Developed and developing country policy makers alike have promoted institutional investors as a pillar of their financial systems. Responsible for managing retirement savings, institutional investors are expected to invest for the long term, follow market fundamentals, and provide liquidity to countries and companies overlooked by other actors in financial markets.
Earlier this month, however, Lead Economist Sergio Schmukler systematically debunked these myths during the course of his presentation at the June Policy Research Talk. The Policy Research Talks are a monthly event held by the research department to foster a dialogue between researchers and their colleagues across the World Bank.
Research Director Asli Demirguc-Kunt, who hosted the event, argued that “policy makers often think that many of the shortcomings of financial systems can be fixed by promoting institutional investors.” She explained, “Their development is seen as leading to the expansion of capital markets, the extension of the maturity structure, and all sorts of other good things. Today we are going to compare these expectations to the data, and see if they are met.”
Given their size, the ability of institutional investors to live up to these expectations is critical. As of 2013, institutional investors based in OECD countries had nearly $100 trillion under management. The role of institutional investors has grown substantially in emerging markets as well, with equity and bond markets nearly quadrupling over the last two decades.
Schmukler and his colleagues’ research shows, however, that not only do institutional investors not invest according to expectations, but sometimes even behave counterintuitively. Drawing both on global data and country examples, he demonstrated that institutional investors exhibit herding behavior, pass over assets with better risk-adjusted returns, and invest pro-cyclically, thereby increasing economic volatility.
The case of Israel provides a particularly stark example. In 2009 MSCI—a major supplier of investor indices—announced that Israel would be upgraded from its emerging markets index to its world index. But when the upgrade became effective a year later, Israel experienced a sudden and massive reversal of capital flows, with a nearly $2 trillion net outflow.
Schmukler explained this counterintuitive behavior in terms of a benchmark effect created by the desire of institutional investors to not let their portfolios deviate too far from either an index or from the portfolios of their competitors. He cited the “incentives for asset managers, who are rewarded for investing in low-risk vehicles that mature over a short period.”