Harvard College Investment Magazine Summer 2005

HARVARD COLLEGE

Investment magazine in this issue Meet Ken Griffin Founder & CEO of Citadel Interview with Jeff Bezos Founder & CEO of Amazon.com

plus A Student’s Perspective on the Financial Recruiting World Guide to Fundamental Analysis

And More...

SUMMER 2005

You and us. A winning partnership for an outstanding future.

Do you thrive on challenges? Are you full of energy and ambition and the desire to make a difference?

At UBS, we offer you a world of opportunity to fulfill your true potential. We seek talented individuals to further enrich a vibrant environment where every employee has the chance to excel, supported by the finest training programs and a diverse culture that encourages fresh thinking and rewards performance.

You and us – a winning partnership.

To learn more about us and to apply for a position, please visit our website: www.ubs.com/graduates.

Wealth Management

I

Global Asset Management

I

Investment Bank

Š 2004 UBS. The key symbol and UBS are the registered and unregistered trademarks of the UBS Group of companies around the world. All rights reserved. In the US, securities underwriting, trading and brokerage activities, and M & A advisory activities are provided

by UBS Securities LLC, a registered broker/dealer that is a wholly owned subsidiary of UBS AG, a member of the New York Stock Exchange and other principle exchanges, and a member of SIPC.

harvard.investment.magazine www.HarvardInvestmentMagazine.org Harvard College Investment Magazine Harvard University University Hall, First Floor Cambridge, MA 02138 Editors-in-Chief

Kuanysh Y. Batyrbekov Benjamin Y. Lee

Executive Editors

Pedro Glaser Jennifer Y. Lan

Associate Editors

Andreea Akerele Oleg Bibergan Shruti Saini Edward Thai

Executive Designer Publishing Director Business Board

Web Designer Faculty Advisors Advisory Board

One-Year Subscription

Subscriptions

Victoria T. Ho

Francisco J. Martinez Helen Poldsam Kristi Poldsam Mimi H. Yu Vivien Wu YiDing Yu John Y. Campbell Tuomo O. Vuolteenaho Allen Chao Michael Hauschild Brian Kozlowski Anna H. Yu

United States Canada International

Personal US$29 US$35 US$39

Institutional US$49 US$59 US$69

Contact 617-548-9650 E-mail subscription@HarvardInvestmentMagazine.org

Article Submissions

Contact 617-548-9650 E-mail editor@HarvardInvestmentMagazine.org

Advertising in HCIM

Contact 617-792-8847 E-mail advertising@HarvardInvestmentMagazine.org

Join HCIM

E-mail

join@HarvardInvestmentMagazine.org

Copyright 2005 (ISSN: 1548-0038) Harvard College Investment Magazine. No material appearing in this publication may be reproduced without written consent of the publisher. The opinions expressed in this magazine are those of the contributors and are not necessarily shared by the editors. All editorial rights reserved.

innovation. inspiration. ingenuity.

H.C.I.M. a r v a r d

email

o l l e g e

n v e s t m e n t

a g a z i n e

join@harvardinvestmentmagazine.org

Inside Scope

A Guide to Fundamental Analysis...............................5

Pedro Glaser

A Student’s Perspective on the Financial.....................9

Recruiting World

Jennifer Y. Lan Cover Stories

An Interview with Jeff Bezos......................................17

Michael Hauschild

Movers and Shakers: Ken Griffin................................21

Anna Yu Global Outlook

Where will Russia Go?............................................... 26

Oleg Bibergan

Constructing Credibility in China............................... 30

Anna Yu

An Interview with Mr. Kairat Kelimbetov....................34

Kuanysh Y. Batyrbekov Research Digest

Aggregate Short Interest and Market Valuations.......... 38

Owen A. Lamont & Jeremy C. Stein

Managing University Endowments.............................. 43

Benjamin Y. Lee

The 2004 Presidential Election and the Municipal........49

Bond Market

Ying Sun

harvard.investment.magazine summer 2005

Issue Contents

a guide to

fundamental analysis

By: Pedro Glaser previously owned shares or wait for a better time to buy the stock.

