Author Bio

U.S. stock prices are no higher today than they were in 1999, and the purchasing power of the major market indices has made no progress in fifteen years.  Meanwhile, the yield available on ten-year Treasury bonds has dropped from close to seven per cent in the mid-1990s to below two per cent.  Not surprisingly, the superior investment performance generated by default-free Treasuries has severely dented the notion that equities are the safest asset for long-term investors.

The sub-par returns generated by stock markets over the past decade has been accompanied by a marked change in the asset allocation of defined-benefit pension plans, with many corporate sponsors electing to reduce their equity exposure and increase their fund’s weighting in fixed income securities.  The latest corporation to effect such a change and capture public attention was Ford Motor Company, who announced earlier this year that it intended to lift the proportion of its pension fund assets invested in bonds to 80 per cent, up from 45 per cent previously.

The trend towards the de-risking of defined-benefit pension schemes has sparked an avalanche of commentary from so-called investment experts, who argue that the asset allocation switch is misguided and could prove to be anything but riskless should the yield on Treasury bonds increase from generational lows to more normalized levels.

Of course, similar arguments were made more than a decade ago when Boots, the British pharmacy retailer, liquidated its entire equity portfolio and moved all of its pension fund assets into high-quality fixed income securities.  Importantly, then as now, the arguments are bogus and demonstrate a complete lack of schooling in elementary financial theory.

The decision to replace equities with bonds in a defined-benefit pension scheme is not a call on the long-term returns expected from either asset class, but a strategy to reduce financial risk, by investing pension plan assets in securities with a duration that better matches the duration of liabilities.  Minimizing the volatility of the value of pension plan assets relative to pension liabilities reduces the probability that a company will have to divert capital and make costly deficit contributions, most likely at a time when the firm can least afford them.

It is important to appreciate that holding equities in a defined-benefit pension scheme increases a firm’s overall leverage, and in turn, the expected costs of financial distress.  Although a defined-benefit pension fund and its corporate sponsor are legally separate entities, the economic reality is very different, and since the company is ultimately liable to meet the pension liabilities, the balance sheets should be consolidated to give a complete view of the firm’s capital structure.

Suppose a firm has $1,000 in operating assets financed by $250 in debt and $750 in equity, which gives a debt/equity ratio of one-to-three.  The capital structure appears to be relatively conservative, but suppose the company has pension liabilities of $500 and pension assets of $500, with $350 invested in stocks and $150 in bonds.  The stocks can be thought of as ‘negative firm equity,’ and the bonds can be regarded as ‘negative pension liabilities.’

A complete picture of the firm’s capital structure, which includes the pension plan in the calculation of leverage, shows that the debt/equity ratio increases from one-to-three to 600/400 or three-to-two.  The pension plan’s asset allocation seriously increases the firm’s overall financial risk, and the observation clearly matters, since academic research confirms that such information is impounded in stock prices.

Further, should the market determine the capital structure to be appropriate, it is still not suitable because the company is forgoing the opportunity to exploit the valuable tax shield that would arise from financial leverage on its own balance sheet.  The same capital structure could be achieved and the tax shield utilized by switching the pension plan’s stock holdings into bonds, while issuing the same amount of debt at the corporate level and using the proceeds to repurchase an equivalent amount of its own shares.  This is akin to the strategy adopted by Boots in 2001, which was so widely criticized at the time.

The de-risking of defined-benefit pension plans continues with Ford Motor Company recently announcing its decision to increase its bond allocation to 80 per cent.  The strategic move has been challenged by investment professionals, who fail to appreciate that just as there are two sides to every story, there are two sides to every balance sheet.

Perhaps the last word on this controversial issue should be left to the late Fischer Black, who wrote in 1980, “My message is simple.  Almost every corporate pension fund should be entirely in fixed dollar investments.”

www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Author Bio

Last week I attended my first academic conference. It was held at UCLA and focused on the field of Behavioral Finance. This is the area of academic research which has been challenging the tenets of Efficient Market Theory. As such, it’s a field of study that is highly applicable to the way most market participants I’ve met and talked with over the years think. I look at it as the study of traders, at least in certain sub-set areas.

One of those sub-sets of Behavioral Finance is the field of neurofinance, which attempts to see how our brains impact on how we trade and invest. During the conference there was a presentation by Dr. Paul Zak (Claremont Graduate University) outlining the findings of research he’s done on learning and market bubbles.

Bubble experiments
For some time now, researchers have studied the development of market bubbles in laboratory experiments. The version used by Zak in his study is one where the participants are given the opportunity to trade an instrument which has a fairly easily calculable value based on its proscribed cash flows (think dividends or interest payments), one which declines steadily toward zero over the span of the experiment.

One would think in a situation like this that trading would be pretty straightforward, but that doesn’t end up being the case. These experiments repeatedly feature the creation of significant bubbles in the price of the asset – meaning it trades well above its fundamental value.

Learning comes into play
It is worth noting, though, that as participants go through the experiment repeated times their behaviors change. The bubbles gradually reduce in size. The implication there is that as people learn they are less likely to act in a manner which drives the market price well above the baseline value of the asset.

Learning is important. Who’d have thunk it?

Bring on the drugs!
To take a closer look at the impact of learning on bubble formation, Zak and his fellow researchers divided the participants into three groups. One was given a drug which impaired learning. A second group received a caffeine pill on the idea that might actually improve learning. The final group was given a placebo. As it turns out, caffeine didn’t end up having any real impact above that seen from the placebo.

The impairment drug, however, did act as advertised. Traders on the drug took longer to see their bubble formation reduced, reflecting slower learning. Part of that was from reduced trading activity. They just simply didn’t trade as often as their un-drugged peers. Less trading equals less learning.

The conclusions
Dr. Zak presented three conclusions from his research (and that which went before).

1)    Traders who learn market history are less prone to inflating bubbles.

2)    Market/trading learning must be salient, meaning there must be a risk/reward factor (participants in these studies always have monetary rewards at stake as the results are different when there is no real risk/reward element). In other words, to learn you need to trade real money, not paper money.

3)    Infrequently traded markets are more subject to bubbles (real estate being the obvious example).

So basically you would do well to invest considerable time and effort in your trading and markets education and make sure it involves real money, not demo trading. Also, be aware of the markets which are more prone to mispricing (smaller, less actively traded ones) as they may either present opportunities or represent unnecessary risks.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.