EquityEquityIn the early days, common stock (equity) enabled a company to separate ownership and control. Professional managers ran a company, while the owners were dispersed.

In such an environment, shareholders had virtually no bargaining power. The only disciplining force on management was the market for corporate control. The inability of shareholders to pressure management to do their bidding is referred to as agency problems.

Shareholders UniteShareholders Unite

The most natural solution to the “agency problem’’ is that there be one large shareholder - or an entity that consolidates disparate shareholders’ control rights.

Pension funds and investment companies represent such an entity.

GovernanceGovernance

The role of institutions in influencing managerial behavior is examined under the rubric of corporate governance.

To date pressure exerted by external large shareholders (TIAA/CREF; CALPERS), has not been as important as the “takeover market” in disciplining management.

DisintermediationDisintermediation

The Economist article (11-6-99) shows that since 1970, mutual funds’ share of total US financial assets has risen from 0 to 20%. While bank deposits fell from 40 to 21%, and pension funds increased from 10 to 30%.

Mutual FundsMutual Funds

A mutual fund is a form of investment company. It is distinguished from a closed-end investment company in that its size changes as new money comes in to the fund, or holders withdraw money from the fund.

Mutual Funds 2Mutual Funds 2

Why would an investor choose a fund rather than direct investment?

Pros:– Professional Management– Reduced Transactions Costs– Solution to Agency Problems– Enhanced Diversification

Cons:– Subordination of individual interests to the fund.

(Examples of this include tax-timing, and timing of liquidity costs.)

Mutual Funds3Mutual Funds3

The relative importance of the costs and benefits can be estimated by the popularity of different types of funds.

Question: What does the growing popularity of low-cost index funds say about the relative importance of possible benefits to mutual funds?

Pension PlansPension Plans

The Economist article shows that since 1975, in the US, the number of participants in defined contribution pension plans has risen from under 10 million to around 50 million, while the number of participants in defined benefit plans has remained around 40 million. It identifies 401(k) plans as retail and defined benefits as wholesale funds.

Insurance Insurance

One of the oldest and most important intermediary is insurance. The Economist article notes that along with disintermediation, the last three decades have seen insurance companies competing more directly with banks and mutual funds.

Perhaps as a result of the roaring bull market of the last 20 years, investors seem unconcerned with investment risk.

Insurance 2Insurance 2

The article correctly identifies that what we usually think of as insurance differs importantly from other intermediation - insurance entails risk sharing - which is accomplished by the law of large numbers (and probability and statistical models). (Although in several weeks we will argue that banks provide “insurance” against liquidity risk.

Insurance 3Insurance 3

Students often misunderstand the role of financial markets in “insuring” various risks. In general, financial contracts like options and futures cannot hedge individual specific risks, such as fire, etc. This can only be accomplished with insurance.

(We have an elective on option pricing and risk management - Yan).

Hedge FundsHedge Funds

The recent collapse of Long-Term Capital Management draws our attention to hedge funds.

• What are they?• Why are they popular?• Why did LTCM fail, and what risks does this

identify?

Hedge Funds - DefinedHedge Funds - Defined

Hedge funds are similar to other investment companies in that they pool individual contributions in a portfolio. However, they restrict the number of investors as well as their expertise to circumvent SEC restrictions on disclosure, etc. So they have virtually no restrictions as compared to other funds.

Hedge Funds - DefinedHedge Funds - Defined

Hedge Fund managers make money from a management fee—usually 1% of assets (to cover operating expenses) + incentive fees, which are often 20% of the fund’s profits. (Contrast to Mutual Fund managers, whose bonuses depend on performance relative to a benchmark.) If a hedge fund is down, incentive fees don’t kick in until investors are made whole (I.e., assets reach the high-water mark).

Hedge Funds- DefinedHedge Funds- Defined

The earliest hedge funds were so-named because they effected positions that were market-neutral.

Today, they often have a specific focus.

As noted by Edwards, one of the reasons for the popularity is that their returns have low correlations with most benchmarks.

In fact, most have dynamic trading strategies that generate returns that resemble options positions. As an example, David Hsieh of Duke has identified that funds who identify themselves as trend followers have payoffs that resemble long positions in a spread on the US stock market. But the payoffs are higher than the comparable option position in stable periods.

