Policy makers around the world have promoted institutional investors as a way to develop financial systems, manage long-term savings, expand maturities, increase access to finance for corporations, diversify risk, and reduce vulnerabilities to crises, among many other things. In fact, the assets held by institutional investors have increased significantly over time and, by now, they have become at least as important as banks in several countries. Still, the impact they have on long-term financial development and international asset allocations (and capital flows) remains to be understood.

New research suggests that institutional investors behave very differently than expected, and that the incentives faced by managers tilt portfolios in ways that, a priori, appear counterintuitive and difficult to comprehend. For example, mutual funds invest in a very limited number of assets when investing internationally, tend to herd in their investment choices, and behave pro-cyclically during crises, contributing to the transmission of shocks across countries. Moreover, mutual and pension funds invest mostly in short-term assets. Benchmark indexes have important effects on how capital is allocated across countries and firms, irrespective of fundamentals.

The evidence suggests that the behaviors lie in the way the industry is organized and in agency problems that push managers to invest short-term in liquid assets. Funds are available for investment but they do not flow to many companies and countries or to assets with longer maturities. Pushing investors to behave differently would entail important trade-offs between short-term monitoring and risk taking. 

Last Updated: Jun 02, 2015