Mutual Funds Strategy Follows Structure


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  • There are lots of terms we use daily that have specific meanings so let’s start by reviewing the basics. It’s a phenonom of aggregated behavior. It’s massively redundant and robust. A willing group- think Russia’s attempt to create an market system or that bond auction that nobody wanted to use. So why is there a market for mutual funds?
  • Otherwise known as supply and demand. Markets are large aggregations of behavior relative to buying and selling. Micro decisions about the individual sale or purchase of securities (stocks or bonds) underpin the macro movements of capital. All pricing decisions are made relative to everything else. Pricing is a valuation in terms of money of (1) effort, (2) material, (3) resources, (4) time and utilities consumed, (5) risks incurred, and (6) opportunity forgone in production and delivery of a good or service. Capital movement in the marketplace is like a wave in football stadium rippling through the fans. Like the market place you had to pay to play or get into the stadium. For a full wave to happen everybody has to agree to stand up at the right time. If you buy the market As a single stock, you’re betting a individual fan stands up at the right time as the wave rolls by, As a mutual fund, you are hoping a whole section of fans stand up together at the right time, As the market through index funds- you’re betting on the whole wave so which fans stand up when doesn’t matter as long as they wave.
  • The marketplace has stocks, bonds etc. Why mutual funds? First attributed investment to King William I of the Netherlands and his wealthy friends. They made small investments in foreign government loans. Mention Bernstein and Risk By the late 1800’s investment companies were popular in England and Scotland. The companies organized a fund, sold the fund’s securities to the public and used the proceeds to acquire a managed portfolio of securities of actual (for example’s sake) manufacturing companies. The fund’s own shares then traded in the market at prices that reflected the supply and demand for the shares. These fund shares could be priced at a premium or discount to the underlying securities in the fund itself. Analogy is going out and buying the parts to make a meal or going and buying takeout- there are costs involved. In Britian, these companies were called investment trusts. I’ll explain more about trusts in a minute but first let’s consider review the mutual fund set up.
  • Neither sell nor buy more stocks and this is an example of a closed end investment company. Investment company itself has no employees only assets who belong to the owners. NAV =Net Asset Value. The dollar value of a single mutual fund share, based on the value of the underlying assets of the fund minus its liabilities, divided by the number of shares outstanding. Calculated at the end of each business day. Here’s an outline of a mutual fund organization but now we need to go back to talk trusts.
  • A lawyer described a trust to me as simply an imaginary bucket, a legal instrument into which assets are poured so they can be managed collectively under certain principles. As you can imagine you can put lots o f different things in the bucket and manage it by many different guidelines. For example there’s a blind trust which is a trust in which the beneficiaries do not have knowledge of the trust's specific assets, and in which a fiduciary third party has complete management discretion. Or The Rockefeller trust
  • If you remember I mentioned British Trusts were popular in the late 1880’s, popular like speculative bubble popular. After the market crashed in 1890 abuses came to light and trusts were forced to incorporate so there would be government oversight for protection of investors and promote an orderly market. The name changes to Investment Companies A unit investment trust (UIT) is a registered investment company that buys and holds a generally fixed portfolio of stocks, bonds, or other securities. "Units" in the trust are sold to investors (unitholders) who receive a share of principal and dividends (or interest). A UIT has a stated date for termination that varies according to the investments held in its portfolio. Investors who choose fixed-income UITs typically receive regular income, usually monthly. In contrast, investors holding bonds directly receive interest semiannually or even annually. Some publications, such as Barron's, call UITs "defined asset funds" and list prices weekly 1976 first index fund
  • Lack of disclosure- Bernie Madoff Diversification- Enron employees or tech bubble Leverage. 1998 Long Term Capital Management collapse, a hedge fund run by two Nobel Prize winning economists that had to be bailed out by the Federal reserve. As we will see the more things change the more they stay the same. These British Trusts were set up as closed end funds so lets look at those because they give rise to open end funds.
  • So you solve the problem of not being currently assessed by the market for value and you are free to extract yourself easily without having to find another investor to buy you out. These conditions create their own problems. Like for a run on a particular stock first one out takes all and the fund has to keep some money as cash to cover redemptions so you’re money is not working for you, it’s sitting around. If you keep offering new shares, the fund could balloon to such a market capitalization it’s not efficient on cost as well as what stocks it can buy but we will get to that later.
