Transcript Lecture 15: Institutional Investing

Lecture 16: Institutional
Investing
Migration of Capital:
Main Street to Wall Street
• Trend over decades has been to greater
institutional investing, and volume of trade on
stock market now dominated by it.
• Increasing tendency for institutions to participate
in corporate governance, solving the control
problem referred to by Berle and Means.
• An epic shift of power in our society towards Wall
Street.
Financial Assets of US
Households 2000-III in $Billions
•
•
•
•
•
•
•
•
•
Pension funds $10348
Corporate equities $7447
Equity in noncorporate business $4848
Deposits $4456
Mutual funds $3274
Personal trusts $1124
Life insurance $821
Corporate & foreign bonds & other $2887
Total $35205
Private Pension Funds’ Assets
2000-III in $Billions
• Corporate equities $2451
• Mutual fund shares $918
• Assets held at insurance companies (GICs,
variable annuities etc.) $506
• US Government securities $457
• Corp & foreign bonds $287
• Other $511
• Total $5129
State & Local Employees’
Retirement Funds 2000-III in $B
•
•
•
•
•
Corporate equities $1953
US government securities $383
Corporate & foreign bonds $324
Other $324
Total $3054
Commercial Banks’Assets
2000-III in $billions
•
•
•
•
•
•
•
Loans $3803
US Government Securities $913
Vault cash $35
Reserves at Federal Reserve $17
Corporate equities $12
Other
Total $6344
S&Ls’ & Savings Banks’ Assets
2000-III in $billions
•
•
•
•
•
•
Mortgages $722
US Government securities $148
Equities $24
Reserves at Federal Reserve $1
Other $308
Total $1203
Credit Unions’ Assets
2000-III in $billions
•
•
•
•
•
Consumer credit $181
Home mortgages $125
US Government securities $75
Other $54
Total $435
Mutual Funds
•
•
•
•
•
•
Corporate equities $3622
US Government securities $393
Corporate & foreign bonds $368
Municipal securities $228
Other $205
Total $4816
Mutual Fund History
• In 1920s, many investment companies
bilked small investors
• Massachusetts Investment Trust (MIT) in
1920s had only one class of investors,
published portfolio, redeemed on demand
• Became model for mutual fund industry
• Investment Company Institute
Structure of Mutual Fund
• Assets of mutual fund are held in common
• Purchases and redemptions are made at
prices as of 4pm market close on that day
• Other people’s purchases and redemptions
affect you
Recent Mutual Fund Scandals
• Late trading: mutual funds accept orders at
4pm prices even though orders were made
after 4pm
• Market timing: mutual fund investors wait
until almost 4pm to buy in or redeem their
shares in foreign funds, such as Japan fund.
ETFs vs. Mutual Funds
• First Exchange Trade Fund: Standard & Poors
Depositary Receipts (SPDRs, Spiders), AMEX
1993
• SPDRs hold portfolio of S&P index
• Management fee: 12 basis points
• Automatic creation and redemption
• QQQs, I-Shares
• Macro securities are analogous to ETFs, but are
based on an index. (AMEX). Macro Securities
Research LLC, Macro Financial LLC
Bank Personal Trusts & Estates
Assets 2000-III in $Billions
•
•
•
•
•
•
Mutual funds $418
Corporate Equities $358
US Government securities $67
Money Market $56
Other $198
Total $1097
Trusts Not Always Institutional
• Common law countries allow individuals to
appoint friends as trustees.
• Spendthrift trust increasingly common form
of inheritance. Planning for divorces
decades hence.
Life Insurance Companies’
Assets 2000-III $Billions
• Credit market instruments (bonds, corp &
gov’t, mortgages, policy loans) $1928
• Corporate equities $1028
• Other $44
• Total $3000
Rest of World Assets in US
2000-III in $Billions
•
•
•
•
•
•
US Government securities $1703
US corporate equities $1691
Foreign & direct investments $1310
US Corporate bonds $953
Other $1320
Total $6977
Pension Funds
• First pension funds in world: late 19th
Century.
• Retirement was not invented until then.
• Increase in life expectancy in 20th Century
brought large numbers of elderly people for
first time in human history.
Milestones in US Pension
History
• 1875 American Express Co. (then a
shipping co.) establishes first US corporate
pension plan: for employees who worked
there 20 years, passed age 60, and were
disabled, 50% of average of last ten years’
pay. Few employees qualified.
Carnegie Steel Pension 1901
• First large industrial pension fund
• Andrew Carnegie: The Gospel of Wealth,
Carnegie Institute of Technology, Carnegie
Endowment for Peace
• By 1929, 329 industrial firms had pension
plans, and these covered 10% of labor force.
• Pension benefits were not a contractual
right.
