Lecture 16: Institutional Investing

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Lecture 16 Institutional Investing
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Migration of CapitalMain 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.

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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

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Private Pension Funds Assets2000-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

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State Local Employees Retirement Funds
2000-III in B

• Corporate equities 1953
• US government securities 383
• Corporate foreign bonds 324
• Other 324
• Total 3054

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Commercial BanksAssets 2000-III in billions

• Loans 3803
• US Government Securities 913
• Vault cash 35
• Reserves at Federal Reserve 17
• Corporate equities 12
• Other
• Total 6344

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SLs Savings Banks Assets 2000-III in
billions

• Mortgages 722
• US Government securities 148
• Equities 24
• Reserves at Federal Reserve 1
• Other 308
• Total 1203

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Credit Unions Assets2000-III in billions

• Consumer credit 181
• Home mortgages 125
• US Government securities 75
• Other 54
• Total 435

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Mutual Funds

• Corporate equities 3622
• US Government securities 393
• Corporate foreign bonds 368
• Municipal securities 228
• Other 205
• Total 4816

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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

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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 peoples purchases and redemptions affect
  you

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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.

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ETFs vs. Mutual Funds

• First Exchange Trade Fund Standard Poors
  Depositary Receipts (SPDRs, Spiders), AMEX 1993
• SPDRs hold portfolio of SP 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

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Bank Personal Trusts EstatesAssets 2000-III in
Billions

• Mutual funds 418
• Corporate Equities 358
• US Government securities 67
• Money Market 56
• Other 198
• Total 1097

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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.

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Life Insurance Companies Assets 2000-III
Billions

• Credit market instruments (bonds, corp govt,
  mortgages, policy loans) 1928
• Corporate equities 1028
• Other 44
• Total 3000

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Rest of World Assets in US2000-III in Billions

• US Government securities 1703
• US corporate equities 1691
• Foreign direct investments 1310
• US Corporate bonds 953
• Other 1320
• Total 6977

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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.

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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.

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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.

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Union Pension Funds

• Patternmakers 1900
• Granitecutters Cigarmakers 1905
• Locomotive Engineers 1912 was first to to grant
  contractual right to pension

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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.

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Why Were Early Pension Plans So Badly Designed?

• Pension benefits not yet perceived as a right or
  standard
• Plans were viewed as incentive for long-term
  company loyalty, which few achieved.
• Reflects general slowness for financial
  innovation.

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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.

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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.

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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 adequatesound actuarial
  principles.
• Created Pension Benefits Guarantee Corp.
• Prudent person standard for managers
• Minimum vesting standards. An employee for ten
  years has complete vesting

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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.

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Problems with Prudent Person Rule

• Legislates conventional wisdom.
• Decisions cannot be based on individual judgment.

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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.

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OBarr Conley Study

• OBarr 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)

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OBarr Conley Cont.

• Creation myths prominent. The great founder
• Displacing responsibility.
• Outside managers used to shift possible blame.
• Blaming the law

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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

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Economics of Nonprofits

• Donations are usually only a minor source of
  income.
• Nonprofit hospitals compete alongside for-profit
  hospitals, look similar.

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Endowments and Foundations

• Not completely tax free
• Grantmaking foundations must give away 5 of
  wealth each year, or else lose tax-exempt status.
  (Does not apply to operating foundations.)
• Two-tier excise tax on income, 1 if they
  maintain or increase giving, 2 otherwise.

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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

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Yale Universitys 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

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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.

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Illiquiditys 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