Could passive funds create a decline in asset prices?

Regulators are reducing fund managers' balance sheet exposure to falling asset prices

Could passive funds create a decline in asset prices?
The global marketplace may see steep declines in asset prices that could be brought about by external shocks.

In his letter to the industry, Investment Industry Association of Canada (IIAC) president and CEO Ian Russell expressed concern about the risks that could trigger a major shock to the global markets.

"Global financial markets are vulnerable to significant reverberations from economic and geopolitical events, even though much progress has been made addressing the stability of the banking system," he said.

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He noted that the dramatic shift to passive index-linked funds and derivatives such as ETFs has concentrated trading in large-cap benchmarks securities.

"The emphasis on index-linked investment management, to lower costs and minimize risk, has caused all asset classes to move closer together," he said.

Russell stressed that the problem lies with the obsession of financial markets with quantitative easing, low-interest rates, and the global growth and political dynamics that drive them.

Additionally, the global markets have witnessed significant concentration among institutional managers to achieve significant business scale.

"Banks and dealers have limited scope as market-makers to absorb panic selling, particularly by asset managers faced with massive exposure to falling asset prices, accelerating withdrawals of client funds as values plummet, and limited liquidity to avoid major asset sales," Russel explained.

Further, the accelerating crash in equity values and the sharp rise in interest rates as bond prices fall would quickly reverberate in the real economy and shock the developing recovery. 

With this, Russell said there was no surprise that regulators have focussed on trimming the balance sheet exposure of fund managers to falling asset prices.

"Moreover, regulators continue to examine the liquidity of corporate bond markets under stressed market conditions," he said.

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