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’ 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

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’ Assets2000-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 & EstatesAssets 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 US2000-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 long-term 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 for-profit hospitals, look similar.

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.

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