Systemic?
Central banks get worried when features of the financial system may have negative impacts on the stability of that system, so called “systemic” risks. This is most obvious in the banking system and central banks pay great attention to the behaviour of banks and the potential impact that their group behaviour may have on the financial system. The investment management industry has typically been scrutinised less.
However, some recent research argues that the ownership dominance of major institutional investment managers has created excessive volatility and noise in the US equity markets. The research states that in 2016, 26.5% of US stocks were managed by the top 10 managers, with the largest one managing 6.3%. The suggestion is that with such ownership dominance, if decisions across firms are correlated then this could mean that those decisions drive US stocks’ performance and volatility. The research finds that:
“…ownership by large institutions is associated with larger volatility in the underlying securities and that this increase reflects an increase in the noise embedded in stock prices. Moreover, we show that in times of market turmoil, stocks with higher ownership by large institutions display significantly larger price drops.”
These are the kind of findings that worry central banks.
In addition, the authors also find that within large organisations, capital flows and trading strategies are correlated, more so than would be expected if the same volume of capital were managed by a number of smaller firms:
“We interpret this evidence as the outcome of centralised functions, such as marketing, research, and risk management as well as of a unique corporate identity that guides managers’ decisions and investors’ responses.”
How might this work out for real estate?
Taking North America as an example, the size of the North American real estate market was estimated as USD3,779bn by MSCI at end 2019. IREI’s global investment manager report for 2019 suggests that the top 10 North American real estate investment managers manage USD655bn, 17.4% of the market, a little less concentrated than for US stocks.
Unlike the stock markets it is not a feature of real estate that all of the properties in the market are jointly owned so it is not possible to examine the same idea as the authors above do for stocks. However, it is possible to look at views on segments of the North American real estate market and to observe what would appear to be correlated trading strategies both within and across the large institutions. From observation, it would appear that the large North American managers tend to move their real estate portfolios in similar ways at similar times.
The trade of the day, for example, is (and has been for a while) sell retail and buy logistics. Might this mean that prices for these market segments are more volatile than they ought to be, and might price declines for retail assets owned by large institutional managers decline more than those owned by other managers / investors, negatively influencing the performance of those assets through the valuation-evidence transmission mechanism?
It may be possible that large-scale trading in and out of particular sectors by dominant North American institutional real estate investment managers has a similar effect in real estate as it does in US stocks, namely increasing volatility, noise and price declines during market turmoil. It would certainly appear to be the case that the potential drivers of this kind of impact would be the same as for US stocks: centralised functions such as marketing, research, risk management and, for real estate, the much favoured ‘house view’ which can drive non-idiosyncratic behaviour across portfolios managed by the same investment manager, neatly fitting into the box of “corporate identity that guides managers’ decisions”. Such impacts might be exacerbated further where the types of funds and mandates run by investment managers are largely similar and so the ‘house view’ influences all funds / mandates similarly.
This discussion would seem to offer up at least two questions that it would be fruitful to answer:
Is there a potentially systemic risk in real estate that central banks ought to concern themselves with as a result of the dominance of large institutional real estate investment managers?
Can smaller managers, or, potentially, managers not acting like the herd, make money out of the possibly correlated behaviour of others which might create higher volatility?