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