AIMR Annual Conference 2003

Phoenix, 12-14 May 2003
Venue: Arizona Biltmore, Phoenix, Arizona
Reported by Michael Brown and Arthur Thompson, CFA

Preamble

The 2003 AIMR Annual Conference was held in Phoenix, Arizona at the Biltmore Resort and Spa – a magnificent venue; however, due to the depressed state of the investment industry the conference this year only attracted about 850 delegates, including 5 from South Africa. There were delegates from 40 countries.

The format of the conference is General Sessions in the morning followed by Focus Sessions in the afternoon. There were 5 concurrent focus tracks and thus one could only attend 4 out of the 20 sessions offered. Similarly, it was only possible to choose 3 of the 13 company/product presentations made available.

[Our Personal comments are contained in square brackets at various points in the notes below. Please be aware that these may not always reflect what the presenter intended].

If anyone wishes to discuss the presentations or our comments, please contact us on

ArthurThompson@yebo.co.za or (011) 370-1964,

MichaelJohn.Brown@Marsh.com or (011) 506-5403

Financial Engineering: The future of Investment Management

Robert C Merton: John and Natty McArthur University Professor

Over the past 25 years enormous strides have been made in the tools, techniques and understanding of finance, which have been to the benefit of both clients and practitioners. However, the needs of the client (the principal) will again have to be reinforced as the primary objective of investment management. Many money managers appear to have lost sight of this. We need to enhance performance by handling risk better with goal of providing the additional benefit to the client.

Unfortunately, the standard tools of risk measurement do not always work well with alternative investments such as hedge funds and option based strategies (i.e. dynamic strategies)  as well as investments where there is infrequent trade or lack of marketability (e.g. real estate).

Non-trading typically understates the risk (say, measured by beta) and overstates the excess return (conventionally reported as alpha) – which is a severe distortion of the intuitive (true?) return – for example real estate investments.

Current risk measures also ignore off-balance sheet leverage risks. (A typical illustration would be 2 vanilla pension funds which both have a surplus of $1 million. The risk is reported to be the same but Fund A has assets of $10m and the other $100m – obviously not the same).

Points of Inflection

Benchmarking

Afternoon Focus Session:

Advancing Good Corporate Governance

The Future of Financial Services: A conversation with Charles Schwab

Debate: How Useful (Really) Is Behavioural Finance For Investment Practitioners?

Professor Jennings attempted to explain the problems that are plaguing investor confidence in the US by focussing on ethics of the parties involved. She was a lawyer originally, but subsequently has been teaching for 27 years and has witnessed 3 major sets of rules with regard to corporate governance and ethics – and where has all this legislation got us?

  • The systemic failure of Worldcom, Enron and others can in hindsight be easily explained as a domino effect, almost as if there is a wish to brush it under the carpet! We have to take these episodes seriously and question the financial morality of society.
  • Many questions are asked about the accountants, auditors, board of directors, the press, the shareholders and the ‘genius’ of pulling this off. HOW can this ever be interpreted as genius, WHAT is WRONG with our core values to even think this?
  • Every criticised person can point a finger at others and plead that they relied on the other individual’s professional integrity. The professionals are all blaming each other. The fundamental question in dealing with systemic failure is: “Where is the bright line between right and wrong?” Sometimes we make an issue too complicated: either it is moral and just or it is not – don’t camouflage it with intricacy.
  • The accountants: It takes the FASB 4 years to come up with a rule, yet the finance guys can circumvent it within 4 hours. Companies are prepared to pay millions of dollars to specialists who can ‘break’ rules.
  • The auditors by the very nature of their business have conflicts – this impairs their ability to say, “No”.
  • The board: the definition of ‘independent’ when talking about non-executive directors is flawed. Expertise, gumption and attendance are three words that independent directors have to be able to deliver on. More often than not the question of fees determines whether a person will accept a non-executive role. The focus should be on competence for the role and the strength to stand up for what is right.
  • The analysts claim they act independently, but do they? They have conflicts, don’t focus on business basics and over-rely on complicated models; they lacked focus on the basics in business analysis; there was an absence on the qualitative aspects of analysis.
  • The press grants celebrity status to CEO’s and CFO’s. There is a constant fear of being wrong. The CEO who ascribed his success to “I spin the debt off the books” was idolised, but surely this should have been a red flag?
  • The investors were focussed on EBITDA. “If we hadn’t had all those expenses, we would have had earnings.” Investors are meant to be rational but did they behave rationally in the bubble? No, but we fell for it.
  • Business Data has reported that:
    • 47% of top executives
    • 41% of controllers
    • 76% of graduate students in business, would commit fraud by understating write-offs that cut into profits.
  • In a recent study, MBA’s were cited as the most ethically challenged employees.
    • Nearly all believed that shareholder value was more important that customer service
    • Convicts in 11 minimum security prisons had higher scores on an ethical dilemma exam than MBA’s!

