insight

February 3, 2015 9:03 am

Reach for returns takes funds into the shadows

Tracy Alloway

Asset managers delve deeper into shadow bank territory for returns 

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©Bloomberg

 

“Holy Cow Batman, these bonds can outperform stocks!” Bill Gross wrote back in 2003.

 

Then chief investment officer at Pimco, he was describing a strategy of effectively borrowing money and using financial instruments to boost returns on fixed income securities, a process better known as deploying leverage.

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.

The extent to which low interest rates have driven mutual funds and other asset managers to become entwined with shadow banking is laid bare in a new research paper by Zoltan Pozsar, former senior adviser at the US Treasury.

 

This shadow banking system has long been described as a network of non-bank financial intermediaries, but it is perhaps better characterised as a reference to a particular set of financial activities.

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.

Traditional notions of shadow banking usually centre on the idea of repo being used to fund the balance sheets of broker-dealers and banks. When entities like Lehman Brothers and Bear Stearns became locked out of the repo market in 2008 they suddenly found themselves starved of financing, triggering an avalanche of stress across the financial system.

 

Regulators have spent the years since the financial crisis trying to clamp down on shadow banking as they attempt to improve the overall safety of the financial system. Since such activities are rarely associated with traditional mutual funds that invest in bonds and other assets on behalf of large investors such as pension funds and insurers, such funds have rarely been mentioned in conjunction with shadow banking.

Mr Pozsar’s research suggests that is a mistake. For example, a cursory look at the balance sheet of Pimco’s flagship Total Return Fund shows a bevy of derivatives including futures, forwards and swaps. Moreover, its repo borrowings at the end of the first quarter of 2014 stood at $1.12bn. The fund’s subsequent annual report shows repo borrowings for the period averaged $5.73bn — more than five times the amount reported at quarter-end.

 

Such window dressing is usually associated with big investment banks that cut back on their leverage ahead of quarter ends as they seek to flatter their funding profiles and impress their investors.

Its presence on Pimco’s balance sheet is symptomatic of a long-term trend that has seen mutual funds evolve from staid, largely “long-only” managers into very different beasts. In addition to accumulating billions of dollars’ worth of fixed income securities in recent years, the funds have reached for an alternative financial toolkit of derivatives, securities lending and other forms of leverage, to help boost returns.

 

How did we arrive at this somewhat unexpected situation? Mr Pozsar’s paper posits two main causes.

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.”

Second, that competition has occurred at the same time as big investors have had to grapple with low interest rates and low growth. While the yield on the benchmark US Treasury has dropped from an average of 6 per cent in 2000 to 1.66 per cent currently, the return expectations of public pension funds have barely budged at roughly 8 per cent, according to the paper.

 

Says Mr Pozsar: “Reach for yield is omnipresent in a financial system where investors are hard-wired to beat their benchmarks, but reach for yield intensifies as actual yields drift farther and farther away from the return targets of investors with fixed liabilities.”

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.