Fiduciary Investors Symposium

Aaron Low, CFA, PhD

Principal, Lumen Advisors

Chair, CFA Institute Board of Governors

Trust and Capital Markets

Trust after the crisis – and why it matters

o Economics of Trust

Building enduring trust

o Regulatory

o Code of Conduct

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A Casualty of the Crisis

Source: 2011 Edelman Trust Barometer® Accessed at

http://www.edelman.com/trust/2011/uploads/Edelman%20Trust%20Barometer%20Global%20Deck.pdf on 8 September 2011

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63%

45%

63%

55%

59%

36%

54%

46% 46%

31%

38%

27%

43%

30%

46%

40%

20%

30%

40%

50%

60%

70%

2008 2009 2010 2011

Trust in Institutions 2008-2011

NGOs Business Media Government

Financial Services Fare Worst

Source: 2011 Edelman Trust Barometer® Accessed at

http://www.edelman.com/trust/2011/uploads/Edelman%20Trust%20Barometer%20Global%20Deck.pdf on 8 September 2011

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81%

69%

68%

66%

65%

65%

63%

63%

62%

59%

57%

57%

54%

52%

51%

50%

Technology

Automotive

Telecommunications

Food and Beverage

Biotech

Retail

Entertainment

Pharmaceuticals

Energy

Consumer Packaged Goods

OTC Persoanl Health Care

Brewing & Spirits

Media

Insurance

Banks

Financial Services

Trust in Industries - Global

Practitioner Perspectives

CFA Institute Financial Market Integrity Outlook Survey

o 32% thought integrity of global capital markets would improve in 2011 relative to 2010; 55% thought about the same, 13% thought it would be worse

o The most serious ethical issues facing global markets

• Market fraud

• Honesty and integrity of financial reporting

• Disclosure and use of financial derivatives

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Fiduciary Symposium Presentation ‹#›

FMI Survey 2011, CFA Institute

Causes of Loss of Trust

6.70%

11.20%

31.60%

50.50% 2.6 2.42

1.97 2.1

0%

10%

20%

30%

40%

50%

60%

0

0.5

1

1.5

2

2.5

3

Global Imbalance Excessive GovtIntervention

Lack of OversightRegulation

Managers's Greed &Poor Governance

Main Causes of Current Crisis

Trust in the Stock Market

Loss of Trust Perceived to be Due to Lax

Regulations/Oversight and Bad Corporate Governance

Source: Financial Trust Index Fiduciary Investors Symposium 7

Source: Financial Trust Index

Loss of Trust Permeates Even to Big Boys

Loss of Trust has even permeated between Institutional partners

o Interbank market has been severely disrupted

• Risk book of banks is not readily transparent

o OTC Markets undergoing structural upheaval

• Central clearing of CDS and discussions on IRS

• Payment upfront and collateralization of OTC risks

Increased costs of funding will severely impact capital markets

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Does Trust Matter?

Unconstrained opportunism imposes costs

o Verification mechanisms can be expensive and cumbersome

o Regulatory/legal constraints can be expensive and cumbersome

Motivations for ethical behavior

o Altruism

o Utility

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Does Trust Matter?

Differences in trust across individuals and countries can, in part, explain why some invest more or less in stocks and other risky assets

Implications

o For a given rate of return, investors are more reluctant to invest

o P/E has to fall to attract investors, with consequences for raising capital

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Trust Not a Proxy for Risk Tolerance

Equity Markets

Principal Agent Conflicts Excessive Risk Taking

Debt Markets

Willingness to Pay Ability to Pay

Investor Perceptions on Capital Markets

Trust Risk / Loss Tolerance

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Economics of Trust

-1.04

-0.69 -0.63

-1.2

-1

-0.8

-0.6

-0.4

-0.2

0

Stock Mkt Banks Government

-6.35%

-0.26% 7.09%

1.62

2.13

2.9

0

0.5

1

1.5

2

2.5

3

3.5

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

People whoplan to

decrease stockinvestments

People whoplan to leave

stockinvestmentunchanged

People whoplan to increaseplan investment

Expectations aboutchanges in stocks

Level of trust in stockmarket2

Source: Financial Trust Index

Change in Trust Market Participation: Expectations and Trust

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Economics of Trust

Loss in Trust

Withdrawal From Risk Assets

Rise in Cost of Capital

Impaired Returns

Economic Implications of Trust is Enormous Through Self Fulfilling Cycle

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Avenues to Restore Trust

Restoring Trust

Government

Regulatory

Markets

Private Contracts

Code of Conduct

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Trust and Regulatory Reform

Systemic risk detection and mitigation

o Counterparty contagion

o Cross-border resolution

o Stronger capital requirements

o Registration of lightly regulated entities such as hedge funds

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Trust and Regulatory Reform

Mis-selling and fiduciary duty

o Mis-selling of complex structured products to retail investors

o Quality of disclosure – vs. quantity

o Financial advice and fiduciary duty

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Gov’t Intervention Added Little to Trust

Source: Financial Trust Index

Government Intervention Has Reduced Confidence Even For

Those Who Believed in Regulatory Oversight

Source: Financial Trust Index

9.40% 10.40%

80.20%

2.55 2.61

2.03

1.5

1.7

1.9

2.1

2.3

2.5

2.7

2.9

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

ConfidenceUnchanged

More Confidence Less Confidence

Confidence in Govt Intervention

Trust in Stock Market

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Beyond Regulation

Ethical conduct as integral to business strategy

Signals

o Included in client discussions

o Tied to brand identity

o Support for voluntary standards

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Motivation for a Code of Conduct

Typical contract enforcement (agency theory):

o Rewarding compliance

o Punishing breaches

Ethical code may be enforced voluntarily via behavorial norms

o If enough people adhere to the code, the economic pie enlargement compensates for the costs and loss in freedom.

o Prisoners Dilemma equilibrium

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Prisoners’ Dilemma and the Code

Agent A

Conform Cheat

Agent

B

Conform 10, 10 -10, 15

Cheat 15, -10 -5, -5

Fiduciary Symposium Presentation ‹#›

One Time Investment

Prisoners’ Dilemma and the Code

Agent A

Conform Cheat

Agent

B

Conform 10, 10 -10, 15

Cheat 15, -10 -5, -5

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Multi-Period Investment

The Asset Manager Code of Professional Conduct

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The Asset Manager Code of Professional Conduct

General Principles of Conduct

Managers have the following responsibilities to their clients.

1. Act in a professional and ethical manner at all times.

2. Act for the benefit of clients.

3. Act with independence and objectivity.

4. Act with skill, competence, and diligence.

5. Communicate with clients in a timely and accurate manner.

6. Uphold the applicable rules governing capital markets.

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The Asset Manager Code of Professional Conduct

Motivations for compliance

o Distinction in marketplace

o Strengthens brand identity

o Satisfy client demand

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Looking Forward

2011 Financial Market Integrity Survey: length of impact of the current crisis on market trust and confidence

o 49%: 3-5 years

o 32%: more than 5 years

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Thank You

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