Title: Current Issues in Financial Institutions and Financial Markets
1Current Issues in Financial Institutions and
Financial Markets
- Mutual Funds
- U.S. Securities Markets
2Mutual 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.
3 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
4Whose 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?
5Conflicts 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.
6Investment 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.
7Unequal 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.
8Gaming 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.
9Cross-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.
10Whats 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.
11Proposed 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.
12The 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.
13Conclusion
- 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.
14Securities 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
15Outline 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
16Old 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.
17Old 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.
18How 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.
19How 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?
20How 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
21Conclusions 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.