Why have we stopped teaching morality at business schools? Attitudes changed over the course of the bubble, we need to inculcate the right values.

Are we teaching our students correctly when post-Enron, Business Schools put out comments and papers: “ What did Enron do right?”, “SPE’s are good for capital structure and benefit shareholders”, “Smooth Earnings Benefit Shareholders”. Some of these ideas are not morally defensible – there is a world beyond high finance and we need to wake up to it.

The answers to the above dilemma can be found in a holistic approach to education.

  • Confronting the human nature issues in conflicts.
  • Understand the market niche that integrity offers.
  • The inherent morality of the free market; while the market will ultimately correct for immorality, we should avoid it in the first place.
  • Set personal, professional and organisational morality standards.

Recognise the basics of finance and economics.

  • Double-digit growth is not possible in the USA. Get real – do not promise what you cannot deliver.
  • Understand that there are cycles and that diversification has merit.
  • Stay focussed on long-term results.
  • Place parameters around achievements.
  • Understand the ease of short-term problem resolution versus the long-term implications. “ The hard truth concealed doesn’t get better with the passage of time.”
  • Differentiate between “could do” and “should do” when confronted by an ethical issue.

Don’t confuse social responsibility with ethics – often the worst culprits will try to disguise their lack of ethics by high profile social responsibility.

  • Environmental responsibility does not mean the financials are transparent.
  • Diversity does not mean honesty.
  • Philanthropic giving does not prevent inadequate disclosure.

The power of the herd instinct is illustrated in the following experiment:

In a study with university students, nine students were shown two sticks, one six inches long and the other nine inches long. They were told that they would be asked: “Which is the bigger stick” when the 10th student is brought in, to which they must one-by-one emphatically insist that it is the 6 inch stick. At the end of the experiment, 76% of the tenth students said the smaller stick was bigger. The 24% that said the others were wrong became leaders, but not necessarily business leaders.

Verdict: you need to have the moral fibre to stand up for what you believe is right

In the recent GE retirement of Jack Welch it was disclosed that the company still sent (and paid for) flowers to his various homes on a weekly basis. The company still paid for his courtside NBA basketball season tickets. When asked about it, he claimed that he was receiving no more than any other CEO before him. Where were the non- executive directors to say, “That is wrong … Buy your own tickets!” Non-executive directors have to be chosen from the pool of 24% of those people who can stand up against public consensus when something is wrong.

Don’t rationalise unethical behaviour, for example:

  • “Everybody else does it”
  • “That’s the way they do it at …”
  • “If we don’t do it someone else will”
  • “It doesn’t really hurt anyone”
  • “Who’s to know?”
  • “Ranking/Ratings will suffer”
  • “The system is unfair”

Ethics is not something that can be learnt in a semester at university. It is a way of life. From speeding on the highway to filling out your tax return. Unethical people in small things tend to be unethical in big things too. We must not make ethics difficult.

  • Trust discomfort
  • Stay focussed on long-term results
  • Be a bit selfish about your and your organisation’s reputation