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’ Assets 2000-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’ Assets 2000-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 & Estates Assets 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 US 2000-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 19 th Century. Retirement was not invented until then. Increase in life expectancy in 20 th 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