trusts, while stocks were owned largely by wealthy individuals. Public speculation
came and went, and wealthy people also owned bonds, but the stock market
was, for the most part, a domain of the wealthy.
When I started out as an investment counsel in the early 1950s, this structure
was still very much in place. All our clients were rich individuals; institutional
accounts were scarce as hen’s teeth. The institutional business in the
equity market would remain in the minor leagues for another decade at least. Insurance
companies, endowments, and trusts were still working under oldfashioned
restraints and held minimal amounts of equities. Not-so-wealthy
individuals were still on the periphery, as most of them did not yet have enough
to start playing in the market while those that did have some money did not yet
have the courage. The first ten years or so after V-J Day were a risk-averse era,
socially, politically and economically. From 1949 to 1954, the dividend yield on
stocks averaged 365 basis points over the yield on Treasury bonds—more than
double the spread during the decade of the 1920s.
As the conviction gradually faded that the return of the Great Depression
was just around the corner, the environment began to change. The shift got
under way during the latter half of the 1950s and became increasingly visible in
the course of the 1960s. In those years, the shell-shocked veterans of the 1930s
were beginning to disappear from the scene, due either to retirement or death—
a development that contributed to the acceptance of a more hopeful view of the
future. Money now came into the market in the expectation that maybe this was
a place that could make you rich, not just a place for the already-rich to park
their assets. That was quite a switch.
The Pension Fund Impact
At the same time, the swelling flow of pension fund money into the stock market
during the course of the 1960s, and more rapidly in the 1970s, injected a
fundamental change into the process of equity investing. The whole purpose of
investing had always been to make money, but precisely how much money an investor
should earn in the market was a matter that only a tiny minority of people
had ever stopped to consider. Actuaries in Wall Street? An oxymoron! The
defined benefit pension funds, however, could not function without calculating
a required rate of return. They had made a set of contractual promises, promises
on which they could welch only at their peril. After the near-catastrophe in the
early 1970s, in fact, ERISA [the Employee Retirement Income Security Act of
1974] came into being with the aim of keeping those promises honest.
Charitable foundations were the next group of institutional investors to
join in this process. Like most investors, the foundations had given little thought
to the matter of required returns; they aimed simply to do their best under whatever
circumstances presented themselves. Most of the funds I encountered in the
1970s—and we built up a significant consulting business in the area—were
managing their investments via committees of Wall Street luminaries but without
any full-time professional staffs.
A large number of foundations at that time were exploiting a glaring loophole
in the tax system. These miscreants typically held mostly donor stock,
which enabled the donors to continue to control their companies while simultaneously
sheltering their shares from estate taxes and the dividends from income
taxes. Doing good works was a secondary objective, often ignored altogether as
the flow of dividends piled up tax-free in the coffers of the foundation.
By the 1970s, Congress had slammed the loophole shut. Foundations were
ordered to distribute annually at least 5% of their assets or all of their income,
whichever was greater. That was a murderous requirement in the inflationary
1970s until the government relented and limited the requirement to 5% of assets.
Nevertheless, as most foundations believe that they have a mandate to exist
into perpetuity, earning 5%-plus-inflation became an obligatory investment objective.
Soon after, the educational endowments started to think like the pension
funds and foundations, setting forth explicit investment objectives and establishing
systematic spending rules to govern transfers of assets from the endowment
to the university budget.
The promises were growing. By the time the 1980s rolled around, increasing
numbers of people were being promised something, and usually more than
had been promised in the past, which meant new investment groups dependent
upon required returns were making their appearance. Meeting those promises
during the 1980s turned out to be easier than people had expected, with high
coupon bonds from the inflationary days still in the portfolios and with a bull
market in stocks that moved forward with impressive energy. Figuring out the
least risky method to keep promises was never simple, but the calculations were
not yet colored by a sense of urgency in the objective.
Solutions create problems. The enemy is us. In order to fulfill all these
promises, investors piled into assets with high expected returns. This process in
and of itself propelled the bull market onward, quite aside from improvements
in the economic environment. Welcome as rising prices of stocks and long-term
bonds may have been after the dark days of the 1970s, the soaring asset values
that investors were inflicting upon themselves complicated the task of meeting
required return objectives for the future. The beautiful fat bond coupons were
reaching maturity or disappearing due to call. The average yield on long Treasury
bonds fell from an average of 10.5% during the 1980s to 8.7% during
1990–1994. The average yield on stocks sank from 4.2% to 3.0%.
Now the only way to meet required returns—to keep those promises—was
to take on even greater risk. Conventional government and high-grade corporate
bond exposure in institutional portfolios shriveled, while cash turned into trash.
Foreign markets with brief histories became irresistible, bonds of dubious quality
sold at diminishing premiums over Treasury yields, and the accumulation of
a wide variety of exotic and less liquid assets was rationalized. The latter appeared
to reduce portfolio risk because of low covariances, but that appearance hid substantial
and costly specific risks within the group and correlation coefficients
whose stability was a matter of debate. Nevertheless, if required returns were to
be earned, there seemed to be no choice but to shift out toward the further limits
of the efficient frontier.
Read More : The Pension Fund Impact
