I Read Academic Research So You Don't Have To: 10 Looming Issues

Ann C. Logue | Jul 21, 2008 12:00am EDT | Comment

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In the June 2008 issue of CFA Institute Conference Proceedings Quarterly are notes on a presentation given by William H. Donaldson, CFA, to CFA Institute members on what he sees as 10 issues that could wallop financial markets but that no one pays much attention to now. By definition, unanticipated events have the greatest effect on market performance; when people expect something to happen, they can incorporate that expectation into their evaluation of when to buy and when to sell. Donaldson is the founder of investment bank Donaldson, Lufkin & Jenrette (now owned by Credit Suisse). He also co-founded the Yale School of Management and served as chairman of the Securities and Exchange Commission from 2003 to 2005. He's as smart as the smart money gets, so mutual fund investors might be interested in what he has to say.

Some of the 10 issues that he discussed are oldies but goodies. One key issue on his list is a mutual fund affliction: short-termism. Mutual fund investors too often chase returns rather than live through a short-lived drawdown, even on what is market-related (like right now) rather than due to the portfolio manager's skill. Portfolio managers want to boost their annual bonuses, so they invest where they currently expect good numbers. Corporate managers, wanting to keep shareholders happy (as they should), emphasize short-term earnings per share gains rather than long-term investments and strategic planning that might make for happier shareholders in the long run. Donaldson argues that investors need to think about long-term performance for their own investments and from the companies that they invest in.

Another issue vexing Donaldson is the decline of fundamental analysis. He was one of the first people to pass the Chartered Financial Analyst exams, and he made good research one of the hallmarks of his firm. But in a world where investors are awash in information, few are willing to collect it to create a comprehensive understanding of a company. He thinks that research these days looks only at whether or not a company can hit this quarter's earnings per share estimates, which means that at least a few people running actively managed mutual funds will be blindsided. That's made worse, he thinks, by the emphasis on history in accounting presentations. Investors don't really care about what happened in the past, they want to know what will happen to their money in the future. He wants to see a change in the accounting system that would allow some type of forward-looking presentation.

Several of Donaldson's issues are about the globalization of financial markets. Mutual fund investors tend to think of international funds as a separate category used to add a soupcon of diversification and return to their portfolios, but in the future, it may make sense to think of international investing as investing, period. In his presentation, Donaldson pointed out four related issues: globalization, which will force investors and investment companies to think in broader terms than they may be used to; global accounting standards, which may affect valuations of emerging markets companies once reporting is standardized; corporate governance, which is viewed differently in different countries and that may affect shareholder rights; and the increased role of sovereign wealth funds in U.S. markets.

One of the items on Donaldson's list doesn't affect mutual fund investors much, but it has been part of the churning in the markets: derivative instruments. He's concerned that few people using derivatives understand exactly how they work. Interest-only and adjustable-rate mortgages are forms of derivatives, and look how so many of them have come back to haunt both the borrowers and the issuers!

The last two issues are shareholder rights and the U.S. regulatory structure. He notes that the current plurality system of voting for boards of directors effectively means that a board member needs only one vote in order to stay on the board. Even if a large group of mutual funds, pensions and other institutional shareholders band together, they would have a hard time forcing a company to change. Donaldson (and plenty of other people) think that's just wrong.

As for regulation, the U.S. has a series of distinct regulators for distinct products. The Federal Reserve Board oversees banks. The Securities and Exchange Commission regulates stock markets. The Commodity Futures Trading Commission watches derivatives markets. State insurance regulators monitor insurance products. However, new types of investments often fall between the cracks, and that has created some of the problems that we see now — and may well create more.