This is a pretty interesting report from the US Treasury that was posted by Reuters a few days ago. The US Treasury Office of Financial Research has posted their findings which show that herding, reaching for risk and other risks in the current financial environment could exacerbate market “fire sales”. This is essentially what I was talking about the other day and the risk that QE potentially creates in the market:
“An extended low interest rate investment climate, low market volatility, or competitive factors may lead some portfolio managers to “reach for yield,” that is, seek higher returns by purchasing relatively riskier assets than they would otherwise for a particular investment strategy. Some asset managers may also crowd or “herd” into popular asset classes or securities regardless of the size or liquidity of those asset classes or securities. These behaviors could contribute to increases in asset prices, as well as magnify market volatility and distress if the markets, or particular market segments, face a sudden shock.
In asset management, the following factors can increase the likelihood and severity of fire sales:
• Large market positions and concentrations. Fire sales may be exacerbated when a single fund or fund complex holds a large market position in a particular asset, sector, or strategy. This risk is heightened if the market has high informational or other barriers to entry; a lack of substitute investors could result in severe price depression if the fund or fund complex unwound its portfolio quickly. Asset managers managing large specialized funds and separate accounts with similar strategies may manage significant shares of important niche markets, which may not be fully transparent. Specialization concerns apply most directly to funds that focus on illiquid investments or funds that make large, concentrated bets.
• Illiquid markets. As markets become more illiquid, potentially due to market stress, they become
increasingly prone to fire sales. Asset classes that tend to be less liquid include fixed-income securities, bank loans, and derivatives such as single-name credit default swaps. Customized or “bespoke”
products can be particularly illiquid if they include complex combinations of derivatives and less liquid
• Reputation risk. If an asset manager or one of its specialized funds suffers damage to its reputation, the redemption risk for the asset manager’s funds could increase and heighten fire-sale risk. The potential asset pricing impact would be heightened if asset managers’ funds and accounts held large positions in sectors with relatively low trading volumes, as in certain fixed income assets or markets.
• Crowded trades. Crowded trades can distort market prices and increase fire-sale risk. As discussed earlier, crowded trades occur when market participants have similar, correlated holdings in an asset class or trading strategy, and herding occurs. In the event of a shock, investors in crowded trades may try to sell or unwind their positions at the same time and in the same direction. Crowded trades may be especially problematic during a crisis, when few substitute investors may emerge to halt the downward spiral.
• Leverage. Excessive leverage can increase the risk that margin calls or other capital calls could prompt increased asset sales to cover positions. This risk is heightened in complex or less liquid funds, because price dislocation may be more severe, and during periods of market stress.
• Transactions with liquidity “puts.” Certain transactions, such as securities lending and repo, have contractual obligations requiring liquidity upon demand and involve a large number of market participants. During periods of market stress, forced sales associated with these contractual obligations could increase the probability of fire sales.
• Funding mismatches. Short-term funding of long-term investments can lead to fire sales when funding liquidity is tight and investment values experience a negative shock.”
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.