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Lecture 16: Institutional Investing

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.

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Lecture 16: Institutional Investing

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  1. Lecture 16: Institutional Investing

  2. 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.

  3. 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

  4. 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

  5. State & Local Employees’ Retirement Funds 2000-III in $B • Corporate equities $1953 • US government securities $383 • Corporate & foreign bonds $324 • Other $324 • Total $3054

  6. 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

  7. 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

  8. Credit Unions’ Assets2000-III in $billions • Consumer credit $181 • Home mortgages $125 • US Government securities $75 • Other $54 • Total $435

  9. Mutual Funds • Corporate equities $3622 • US Government securities $393 • Corporate & foreign bonds $368 • Municipal securities $228 • Other $205 • Total $4816

  10. 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

  11. 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

  12. 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.

  13. 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

  14. 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

  15. 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.

  16. 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

  17. 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

  18. 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.

  19. 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.

  20. 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.

  21. Union Pension Funds • Patternmakers 1900 • Granitecutters & Cigarmakers 1905 • Locomotive Engineers 1912 was first to to grant contractual right to pension

  22. 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.

  23. 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.

  24. 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.

  25. 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.

  26. 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

  27. 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.”

  28. Problems with Prudent Person Rule • Legislates conventional wisdom. • Decisions cannot be based on individual judgment.

  29. 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.

  30. 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)

  31. O’Barr & Conley Cont. • Creation myths prominent. The great founder • Displacing responsibility. • Outside managers used to shift possible blame. • Blaming the law

  32. 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

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

  34. 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.

  35. 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

  36. 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

  37. 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.

  38. “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

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