Fundamental analysis rests on two key assumptions. The first is that a company’s intrinsic value can be different from its market value.

Given the stock market’s wild swings, this seems like an obvious scenario. Some theories, however, suggest that a company’s market value is the best and only measure of its intrinsic value, implying that the two should generally be equal. These theories argue that since the market value of a company reflects all available information about its intrinsic value at any given moment, the market value is the most accurate estimate of what the intrinsic value should be. This is one result of the so called How do investors decide what stocks efficient markets hypothesis. to buy and sell? In our Spring 2005 issue , The second assumption we looked at technical analysis, a strategy is that even if a company’s used to help answer this question. In intrinsic value deviates from its most basic form, technical analysis its market value, the two will eventually The goal of fundamental uses the information provided by converge in the long-run. This means that a stock’s past price fluctuations to if you think a company is undervalued, analysis is to provide invespredict its future price movements. you should buy the stock and wait for tors with a measure of the While many investors use technical the price to increase as other investors analysis when making investment begin to discover that the company is actual value of a company. decisions, some criticize the method indeed undervalued. Thus, a fundamental for trying to analyze a company’s analyst believes that a weaker version of stock price without ever looking the efficient markets hypothesis applies at the underlying company. According to these critics, technical in the long run, but that short run inefficiencies like sticky prices analysts are buying price charts instead of companies. and wages, imperfect information, and psychological factors cause An alternative to technical analysis preferred by many investors the two to deviate from one another in the short-term. is fundamental analysis, a method which stresses the importance With the underlying assumptions of fundamental analysis in of looking at the details of a company’s financial health. The goal mind, the next part of this article will discuss how a company’s of fundamental analysis is to provide investors with estimates of intrinsic value is calculated and how investors decide whether or a company’s intrinsic value - a measure of the actual value of a not a company is undervalued or overvalued. company. When this value is greater than the company’s current market value, the general rule is to buy shares in that company. If, Part 1: Balance Sheets on the other hand, the firm’s intrinsic value is smaller than what The balance sheet is the first place an individual investor the market says the company is currently worth, either sell any should look for information about a company. A balance sheet 1 Available online at www.harvardinvestmentmagazine.org provides information about the value of a company’s assets, the

5 :: Harvard Investment Magazine

fundamental analysis about the firm’s financial health. We will now examine some specific indicators to see how information from the balance sheet can help decide what company to invest in.

Book Value The most basic estimate of a company’s intrinsic value is its book value. This is a measure of the total value of each component of a company’s assets if they were separated from the company and sold individually at the price they were originally bought for.

In the case of Exxon, this translates into the sum of the value of its refineries, offices, oil reserves, ships and so on. Dividing this value by the total number of shares outstanding gives us a company’s price to book value per share. For Exxon, this value is $15.90.

The first thing you should notice about this number is that it is far smaller than XOM’s current stock price of about $60. This does not necessarily mean that the stock market overvalues the company. Book value is a measure of the value of a company’s assets by themselves. It does not take into account the value added by the configuration of those assets within a well-functioning business. The difference between a company’s market value and its book value is the amount by which investors believe that XOM’s managers have increased the value of those assets. So, while a company’s book value by itself is not a good estimate of a company’s intrinsic value, the ratio of a stock’s price and its book

kinds of debt it has incurred, and its ability to pay off those debts at a given point in time. An updated balance sheet for most public companies can be found for free at www.freeedgar.com, which provides information directly from the US Securities and Exchange Commission (SEC).