  • ETFs are more tax-efficient than normal mutual funds, and since they track indexes they have very low operating and transaction costs associated with them. There are no sales loads or investment minimums required to purchase an ETF but you do have to pay a commission to purchase shares. Now who do you trust to help you to pick out the right kind of investment/fund for you? Several years later came "Qubes" (so named because of their QQQQ ticker symbol), which track the 100 largest nonfinancial companies on the Nasdaq. Qubes were all the rage prior to the market's meltdown in early 2000 because of they contained some of the best-known and, at the time, highest-flying tech stocks. Today, by sifting through the offerings of the Big Kahunas in the ETF market -- State Street Global Advisors, Barclay's Global Fund Advisors and Vanguard -- you'll come across ETFs that track everything from the entire U.S. stock market to various slices of it: large stocks, small stocks, value, growth, energy, tech, utilities, REITs -- virtually any industry or sector of the market. Looking to invest "Over there"? You'll find ETFs that track developed foreign markets overall, individual countries (Austria, China, Malaysia and the United Kingdom to name a few) or even emerging markets. You can invest in ETFs that mirror the entire U.S. bond market, the corporate bond market, indexes of short-, intermediate or long-term Treasury bonds and TIPS (Treasury Inflation Protected Securities).
  • the term investment adviser is a legal term that refers to an individual or company that is registered as such with either the Securities and Exchange Commission or a state securities regulator. Common names for investment advisers include asset managers, investment counselors, investment managers, portfolio managers, and wealth managers. Investment adviser representatives are individuals who work for and give advice on behalf of registered investment advisers. You can look up ADV form at SEC public reference branch * Who regulates them: The SEC regulates investment advisers who manage $25 million or more in client assets. Advisers who manage less are regulated by the securities regulator for the state where the adviser has its principal place of business.
  • Stockbrokers are busy people so you probably end up talking to people who help the stockbroker. NYSE is an auction market, floor specialist, 9 ECN and NASDAQ is a dealer market, market maker. Stockbroker also called an account executive. Dealer buys at bid price and sells at asking price. Spread is profit to dealer. The lowest price for which any investor or dealer has declared that he/she will sell a given security or commodity. For over-the-counter stocks, the asking price is the best quoted price at which a Market Maker is willing to sell a stock. For mutual funds, the asking price is the net asset value plus any sales charges. also called asked price or offering price or ask. The highest price any buyer is willing to pay for a given security at a given time; also called bid price. Quoted bid is a maximum price that a market maker will pay for a security . Spread is difference between the current bid and the current ask (in over-the-counter trading ) or offered (in exchange trading) of a given security ; also called bid/ask spread . Full commission broker offers research, advice bundled into the commission Discount broker-offers back office facilities to independent and fee based investment advisers.
  • Registered representatives—who may also go by such generic titles as financial consultant, financial adviser, or investment consultant—are primarily securities salespeople.
  • Research part of brokerage or investment firm. CFA designation pushed by Benjamin Graham so a professional title existed like CPA, pass exams and years of training.
  • Underwriting is to guarantee to issuing corporation that security will be fully sold. Acting as adviser and salesman is conflict of interest.
  • The breadth and depth of services a financial planner offers will vary from provider to provider. Some create comprehensive plans that delve into every aspect of your financial life, including savings, investments, insurance, college savings, retirement, taxes and estate planning. Regulated only by the background from which they come. Having covered all the people involved in supporting the mutual fund industry lets look at mutual funds.
  • Sole responsibility of SEC is to protect investors interests. Big turf war between bankers and New Dealers. Market people wanted to have technical specialists in agency not politicians 1936 pass thru only for open funds, closed funds get it in 1940 No to proposed limitation on size of funds No to restriction on the number of funds owned by one person/firm Modified prohibitions on affiliations Permitted provision for fund organizations to establish sales load charged by broker-dealer (no undercutting).
