Sunday, March 17, 2013

Governmental ‘Good Efforts’ and their Unintended Consequences

All too often what is intended to be good works by members of government lead to significantly more powerful consequences to the unsuspecting beneficiaries of institutional investment. This reaction holds true for the present day and future implications of actions that took place in 1830 in Massachusetts and this week in Washington.

The “Prudent Man Rule” causing investment mistakes

In 1830 Judge Putnam found against Harvard College in how the college's endowment was invested. He held that a trustee should invest the funds that he is responsible for as other men of intelligence and prudence invest their own funds. In our more politically correct world this precept is now entitled “The Prudent Person Rule” and has been adopted as dictum for institutional investment. This concept has been particularly helpful to me in building my commercial career as it introduced the “need for peer related comparisons.” This was the legal basis for me to begin to sell the Lipper Mutual Fund Performance Analysis which in turn led to further performance, fee and expense, and portfolio analyses.

Now that I serve on various non-profit investment committees and have some as fee paying clients, I perceive that the prudent person rule can lead to significant losses. Note that the good judge’s words did not define prudence, only how to compare it. The rule suggests that to avoid being found to be imprudent one needs to do what others do with their investment portfolios. In many fields of human endeavor being part of a crowd is comforting. Any serious history of investments (particularly of major declines) will conclude that being with the crowd is to lose substantial amounts of money and perhaps more importantly the confidence to take advantage of rare opportunities that only occur at the emotional bottom of a market. Further, the courage at the top of a market to take different actions than the crowd can be the savior of various non-profit institutions that will leave them with capital when others have to curtail their good works or close their doors. Recently, I have been a witness to situations where well intentioned executive committees made up of people without career knowledge of investments were dictating investment policies to investment committees of professionals. The executive committee or full boards wanted the comfort of “looking like the others” rather than giving the professionals the latitude to be different. For example, following the popular view that diversification is a risk avoidance technique, a certain non-profit board would not approve of allowing its investment committee to have the discretion not to own any of a particular type of asset. I guess the view is that we should have investments in a large number of asset classes even though the professionals believe that there is a substantial risk of loss of capital. (Can you think of situations when you would want to own US Government Bonds with the possible exception of TIPS securities?!)

A more current concern is the inclusion of separate analytic slices for domestic and foreign stocks. As a practical matter many large and small US companies are dependent upon non-US customers for their growth and manage their foreign exchange risks for the most part well. These so-called domestic companies compete with both foreign multinationals as well as local companies and all three groups are subject to the same trends in their business. As an investor for over 30 years in stocks whose main trading markets are outside of the US and as an analyst who has been studying both domestic and foreign multinationals for fifty years, I see less and less distinction between stocks that trade in any of the major marketplaces in the world. In my mind the world is made up of equities for growth of capital and dividend income; and fixed income for interest and capital along with interest on interest. In many ways the main difference between the two is that in theory equities have an indeterminate life and fixed income has stated maturities. There are other legal differences of some importance.

I suggest that the first definition of investment prudence is the avoidance of permanent loss of purchasing power to the extent that the beneficiaries must alter their important plans. The bottom line: one wants to have both the capital and courage to survive and take advantage of investment and other opportunities that occur in periods of stress. To me prudence is all about not taking comfort from seating next to others as a ship is going down.

Senate investigations may lead to unintended structural changes

On Friday the US Senate Permanent Committee on Investigations held forth on three panels involved with the $6 Billion loss of JP Morgan Chase* through the actions of the so-called “whale.” As a practical matter most of the time was taken up by the soon-to-retire chairman of the committee asking pointed questions of people that were in the US that had some involvement with the loss or the intensive internal investigation by uninvolved senior officials of JP Morgan. I listened to most of the ranting questions by the chair and the ranking Republican member. But most of the time the chair was the only questioner in the chamber. As far as I was concerned, I learned nothing particularly new from what I have read in the papers. However, the hearing perhaps did have some effect in the marketplace. The volume of trading of the bank’s stock was 60 million shares on Friday compared with 26 million on Thursday and 16 million on Wednesday all with relatively little final price move. On Friday, in addition to the hearing, there was the announcement of what the Federal Reserve Board (FRB) would permit the bank to do in terms of dividend increases and stock buybacks. The key to me is that there are enough buyers to absorb the sellers’ disappointments emanating from either the hearing or the FRB action. Thus, I would conclude that there was a lot excitement, but no serious damage to the value of the stock. 

However, there may well be a future development coming out of the hearing that could impact depositors in not only this bank, but a number of others as well. To justify the extensive work of the committee staff for three months and the expense of the hearing, the ranking Republican kept referring to the fact that some of the money that was being hedged was depositors’ money that was protected by the taxpayers through the Federal Deposit Insurance Corporation (FDIC).  Perhaps what the ranking member was saying is if there were no direct risk to the US taxpayer that the Congress would not be investigating a loss that was fully absorbed by the shareholders of the bank, including me in a tiny way. At this point JP Morgan is awash with depositors in the US and overseas because of its reputation for possessing a fortress balance sheet. Many other banks including community banks are similarly burdened with deposits that require they pay fees to the FDIC and cannot earn a reasonable return by investing in the government market and/or find relatively safe loans to make. Under these conditions, I wonder whether a number of banks will elect to leave the FDIC system. If some depositors want similar insurance, I am reasonably confident the private sector will provide such services on a risk assumed basis.
*  I have owned shares of JP Morgan for many years.

Tip to the wise

We should all be sensitive to the deeper implications of “good works” that we perform and how they could impact how others will act in the future.

Please share some of your thoughts with me.   
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