As an example, we can look to Exxon’s (stock symbol XOM) balance sheet for the last quarter of 2004. In general, balance sheets are divided into two categories: assets and liabilities. The former is a list of what the company owns, while the latter is what the company owes. The difference between the two is called a company’s net worth. There are many ways to interpret the financial data presented in a company’s balance sheet, with each method providing specific and somewhat different information

Harvard Investment Magazine :: 6

fundamental analysis value per share – its price-to-book ratio - provides a convenient way of summarizing how much value a company has added to its assets. Exxon’s price-to-book ratio is 3.94. Relative to other stocks in the oil sector, this is a large number. Chevron Texaco’s price-tobook ratio, for example, is 3.04.

Working Capital and the Current Ratio In order to pay its current liabilities and other short-term obligations, a company must use its current assets like cash. The difference between these two amounts, current assets and current liabilities, is a company’s working capital. In order to estimate whether a company has enough cash and other short-term assets to meet its obligations, investors use an indicator called the current asset ratio. This is the ratio between a company’s current shortterm assets and its current liabilities. XOM’s current ratio in the last quarter of 2004 was 1.405.

Is this a large number or a small number? In general, the range of acceptable current ratios depends on the type of company being analyzed. Young companies that need to spend more cash in order to finance their growth usually have ratios of two or more.

Large and more established companies, like Exxon, can sustain

themselves with smaller ratios.

Fluctuations in a company’s current ratio trends over time are also a good indicator of what a company’s financial situation may be like in the near future. If this ratio is too low, the company may not have the resources it needs to invest in new projects or pay off its debts. A chart of XOM’s current ratio during the last five quarters is displayed below. The chart was created using information provided from freeEdgar.com.

This is a very healthy looking trend, as it shows that despite Exxon’s recent growth, it has managed to accumulate more shortterm assets than short-term liabilities. Had the trend followed the opposite direction, it could have indicated a potential decline in growth prospects or poor financial management. Neither of these possibilities seems to apply to Exxon.

Debt-to-Equity Ratio In addition to short-term liabilities, an investor should also be

7 :: Harvard Investment Magazine

concerned about a company’s long-term debt. A good measure of a company’s debt burden is its debt-to-equity ratio, which equals a company’s long-term debt divided by its shareholder’s equity.

From its balance sheet, we can see that XOM’s debt-to-equity ratio is 0.081 [8.97 million/108.64 million]. Comparing this number to Chevron Texaco’s debt-to-equity ratio of .277 reveals just how small a concern long-term debt seems to be for Exxon. As a general rule, investors will tend to avoid companies with debt-to-equity ratios above 1, for a high ratio may restrict a company’s growth options by crushing it under the weight of interest payments and future obligations.

Part 2: The Income Statement The second main source of information about a company’s financial situation is its income statement. This describes a company’s revenue and earnings during a given time period. Once again, www.freeEdgar.com was used to download XOM’s income statement for the last five quarters beginning with the 4th quarter of 2003.

In general terms, an income statement begins by stating a company’s total revenues, and then proceeds to subtract expenses like operating costs, taxes and interest payments. The resulting figure is the company’s net income for that period. One reason shareholders pay attention to this number is that it is the source of stock dividend payments. If net income falls significantly, a company may cancel its dividend payments. In the 4th quarter of 2004, XOM had a net income of about $8.5 billion.

Profit Margin Dividing a firm’s net income by its total revenues yields the company’s profit margins. Below is a chart of XOM’s profit margins during the last five years. This figure represents the fraction of revenue that a company is able to retain as profit after deducting its expenses.

Although its margins have fluctuated a bit in recent years, XOM seems to have successfully reversed the trend of falling profit margins from 2000 to 2002, and is now able to keep them stable at above 8%. Compared to a competitor like BP Global, whose most recent profit margin was 5.6%, XOM seems to be doing a good job of retaining a large share of its revenues as profits.

This will help preserve a company’s stock price and ensure that dividends promised are paid out.

