By Erik Oppers
What drives the investment decisions of investors with a longer time horizon? Our research found these investors generally do not look at differences in interest rates among countries when deciding where to invest.
It turns out the factors they do consider in making these decisions are good and stable growth prospects, low country risks—including political and economic stability—and a stable exchange rate. This all makes good sense for long-term investors such as pension funds and insurance companies.
So why all this talk about how low interest rates in advanced economies are “pushing” investment flows to emerging countries, where interest rates are generally higher—is this story wrong?
Our research for the Global Financial Stability Report used detailed data on flows into and out of bond and equity mutual funds to look at the underlying drivers of investment decisions made by institutional investors.
These investors usually have a long investment horizon, with obligations that often stretch out over decades. They are focused on long-run returns, and—importantly—they invest their own cash, rather than investing with borrowed money.
Interest rates just don’t matter much for these investors. We looked at short-term interest rates, long-term interest rates, real interest rates, and nominal interest rates. Institutional investors generally did not respond to any of them, for investments in equities or bonds.
Interest rates matter for investors on borrowed time
There are two important nuances to this story.
First, there is a diversity of investors; they come in many shapes and sizes, with different objectives and incentives tied to the source of their funds (their own cash or borrowed money), who they represent (pensioners or risk-takers), and their investment horizon.
In addition to the behavior of long-term institutional investors, there is a set of investors that borrow the money they invest. This class—often referred to as leveraged investors—includes hedge funds and carry traders.
Although the research doesn’t cover these investors, there are a number of reasons to think leveraged investors are more likely to respond to interest-rate differentials.
- Because leveraged investors borrow funds to invest, the interest rate at which they borrow is a direct cost of doing business for them, compared to an opportunity cost for unleveraged investors. This more direct link between interest rates and portfolio returns by definition makes them more sensitive to interest rate differentials between countries.
- Leverage generally increases risk, since a smaller amount of initial investment controls a larger stake. The increased risk is likely to make their portfolio much more sensitive to all underlying fundamental investment drivers, including interest rates.
Given that these two groups of investors appear to respond differently to interest rates, their relative size matters for the overall effect of interest rate differentials on investment flows. The institutional investors we looked at have by far the largest amount of total assets to invest—over $70 trillion dollars. Total investable assets of leveraged investors are much smaller, probably around one-tenth of the assets of institutional investors.
While their invested assets may be smaller, we found their impact on market volatility may be large because leveraged investors trade much more frequently, moving money in and out of markets and countries looking for short-term opportunities to maximize the return on their portfolio.
This is especially true in times of market turmoil, when leveraged investors may be forced to sell—for example to avoid losses that exceed their initial investment. Long-term investors may be more inclined to ride out the storm since they don’t have to return any borrowed funds.
The second nuance to the story is that even longer-term investors could become more sensitive to the level of interest rates if the current low-interest rate environment persists.
Low interest rates hurt the financial position of institutional investors that need to earn a certain minimum return, such as pension plans that have made pension promises based on much higher expected rates of return than they can earn in the current environment.
For now, most of these institutional investors are biding their time, accepting lower returns without moving funds to countries with higher interest rates and perceived higher risk, or into other riskier domestic assets. The longer the low interest rates prevail, however, the more difficult the financial situation of these investors becomes and the higher the pressure for them to “search for yield.”
Still, over the long run, the story remains intact. Long-term investment flows are likely to be dominated by long-run institutional investors, who look mostly at growth prospects and country risks. Interest rate differentials between countries are likely not to affect these longer-term flows.