Capital markets are becoming more volatile, and it isn’t simply due to fear of bubbles and crashes. Those have always existed, though recent history suggests they may be happening more frequently and more intensely.
No, market volatility is broader than that. For example, the S&P 500, a largely representative index of U.S. large-capitalization stocks, was 15 per cent more volatile in the period 1980-2010 than it was between 1950 and 1980. Fifteen per cent may not seem like a lot, but when the effect is felt on your retirement savings, it becomes very significant. Where is all that volatility coming from?
In our view, it is because of a shift in the structure of our capital markets. Once upon a time, there was equilibrium across the players that helped keep volatility in check. At one end were stockbrokers and floor traders, who derived economic benefits from short-term volatility and acted in ways that helped produce it. They produced volatility in the market, especially when trades were large.
This wasn’t a problem so long as there were other players with different incentives who acted as volatility absorbers. These were organizations with long-term perspectives – pension funds, insurance companies, sovereign wealth funds. So long as their aim was to continue as a going concern more or less forever, their investment decisions and risk tolerance could take the very, very long view. They were able to operate independently from short-term financial conditions, mitigating a good deal of market volatility.
Over the past 20 years, however, the volatility producers have grown substantially. Day traders, hedge funds and high-frequency traders entered the market in large numbers. A Yale University study estimates that as much as 78 per cent of trades in U.S. markets are driven by high-frequency trading firms. More worryingly, the volatility absorbers have lost their ability to take a truly long-range view, tipping the balance of the financial markets in the direction of increased volatility.
Why are so many investment organizations no longer able to take a long-term view? Our answer: a seemingly helpful accounting policy called “mark to market.” In mark-to-market accounting, companies’ financial statements must indicate the current market value of investments (what they could be sold for today) rather than their book value (what the firm paid for the asset).
Mark-to-market was intended to provide a fair representation of an organization’s current financial situation, allowing investors to understand the true value of its investments and assets. It provides a level of transparency to aid better investing decisions; for example, when considering an operating company’s stock, it is helpful to know if its pension fund has a billion-dollar insufficiency that could hamper its future profitability.
But in capital markets, mark-to-market can be unhelpful. When a pension fund or insurance company must reflect the current market value of holdings in its financial statements, it has to consider short-term market fluctuations in its investment decisions, even if it has no plan to shift those assets into the medium term. If investments go down in the short term, the firm’s financial statements look bad.
In many countries, as well, pension funds must hold enough capital to cover a paper loss, which diminishes their ability to invest with the long term in mind. Required capital goes up, the accounted value of the capital goes down – diminishing both the real and perceived performance of the fund.
Long-term investors once provided a volatility buffer for the rest of us. But imagine a crisis in which there is panic in the European markets. In the past, large insurers and pensions funds were in a position to ride out the crisis and provide stability to the market. Now, with mark-to-market, these institutions have the incentive to pull out of those markets along with everyone else and, given the size of their holdings, help accelerate the crisis.
Mark-to-market seems, at first blush, like a helpful tool to increase transparency. Ultimately, it obscures it and injects unwarranted volatility. As currently applied, this accounting rule produces the wrong behaviour and obscures the real measures of economic growth.
We should adapt our approach. Long-term investors such as pension funds and insurance companies could be required to report the mark-to-market number – but as a footnote to their financial statements, rather the heart of them. That shift would produce the desired transparency without the negative side effects.
Donald Guloien is CEO of Manulife Financial Corp.; Roger Martin is dean, Rotman School of Management, University of Toronto.