Interest Coverage Ratio A measure of a company’s ability to pay its interest obligations at any given time is called its interest coverage ratio. Since the obligations include coupon payments to bond holders, the firm’s interest coverage ratio is an indicator that fixed income investors like bond holders will want to pay special attention to. A company’s interest coverage ratio is the ratio of its earnings before interest payments and taxes (EBIT) to total interest expenses. From the numbers in Exxon’s income statement, its interest coverage ratio can be easily calculated. Since its EBIT is $13.35 billion and its interest expenses are $81 million, XOM’s interest coverage ratio is about 164.8. This means that Exxon generates more that 164 times the income it needs to pay off its interest obligations. In most

cases, an acceptable number is as small as 5. Debt does not seem to be a problem for Exxon.

fundamental analysis

But even when using P/E ratios to compare companies in the same sector, it is important to remember that the simple rule of buying low P/E ratio stocks can be potentially misleading. There are many reasons why a company can have a low P/E ratio and not all of them should encourage investors to buy its stock. One possible cause is a sudden collapse in the stock’s price. Although such a collapse could be driven by a fall in earnings, in which case the P/E ratio may not change too much, it could also be due to a variety of other factors – including an accounting scandal, a fall in expected number of profitable projects and a decline in a company’s growth potential. All of these represent company specific shocks leading to a fall in the stock’s price. As long as P/E Ratio these problems cause a company’s stock price to fall faster than its One of the most common indicators used to assess whether a reported earnings, it will have a low P/E ratio. In these cases the stock is relatively “cheap” or “expensive” is its price-to-earnings low P/E ratio should not be interpreted as a buying signal. To avoid ratio (P/E ratio), which this problem, many investors try to calculate what in basic terms describes the forward P/E ratio. This is simply the Just as with technical analy- isP/Ecalled the price an investor is ratio calculated with projected, future earnings sis, there is no single combi- instead of past earnings. willing to pay for $1 of a firm’s present earnings. nation of indicators capable This ratio is very simple to Conclusion of providing unambiguous buy calculate – simply divide a Although the indicators presented in this company’s stock price by article seem fairly simple to calculate and interpret, or sell signals. its earnings per share. P/E fundamental analysis in all of its complexity is far ratios provide a very from straightforward. basic method to Different investors Exxon Mobil Profit Margin compare the relative will disagree on which 10.0% stock prices of indicators matter most several companies. and what their values 9.0% A company with actually mean for a given 8.0% a P/E ratio higher company. Although this than another similar article has only stressed 7.0% company is said to the limitations of P/E ratio, 6.0% be more expensive similar warnings apply to 5.0% regardless of what all indicators. Just as with the actual price of technical analysis, there 4.0% that stock is. is no simple combination 3.0% In general, a of indicators capable of low relative P/E providing unambiguous 2.0% ratio means that buy or sell signals.

1.0% a stock is cheap Instead, the indicators relative to stocks of of fundamental analysis 0.0% 2000 2001 2002 2003 2004 other identical firms. should be thought of Year Many investors will as just one more set of buy stocks with low tools that investors have P/E ratios because at their disposal to make they expect that the price of the stock will increase until its P/E decisions in the complex world of investing. Unfortunately, for ratio converges with the P/E ratio of other similar companies. How new investors, the tools of both technical and fundamental analysis low is a low P/E ratio? Again, it depends on what kind of company often do not come with a straightforward instruction booklet. While is considered. A high P/E ratio in one sector may be considered a this article has attempted to explain the basic tools of fundamental low P/E ratio in another. High tech growth stocks, for example, analysis, there is no universal rule about how these tools should have very high ratios (those with no earnings have infinitely high be used. The best way to discover which tools you think are most ratios). Yahoo, for example, has a P/E ratio of about 50. Exxon, on valuable is to apply them to the real world. If you are right, you the other hand, has a P/E ratio of about 16. The lesson is that in will be rewarded. If you are wrong, you may lose some money, but general, P/E ratios should only be used to compare companies in at least you will learn something. the same industry.

Profit Margin

It should be noted, however, that the interest coverage ratio of 164.8 is a bit deceptive because it comes from only one quarter of financial data. Recalculating the interest coverage ratio for the previous quarter yields a ratio of 21.77, which is still fairly high, but significantly lower than the fourth quarter estimate.

