August 21, 2007
ETFs: They're Unbelievable.
Posted by William Birdthistle

I'm fascinated by ETFs.  A strange affliction, I confess, since they're not well recognized as a source of charm.  But they do have quite a repertoire of entertaining tricks.

An exchange traded fund (or, perhaps, grammatically more correct, an exchange-traded fund) is, in essence, a mutual fund that an investor can buy and sell on an exchange at market prices all day long, as opposed to having to accept a single price calculated just once each day after the close of business.  In a widely fluctuating market with huge intra-day swings in the value of indices, as we have recently enjoyed, the advantage of real-time prices is manifest.

The structure of ETFs also has the advantage of eliminating many of the problems that arose in the late unpleasantness with mutual funds.  That is, ETFs are nowhere near as vulnerable to market timing, late trading, unfair valuation, front running, and so on.

Perhaps not surprisingly, then, the cash has started to flow in, and, freshly watered by this generous fount, new funds have been sprouting like weeds.  So far, the ETF has been quite free from disapprobation, but John Bogle as offered up a few objections (W$J).

The essence of his dissent appears to be his prediction that investors are bound to hurt themselves with ETFs.  He notes that of the hundreds of ETFs now available, only a small proportion track broad-based indices, while the others represent undiversified investment niches (e.g., the home construction industry, Malaysia, &c.); the trading of ETFs involves brokerage fees (because they trade on exchanges) that can make them more costly than mutual funds; and, because of their regular price fluctuation, ETFs will entice investors to chase performance.

So, is this the equivalent of arguing that farmers should stick with pony carts to carry produce to market because motor vehicles (a) are sometimes ill-suited to the task of vegetable conveyance, (b) come with costs unassociated with some pony carts, and (c) are capable of being driven really fast and dangerously?

Or is Bogle (like David Swensen, who makes similarly paternalistic arguments with respect to actively managed mutual funds) simply being a benevolent realist who recognizes that people will hurt themselves if given dangerous toys?  And, therefore, when it comes to nest eggs, we must keep the cork on the fork, or else the rest of us will end up having to bail out the incontinent day traders?

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August 14, 2007
Do Our Neighbors Make Us Fat and Rich?
Posted by Christine Hurt

In recent weeks we've learned what we all sort of knew before:  our friends influence our eating patterns and can make our weight rise to meet theirs.  Meanwhile, two finance professors at the U. of Illinois have been studying the effects of social networks on the stocks that investors buy.  (The paper is available on NBER, if you have a subscription.  Only the abstract seems to be available on SSRN.)  After studying the stocks purchased by 35,673 households between 1991 and 1996, the authors, Zoran Ivkovich and Scott Weisbenner, found that a 10% increase in neighbors' purchases of stock in a particular industry was associated with a 2% increase in stock purchases in the same industry by those living nearby.  Although the authors concede that one factor was the purchase of stock in companies headquartered within 50 miles of a household, they state that even accounting for this and other factors, that word-of-mouth stock recommendations accounts for a large percentage of the correlation.  (So, yes, if you lived in Austin 10 or 15 years ago, you may have bought Dell stock along with your neighbors but without ever mentioning it to each other, but you may have discussed other, non-local stocks.) 

I think this is an interesting finding, but I always wonder how we can assume that people in the same zip code actually talk to each other.  I have lots of neighbors, but I don't speak to all of them, and I rarely talk about the stock market!  Maybe I did in 1994, though.  I even joined an investment club, which was a really silly idea.  I could even tell you who on my floor at work had shares in Magellan.  (Remember Magellan?)  I wonder if neighbors chat more about the stock market at some times than others.

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August 09, 2007
Whole Foods on the Move
Posted by Gordon Smith

What's up with Whole Foods? Since August 27, the stock has risen almost $11/share! And on a day when the market is languishing, Whole Foods is up again. All this while news of the company is mundane. Is the market anticipating movement on the merger with Wild Oats?

Just curious because I have an academic interest in stock pricing. I sold my meager investment in the company yesterday.

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July 10, 2007
Conflicts of Interest and the "Certified Senior Advisor"
Posted by Christine Hurt

The NYT has had a series of articles lately on sharp business practices that prey on seniors.  Last Sunday's Times featured an article entitled For Elderly Investors, Instant Experts Abound.  The gist of the story is that an increasing number of individuals are marketing themselves as "certified senior advisor," "certified elder planning specialist," "certified retirement financial advisor," or similar title.  Although these titles sound like the more weighty "certified financial planner," these titles can be earned by correspondence courses in very short periods of time or by attending multi-day seminars and may not require a bachelor's degree.  These individuals go on to become independent agents working for insurance companies.  Stories abound of these agents selling inappropriate, expensive insurance and annuity products to seniors.  (One example given is the agent who sold a 72 year-old widow supporting a son with Downs Syndrome a deferred annuity, payable beginning in ten years, in return for her entire $75,000 savings.)

