Equity

1
Equity

• In the early days, common stock (equity) enabled
  a company to separate ownership and control.
  Professional managers ran a company, while the
  owners were dispersed.
• In such an environment, shareholders had
  virtually no bargaining power. The only
  disciplining force on management was the market
  for corporate control. The inability of
  shareholders to pressure management to do their
  bidding is referred to as agency problems.

2
Shareholders Unite

• The most natural solution to the agency
  problem is that there be one large shareholder
  - or an entity that consolidates disparate
  shareholders control rights.
• Pension funds and investment companies represent
  such an entity.

3
Governance

• The role of institutions in influencing
  managerial behavior is examined under the rubric
  of corporate governance.
• To date pressure exerted by external large
  shareholders (TIAA/CREF CALPERS), has not been
  as important as the takeover market in
  disciplining management.

4
Disintermediation

• The Economist article (11-6-99) shows that since
  1970, mutual funds share of total US financial
  assets has risen from 0 to 20. While bank
  deposits fell from 40 to 21, and pension funds
  increased from 10 to 30.

5
Mutual Funds

• A mutual fund is a form of investment company.
  It is distinguished from a closed-end investment
  company in that its size changes as new money
  comes in to the fund, or holders withdraw money
  from the fund.

6
Mutual Funds 2

• Why would an investor choose a fund rather than
  direct investment?
• Pros
• Professional Management
• Reduced Transactions Costs
• Solution to Agency Problems
• Enhanced Diversification
• Cons
• Subordination of individual interests to the
  fund. (Examples of this include tax-timing, and
  timing of liquidity costs.)

7
Mutual Funds3

• The relative importance of the costs and benefits
  can be estimated by the popularity of different
  types of funds.
• Question What does the growing popularity of
  low-cost index funds say about the relative
  importance of possible benefits to mutual funds?

8
Pension Plans

• The Economist article shows that since 1975, in
  the US, the number of participants in defined
  contribution pension plans has risen from under
  10 million to around 50 million, while the number
  of participants in defined benefit plans has
  remained around 40 million. It identifies 401(k)
  plans as retail and defined benefits as wholesale
  funds.

9
Insurance

• One of the oldest and most important intermediary
  is insurance. The Economist article notes that
  along with disintermediation, the last three
  decades have seen insurance companies competing
  more directly with banks and mutual funds.
• Perhaps as a result of the roaring bull market of
  the last 20 years, investors seem unconcerned
  with investment risk.

10
Insurance 2

• The article correctly identifies that what we
  usually think of as insurance differs importantly
  from other intermediation - insurance entails
  risk sharing - which is accomplished by the law
  of large numbers (and probability and statistical
  models). (Although in several weeks we will
  argue that banks provide insurance against
  liquidity risk.

11
Insurance 3

• Students often misunderstand the role of
  financial markets in insuring various risks.
  In general, financial contracts like options and
  futures cannot hedge individual specific risks,
  such as fire, etc. This can only be accomplished
  with insurance.
• (We have an elective on option pricing and risk
  management - Yan).

12
Hedge Funds

• The recent collapse of Long-Term Capital
  Management draws our attention to hedge funds.
• What are they?
• Why are they popular?
• Why did LTCM fail, and what risks does this
  identify?

13
Hedge Funds - Defined

• Hedge funds are similar to other investment
  companies in that they pool individual
  contributions in a portfolio. However, they
  restrict the number of investors as well as their
  expertise to circumvent SEC restrictions on
  disclosure, etc. So they have virtually no
  restrictions as compared to other funds.

14
Hedge Funds - Defined

• Hedge Fund managers make money from a management
  feeusually 1 of assets (to cover operating
  expenses) incentive fees, which are often 20
  of the funds profits. (Contrast to Mutual Fund
  managers, whose bonuses depend on performance
  relative to a benchmark.) If a hedge fund is
  down, incentive fees dont kick in until
  investors are made whole (I.e., assets reach the
  high-water mark).

15
Hedge Funds- Defined

• The earliest hedge funds were so-named because
  they effected positions that were market-neutral.
  
• Today, they often have a specific focus.
• As noted by Edwards, one of the reasons for the
  popularity is that their returns have low
  correlations with most benchmarks.
• In fact, most have dynamic trading strategies
  that generate returns that resemble options
  positions. As an example, David Hsieh of Duke
  has identified that funds who identify themselves
  as trend followers have payoffs that resemble
  long positions in a spread on the US stock
  market. But the payoffs are higher than the
  comparable option position in stable periods.