Since fundamental analysis is usually used to evaluate long-term trading options, it usually requires the use of a wide sample of data spanning several years. Using long-term data will distinguish short-term fluctuations from long-term trends and generate a more consistent picture of a company’s performance.

Harvard Investment Magazine :: 8

Student’s Perspective:

The Financial Recruiting World

By: Jennifer Ying Lan Once known only as a small summer job, the prestigious summer internship has now become one of the most soughtafter treasures on college campuses around America. One of the reasons for the increase in the value of the summer internship is the steadily increasing relationship between participating in summer programs and receiving full-time job offers. The National Association of Colleges and Employers reported that in 2001, 25% of all interns went on to full-time positions. Over the past four years, the percentage of summer interns who received job offers rose to 38% in 2005.

Students all around America now covet these internships, especially those in the financial sector. With more students vying for those few and valuable positions, the rigorous application process for internships now rivals many companies’ regular recruiting efforts. However, many students who want to get into this financial recruiting world do not know exactly where to start.

At Harvard, a good place to begin is to make that initial trip into the Office of Career Services (OCS). Although OCS may seem intimidating to strangers, it could quickly become one of your best friends on campus. Most major companies offer information sessions and go through OCS to recruit students on-campus for these prime internships.

9 :: Harvard Investment Magazine

However, once your resume gets reviewed and by chance, you receive the ever important first round interview, how do you know what to expect? Many students do not know what questions are going to be asked, what to wear, and basically, what is going to happen in that foreboding interview room. In comes the ever-important advice from the been-there, done-that upperclassman. The following interviews are of Harvard College upperclassmen and tutors who have gone through the summer internship interview processes and have witnessed first-hand the realities of the interview world. Hopefully, their mistakes will teach you and their successes will guide you through the world of financial internship recruiting.

Daniel Kafie Daniel Kafie ’05, an economics concentrator from Honduras, got into the recruiting world early on. As a sophomore, Kafie landed an investment banking internship with Credit Suisse First Boston. Kafie felt the early exposure to the intense interview processes acclimated him to the world of financial interviews.

During his junior and senior years at Harvard, Kafie went on to interview for an impressive list of firms which include: McKinsey, Goldman Sachs, Mercer Management Consulting, and Lehman Brothers.

When asked what was the one thing that struck him the most about the interview processes for these firms, Kafie replied, “The interviews were more personality interviews than skills interviews. They were to see how you fit with the bank’s culture.

As an international student, I felt I was a strong fit with what Credit Suisse was looking for.” As advice to underclassmen who want to start looking for internship opportunities, Kafie warned that the Office of Career Services (OCS) on campus may be geared more towards juniors and graduating seniors and not towards first-years. However, Kafie said, “Students should not be discouraged if they cannot find the attention they are looking for at OCS. They should still visit OCS and attend the company presentations even though you actually do not learn much about the company through the presentations. The interview process is where you truly learn and interact with the people who you will be working with at the company. Therefore, you develop a more accurate assessment of the firm through its own interview process. For example, a major firm based out of NYC had the same interviewers during final rounds for both summer and full time recruiting. Even though the interviews were months apart, I ended up getting the same questions. To me, that was very indicative of a serious lack of attention to detail or even a mere effort towards examining candidates under a fair light. In the end, it really weighed down on my overall impressions of that firm’s culture.”

As a general approach to preparing for the interviews, Kafie recommended that people try to be “as laid-back as possible. Do not put too much pressure on yourself.

Go in there and present yourself. Definitely be smart and attentive, but be normal.

Try to turn the interview around so that the interviewer starts to sell you the company, instead

student’s perspective of you trying to sell yourself. Once you turn the interview around, the interviewer will try to convince you, the student, that the company is worth working for. You really need to make them want you by the end of the interview.”