  • No to proposed limitation on size of funds No to restriction on the number of funds owned by one person/firm Modified prohibitions on affiliations Permitted provision for fund organizations to establish sales load charged by broker-dealer (no undercutting). Several sections of ICA were so written in so complicated that they dropped them and left the SEC with the power to grant exemptions and set rules as needed to allow innovation. Will see that with insurance and banking trying to get money that will be poured into mutual funds
  • So what do mutual fund complexes look like today
  • Shareholders provide the capital to the fund and elect the board of directors who are paid by the fund “to serve the interests of the shareholders of the corporation” or govern the fund. 40% which should be independent of the mgmt company. The BOD establishes corporate management policy and makes decisions about major company issues like dividend policies and contracting with external management company. The Ex Mgmt Co runs the fund
  • Distributions on 1099 tax report two kinds - stock dividends, and bond interest
  • Mutual- fund family manages its own affairs though a separate management company 100% owned by the fund family. The officers and directors of both management company and mutual fund family are one and the same. Neither own stock in the management company. The fund directors take responsibility for management of the funds and the fund complex so only the interests of the fund shareholders are served. In a conventional stucture, the fund is a corporate shell and it’s only role to be the legal owner of a portfolio of investment securities. Control is effectively vested in the management company who formed the fund, select the directors and officers and performs all functions necessary to the funds existence. The management fee is an annual percentage of the funds assets.
  • A fund can call itself a no-load fund if 12b-1 fee is less than <.25%. So ask for a roundtrip cost. If you bought a $1 share today and sold it for a $1 tomorrow at constant NAV then it’s true no-load fund.
  • Vanguard called the “Wal-Mart” of the fund industry
  • Mutual Funds Strategy Follows Structure

    1. 1. Mutual Funds Strategy Follows Structure
    2. 2. Overview <ul><li>Markets & Mutual Funds </li></ul><ul><li>Players and Terminology </li></ul><ul><li>Government oversight </li></ul><ul><li>Fund structures </li></ul><ul><li>Fund expenses </li></ul>
    3. 3. What is a Market? <ul><li>A human invention for our collective use </li></ul><ul><li>No central control- it’s a distributed network. </li></ul><ul><li>It sets prices, distributes investment risk and provides capital to future business among a willing group of participants who want to maximize gain and minimize risk. </li></ul>
    4. 4. Price vs. Value <ul><li>Markets clear goods from the market place by auction- buy and sell </li></ul><ul><li>No two investors have the same information so they never value an item identically and this creates price differences </li></ul><ul><li>Price exists at the moment of completed sale of an item- an arbitrarily agreed upon value. </li></ul><ul><li>Low quality/high volume prices discounted </li></ul><ul><li>High quality/low volume prices at a premium </li></ul>
    5. 5. Why have Mutual Funds? <ul><li>A mutual fund provides small investors with the same diversification and professional management of investment available to a wealthy investor. </li></ul><ul><li>In 1822 the first investment company formed by King of Netherlands. A group of wealthy, interested people pooled their money to invest primarily in securities, thereby sharing the risk and rewards. </li></ul>
    6. 6. Wealthy Investor 10 investors Capital Fund Management Fund Management Fund Company Owner/Shareholders Stock 3 Stock 4 Stock 5 Stock 6 Stock 7 Stock 8 Stock 9 Stock 10 Portfolio of Securities NAV = $100 / 1 shareholder =$100 NAV = $100 / 10 shareholder =$10 Stock 2 Stock 1 Stock 3 Stock 4 Stock 5 Stock 6 Stock 7 Stock 8 Stock 9 Stock 10 Stock 2 Stock 1 hires
    7. 7. Terminology <ul><li>Trust </li></ul><ul><li>1) A legal arrangement in which an individual (the trustor) gives fiduciary control of property to a person or institution (the trustee) for the benefit of beneficiaries. </li></ul><ul><li>2) A monopolistic corporation, prior to the enactment of antitrust laws. </li></ul>
