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  1. 1. Chapter 25 Contemporary Issues in Portfolio Management Portfolio Construction, Management, & Protection , 5e, Robert A. Strong Copyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.
  2. 2. <ul><li>There are clearly some real bad people out there who have done bad things, but there are also 15,000 companies out there, the great majority of which are run by honest people. Having said that, there has been a general erosion of professional standards [fueled by] an attitude that “everybody else is doing it” and a perceived need to meet quarterly earnings numbers. We’ve got to get back to an honest approach and a broad-gauged concept of what we really mean by management performance. </li></ul><ul><li>William Donaldson, Chairman, Securities & Exchange Commission </li></ul>
  3. 3. Introduction <ul><li>Some contemporary issues are factual: </li></ul><ul><ul><li>The rising importance of Exchange-Traded Funds </li></ul></ul><ul><ul><li>Increasingly common practice of certificateless trading </li></ul></ul><ul><ul><li>Integration of Islamic society, and Shariah law which does not permit paying or receiving interest, into the global marketplace </li></ul></ul><ul><li>Some contemporary issues are controversial: </li></ul><ul><ul><li>Security analyst objectivity has been the subject of numerous Congressional hearings </li></ul></ul><ul><ul><li>Stock lending and program trading have image problems </li></ul></ul><ul><ul><li>Derivatives are not permitted in some portfolios </li></ul></ul>
  4. 4. Exchange-Traded Funds <ul><li>Portfolio of stocks, bonds, futures, or other assets that trade throughout the day </li></ul><ul><li>Mutual fund exchanges only take place at the end-of-day net asset value </li></ul><ul><li>In March 2008, there were 644 ETFs with $571 billion in the United States </li></ul><ul><li>ETFs provide transparency and liquidity </li></ul><ul><ul><li>Portfolio contents are published </li></ul></ul><ul><ul><li>Investors can exit at any given time </li></ul></ul>
  5. 5. Security Analyst Objectivity <ul><li>There is a theoretical “fire wall” between the investment banking function of an investment house and its research department </li></ul><ul><ul><li>A conflict of interest may arise if an investment bank is courting a firm for some underwriting business at the same time that its analysts are developing an investment opinion </li></ul></ul><ul><ul><li>In the late 1990s, less than 2 percent of analyst opinions were “sell” </li></ul></ul>
  6. 6. Security Analyst Objectivity (cont’d) <ul><li>In 2001 and 2002, there were some highly visible breaches of this fire wall </li></ul><ul><li>In March 2002, the NASD filed rules with the SEC that address the lack of objectivity </li></ul><ul><li>The CFA Institute issued a document on Research Objectivity Standards for public comment </li></ul><ul><li>The SEC adopted Regulation Analyst Certification in April 2003 </li></ul><ul><ul><li>Requires analysts to certify that their reports reflect their opinions and not someone else’s </li></ul></ul>
  7. 7. Stock Lending <ul><li>Stock lending : </li></ul><ul><ul><li>Is the practice by which one institution loans stock to another institution </li></ul></ul><ul><ul><li>Is often used to support short-selling by customers of the second institution </li></ul></ul><ul><ul><li>Can earn substantial income with very little risk </li></ul></ul>
  8. 8. Stock Lending (cont’d) <ul><li>Stock lending is similar to a repurchase agreement: </li></ul><ul><ul><li>The institution wanting to borrow stock </li></ul></ul><ul><ul><ul><li>Puts up collateral (about 102 percent of the securities lent) </li></ul></ul></ul><ul><ul><ul><li>Agrees to return the securities at a later date </li></ul></ul></ul><ul><ul><li>The lender can earn interest on the cash collateral </li></ul></ul>