Although the article tends to link the agents' lack of financial training with the selling of these unsuitable savings vehicles, additional training would not have stopped these fiascos.  The agents weren't investing clients money in products that made no financial sense.  They were selling clients products that made huge financial sense to the agent, but no financial sense to the client.  These were the products that their employers liked them to sell, the products that carried the largest commissions.  I suppose one could say that theoretically, if the agent had been more financially astute, then the agent would have realized what bad financial sense thse products were for his clients.  (This assumes that he did not know already -- a big assumption)  However, as someone who has endured the "whole life insurance" pitch from her certified financial planner for years, I'm not sure.  Any time that a financial planner has an employer who sells investment products, there will be a conflict of interest between the advisor that wants to sell a complex product with a large commission and the client who would just like a simple index fund, thank you.

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July 03, 2007
Synthetic Hedge Funds
Posted by Fred Tung

Fc The most recent issue of the New Yorker has an interesting story about an economist/ statistician who has written a computer program to mimic the medium-term returns of specific hedge funds using a relatively mechanical futures-trading strategy.  Harry Kat, now a professor of risk management at Cass Business School (City University, London), worked trading derivatives before moving into the academy.  To design his software, he relied on databases of historical hedge fund performance to figure out how to mimic the most important statistical properties of each fund's results--returns, volatility, correlation with the stock market, the likelihood of large losses.  The program is called FundCreator, and it has developed some following among institutional investors.  Kat undercuts the hedge funds' two-and-twenty (see Vic--the go-to guy on the tax issues--here and here and here) by a wide margin, charging only about one-third of one percent of money invested. 

It may be too early to tell if the program "works," but it's certainly cheaper than hedge funds' two-and-twenty charges (or the effective three-and-thirty charges for funds of funds).

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June 09, 2007
Connections, Connections, Connections
Posted by Fred Tung

Mutual fund managers invest more in companies run by their college and grad school pals than in other companies, according to a study described in today's NYT.  These investments also perform significantly better than other investments.  “Something about these social networks is allowing portfolio managers to better predict the future returns of companies within the network,” according to one co-author, Lauren Cohen from Yale.   According to NYT, the authors offer two explanations, without deciding between the two.  Either school ties simply enable fund managers to better assess the quality of company managers with the same school connections, or there is insider trading going on.  The study's evidence is consistent with both explanations, and there is “no evidence of wrongdoing by any of these fund managers,” according to co-author Andrea Frazzini from U. Chicago.  But the SEC is apparently interested in the study:  it's invited the authors to present their study at an SEC Office of Economic Analysis seminar.  Christopher Malloy of LBS is the third co-author.

Here's the abstract for The Small World of Investing:  Board Connections and Mutual Fund Returns:

This paper uses social networks to identify information transfer in security markets.  We focus on connections between mutual fund managers and corporate board members via shared education networks.  We find that portfolio managers place larger bets on firms they are connected to through their network, and perform significantly better on these holdings relative to their non-connected holdings.  A replicating portfolio of connected stocks outperforms a replicating portfolio of non-connected stocks by up to 8.4% per year.  Returns are concentrated around corporate news announcements, consistent with mutual fund managers gaining an informational advantage through the education networks.  Our results suggest that social networks may be an important mechanism for information flow into asset prices.

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June 01, 2007
Dell & Leo
Posted by Gordon Smith

A few weeks back, I mentioned the "fun fund" that I use to invest in individual stocks. In that post, I noted that I had purchased Yahoo! and Whole Foods. I sold Yahoo! almost immediately after it became the subject of Microsoft takeover rumors. That turned out to be a lucky move, as the stock has been falling lately and executives are leaving like they don't want to be responsible for turning out the lights.

I should have sold Whole Foods within a week of my purchase. It immediately spiked on some favorable reports about the proposed merger with Wild Oats, but it abruptly tanked on some negative earnings results and word that the FTC is concerned about the merger. (By the way, the notion that these two companies have any market power seems ridiculous to me.) Oh well ... maybe next quarter will bring better news.

I didn't mention a third stock, which I have been holding for a while: Dell. One of the things I like about my fun fund is that is causes me to follow certain companies quite closely. Given that I teach and write about corporations, getting down and dirty with corporate info is a good thing. Having watched Dell for a couple of years now, I am very intrigued by Michael Dell's strategy for dealing with his languishing company.

If you know anything about Dell's recent performance, you will know that HP took the lead in personal computer sales last year, and then-CEO Kevin Rollins (also a BYU alum) was fired. Michael Dell is back at the helm and in search of a new winning strategy. Last week, analysts fretted about his decision to sell computers through Wal-Mart. Inventory!