16
Hedge Funds - Why?

• The human condition is tied to the search for the
  phlogiston - or grail.
• But, even if markets are generally
  informationally efficient, we would expect a
  reward to efficient and innovative information
  processing.
• For example, in the early days of LTCM, much of
  their positive abnormal returns was attributed to
  identifying arbitrage opportunities across the
  globe.

17
Hedge Funds - Why? 2

• LTCM was likened to a big vacuum cleaner -
  picking up pennies lying around all the worlds
  exchanges.
• However, it is very important to note that after
  they identified and profited from these
  mis-pricings, they disappeared.

18
Hedge Funds Return Structures

• Now, analyses of hedge fund returns identifies
  that those funds who call themselves trend
  followers have payoffs that resemble a straddle
  on the SP 500 or perhaps the US or gold.
• Global/Macro funds payoffs look like a collar.

19
Hedge Funds 2

• Chris Lamoureux
• For the seminal study on hedge funds returns
  see William Fung and David Hsieh, Empirical
  Characteristics of Dynamic Trading Strategies
  The Case of Hedge Funds, The Review of
  Financial Studies 10, 1997, pp. 273302.

• Studies of Hedge fund returns find that
  portfolios that use the Systems/Trend Following
  strategy show that these portfolios do best
  during rallies in US bonds, non-US bonds, and
  gold, and during declines in the US Dollar.
• The Global/Macro style is most profitable during
  rallies in non-US equities and bonds and during
  declines in the US Dollar.

20
Hedge Funds - LTCM

• While we may never fully understand the reasons
  for the collapse of LTCM in September, 1998, the
  crux of the issue is probably related to
  liquidity.
• According to Edwards, LTCM created highly
  leveraged bets based on arbitrage and long-term
  relationships. (The funds very name highlights
  this latter focus. It required a commitment on
  investors parts not to withdraw money for three
  years.

21
LTCM 2

• But illiquidities beset our capital markets.
  Recall the strange case of MIPS from the
  syllabus. Suppose we know that MIPS and MIPS-B
  must have the same price in the long-run, and
  short MIPS and buy MIPS-B - using tons of
  borrowed money.
• Now suppose a short squeeze occurs (on Sept. 5,
  2000, MIPS closed at 59.25, and MIPS-B at 52.5).

22
LTCM 3

• Now, were done for. We would be unable to pay
  back our creditors, etc.
• In the case of LTCM, the analog of the short
  squeeze was the collapse of the Russian
  financial system on August 17, 1998. As in the
  past, such events beget a flight to quality -
  widening the spreads between liquid and illiquid
  instruments.

23
LTCM 4

• LTCM had large positions in relatively illiquid
  assets.
• In a time of stress (esp.) LTCM was immobilized
  by its size. Smaller positions in its bonds were
  being liquidated, if LTCM started to sell the
  effect on the prices (and on the value of the
  majority of the portfolio) could be devastating.

24
LTCM Policy Implications

• Central Bankers and even Pierpont Morgan have
  long felt compelled to inject liquidity into the
  financial system in times of crisis. Edwards
  notes FED policy in response to Penn Centrals
  bankruptcy in 1970, and the stock market crash of
  October, 1987.
• In a disintermediated financial system, these
  liquidity crises are the new bank runs.

25
Hedge FundsPost LTCM

• Tremont Advisers Inc is a big hedge fund investor
  and it maintains the TASS database on hedge
  funds. There were 805 funds at the end of 1993,
  managing less than 50 billion. This has grown
  steadily to 1999, when some 1,500 hedge funds
  managed 190 billion. Since 1999, the number of
  hedge funds has been flat, but the amount
  invested in hedge funds has continued to rise to
  around 280 billion. (These are the funds tracked
  by TASSwhich estimates that there are an equal
  number of funds that they do not track.)

26
Hedge Funds of late

• Most hedge funds are relatively small. More than
  ½ of the TASS funds have less than 50 million
  (as of 7-31-2002). Less than 1/3 manage more
  than 100 million.
• On July 31, 2002, 55 of the hedge funds were
  down for the year. Some analysts expressed
  concern that this situation could induce
  excessive risk taking (since the high-water mark
  means that the managers have little to lose from
  taking risky bets).