  9. 9. Mechanics of a Short Sale <ul><li>A short sale : </li></ul><ul><ul><li>Involves borrowing securities from someone </li></ul></ul><ul><ul><li>Selling the securities to another market participant </li></ul></ul><ul><ul><li>Eventually purchasing shares from another market participant and </li></ul></ul><ul><ul><li>Returning the substitute shares to the original lender </li></ul></ul>
  10. 10. Mechanics of a Short Sale (cont’d) <ul><li>A short sale is normally motivated by a bearish sentiment </li></ul><ul><li>The actual lender in a short sale is normally an unknowing participant </li></ul><ul><ul><li>A hypothecation agreement gives the broker the right to lend shares to someone else </li></ul></ul><ul><ul><ul><li>The investor can still trade the shares and continues to earn dividends </li></ul></ul></ul>
  11. 11. Mechanics of a Short Sale (cont’d) <ul><li>The short seller: </li></ul><ul><ul><li>Has an obligation to return what was borrowed at some point in the future </li></ul></ul><ul><ul><li>Must pay dividends to the lender </li></ul></ul><ul><ul><li>Eventually covers the short by repurchasing shares to replace the shares borrowed earlier </li></ul></ul><ul><ul><ul><li>If the purchase price is below the selling price, the short seller makes a profit </li></ul></ul></ul>
  12. 13. How a Stock Lending Transaction Works <ul><li>If the customer wants to short sell: </li></ul><ul><ul><li>The brokerage firm first checks if other customers have the stock in their margin accounts </li></ul></ul><ul><ul><li>The brokerage firm may use a stock loan finder to locate another firm with the needed shares </li></ul></ul><ul><ul><li>The first firm deposits collateral with the second firm (T-bills or cash) </li></ul></ul><ul><ul><ul><li>Part of the interest is used to pay a finder’s fee to the stock loan finder </li></ul></ul></ul>
  13. 14. Advantages of Stock Lending <ul><li>Stock lending is very lucrative </li></ul><ul><ul><li>In 1999, the total income to stock lenders approached $1 billion </li></ul></ul><ul><ul><li>In 2005, over $2.4 billion of short-term bonds </li></ul></ul><ul><li>Stock lending can be used by brokerage firms to finance the margin purchases of their customers </li></ul><ul><li>Stock lending is popular when markets see increased merger and acquisition activity: </li></ul><ul><ul><li>Merger arbitrage involves buying shares of likely takeover candidates and short selling shares of the anticipated acquirer </li></ul></ul>
  14. 15. Disadvantages of Stock Lending <ul><li>A customer potentially gives up the right to vote: </li></ul><ul><ul><li>The short seller is essentially a negative owner </li></ul></ul><ul><li>Some risk is associated with the possibility that the stock borrower might not return the securities </li></ul><ul><ul><li>Stock loans are “marked to market” </li></ul></ul>
  15. 16. Regulatory Concerns <ul><li>Stock lending does technically not fall under SEC jurisdiction </li></ul><ul><ul><li>Does not involve the purchase or sale of securities </li></ul></ul><ul><li>A possible area of abuse lies in the lending of shares in cash accounts </li></ul><ul><ul><li>Cash account holders do not sign hypothecation agreements </li></ul></ul>
  16. 17. Certificateless Trading <ul><li>The difference in settlement procedures across countries can cause significant problems </li></ul><ul><ul><li>e.g., U.S. settlement takes 3 business days versus 6 weeks in France </li></ul></ul><ul><li>Computer automation makes it possible to process some types of transactions almost immediately </li></ul><ul><ul><li>e.g., newly issued U.S. government bonds are registered in book entry form only and can be transferred from buyer to seller with a few strokes at the keyboard </li></ul></ul>
  17. 18. Proxy Voting <ul><li>Two Corporate Governance Questions getting Attention: </li></ul><ul><ul><li>Do withheld vote count as votes against a candidate for a board of directors? </li></ul></ul><ul><ul><li>Are the CEO and Chairman of the Board separate individuals? </li></ul></ul>
