Should money funds be allowed to continue to price their shares by “buck” accounting, whereby the price of each share is fixed at one dollar? Or should they be compelled to price them by “mark-to-market” accounting, common to all other mutual funds, whereby changes in the market value of shares move their prices higher or lower than a dollar?
Today’s money fund agenda centers on mitigating systemic risks associated with money funds. These risks compelled the U.S. Treasury to offer a taxpayer guarantee on all money funds in September 2008, when the Reserve Primary money fund was forced to “break the buck,” setting the price of shares below a dollar.
A proposal to price money fund shares by mark-to-market accounting has been met with fierce opposition. Paul Schott Stevens of the Investment Company Institute wrote that “investors prize the stability, simplicity, and convenience” of money funds. David Hirschmann of the U.S. Chamber of Commerce wrote that investors would flee from money funds burdened by “the complexity and cost of accounting” of mark-to-market funds. And Kenneth White, a Chicago investor, threatened to liquidate his money funds if their prices were set by mark-to-market accounting.
We cannot understand the passions underlying the money fund debate unless we understand the psychology that underlies the attraction of buck accounting. That psychology centers on our cognitive errors of mental accounting and hindsight, and our emotions of regret and pride. An understanding of the attraction of buck accounting would help us overcome it.
Money funds were introduced in the early 1970s to circumvent regulations that limited the rate of interest banks could pay. They soon turned into substitutes for bank checking accounts. Money fund investors received checkbooks similar to bank checkbooks and could write checks for use everywhere. But money funds were not a close enough substitute for checking accounts because they lacked the “no-loss” psychological benefit.
Investors who deposited a dollar in a checking account were assured that they would be able to withdraw a dollar the following day, week, or year. But money fund investors had no such assurance. A dollar invested in a money fund one day might be worth 98 cents the following day. Investors who contemplated buying a television set for $500 would have had to withdraw 510 shares of the money fund if its share price declined from $1 on the day of the purchase to 98 cents when their check was cashed. The extra ten shares registered as a loss in the minds of money fund investors.
Investing, whether in a stock or a money fund, marks a hopeful beginning. We place a stock into a mental account, record its $100 purchase price and hope to close the account at a gain, perhaps selling the stock at $150. As stock fate has it, the stock’s price plummets to $40 during the following month rather than increase to $150.
Losses make us feel stupid. Hindsight error misleads us into thinking that what is clear in hindsight was equally clear in foresight. We bought the stock at $100 because, in foresight, it seemed destined to go to $150. But now, in hindsight, we remember all the warning signs displayed in plain sight on the day we bought our stock. Interest rates were about to increase. The CEO was about to resign. A competitor was ready to introduce a better product.
The cognitive error of hindsight is accompanied by the emotion of regret. We kick ourselves for being so stupid and contemplate how much happier we would have been if only we had kept our $100 in our savings account or invested it in another stock that zoomed as our stock plummeted. Pride is at the opposite end of the emotional spectrum from regret. Pride accompanies gains. We congratulate ourselves and feel proud for seeing in foresight that our $100 stock would soon zoom to $150. Mark-to-market accounting of money funds opens the door to both regret and pride every time we write a check, but regret is more painful than pride is pleasurable. It is no wonder that money fund investors prefer buck accounting over mark-to-market accounting, and money fund executives hear their voices.
In 1977, following much lobbying by mutual fund companies, the SEC approved the use of buck accounting such that the price of their shares remains at $1 even when the market value of the shares deviates from it. Managers of money funds promised not to “break the buck” and, at last, money funds seemed to have acquired the no-loss benefits of checking accounts.
The promise of managers of money funds not to break the buck was sincere but not guaranteed. The small print always said that the buck might be broken. Still, managers of money funds kept their promise for many years, on occasion paying from their own pockets so as not to break the buck. But when the financial crisis arrived in 2008 the managers of the Reserve fund announced that their fund contained securities of bankrupt Lehman Brothers and they must break the buck and set its shares to 97 cents. The development “is really, really bad,” said Don Phillips of Morningstar. “You talk about Lehman and Merrill having been stellar institutions, but breaking the buck is sacred territory.” This breaking of the buck was prominent among the events that led Henry Paulson and Ben Bernanke to recommend drastic measures, including government insurance of money funds, fearing the panic that would ensue if money fund investors raced to withdraw their money.