    8. 8. Pooled Investment Vehicles <ul><li>Investment Trusts (British late 1800’s) </li></ul><ul><li>Investment Companies (regulation- incorporated) </li></ul><ul><li>Investment Funds (America in 1920s) </li></ul><ul><li>Mutual Investment Funds </li></ul><ul><li>Mutual Funds </li></ul><ul><ul><li>Closed End Funds </li></ul></ul><ul><ul><li>Open End Funds </li></ul></ul><ul><ul><li>Unit Investment Trusts (Money market funds) </li></ul></ul><ul><ul><li>Fixed Trusts </li></ul></ul><ul><ul><li>Exchange Traded Funds (ETF) </li></ul></ul><ul><ul><li>Hedge Funds </li></ul></ul><ul><ul><ul><li><100 shareholders or knowledgeable, wealthy investors $MM </li></ul></ul></ul>
    9. 9. Fund Abuses of 1880s <ul><li>Lack of Disclosure </li></ul><ul><li>Insufficient portfolio diversification </li></ul><ul><li>Excessive leverage by borrowing through: </li></ul><ul><ul><li>Issue of senior securities </li></ul></ul><ul><ul><li>Funds engaging in underwriting and non investment activities </li></ul></ul><ul><ul><li>Issue cheap “founder’s shares” to funds promoters </li></ul></ul>
    10. 10. Closed End Funds <ul><ul><li>Do not offer new shares continuously. </li></ul></ul><ul><ul><li>To buy in, you must find an current shareholder willing to sell their shares. </li></ul></ul><ul><ul><li>2) Fund shares of portfolio traded in market at more or less than liquidation value of the portfolio of securities </li></ul></ul><ul><ul><li>$100 portfolio of 5 shares, each share = $20 </li></ul></ul><ul><ul><li>if selling for $23, premium is $3 </li></ul></ul><ul><ul><li>if selling for $18, discount is $2 </li></ul></ul>
    11. 11. Open End Funds <ul><ul><li>Offer redemption of shares at any time. Receive proceeds based on current value of portfolio at the end of the day. </li></ul></ul><ul><ul><li>Continuously offer new shares to investors </li></ul></ul>
    12. 12. Exchange Traded Funds <ul><ul><li>ETFs always bundle together the individual securities that are in an particular index of virtually any industry or sector of a market. ETF’s track that index and can be traded like a stock </li></ul></ul><ul><ul><li>Institutional investor purchases a pre-specified basket of securities. A creation unit of ETF is produced that the investor then can sell or hold their at anytime of day like a stock share. Retail investors buy an interest in the unit. </li></ul></ul><ul><ul><li>The first ETF created was the Standard and Poor's Deposit Receipt (SPDR, pronounced &quot;Spider&quot;) in 1993. SPDRs gave investors an easy way to track the S&P 500 without buying an index fund. On NASDAQ, it was “Qubes” for QQQQ ticket symbol </li></ul></ul>
    13. 13. Advice -Trust but Verify <ul><li>Investment Adviser (Counsel) / Trust Services of Banks </li></ul><ul><li>Conservative, Competent, Defensive </li></ul><ul><li>For investors with >$5M; Substantial annual fees </li></ul><ul><li>Registered Investment Adviser (RIA) – is listed with SEC and in states they do work. They manage assets worth >25 M and >100 clients. Should provide a Part II Form ADV which summarizes background and fees. </li></ul><ul><li>Financial Services Advisers </li></ul><ul><li>Newsletters & Statistical Information </li></ul><ul><li>Standard & Poor, Moody’s, Morningstar; Subscription fees </li></ul>
    14. 14. Advice -Trust but Verify <ul><li>Brokerage (Wire) Houses / Firms </li></ul><ul><ul><li>Stockbroker must be member of a SEC registered exchange (NYSE,NASDAQ, Regional or Int’l Exchanges) </li></ul></ul><ul><ul><li>broker/dealer is any individual or firm in the business of buying and selling securities for itself and others </li></ul></ul><ul><ul><ul><ul><li>When acting as a broker, a broker/dealer executes orders on behalf of his/her client. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>When acting as a dealer, a broker/dealer executes trades for his/her firm's own account. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Securities bought for the firm's own account may be sold to clients or other firms, or become a part of the firm's holdings. </li></ul></ul></ul></ul>
