midterm exam review fnce 254

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Exam review: 1 st 3 topics Important concepts: 1. Fiduciary duties General care and loyalty Putting client’s interest first Treating all clients equally Full disclosure of investment risk Avoid conflicts of interest Acting in good faith Reasonable basis for investment advice Seeking best execution for client trades 2. Memorize and know to calculate 3 formulas: a. Beta: covar (Ri,Rm) / market volatility squared b. Expected return = rf + (beta * rm – rf) c. Sharpe ratio = [E(r) – rf ] / std dev of returns d. See HW #1 canvas 3. Required readings last Socially Responsible Investing (SRI) - What is SRI? Positive and/or negative screening of certain constraints to achieve social as well as investment returns - Size of SRI market: $6.5 trillion, 18% of all managed assets in the US were in SRI (2014) - Question on AUM, question on # funds (these are different) - Please note growth in AUM or # funds - AUM Growth: 3 trillion in 2010, to 4 trillion in 2012, and 6.5 trillion in 2014 Fiduciary - Can be part of common law, contract, or gov regulation- managers subject to all of these - Managers of an ERISA plan are ERISA fiduciaries - Know some duties and how they might affect decision to invest in SRI funds vs normal funds

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Midterm review sheet for impact investing

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Page 1: Midterm Exam Review FNCE 254

Exam review:

1st 3 topics

Important concepts:

1. Fiduciary duties General care and loyalty Putting client’s interest first Treating all clients equally Full disclosure of investment risk Avoid conflicts of interest Acting in good faith Reasonable basis for investment advice Seeking best execution for client trades2. Memorize and know to calculate 3 formulas:

a. Beta: covar (Ri,Rm) / market volatility squaredb. Expected return = rf + (beta * rm – rf)c. Sharpe ratio = [E(r) – rf ] / std dev of returnsd. See HW #1 canvas

3. Required readings last

Socially Responsible Investing (SRI)

- What is SRI? Positive and/or negative screening of certain constraints to achieve social as well as investment returns

- Size of SRI market: $6.5 trillion, 18% of all managed assets in the US were in SRI (2014)- Question on AUM, question on # funds (these are different)- Please note growth in AUM or # funds- AUM Growth: 3 trillion in 2010, to 4 trillion in 2012, and 6.5 trillion in 2014

Fiduciary

- Can be part of common law, contract, or gov regulation- managers subject to all of these- Managers of an ERISA plan are ERISA fiduciaries- Know some duties and how they might affect decision to invest in SRI funds vs normal funds- ERISA = employee retirement income security act of 1974: governms private pension plan

investing, strictest fiduciary duty- manager must act in interests of plan beneficiaries only (significant for shareholder activism)

What is the US Gov’t’s view on SRI?

- Opinion letter, Robert Doyle- says ERISA managers may invest in SRI if they find risk and return is competitive with available alternatives- must document analysis of risk/reward comparison

- SRI is consistent with fiduciary duty if risk/return is competitive with alternatives

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- Dept of Labor’s current policy toward SRI changed importantly last year (2015) under Obama administration: Obama believed Bush policies discouraged SRI due to high burden of

- Obama letter did not change the policy but instead signaled positive regulatory attitude.- Also allowed you to consider the ESG policies of companies as potentially improving the

risk/return to a point where it is comparable or even better than non-SRI alternatives.

Difference between Defined benefit plans vs. defined contribution plan

- Defined benefit plan – fund manager decides- Defined contribution plan – manager decides on options in the plan, participants choose among

these options themselves

Charitable boards

- Not official gov regulation but attitude: Charitable boards might have a duty to consider SRI- In order to fulfill the responsibility to see the NGO meets its charitable purposes, board

members may have a duty to consider whether their investments will further those purposes, or at least not run counter to them (i.e. American Cancer Asosciation invest tobacco?)

ESG: environmental, social, governance, factors in investment decisions

Social: any social factor, relationship with stakeholders, returns: Rees: good governance is considered inherently a social good and there is evidence it leads to better outcomes for companies and thus for investors

- ON EXAM: # SRI funds over time increased more than 10X between 1990 (20 funds) and 2014 (190 funds)

- Note: leading ESG criteria are Governance, Sudan, ~200, then Tobacco/Alcohol ~150, then Human rights, labor, military/weapons, gambling, social, environmental ~100

Exam won’t go into great detail for indices- that’s more homework

But know different between SRI and normal index

Ex. MSCI KLD 400 Social Index (Aka Domini 400 Social Index) created by Amy domini, designed to mimic S&P500 except with SRI screens

Professor’s paper: Is there a Cost for SRI?

- Work looked only at mutual funds: how do you measure and analyze the cost of SRI investing in mutual funds?

- Couple topics: o Does the investor base their investment decision on prior track record (alpha-creating

managers)? The study found that the cost is a lot higher when the investor does soo 2nd way costs were found to be large was if the investor wanted a style or factor tilt

Study looked at 4 factors: remember Prof’s lecture on Fama French 3 factor model: momentum (MOM), growth (SMB), value(HML), and MKT

But, Morningstar ratings show SRI funds are higher rated than non-SRI

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o EXAM: Study finds cost of SRI vs normal investing is relatively insignificant unless the investor 1) wants a manager who delivers alpha 2) wants style tilts or factors

o Re-read the Geczy study abstract + conclusions, no formulas, understand what they were looking for and results, not great detail

- Summary: difference between expected costs of SRI vs non SRI (1.1 vs 1.3 expense ratio) is not large in Geczy study

Don’t need to know impact measurement stuff on exam- next lecture

Moving on to Shareholder Activism (Topic 2):

- What is it? Using a minority equity stake in a company to influence manager actions- Financial activists want to increase share price- “Nonfinancial” shareholder activitsm wants to use quity stakes to bring about social change by

trying to impose costs on target companies (media pressure) greater than the perceived cost of agreeing to demands- we expect a rational manager to submit

- Note: don’t need shareholder action, sometimes just pressure and awareness is enough- Proxy advisory, institutional shareholder services- Dodd Frank increased the power of shareholder activism

Question: is shareholder activism compatible with dicuary duty?