Yesterday afternoon, Dell announced that it would reduce its workforce by 10% over the next year. Stocks are up 7% in after-hours trading.

What would Leo think? I am referring, of course, to Leo Strine, who has stepped out from behind the bench to produce a thoughtful essay entitled Toward Common Sense and Common Ground? Reflections on the Shared Interests of Managers and Labor in a More Rational System of Corporate Governance. (More from Steve Bainbridge.) Here is the starting point for Leo's argument:

I accept as a reality that management and labor now derive much more of their economic wealth than they used to from the equity they own in the corporations for whom they toil and the stock market more generally. Therefore, both management and labor share an interest in the vitality of American equity markets. At the same time, I also accept the notion that most American workers obtain the bulk of their wealth from their labor and that even most top American managers can trace their wealth (including the equity they have accumulated) to their labor as executives. Therefore, both management and labor might be thought to have more concern than trust fund babies or investment bankers do for the continued ability of American corporations to support domestic employment. Likewise, both management and labor are likely to view a public corporation as something more than a nexus of contracts, as more akin to a social institution that, albeit having the ultimate goal of producing profits for stockholders, also durably serves and exemplifies other societal values. In particular, both management and labor recoil at the notion that a corporation’s worth can be summed up entirely by the current price the equity markets place on its stock, much less that the immediate demands of the stock market should thwart the long-term pursuit of corporate growth.

Ok, I'll play along. So what? According to Leo, workers are investing in stocks, and, ironically given the premise of this post, "If you are acting with the most rationality, you will invest in index funds." So they have an interest in the stock market, but their interest lies in stable, long-term growth.

Standing in opposition are hedge funds and the "corporate governance industry" (to which, apparently, I belong). With regard to the latter, Leo remarks: "To say that these folks profit from tumult is not a normative argument, it is a positive claim."

He goes on an extended rant against corporate law professors. He even calls them lazy for fetishizing agency costs and not focusing on the "separation of ownership from ownership" (i.e., the fact that most stock is owned by intermediaries, like mutual funds).

Next on the chopping block: "independent directors":

Rather than trustees willing to sacrifice their office over matters of principle, independent directors increasingly look more like elected officials, who rationalize away compromises in conviction on the basis that the good produced by their continued service justifies the accommodation of sub-optimal proposals when that is necessary to avoid electoral defeat.

Notably absent from this collection, of course, is the Delaware judiciary. Hmm. If the world of corporate governance is a mess, can they really bear no responsibility?

But I digress. Leo offers a number of suggested reforms that might gain the support of both management and labor. I won't go through all of them here, but the most attractive to me: "Create a Rational Corporate Election and Accountability System." Leo floats an interesting idea:

For long-term investors and management, there might be gains to be made by reforming the corporate election process to provide for greater access periodically, say every three years. This access could be made available only to investors who have held their shares for at least a year and who are not bidders for control, and could involve the reimbursement of solicitation expenses for any rival slate that gains a material percentage of the votes. By this means, corporate boards would be subject to the greater possibility of electoral defeat on a regular, but not annual, basis. In exchange for this access, management could demand a restoration of the plurality voting system, on the reasonable ground that stockholders now have a means to influence board composition by using the responsible means of naming a rival slate of actual people willing to serve on the board.

This reminds me of a proposal for extended board terms in my first article. Anyway, I remain convinced that election reform is the most meaningful aspiration in corporate governance. Period.

Leo also endorses shareholder bylaws: "Instead of a pretend polity, stockholders would do real things. If they have a proposal to make, it would be in the form of a bylaw with real effect." Perhaps Delaware should just amend the code and get rid of the ridiculous structure of the current code, which I describe here.

I also appreciate the fact that Leo recognizes the importance of resolving health care issues by "eliminat[ing] the connection between health insurance access and employment at a particular corporation." I have never classified this as a corporate governance issue, but it is of the highest importance to the competitiveness of US corporations. I can't claim to have the answer, but improving the status quo would lift all boats.

So, after that long romp, I return to Dell's decision to trim its ranks by 1000 employees over the next year. These are the sorts of decisions that challenge the "shared interests" thesis. Would corporations in Leo's imaginary world still make decisions like this? I think so. Leo wants a world in which investors, managers, and employees are invested for the long haul, but he doesn't want to destroy markets.

In his world, Dell's bogeyman is not HP, but corporations located in "nations without functioning environmental standards, without protections for labor, and where the prevailing wages for skilled labor make the American minimum wage look generous." He argues for "enlightened externality regulation," though he is light on details, concluding rather lamely that "Human ingenuity ought to be sufficient for the West — with strong, joint United States and European leadership — to figure out how to foster globalized trade without compromising the core aspects of our enlightened approach to capitalism."

As we have come to expect from Leo, his paper is -- except for that last bit -- provocative, ambitious, and smart. Read it.

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