Institutional Investors. . - book review

Business Economics, Jan, 2002 by Edmund A. Mennis

By E. Philip Davis and Benn Steil. 2001. Cambridge MA and London, England: The MIT Press. Pp. 524. $47.95 hardcover.

With the growth of pension funds, life insurance companies, and mutual funds, an increasing proportion of household saving is being institutionalized. A greater proportion of assets are now managed by professional portfolio managers instead of invested directly in the securities markets or held as bank deposits. This book provides a broad and thorough review of both institutional investors (specialized financial institutions that manage savings collectively) and asset management (the process by which assets collected by institutional investors are invested in the capital markets).

A substantial portion of the book focuses on the United Kingdom and the United States, which have, experienced the greatest growth of institutional investing, where regulation has been less restrictive and where academic research has been most extensive. However, the book also covers institutional investing in Continental Europe, Japan, and emerging market economies, offering comparisons across a broad spectrum.

Both authors have excellent backgrounds to do the research for this book. E. Philip Davis is Professor of Economics and Finance at Brunel University in West London and a Research Associate of the LSE Financial Markets Group, an Associate Fellow of the Royal Institute of International Affairs, and Research Fellow at the Pensions Institute of Birbeck College in London. Benn Steil is Senior Fellow and holds the Linda J. Wachner Chair in Foreign Economic Policy at the Council of Foreign Relations in New York. Much of the research for this book was carried out while he was Director of the International Economics Program at the Royal Institute of International Affairs in London.

The early chapters of the book focus on the development of institutional investors, who have grown substantially in the past decades. Their claims are valued at 100 percent of gross domestic product of the G-7 nations (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States). This percentage is almost twice GDP in the United States and the United Kingdom. Movement of the rest of the G-7 countries to this level would cause massive expansion of institutional investment. Several factors account for this significant growth: ease of diversification, improved corporate control, deregulation, technological developments, enhanced competition, demographic shifts, growing wealth, and deficiencies in the social security systems.

A review of the performance of asset managers indicates that their most important tasks are asset allocation and security selection; the former is very important, but research in the United States and the United Kingdom suggests the latter is value deducting--index investing is more rewarding. As for the structure of the asset management industry, the Anglo-Saxon countries differ from Continental Europe because of greater competition, resulting in higher fees and less focus on performance in Europe. Another difference is that specialist managers dominate in the United States, while balanced managers tend to dominate in the United Kingdom.

As for the future of asset management, growth prospects are good. However, marked structural change is under way. For example, there is a trend to global management through mergers, reflecting the benefits of size; the European Monetary Union may break down barriers to entry; and a shift from defined benefit to defined contribution pension plans favors a different style of management. The next sections of the book examine the effects of the growth of institutional investors on the capital markets and on banks, followed by a discussion of the impact on the nonfinancial sectors.

One of the most interesting parts of the book is an extended discussion of the trading environment. Institutional trading is done in much larger blocks of securities and requires considerable skill and different techniques to minimize the market impact of transactions. Increasing automation permits the saving of significant trading costs, although a number of common market practices limit the incentive for cost minimization in fund management firms. Fiduciary problems and regulatory implications are additional influences on trading activity.

Measuring trading costs is difficult. Explicit costs, like brokerage commissions and taxes, frequently include payments unrelated to the actual buying and selling of securities, like payment for research and other services. Bid-offer spreads vary by transaction size and the relevant market. Market impact varies by size of transaction and market liquidity. Opportunity costs reflect incompletely filled or delayed trading orders. One study cited an institutional portfolio that for a thirteen-year period had an annualized return of 26.2 percent on paper but had a return of 16.1 percent as implemented!

In summary, as a reference book, Institutional Investors is invaluable. It is not an easy read, but the material is well organized so that answers to particular questions or coverage of particular topics are easily available. The breadth of coverage is impressive, and the literature review provides an excellent source for further information. The discussions on institutional investing outside the United States are especially revealing, given the often parochial nature of the literature in the United States. Anyone in the financial services industry will find the book a valuable source of information. Anyone with an interest in corporate pension plans or in the services of the financial sector for personal investing will also find the book of interest. Moreover, no other source of such comprehensive information on institutional investing is currently available; the book is a significant contribution to the literature on the subject.