    15. 15. Advice -Trust but Verify <ul><li>Individuals who work for broker-dealers: </li></ul><ul><li>sales personnel whom most people call brokers are technically known as registered representatives (RR). </li></ul><ul><li>When a RR suggests that you buy or sell a particular security, they must have reason to believe that the recommendation is suitable for you based on a host of factors, including your income, portfolio, and overall financial situation, your tolerance for risk, and your stated investment objectives. </li></ul><ul><li>The products they can sell depend on SEC licenses they hold. </li></ul><ul><ul><li>A RR with a Series 6 license can sell only mutual funds, variable annuities, and similar products. </li></ul></ul><ul><ul><li>A RR with a Series 7 license can sell a broader array of securities. </li></ul></ul>
    16. 16. Advice -Trust but Verify <ul><li>Individuals who work for broker-dealers: </li></ul><ul><li>Financial Analyst /Security Analyst </li></ul><ul><ul><li>Performs detailed studies of individual securities and forms a judgment on their value as a stock price forecast (not business analysis) </li></ul></ul><ul><ul><li>No formal requirements for training but generally have a business school training or equivalent. Often CFA </li></ul></ul><ul><ul><li>Usually only speak to institutional or wealthy investors directly </li></ul></ul>
    17. 17. Advice -Trust but Verify <ul><li>Investment Banker/Firm </li></ul><ul><li>Supplies new capital for expansion of industry </li></ul><ul><li>Engages in originating, underwriting, and selling new issues of securities </li></ul><ul><li>Normally sells to professional investor who is prudent and shrewd. </li></ul>
    18. 18. Advice -Trust but Verify <ul><li>“Financial planners” </li></ul><ul><li>Come from a variety of backgrounds and offer a variety of services. They could be brokers or investment advisers, insurance agents or practicing accountants—or they have no financial credentials at all. </li></ul><ul><li>Some will examine your entire financial picture and help you develop a detailed plan for achieving your financial goals. </li></ul><ul><li>Others will recommend only the products they sell, which may give you a limited range of choices. </li></ul><ul><ul><li>* CFP Certified Financial Planner </li></ul></ul><ul><ul><li>* CFA Chartered Financial Analyst </li></ul></ul>
    19. 19. Government Regulation of Abuses <ul><li>1924 First American open end mutual funds created </li></ul><ul><li>1929 American Market Crash </li></ul><ul><li>Securities Act of 1933 “Truth in Securities” Law </li></ul><ul><ul><li>Fund must provide prospectus with financial, management, and information to investors. Laws for selling fraudulent securities made </li></ul></ul><ul><li>Securities Act of 1934 </li></ul><ul><ul><li>Creates the Securities and Exchange Commission (SEC) with authority over securities industry to oversee, regulate, register clearing agencies, brokerage firms, transfer agent and SRO (self regulating organizations) like NYSE, AMEX, and later NASDAQ. </li></ul></ul><ul><li>Revenue Act of 1936 </li></ul><ul><ul><li>Investment companies pass through dividends to shareholders who pay tax. To prevent speculation no more than 30% of fund’s gross income could be derived from sale of securities held less than 3 months. Company could hold no more than 5% of assets in one company. </li></ul></ul>
    20. 20. Government Regulation of Abuses <ul><li>Investment Advisers Act of 1940 </li></ul><ul><ul><li>Individuals and firms dealing in advice for compensation must register with the SEC. (amended 1996- 25M under management to register) </li></ul></ul><ul><li>Investment Company Act of 1940 </li></ul><ul><ul><li>Company must provide information to investors about their investment policies and financial condition upon original sale and then regular basis </li></ul></ul><ul><li>Securities Investor Protection Act of 1970 </li></ul><ul><ul><li>Establishes Securities Investor Protection Corporation (SPIC) to protect investors from a failed brokerage firm. If cash or securities are missing from an account (except fraudulent securities) most investors get their money back. </li></ul></ul><ul><li>Securities Act Amendments of 1975 </li></ul><ul><ul><li>SEC directed to establish National Market System for OTC Trading </li></ul></ul>
