The unseen power of mutual funds

Mass investment calls the shots to government

By: Adam Harmes

  While many critics of free market globalization have focussed on the growing power of large multinational corporations, it's the mutual fund managers who now wield the greatest clout in the global economy.
  In fact, beyond the information revolution, what is really new about the new economy is the revolution of mass investment and the growing size of mutual funds.
  With governments and firms having sought to free themselves from the burden of providing fixed retirement benefits, more and more people have been forced to become active investors. So many, in fact, that over 50 percent of North American households now have a stake in the stock market. That's up from only 25 percent in 1987 and only 3 percent in pre-crash 1929. Also, as more of us have delegated control over our savings to mutual funds, it's led to a massive concentration of power in the financial markets; Fidelity Investments, a mutual funds company, alone now controls almost $1 trillion. And with money comes power.
 

Herd behaviour and investor overreaction have altered the balance of power between Bay Street and Main Street...

  In the run-up to the Mexican peso crisis of December 1994, the Mexican government took the curious step of allowing foreign investors to convert their bonds priced in pesos for bonds priced in dollars. This is the equivalent of Mexico borrowing in U.S. dollars and it meant that when the peso collapsed, the size of Mexico's debt exploded to crisis proportions.
  Why did Mexico do something so silly? Well, it seems that in early 1994, when the peso was being rattled by a series of domestic political shocks, officials at the Mexican central bank received a call from Robert Citrone, a fund manager with Fidelity Investments. Having bought a truckload of bonds priced in pesos, Citrone was worried that if the peso collapsed, so too would the value of his investments. He demanded that the Mexicans do whatever was necessary to protect his investments and, two weeks later, a group of fund managers turned up the heat by refusing to purchase some newly issued treasury certificates, causing the stock market to drop and interest rates to rise. The Mexicans got the message and the rest is history.
  As Moises Naim, editor of the prestigious journal Foreign Policy commented, "developing countries used to chastise the IMF and the World Bank for the conditions these institutions impose on their loans, such as policy reforms or budget cuts. But now those mutual fund managers exert an unprecedented influence on the behaviour of governments, the conditionalities of the IMF. And the World Bank look enlightened and flexible - even benevolent - by comparison."
  Concentrated control over retirement savings is only part of the story of the new power of mutual funds. Even more important is the way that short-term performance pressures on fund managers have made international financial markets much less efficient and much more prone to overreacting to economic news.
  Despite the fact that they manage retirement savings with long-term horizons, most fund managers are evaluated on a quarterly basis, a practice that dramatically shortens their investment outlook. They are also evaluated in relation to the performance of other fund managers (known as "relative performance"), which in turn encourages herd behaviour. Together, short-term and herd behaviour can cause the financial markets to overreact to economic news, which then causes the prices of stocks, bonds, and currencies to move far away from their actual value.
  From Mexico in 1994 to Asia in 1997, it's no coincidence that economists identified a new type of currency crisis in the 1990s, where investor overreaction created bubbles and busts that were not justified by the underlying economic fundamentals. It's also no coincidence that the longest-running stock market boom in history (and the current bust) emerged simultaneously as the revolution of mass investment and the rise of mutual funds.
  Herd behaviour and investor overreaction have altered the balance of power between Bay Street and Main Street by increasing the pressures on governments to pursue the types of economic policies that investors want. Paul Martin's deficit-slashing budget of February 1995 came on the heels of the Mexican peso crisis, where investors overreacted and the currency plummeted. Commenting on the lesson taught to the Liberals by the peso crisis, journalists Edward Greenspon and Anthony Wilson-Smith (of the Globe and Maclean's respectively) noted, "Mexico would provide a lesson for nation-states in just how dependent they were on the vagaries - even potential irrationalities - of the financial markets."
  So it seems that we live in a time where the destiny of countries often lies in the hands of unseen fund managers, rather than with the elected representatives of citizens.
  We also live in a time of excessive corporate downsizing and "shareholder value" where fund managers, and not CEOs, determine the fate of corporations... but that's another story.

Adam Harmes is the author of Unseen Power: How Mutual Funds Threaten the Political and Economic Wealth of Nations, Stoddart, 2001.

Check out another Straight Goods story by Adam Harmes on fund managers and corporate downsizing.

Posted: April 24, 2001

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