Union Pension Funds
• Patternmakers 1900
• Granitecutters & Cigarmakers 1905
• Locomotive Engineers 1912 was first to to
grant contractual right to pension
Collapse of Pensions after 1929
• Plans almost all unfunded, benefits paid out of
profits now nonexistent. With Great Depression,
benefits were cut sharply. Those funded were
often invested in company stock.
• Union plans failed disastrously, leading to their
near extinction
• Failures were impetus to Social Security Act of
1935.
Why Were Early Pension Plans
So Badly Designed?
• Pension benefits not yet perceived as a right
or standard
• Plans were viewed as incentive for longterm company loyalty, which few achieved.
• Reflects general slowness for financial
innovation.
General Motors Pension Plan
1950
• In labor negotiations, GM Chairman
Charles Wilson proposed fully funded plan
managed by financial professionals.
• Proposed investing in the stock market,
rather than fixed incomes, but no more than
5% in any one stock. Diversification.
• Wilson made stunning proposal that funding
not be invested in GM stock.
Studebaker Pension Default,
1963
• UAW accused of acquiescing in underfunding of
pension plan so that it could obtain a false
“victory” in prior negotiations with management.
• After default, UAW negotiated full benefits for
senior workers, little or nothing for others.
• Scandal led to Employee Retirement Income
Security Act (ERISA) 1974.
Employment Retirement Income
Security Act (ERISA) 1974
• Act was in response to abuses in earlier defined
benefit pensions
• Prohibits pay-as-you-go pension plans, defined
benefit plans must be fully funded.
• Funds must be adequate:sound actuarial
principles.
• Created Pension Benefits Guarantee Corp.
• Prudent person standard for managers
• Minimum vesting standards. An employee for ten
years has complete vesting
Prudent Person Rule
• ERISA: Investments must be made with
“the care, skill prudence and diligence
under the circumstances then prevailing that
a prudent man acting in a like capacity and
familiar with such matters would use in the
conduct of an enterprise of a like character
and with like aims.”
Problems with Prudent Person
Rule
• Legislates conventional wisdom.
• Decisions cannot be based on individual
judgment.
Pension Funds Types
• Defined Benefit: Traditional, old-line
manufacturing, supported by labor unions.
Now in decline. Not usually indexed.
• Defined Contribution: Employee
contributes to own account. 401(k) plans
begun in 1981 in US.
• In defined contribution, individuals choose
allocations across broad asset classes.
O’Barr & Conley Study
• O’Barr & Conley (Fortune & Folly, 1992)
“questions [about pension strategy] elicited
lengthy narratives about such cultural issues as
history, politics, and relationships, but little talk
about economics or finance.” (p. 75)
• Fund executives “rarely rise above their personal
perspectives to articulate a corporate vision.” “too
busy living through an event to stop and analyze
it.” (p. 76)
O’Barr & Conley Cont.
• Creation myths prominent. The great
founder
• Displacing responsibility.
• Outside managers used to shift possible
blame.
• Blaming the law
Nonprofit Organizations
• Non distribution constraint. Effectively,
there are no owners. Tax exempt. Board of
trustees appoints own successors.
• 900,000 tax-exempt nonprofits in the US
• 120,000 non-profit charities in the UK
• Many other countries
• Nonprofits contribute 4% of US national
income
Economics of Nonprofits
• Donations are usually only a minor source
of income.
• Nonprofit hospitals compete alongside forprofit hospitals, look similar.
Endowments and Foundations
• Not completely tax free
• Grantmaking foundations must give away
5% of wealth each year, or else lose taxexempt status. (Does not apply to operating
foundations.)
• Two-tier excise tax on income, 1% if they
maintain or increase giving, 2% otherwise.
Fragility & Importance of
University Endowments
• Yale University and Eagle Bank 1825 Yale
lost virtually its entire endowment in this
bank.
• Boston University John Silber and Seragen
$90 million in one company, lost 90%.
• University of Bridgeport & Reverend Sung
Myung Moon Unification Church 1992
Yale University’s Independence
• Yale initially supported by Colony of
Connecticut. Yale mostly supported by CT
• 1755 CT refused annual grant to Yale over
religious controversy.
• 1792 CT made legislators fellows of Yale
Corporation. Elected officials govern Yale
• 1871 CT terminates all support for Yale
Endowment Investing Strategy
Differences
• Endowments have very long-term focus, so
can invest in illiquid assets
• No risk of clients pulling money after poor
performance
• Endowments can earn liquidity premium
• University endowments have higher
purpose, can generate loyal support.
“Illiquidity’s Attractions”
(Swensen)
• Less info available on illiquid assets, so
universities better able to find nuggets.
• High market cap stocks are too well known.
Microsoft mentioned 19,899 times in 1998
in the Wall Street Journal alone.
• Illiquid investments accord with “value
investing,” which is inherently a long-term
strategy