Answer: Maybe, but could also

- CalPERS corporate engagement process has been the overarching objective of improving alignment of interest between providers of capital (investors) and cpmpany management. CalPERS believes that improved aligning of interests will enable the fund to fulfill its fiduciary duty to achieve risk/returns

- Critique of shareholder’s activism:- ERISA requires fund trustees to promote economic interests of plan beneficiaries only- Firms like AFL-CIO actively file shareholder proposals against companies whose workforces it is

trying to organize- Dept of Labor in 2011 found pension fund proxy voting often unrelated to economic benefits for

plan beneficiaries- Larcker & Tayan argue that CalPERS and AFL-CIO provide little analysis showing how proxy

voting benefits the pension plan beneficiaries- Summary: US Dept of Labor is clear that using the pension fund’s ownership position in a firm

for advocacy purposes without proof of economic benefit for the fund beneficiaries (pensioners) is a violation of ERISA

- Shareholder Activism information from Brandon Rees talk- Rees’ (AFL-CIO) Rebuttal to Larcker & Tayan’s critique of Shareholder Activism

o Dept of Labor says you can be a shareholder activist with a “reasonable expectation that activism will enhance the economic value of the plan’s investment in the corporation, after costs”, and every AFL-CIO shareholder resolution contains this analysis and statement explaining how it will benefit economic interests

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o CalPERS is actually run by the State of CA, not by unionso Larcker & Tayan argue that AFL-CIO targeted Comcast because it was resisting

unionization, but AFL-CIO responded that Comcast was targeted due to poor governance and depressed stock price

- Research shows positive abnormal returns for companies “engaged” by activists- Reading “Active ownership” – not on exam, just know CSR activities, if successful, create a

positive abnormal return, but no effect if unsuccessful- EXAM: Question: Occupy Wall Street – is this a form of socially responsible shareholder

activism, just without the shares? Some success in changing management decisions?- Gadflies have greatest % of shareholder proposals (33%), but many are junk- the ones that really

count are labor unions, religious, think tanks/institutions- Biggest % of shareholder proposals by type are 1) Environmental 2)Political spending/lobbying

Shareholder Activism: Community

- EXAM QUESTION: SEC Rule 14-a-8 = what are the requirements to get a shareholder resolution on the proxy ballot? Aka what factors will require management consideration of an activist resolution? MUST READ

- 1988: Avon Letter, says ERISA fiduciaries have a duty to vote shares in portfolios. This is because voting rights are an economic benefit, so to serve the economic interests of the beneficiaries, you must vote these shares- must use the economic power, can’t abstain

- Know the key roles of ISS and of CalPERS- Question on Read Brad Barder Study- lecture notes

o In general, when CalPERs puts targeted company on its “focus” list it tends to pursue it, AND that this causes stock price to increase

o CalPERS decided to keep the list a secret, because Brad Barber’s publications would let people use the CalPERS list as a long-only strategy, and their own employees with knowledge could be insider trading – since the list is now secret, no more effect on stock price. Also avoid the perverse effect that being targeted (presumably for bad practices) would boost stock price.

o Forms of shareholder activism instead of trying to pass resolution: 1) investment/divestment

Investing = create or increase equity stake to engage the company Divest = sell or threater selling to signal objection to company actions,

aka “voting with your feet”, “The Wall Street Walk” = sell the shares and walking away, sending a message without trying to work through shareholder resolution

Divesting also can mean engaging a company to unload its own investment in tobacco or Sudan, etc.

2) Proxy battles Proxy battle = shareholder efforts to change the board (replace board

members), note Dodd-Frank regulation, though not finalized and limited by court challenges, may boost efforts to elect directors representing activist shareholders

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Currently, no non-financial activist has ever actually taken over a company, but sometimes efforts are made to get a rep on the board

Generally less successful hostile resolutions nowadays- usually management caves in earlier…but this doesn’t mean activism is not successful

Thus you can’t judge success of activism by # of resolution passed, because a sensible manager if they see they might lose ,will quickly make the operational changes to the company pre-emptively, rendering the resolution obsolete

Some requirements to put a shareholder resolution on the meeting agenda (from 14-a-8):

o Putting a resolution on the agenda depends on individual company by-laws

o $2000 minimum investment (prevent gadfly swarm owning 1 share)

o Attend meeting in persono Some resolutions are non-binding

Cost of shareholder resolutions: shareholder communication, lawyer fees, publicity

Evidence that active ownership increases returns (Dimson and Li study) 18% success rates for SRI activist engagements vs. 40-60% success rates

for hedge funds’ financial activist engagements Conclude: CSR activism improves social welfare: increases shareholder

value when engagements succeed but doesn’t destroy value when engagements are unsuccessful

Reading list:

- Topic 1: don’t need to know details of A. except 3 formulas- Topic 2:- Definitions of fiduciary duty- Stambaun/Levin study- Topic 3:- Brad Barber study!!!!- DImsum + Li not impt- Larcker & Tayan – likely question- 14-a-8: know list