The demise of Reserve fund is ironic because Bruce Bent, one of its founders, opposed buck accounting when it was considered in the 1970s. Bent feared that buck accounting would compel money fund managers to buy risky securities in attempts to provide higher returns than their competitors. In a 1978 letter to the SEC Bent wrote that buck accounting “presents the illusion of higher returns in times of declining interest rates” and makes money funds “appear to have overcome the risk” of fluctuating interest rates. Bent noted further that buck accounting would encourage money funds to buy risky securities that “pay higher interest rates than those which must achieve stability by exercising judgment…” Bent vowed not to buy such risky securities, but he broke his vow under the pressure of competition. This is why the Reserve fund held Lehman securities when Lehman went bankrupt. What started as an attempt to turn money funds into no-loss investments ended with very real losses.
Jeffrey Lacker, President of the Federal Reserve Bank of Richmond, advocated mark-to-market accounting for money funds, noting that buck accounting promotes runs on money funds. I agree. Regret over losses is likely to seize money fund investors from time to time, but such regret is a small price to pay for a central block of a stable financial system.
Charles Schwab’s YieldPlus funds promised returns higher than those of bonds at only slightly higher risk. Schwab classified the funds as ultrashort bond funds yet their holding were concentrated in mortgage backed securities which were decimated in the financial crisis.
The story of YieldPlus is only one example of the sad consequences of investors’ perennial search for returns higher than risk. A century ago investors sought such returns in stocks of mining companies. A magazine of the time told the story of a man, the son of a country doctor, who reached adulthood and was about to go into business. His father took him into the little back office, swung open the door of the rusty old safe, and took out a thick bundle of stock certificates. “My son,” he said, “you are going into business, and, I hope, will make some money. . . . When the time comes you will wish to buy some mining stock. Everyone does. When that time arrives come to see me. I will sell you some of mine. They are just as good, and will keep the money in the family.’”
Lessons from a century ago need repeating because we fail to learn. Almost half a million Italian retirees bought Argentine bonds in the 1990s because they offered higher interest rates than Italian bonds. The word default became an Italian word in 2001 when Argentina defaulted on its bonds. In 2005 Nestor Kirchner, Argentina’s president at the time, offered to pay bondholders less than a third of their investment. When Rodrigo de Rato of the International Monetary Fund called on Argentina to be respectful to bondholders, Kirchner mocked him, “It’s pathetic to listen to them sometimes.” “Enter now,” said Kirchner to the bondholders, “or it will be your problem.”
Banks sold $7 billion of reverse convertibles in 2008, promising returns higher than risks and collecting fees in the process. Reverse convertibles are bonds linked to stocks such as Apple and Johnson & Johnson. Investors were promised high interest rates during the life of the bonds in addition to their invested money when the bonds mature. Yet if the prices of the stocks to which the bonds are linked fall, investors get the stocks rather than their invested money. The high interest rates of reverse convertibles were enticing, but not all investors were aware of their risks. Lawrence Batlan, an 85-year-old retired radiologist, invested $400,000 in reverse convertibles linked to stocks such as Yahoo! and SanDisk. He lost $75,000 of it when stock prices declined. “I had no idea this could happen,” said Dr. Batlan. “I have no desire to own Yahoo! stock or the others.”
The “accumulator” was also an investment that was too good to be true, but this one was offered mainly to investors in Hong Kong. Accumulators obliged investors to buy shares of a stock at a fixed price. Investors profited if the price of the shares increased but lost if the price decreased. Yet the profit potential of investors was limited by a condition mandating that they sell their shares back to the issuer if their price increases to a specified level. The year 2008 was bad for investors in accumulators as stock prices declined and investors nicknamed accumulators “I kill you later.” The fundamental flaw . . . is something that I learned from my grandmother,” said Kathryn Matthews, an investment professional. “You get nothing for free.”
Next time when you see an investment with “plus” in its name, substitute “minus” in its place and see if it is still as enticing.
Thanks to Kees Koedijk and Alfred Slager for this guest post. Visit their blog here.
Top 10 stocks and funds to invest in for 2011 circulate widely. It’s a recurring theme with a predictable storyline at the end of the year. The analyst: “Well, we indicated that stock XYZ should be the best performing one this year, and it should have been the case, but it has not for good reasons.” Analysts then borrow the “deus ex machina” plot device from the theatre (literally, “God out of the machine”), in which a seemingly inextricable problem is suddenly and abruptly solved with the unexpected intervention of some new character. For analysts this usually boils down to central banks not behaving like they should, politicians meddling with economics or misplaced optimism or pessimism of consumers or companies.
