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E-MailMassimo Massa is the Rothschild Professor of Banking and a Professor of Finance at INSEAD; David Schumacher is an Assistant Professor of Finance at the Desautels Faculty of Management at McGill University; and Yan Wang is an Assistant Professor of Finance at the DeGroote School of Business at McMaster University. This post is based on their recent paper, forthcoming in the Review of Financial Studies, and their recent working paper.
The global asset management industry continues to consolidate and a small number of very large asset managers play an increasingly dominant role. At the same time, one of the main folk theorems in finance posits that asset managers do not pose a risk to financial market stability because they are not levered. This lack of leverage could make concentrated stock ownership in the hands of big asset management families a source of stock price stability.
In our research, we investigate if the rise of large asset managers like BlackRock and others raises concerns about financial market stability. We ask the following questions: Does the rise of such large asset management firms induce “fear of financial fragility” in other market participants? If so, how do these other market participants respond to such fear and how does the market overall adjust as a result? Moreover, what are the corporate implications for firms with “fragile” stocks?
In a first of two studies, we highlight that while large asset managers are not levered, many of their products are subject to volatile and correlated investor flows. As such, increasing concentration of stock ownership in the hands of few players may exacerbate the potentially destabilizing market impact should any asset manager face fire sales and in this way increase financial fragility. If this is the case and if this is relevant to other market participants, than the rise and creation of large asset managers will pose a risk to which other portfolio managers respond.
To test this argument, we exploit mergers between global asset management firms in order to study how changes in expected ownership concentration induced by a merger between two asset managers with strong portfolio overlap in certain stocks affect the investment behavior of other investment funds that are not directly involved in the merger. Do other investment funds change their positions in stocks with a merger-induced increase in expected ownership concentration? If so, which funds respond more aggressively to such a rise in expected financial fragility?
We postulate that such merger-induced increases in expected ownership concentration should be a particular concern for other funds with open-end structures who themselves face volatile investment flows that are correlated with the flows of other funds holding the same stock. In addition, exposure to potential future fire sales is a particular concern for open-end funds because their open-end structure gives rise to strategic complementarities: since investors in open-end funds can redeem their fund shares at the daily-close net asset value, redemption costs due to large liquidations are heavily borne by investors who stay in the fund. Therefore, large redemptions can lead to a spiral in which all fund investors seek to redeem their shares at the same time, further elevating the exposure to higher financial fragility of open-end funds. As a result, open-end funds should respond more aggressively to merger-induced changes in expected ownership concentration.
Our findings give strong support to this argument: open-end funds with volatile and correlated flows begin avoiding stocks with a strong increase in expected ownership concentration. Such funds act strategically to manage their future exposure to stocks that are expected to become more fragile because of a merger-induced change in expected ownership concentration.
We also find that other fund types that are less sensitive to financial fragility accommodate the rebalancing of such open-end funds. In other words, such mergers lead to a change in the composition of ownership—away from funds with a high sensitivity to financial fragility (i.e., open-end funds) and towards funds with a low sensitivity (i.e., non-open-end funds).
Does this merger-induced reshuffling of ownership have stock price impact? The answer is yes. Affected stocks experience permanent negative price and liquidity effects. In other words, non-open-end funds accommodate the rebalancing of open-end funds at a discount. In addition, the increased presence of non-open-end funds with different flow and liquidity characteristics than the previous open-end funds permanently lower stock liquidity.
So, what is the net result—given that funds with the highest exposure to financial fragility rebalance their portfolios away from the most severely affected stocks, does financial fragility ultimately increase or not? The surprising answer is that, overall, financial fragility decreases! It is for this reason that we put an emphasis on the word “expected” to highlight that portfolio managers act on the expected change in fragility that would follow a merger-induced change in ownership concentration everything else equal. However, because the most vulnerable funds act strategically and actively manage this risk by rebalancing away from affected stocks, the composition of ownership changes and investors who are better able to manage positions in fragile stocks play a more dominant role. As a result, overall fragility ends up being lower than before!
In a second study, we investigate in more detail the implications of these results from a corporate finance perspective: what does all this mean for firms with “fragile” stocks? While there is a prevailing negative view of financial fragility, we argue that such a view is incomplete because it only focuses on “volatility-related” consequences for fragile stocks. However, it is worthwhile to remember what drives the high return volatility of fragile stocks. Fragile stocks are volatile because they are subject to non-fundamental demand (i.e., liquidity) shocks. But by the very definition, these demand shocks are ultimately “non-fundamental”. It means they have little to no information content about the future cash flows or fundamental sources of firm risk. In other words, these non-fundamental demand shocks represent non-informative trading. Therefore, they increase stock liquidity.
This argument implies that fragility has an important but overlooked “bright side” because fragile stocks are not only more volatile but also more liquid. We therefore argue that fragile stocks are less sensitive to corporate actions that are usually associated with stock price impact because they convey firm-specific information. A related analogy is to think of fragile stocks as stocks with a “flat” demand curve. We postulate that firms with fragile stocks are not only aware of this aspect of fragility but take advantage of it by adjusting specific corporate actions in response to changes in financial fragility.
We focus on corporate actions that are known to have a strong stock price impact: share repurchases. We expect that the high liquidity of fragile stocks reduces firms’ incentive to repurchase their own stock because the high liquidity of fragile stocks attenuates the positive price impact of share repurchases. In addition, because firms with fragile stocks repurchase less of their own stock, they can instead invest more.
We rely on the same setting of asset management mergers as before. In our first study, we have shown that the stocks of firms heavily held by buyer- or target-affiliated funds ultimately experience a reduction in fragility due to the reshuffle in ownership composition. Because mergers between asset managers ultimately lead to a decline in financial fragility (i.e., a decline in stock liquidity), we find that stocks affected by those mergers experience an increase in payout in the 2 years after as well as a decline in investment. Interestingly, the increase in payout is exclusively due to an increase in share repurchases. We find no changes in the dividend policies for these firms, which we expect because share repurchases are more opportunistic than dividend payments and their “lumpy” nature better exploits changes in the demand curve for their stock. Additional tests show that the argument extends to equity issuances (a reduction in fragility not only increases repurchases, it also lowers equity issuances) and that the effects are pronounced for financially constrained firms who have less flexibility in their financing policies.
The overall sense of our findings is that financial fragility is a serious concern for market participants. But because it is a serious concern, market participants act strategically and respond to it. Therefore, changes in expected fragility lead to compensating actions that may ultimately reduce realized fragility. At the same time, this reduction in fragility also reduces liquidity, which encourages firms to increase payout, and especially share repurchases, at the expense of investment. Put differently, because of the tight link between fragility and liquidity, efforts to reduce fragility may have the unintended consequence of reducing corporate investment, jeopardizing the “bright side” of financial fragility.
The first study is entitled “Who is Afraid of BlackRock?” and it is forthcoming in the Review of Financial Studies. The second study is entitled “The Bright Side of Financial Fragility” and is a working paper.