    21. 21. Government Regulation of Abuses <ul><li>1976 SEC rule change- lifted federal law prohibiting tax exempt mutual funds by allowing dividend pass through on municipal funds </li></ul><ul><li>1980 SEC rule change- 12b-1 rule. </li></ul><ul><ul><li>Funds allowed to pay for distribution expenses out of funds. Old shareholders now paying for newly added shareholders. </li></ul></ul><ul><li>Insider Trading Sanctions Act of 1984 </li></ul><ul><ul><li>SEC can fine insider trading to triple of profits </li></ul></ul><ul><li>Insider Trading Act of 1988 </li></ul><ul><ul><li>More punishments for insider trading and pay for whistleblower </li></ul></ul><ul><li>Sarbanes-Oxley Act of 2002 </li></ul><ul><ul><li>Creates the public company accounting oversight board. </li></ul></ul><ul><ul><li>The auditing profession is not to engage in fraud. </li></ul></ul>
    22. 22. Typical Mutual Fund Complex Mutual Fund Board of Directors/ Trustees Shareholders Investment Adviser Principal Underwriter Transfer Agent Administrator Custodian Independent Public Accountant Attorney/Legal Officers
    23. 23. External Management Company <ul><li>Runs the fund for a fee </li></ul><ul><ul><li>Covers office costs </li></ul></ul><ul><ul><li>Hires investment adviser </li></ul></ul><ul><ul><li>Handles distribution services </li></ul></ul><ul><ul><ul><li>Commissions & fees paid to broker-dealers for selling fund shares </li></ul></ul></ul><ul><ul><ul><li>Marketing services- branding, direct mail, literature, promotions </li></ul></ul></ul><ul><ul><li>Custodial </li></ul></ul><ul><ul><ul><li>Operations: account tracking and maintenance, compliance, prospectus printed </li></ul></ul></ul><ul><ul><li>Administration </li></ul></ul><ul><ul><ul><li>bookkeeping, banking, insurance, forecasting, </li></ul></ul></ul>
    24. 24. Capital flow in a Mutual Fund Mutual Fund Assets Shares redeemed Shareholders & Shares purchased Dividend (stocks) Interest (bonds) Realized capital gains from securities sold Expenses not covered By Mgmt fee Commissions, loads & 12b-1 fees Portfolio trading costs from turnover~ 0.25-3% Management Fee 1-1.5% annual Capital gains paid out
    25. 25. Mutual Ownership Structure vs. Traditional Corporate Structure own Fund Shareholders Mutual Mutual Funds Mutual Funds Management Company Traditional own own controls own Mgmt. Co. Shareholders Management Company Fund Shareholders Bogle p. 376
    26. 26. Purchasing Funds <ul><li>Direct purchase </li></ul><ul><li>From Salespeople (Broker, RR) </li></ul><ul><ul><li>Method determines how they get paid </li></ul></ul><ul><ul><li>A shares- Front end load. Charge up to 8.5% of sale </li></ul></ul><ul><ul><ul><ul><ul><li>Breakpoints for larger investments </li></ul></ul></ul></ul></ul><ul><ul><li>B shares- Back end surrender charges. 12b-1 fees </li></ul></ul><ul><ul><ul><li>If investor sold shares before commission paid off, usually at 1.5% to fund annually, get charged for commission & interest </li></ul></ul></ul><ul><ul><li>C shares- Back end load. Pay charges after redeem </li></ul></ul><ul><ul><li>D shares- 1% paid to salesperson each year </li></ul></ul>
    27. 27. Expense Ratios for Portfolios 1999 <ul><li>low avg high </li></ul><ul><li>Equity MF 0.2% 1.5% 2.2% </li></ul><ul><li>Balanced MF 0.2% 1.4% 1.8% </li></ul><ul><li>Bond MF 0.2% 1.1% 1.5% </li></ul><ul><li>Pension Fund 0.3% 0.7% 1.0% </li></ul>Bogle
    28. 28. 2008 Expense Ratios <ul><ul><li>Avg Avg </li></ul></ul><ul><ul><li>Vanguard Industry </li></ul></ul><ul><li>Active Funds 0.23% 1.32% </li></ul><ul><li>Index Funds 0.18% 0.95% </li></ul><ul><li>ETF 0.15 0.60% </li></ul>Barron’s, 1/12/2009, Market Funds 4Q08, p2
    29. 29. Book References <ul><li>Common sense on mutual funds: New imperatives for the intelligent investor; John C. Bogle, 2000 </li></ul><ul><li>The rise of mutual funds: an insider’s view; Matthew P. Fink, 2008 </li></ul><ul><li>Stop wasting your wealth in mutual funds; Separately managed Accounts: the smart alternativ, Don F. Wilkinson, 2005. </li></ul><ul><li>How markets really work; Joel Kurtzman, 2002 </li></ul><ul><li>Complete guide to online investing: everything you need to know explained simply; Michelle Dawn Hooper, 2008 </li></ul><ul><li>Against the gods: the remarkable story of risk; Peter L. Bernstein, 1996 </li></ul>