So unless the investing public suffers from collective amnesia with a yearly cycle, the real merit of predicting is not the prediction itself. Maybe it’s a form of mating game in the investment industry. The analyst, bank or mutual fund signals with his prediction to the investor that he knows the intricate details of financial markets, and is therefore fully in control of the risks attached to an investment. And once you’re in control of the risks, then there is actually no risk attached, is there? An elegant way to play into investor’s permanent desire for free investment lunches, an important theme in Meir Statman’s insightful book “What Investors Really Want”.
Maybe institutional investors and pension trustees should be given a second chance for better New Year’s resolutions. If they’re smart, they won’t focus on predictions, but on understanding why predictions continually fail, and how to benefit from this insight. This requires delving more into the beliefs behind the economic theories, and how they affect your investment decisions, the central theme of our recently published book Investment Beliefs. A Positive Approach to Institutional Investing. The problem at hand is quite simple. Despite all the research done and money spent in the financial industry, diverging views persist in economics and finance. A solid theory, broad dataset and sound research methods should be able to resolve ongoing debates and lead to accurate predictions. Economists and researchers surely put an enormous effort into research, but resolving debates tends to move slowly. Economics and finance are tough subjects to investigate. Why is this?
A historic perspective comes in handy. Investing theory and practice have developed dramatically over the past five decades, yet as Andrew Lo argues, there still is no objective framework around for viewing capital markets and deciding how to apply these insights for investment purposes. Active management, passive management, absolute return strategies – all are different views of capital markets that happily co-exist. Yet none can be pinpointed as the right one. Theories in investments and finance simply do not have the same degree of confidence as theories in physical sciences. The main theories have not been road tested; basic premises are not conclusive. For example, is there any agreement on whether financial market pricing is efficient; the basis for passive management? Research findings are inconclusive. There is an increasing amount of evidence on “anomalies”, unexplained gaps between predictions and realizations. However, no workable alternative for the underlying theory has been formulated that can be put to good use on a large scale. Moreover, few investors are actually able to exploit these “anomalies” and turn them into higher returns.
So in the meantime, students and investment managers learn that efficient pricing exists, but observe and act otherwise in practice. Believers in inefficient markets usually invest in what they perceive as undervalued stocks, sectors or assets, and do appreciate market-timing. In a brilliant stroke of marketing, they have labeled themselves as “active” managers, ideally positioned for investors who want to be in control and want to win. Believers in efficient markets on the other hand focus on buying the index against the lowest costs possible: costs are after all a certain drag on your returns, while the free investment lunches pictured by the active managers have yet to materialize.
This discussion suggests that the smart, rational money is on passive investing. The reality is the other way around. The overwhelming share of equities is invested by active managers. Our experience is however that pension funds would make fundamentally different choices if they were aware of the uncertainties behind the economic and finance theories – after all, it boils down to what you believe in. We call this investment beliefs: an explicit view on how to interpret, and approach a debate in the financial markets. We covered active versus passive management as a noteworthy investment belief, but there are many other beliefs out there: on sustainability, risk premium, investment horizon, risk management- to name a few.
Investors simply have to deal with the fact that many debates never really reach a firm conclusion and keep haunting them. Proponents of active management have just as much ammunition in the form of anecdotal evidence or research to prove their case to sympathizers of passive management as the other way round. There is no single objective truth in the financial markets, just an accumulation of learning by doing and adapting to new realities. Investment beliefs address this uncertainty and make it manageable – not predictable.
So, chances are that the predictions will once again miss the mark. This shouldn’t worry investors, and certainly not prevent us from filling out the sweepstakes. The process of arriving at a prediction might well be more important than the prediction itself. Wouldn’t that be a great way to actually realize a New Year’s resolution?
Are you wondering what’s next in 2011? McGraw-Hill Professional the publisher of my book What Investors Really Want asked a few of their authors (including me) what we think the New Year will bring. They then collected these ideas and predictions into a thought-leadership e-Book, aptly titled What’s Next 2011 that covers the business outlook in a range of areas including Marketing, Sales, Finance, Leadership and Innovation. If you would like to download the e-book I invite you to go here.