In praise of the portfolio investment revolution
Tuesday 16 July 1996
The two studies were last week's figures from British invisibles on the City of London's foreign earnings; and the annual survey of equity fund management, ranking the largest cities of the world, from the New York research group Technimetrics.
The City Table, as it is called, attracted some attention because it showed that net overseas earnings of the UK financial sector last year topped pounds 20bn for the first time. Of that, pounds 7.2bn was portfolio investment income - there was another billion of direct investment income and the remaining pounds 12bn was income from services. To put that pounds 7.2bn figure in perspective, it is more than twice the size of the current account deficit last year of pounds 2.9bn, and more than half the size of the shortfall on physical trade, pounds 11.6bn or the deficit on government transactions of just under pounds 12bn. So at the margin, the City's portfolio income is enormously important.
It has one further attraction aside from its size: it is regular. While the trade account swings from one extreme to the other, and the rest of the invisible trade account is also subject to fluctuations, the portfolio component is steadily climbing. It has risen from a surplus of pounds 2.8bn 10 years ago.
Now look at portfolio investment, not from a balance of payments point of view but from the point of view of the fund management industry, as shown in the Technimetrics study. The obvious headline point here is that London now manages more than $1,000bn (pounds 645bn) of institutional equities, well ahead of New York, and second only to Tokyo on this measure. Thanks to the lack-lustre performance of Japanese share prices last year, it significantly narrowed the gap with Tokyo: funds managed here rose by more than 30 per cent while in Tokyo there was no movement at all. But of course the scoreboard can be distorted by swings in currencies and markets, and all US fund management centres last year were flattered by the strong US share performance. A crash on Wall Street and a recovery in Japanese share prices would quickly push Tokyo's position up again vis-a-vis New York and possibly London.
The pecking order of cities raises a further point: why is London a more important portfolio management centre than New York? The domestic market here is less than one- fifth of the size of the US. The answer is partly that fund management is more widely spread in North America than it is here; there are a host of important other fund management centres in the US, Boston in particular, whereas here only Edinburgh reaches the list at number 14. But the main reason is that London is not just managing UK money invested in UK shares. New York is principally placing US finds into US equities; Tokyo, Japanese savings into Japanese shares; but London is running international portfolios for anyone with the funds.
Figures on this area are always hard to come by, and often harder to interpret. London is certainly the largest international equity management centre. We know that about 60-70 per cent of the world's cross-border equity trading takes place in London and it looks as though something like that proportion of cross-border fund management may also take place here. But we do not know much about the long-term trends of the business. We do not even know the answer to basic questions such as whether the trend will be to manage funds from the places where the investments are placed (i.e. manage Chinese shares from, say, Hong Kong even though the money comes from elsewhere), or whether management will move to where the savings are coming from (i.e. manage Chinese savings from Hong Kong even though the funds are placed elsewhere).
What we can see from this chart is a very concentrated industry - after the top five the graph slopes away pretty fast. This suggests that critical mass is an important factor in the comparative advantage of portfolio management centres. What we cannot see is whether portfolio management skills will become a relatively more important aspect of economic competition that they have been in the past. I think, however, they will for two broad reasons.
The first is that the process of globalisation of financial markets still has a lot of momentum behind it. There is no evidence at all of a decline in the appetite for cross-border investment, nor does it seem to arouse the nationalistic responses that some cross-border takeovers seem to generate. It suits companies. Multinationals are seeking to broaden their shareholder base, seeing this as a useful way of establishing a local lobby of support in the countries in which they operate. And it suits investors to broaden the base of their savings, rather than relying too heavily on any one national market. While there is concern about some aspects of the power of international markets - in particular that of the foreign exchanges - there is less concern about attracting international funds.
The second is that the pool of global savings will rise very rapidly over the next 20 years. Ageing Western societies will have to save a larger proportion of their GNP to cushion the cost of pensions for their older populations. Ageing will also affect what we think of as the newly industrialised countries, which already save a lot, as it has already affected Japan.
In theory this pool of savings could be redistributed by the banking system, but the last few years have demonstrated the limits of that. While banks will always have a place in the allocation of funds, it seems clear that markets will continue to play a greater relative role in allocation of savings for at least the next decade, maybe longer.
If managing this pool of savings will be a growing business, doing it well will be an economically important one.
At the moment we as individuals think of a well-managed pension fund as helping guarantee a good standard of living in retirement. Transfer that thought to an ageing country: a well-managed portfolio of investments will help guarantee a good standard of living for is future generations of retired people.
Since the war, investment income from abroad has for most countries been a tiny proportion of income when set against current income from producing goods and services. It still is. That pounds 7bn of portfolio income noted above is only about 1 per cent of our national income. But before the First World War the situation was quite different.
The UK received more than 10 per cent of its income from overseas investments. As savings mount, and as part of those savings are invested overseas, expect the proportion of earnings from this source to rise everywhere.
Wise portfolio management will matter more and more.
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