  18. 19. Majority Trading (cont’d) <ul><li>Historically, individual investors did not return proxy ballots </li></ul><ul><li>Today, 45% of individuals and nearly all institutional investors return proxy ballots </li></ul><ul><li>Over half the companies in the S&P 500 index have adopted a majority voting provision </li></ul><ul><ul><li>Only 16% had such a provision as recently as February 2007 </li></ul></ul>
  19. 20. Separation of Board Chairman and CEO (cont’d) <ul><li>Historically, 22 percent had separate individuals as board chairmen and CEO </li></ul><ul><li>Today, the number is up to 36 percent </li></ul><ul><li>The importance arises from the fact that the Board of Directors looks out for the best interests of the shareholders </li></ul>
  20. 21. Role of Derivative Assets <ul><li>People think derivatives are speculative </li></ul><ul><li>Various exchanges offer seminars on ways in which derivative assets can be used in conservative portfolios </li></ul><ul><ul><li>e.g., risk management conferences by CBOE, CBOT, CME, LIFFE </li></ul></ul><ul><ul><li>Derivative asset education is designed to give people more choices </li></ul></ul>
  21. 22. Getting Board Approval <ul><li>Once the portfolio manager is convinced of futures and/or options, he must convince: </li></ul><ul><ul><li>Boards of trustees </li></ul></ul><ul><ul><li>Supervisors </li></ul></ul><ul><ul><li>Fund beneficiaries </li></ul></ul><ul><li>The manager should be able to explain the merits of derivatives using everyday language </li></ul>
  22. 23. Portfolio Margining <ul><li>Margin is a sum of money invested as a good faith deposit </li></ul><ul><ul><li>Improving the chance that any losses will be paid </li></ul></ul><ul><li>Historically, margins amount were based on portfolio asset positions individually </li></ul><ul><ul><li>Risk of loss in portfolios with off-setting positions is limited </li></ul></ul><ul><li>Today, institutional investors and individuals with large portfolios are allowed to post margins based upon net losses arising from the interaction of securities </li></ul><ul><ul><li>Less money has to be put into performance bonds </li></ul></ul><ul><ul><li>Leaves more money for additional investment </li></ul></ul>
  23. 24. Islamic Finance <ul><li>Islamic law, or Shariah, forbids: </li></ul><ul><ul><li>Paying or receiving interest </li></ul></ul><ul><ul><ul><li>Hence, Most Muslims rent </li></ul></ul></ul><ul><ul><li>Investment in firms dealing in interest products (like banks) </li></ul></ul><ul><ul><li>Investment in firms dealing with alcohol, tobacco, gambling, pornography, or defense </li></ul></ul><ul><li>Muslims enter into somewhat elaborate “partnerships” with banks to purchase homes </li></ul><ul><ul><li>Instead of paying interest, they buy out the bank’s ownership position over time </li></ul></ul>
  24. 25. Structured Finance <ul><li>Generally include options and futures to alter the risk and return characteristics of some portfolio </li></ul><ul><li>Examples include: </li></ul><ul><ul><li>Selling a call (for revenue) and holding the stock </li></ul></ul><ul><ul><li>Shorting a stock and buying a call </li></ul></ul><ul><ul><ul><li>The combination acts like a put </li></ul></ul></ul><ul><li>U.S. investors are less likely to invest in structured products </li></ul><ul><ul><li>30% of European and Asian portfolios consist of structured products </li></ul></ul>
  25. 26. Chartered Financial Analyst Program <ul><li>The Chartered Financial Analyst program began in 1959 when the Institute of Chartered Financial Analysts (ICFA) was formed </li></ul><ul><ul><ul><li>Promotes investment education and ethical behavior </li></ul></ul></ul><ul><ul><ul><li>Awarded the first charter in 1963 </li></ul></ul></ul><ul><li>The Financial Analysts Federation (FAF) merged with the ICFA in 1990 to form the Association for Investment Management and Research (AIMR) </li></ul>
  26. 27. The CFA Program Exams <ul><li>To earn the CFA designation, candidates must pass three separate exams taken at least a year apart </li></ul>
