Current Issues in Financial Institutions and Financial Markets

1
Current Issues in Financial Institutions and
Financial Markets

• Mutual Funds
• U.S. Securities Markets

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Mutual Funds Temporary Problem or Permanent
Morass? By Paula Tkac

• Background
• What were the issues uncovered in fall 2003 that
  is associated with the scandals in the mutual
  fund industry?
• Late Trading
• Market Timing
• What are each? Explain.

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Outline of Tkac Article

• Whose Money is it anyway?
• Conflicts of Interest
• Unequal risk tolerance
• Gaming investor flow patterns
• Cross-subsidization
• Whats the harm?
• Methods of reducing conflicts of interest and
  proposed legislation and regulation
• Compensation-based solutions
• Separation of functions
• Proposed regulation and legislation
• Monitoring and information disclosure
• The powers of investors
• Conclusion

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Whose money is it anyway?

• Two views mutual fund shareholders as owners of
  the fund or as customers of the fund.
• Both views have validity and help understand
• The owners view treats fees as charged out of
  investors assets
• The customers view treats fees as being paid for
  a service. In this case, investors can be viewed
  as being equipped to help mitigate and protect
  themselves against conflicts of interest. They
  can fire the investment advisor if not getting
  the services they need.
• Are fees too high?

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Conflicts of Interest

• The mutual fund shareholder and the investor
  advisor represents a classic principal-agent
  problem. As a shareholder you would like the
  investment advisor to maximize his/her investment
  returns for an acceptable level of risk, but the
  advisor can be expected to operate in his/her own
  best interest.
• The two parties have differing objectives.
  Something quite common in our financial system.

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Investment Advisory Compensation

• The standard mutual fund compensates the
  investment adviser with a fixed percentage of
  assets under management (AUM), e.g. 0.01 of AUM.
• Viewed as a step to align adviser and investors
  interests. But not perfect.

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Unequal risk tolerance

• If the risk tolerances of the investor and the
  advisory firm differ, the adviser has an
  incentive to pursue and risk-return strategy of
  his/her liking, not that of the investor.

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Gaming investor flow patterns

• Advisers might market themselves as one style
  while pursuing another style altogether. In
  others words, they might lie to investors for
  their own benefit.
• In this case investors will not be getting what
  they think they are buying.

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Cross-subsidization

• Some mutual funds allowed market timing in some
  funds in return for the timing shareholders
  agreeing to park funds in other funds with the
  same adviser.
• This was generally against the prospectus of the
  fund, but the adviser saw benefits to him/her
  self arising from turning their head.

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Whats the harm?

• What are fund investors losing?
• In most cases there is no out-of-pocket costs,
  only opportunity costs.
• Investor costs of market timing
• 1. Additional cost of managing more volatile cash
  flows.
• 2. Dilution effect due to fund holding more cash.

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Proposed Legislation and Regulation

• Compensation-based solution.
• It is not likely that explicit performance-based
  fees will solve the problem. Very difficult to
  find benchmark that represents all investors.
• Separation of functions
• Allow advisory firms to advise only one mutual
  fund.
• Contrary to economies of scale in this industry
• Proposed regulation and legislation
• 75 independent directors
• Elimination of 12b-1 fees (Professor Dukes!)
• Tkac is against this proposal. Arguing investors
  get something for this fee.
• Eliminate soft dollar brokerage agreements.
• Tkac doesnt see this as useful.
• Monitoring and Information Disclosure
• Monitoring is a classic solution to
  principal-agent problems.
• Increased information disclosure might be costly
  and might destroy advisers human capital. There
  is a rich industry of information intermediaries
  available like Morningstar, Lipper and Money
  magazine.
• This information should allow investors to
  discipline managers of mutual funds.

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The Power of Investors

• Investors, as demanders of advisory services,
  can pressure advisers to deliver the services
  they prefer at prices they are willing to pay.
• Evidence that fund flows follow performance
• Evidence doesnt show that fees greatly effect
  fund flows.
• Putnam, Janus, and Invesco experienced 42
  billion in net outflows following market timing
  charges, losing 63 million in revenue in
  management fees.

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Conclusion

• Temporary problem charges of market timing and
  late trading. Investor scrutiny will temper this
  behavior even in the absence of new regulations.
• Permanent morass There will never be a complete
  alignment of advisers and investors interests.
  But, investors, as customers of mutual fund
  services can influence this behavior by their own
  demand.

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Securities Markets

• Searching for a New Center U.S. Securities
  Markets in Transition, Maureen OHara
• National Market System, NMS, envisioned a market
  characterized by a single, dominant exchange
  competing via market linkages with several
  smaller regional exchanges with self regulation.
• ECNs electronic communications networks like
  Instinet, are new to the securities markets

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Outline Searching for a New Center U.S.
Securities Markets in Transition, OHara

• Introduction
• Old visions, new realities
• Structural Issues
• How should markets compete?
• How should markets be linked?
• How should markets be regulated?
• Conclusion

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Old visions, new realities

• One single market one proposal would be a
  consolidated limit order book, CLOB.
• Never implemented. We have an intermarket trading
  system instead. Orders first routed to an
  exchange and then sent to another market quoting
  a better price. As long as the better price is
  offered the order can be executed on the original
  exchange.
• ECNs are essentially electronic limit order books
  that allow customers to interact with each other.
  This is attractive to day traders. Results in
  small bid-ask spreads, but large institutional
  traders may be more concerned with price impact
  of their trades and dont like ECNs.
• ECNs are generally privately owned. A new
  structure in exchanges.

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Old visions, new realities

• Another new reality is a worldwide shift of
  exchanges to public ownership.
• Raises concerns about self-regulation.
• In summary, the current realities of the market
  are far removed from the visions that created in
  with NMS.

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How should markets compete?

• Priority rules
• A trader wishing to buy (sell) stock pays the
  lowest (highest) available price.
• But what about price impact?
• Or, what about speed of execution? Doesnt this
  matter?
• This has resulted in a couple of exceptions to
  priority rule
• 1 to 5 cent limit
• Trader may opt out.
• Tape revenue CTA collects and sells data from
  exchanges and markets. Raises questions about
  revenue sharing.

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How should markets be linked?

• Who can place orders?
• Who can access orders?
• How easy is it for orders to be placed and
  accessed?
• Access fees?

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How should markets be regulated?

• Why have stock exchanges converted from
  member-owned coops to publicly traded
  corporations?
• Access to capital.
• Greater efficiency in operation
• Increasing heterogeneity of members interests
• Regardless self regulation is likely to be less
  viable with such ownership structures

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Conclusions regarding securities markets in the US

• Regulation NMS is dated. We need a new vision,
  rather than a piecemeal approach of making
  changes.
• The new reality is that markets are technology
  driven, fragmented and highly competitive.