Hedge Funds - Why?Hedge Funds - Why?

The human condition is tied to the search for the phlogiston - or grail.

But, even if markets are generally informationally efficient, we would expect a reward to efficient and innovative information processing.

For example, in the early days of LTCM, much of their positive abnormal returns was attributed to identifying arbitrage opportunities across the globe.

Hedge Funds - Why? 2Hedge Funds - Why? 2

LTCM was likened to a big vacuum cleaner - picking up pennies lying around all the worlds’ exchanges.

However, it is very important to note that after they identified and profited from these mis-pricings, they disappeared.

Hedge Funds – Return Hedge Funds – Return StructuresStructuresNow, analyses of hedge fund returns

identifies that those funds who call themselves trend followers have payoffs that resemble a straddle on the S&P 500 or perhaps the US $ or gold.

Global/Macro funds’ payoffs look like a collar.

Hedge Funds 2Hedge Funds 2

Studies of Hedge fund returns find that portfolios that use the Systems/Trend Following strategy show that these portfolios do best during rallies in US bonds, non-US bonds, and gold, and during declines in the US Dollar.

The Global/Macro style is most profitable during rallies in non-US equities and bonds and during declines in the US Dollar.

•Chris Lamoureux:

For the seminal study on hedge funds’ returns see: William Fung and David Hsieh, “Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds,’’ The Review of Financial Studies 10, 1997, pp. 273—302.

•Chris Lamoureux:

For the seminal study on hedge funds’ returns see: William Fung and David Hsieh, “Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds,’’ The Review of Financial Studies 10, 1997, pp. 273—302.

Hedge Funds - LTCMHedge Funds - LTCM

While we may never fully understand the reasons for the collapse of LTCM in September, 1998, the crux of the issue is probably related to liquidity.

According to Edwards, LTCM created highly leveraged bets based on arbitrage and long-term relationships. (The fund’s very name highlights this latter focus. It required a commitment on investors’ parts not to withdraw money for three years.

LTCM 2LTCM 2

But illiquidities beset our capital markets. Recall the strange case of MIPS from the syllabus. Suppose we know that MIPS and MIPS-B must have the same price in the long-run, and short MIPS and buy MIPS-B - using tons of borrowed money.

Now suppose a short squeeze occurs (on Sept. 5, 2000, MIPS closed at 59.25, and MIPS-B at 52.5).

LTCM 3LTCM 3

Now, we’re done for. We would be unable to pay back our creditors, etc.

In the case of LTCM, the analog of the short squeeze was the collapse of the Russian financial system on August 17, 1998. As in the past, such events beget a flight to quality - widening the spreads between liquid and illiquid instruments.

LTCM 4LTCM 4

LTCM had large positions in relatively illiquid assets.

In a time of stress (esp.) LTCM was immobilized by its size. Smaller positions in its bonds were being liquidated, if LTCM started to sell the effect on the prices (and on the value of the majority of the portfolio) could be devastating.

LTCM Policy ImplicationsLTCM Policy Implications

Central Bankers and even Pierpont Morgan have long felt compelled to inject liquidity into the financial system in times of crisis. Edwards notes FED policy in response to Penn Central’s bankruptcy in 1970, and the stock market crash of October, 1987.

In a disintermediated financial system, these liquidity crises are the new “bank runs.”

Hedge Funds—Post LTCMHedge Funds—Post LTCM

Tremont Advisers Inc is a big hedge fund investor and it maintains the TASS database on hedge funds. There were 805 funds at the end of 1993, managing less than $50 billion. This has grown steadily to 1999, when some 1,500 hedge funds managed $190 billion. Since 1999, the number of hedge funds has been flat, but the amount invested in hedge funds has continued to rise to around $280 billion. (These are the funds tracked by TASS—which estimates that there are an equal number of funds that they do not track.)

Hedge Funds of lateHedge Funds of late

Most hedge funds are relatively small. More than ½ of the TASS funds have less than $50 million (as of 7-31-2002). Less than 1/3 manage more than $100 million.

On July 31, 2002, 55% of the hedge funds were down for the year. Some analysts expressed concern that this situation could induce excessive risk taking (since the high-water mark means that the managers have little to lose from taking risky bets).