  27. 28. The CFA Program Exams (cont’d) <ul><li>Level I is entirely item sets </li></ul><ul><ul><li>Covers basic tools and inputs to the investment valuation process </li></ul></ul><ul><li>Level II is also entirely item sets </li></ul><ul><ul><li>Emphasizes security valuation and specialized topics </li></ul></ul>
  28. 29. The CFA Program Exams (cont’d) <ul><li>Level III is essay, valuation, analysis, and item sets </li></ul><ul><ul><li>Covers portfolio management </li></ul></ul>
  29. 30. CFA Program Themes <ul><li>Competence </li></ul><ul><li>Presentation Standards </li></ul><ul><li>Fiduciary Duties </li></ul><ul><li>Ethics </li></ul>
  30. 31. Competence <ul><li>People who complete the CFA program are technically very competent and are likely to keep their noses clean during their professional careers </li></ul>
  31. 32. Presentation Standards <ul><li>CFA candidates learn state-of-the-art standards and may prepare their own reports in accordance with CFA Institute requirements </li></ul><ul><li>From a fiduciary perspective, compliance with CFA Institute requirements is on its way to being mandatory </li></ul>
  32. 33. Fiduciary Duties <ul><li>Fiduciary duties require conduct that: </li></ul><ul><ul><li>Is in the individual client’s best interest </li></ul></ul><ul><ul><li>Is fair to the collective group of all clients </li></ul></ul><ul><li>Research reports are an important part of fiduciary duties </li></ul>
  33. 34. Ethics <ul><li>The coverage of ethics in the CFA program is very useful: </li></ul><ul><ul><li>For example: </li></ul></ul><ul><ul><ul><li>Analysts must distinguish between fact and opinion </li></ul></ul></ul><ul><ul><ul><li>Research reports should be objective, unbiased, and have a reasonable basis </li></ul></ul></ul><ul><ul><ul><li>Bigger clients should not be given preferential treatment </li></ul></ul></ul>
  34. 35. Regulation Fair Disclosure <ul><li>Regulation FD was approved by the SEC in August 2000 </li></ul><ul><li>The key provision: </li></ul><ul><ul><li>Prevents companies from giving material information to security analysts, mutual funds, or institutional investors unless the company simultaneously issues the same information to the general public </li></ul></ul>
  35. 36. The SEC Position <ul><li>The purpose of Regulation FD is: </li></ul><ul><ul><li>To increase the quantity and quality of available information to investors </li></ul></ul><ul><ul><li>To eliminate what some perceive as an unfair advantage historically enjoyed by Wall Street’s big guns </li></ul></ul>
  36. 37. The Industry Position <ul><li>Evidence indicates that less information is available to the public: </li></ul><ul><ul><li>Companies are reluctant to answer questions not publicly answered before </li></ul></ul><ul><ul><li>Companies have begun to provide less information between quarterly reports </li></ul></ul><ul><ul><li>Quarterly conference calls between firms and the brokerage industry have become scripted </li></ul></ul>
  37. 38. CFA Institute Response <ul><li>CFA Institute study when Regulation FD was first announced anticipated that: </li></ul><ul><ul><li>“to avoid any possible SEC enforcement actions, corporations will reduce their communications to ‘sound bites’ and ‘boilerplate’ disclosures, which contain little information to analysts and the public at large” </li></ul></ul>
  38. 39. CFA Institute Response (cont’d) <ul><li>CFA Institute study one year later found that: </li></ul><ul><ul><li>“while the overall goal of providing small investors and investment professionals with the same information is being achieved, it has been at the cost of less information in terms of quantity and quality” </li></ul></ul>
  39. 40. The Future of the Regulation <ul><li>SEC Commissioner Laura Unger’s recommendations regarding Regulation FD: </li></ul><ul><ul><li>The SEC should provide more guidance on materiality </li></ul></ul><ul><ul><li>The SEC should make it easier for issuers to use technology to comply with Regulation FD </li></ul></ul><ul><ul><li>The SEC should analyze what issuers are saying post-FD </li></ul></ul>