Most first-round interviews are conducted at 1414 Massachusetts Avenue, one of OCS’s facilities. Kafie recalls the atmosphere at the interviews as having “people camped out. You meet mostly the same people throughout all of the interviews over and over again. It is kind of a tense atmosphere in the room because people are nervous. You just make small talk or crack friendly jokes with people. Once you start the interview, however, it gets a lot better. It is a small room so it is just you and the interviewer, and that way you have privacy and more control. 1414 Mass Ave is a neutral space because the company’s culture is not stamped on it. This is a sharp contrast to the final interview which is in someone’s office. It is their space, and you feel foreign to it so it is a lot more intimidating.”

These days, a lot of college students have already gone through numerous interviews for scholarships, awards, and colleges so they know the general feel of the interview. However, many do not know what types of questions are asked in financial internship interviews. Kafie remembered the interviewers not asking many specific financial questions like, for example, how the interest rate hike would affect mortgages in Poland. “The questions were more psychological. They wanted to know how you thought

student’s perspective

Daniel

as a person, rather than how big your knowledge base was.

One of the weirdest questions I got was, ‘If I gave you ten million dollars, what would you do with it?’ They did not really care about the details on how I would spend the money. They just wanted to see how ambitious I was as a person.”

Kafie’s final advice to students who are about to enter the financial internship world is to “be yourself during interviews. Put yourself in the interviewer’s shoes and try to see Kafie what the interviewer is trying to get out of you.

They want leadership and commitment; therefore, present yourself as someone who is strong in those areas. In the end, in order to realize whether this world is for you or not, you really just have to go through with it. That will be the only way you can see if you really want to do this for a career.”

for students “to go to the information sessions hosted

by OCS. Go to the companies that interest you the most in addition to some of the smaller ones. Those in the fall are more tailored to seniors who are looking for full-time jobs, but it is helpful to attend them to experience the environment and learn about the companies. More companies come to campus in the fall, which will show you a better idea of what is out there. The spring information sessions are geared towards underclassmen, so those are more helpful to undergraduates looking for summer internships.”

After interviewing for companies like Goldman Sachs, Citigroup, Morgan Stanley, and Banc of America, Finn decided on interning with Citigroup her junior summer.

Finn strongly believes that “doing the internship was the way to go. I got to see what it was all about. It either told me ‘yes, definitely’ or ‘no way’ concerning whether I wanted to pursue this as a career after graduation. During the internship, I learned so much that was not taught anywhere in a Harvard

They want leadership and commitment... present yourself as someone who is strong in those areas.

Daniel Kafie ’05 will be entering Harvard Business School to pursue an MBA this fall.

Meredith Finn Meredith Finn ‘05, an economics concentrator from New York City, approached the financial recruiting world with the help and advice of her upperclassman friends.

Finn believes that “the most important thing that you can do is to talk to your friends, especially upperclassman friends, who have already gone through the process. They will give you the most frank advice that you are looking for because they know you. They will not try to mislead you about the process. They allow you to test the waters, and once you get your feet wet, it is a lot easier to figure out what to do next.”

Another thing that Finn really recommends is

11 :: Harvard Investment Magazine

Meredith Finn

classroom.

Citigroup’s summer internship was a major program so there was time for a one-week training program. I took accounting lessons, computer lessons, and such from 9-5 everyday. We learned how to do things from integrating financial modeling to using Excel and PowerPoint.”

When asked about the interview processes for the summer internships, Finn recalls the questions as being “straightforward and pretty similar among companies.

They asked me things like what are your three greatest faults or failures. I was thrown off slightly because I had prepared to talk about one, not three. I recommend going in and being able to talk about your resume. You cannot just let them look at it; you have to really flush it out for them and let them know what you contributed and what you gained from your activities and accomplishments.”

For advice to students who are preparing for the financial recruiting season, Finn added, “the real interviews

are done at 1414 Mass Ave in the OCS building down there. However, OCS also offers mock interviews. These are really important because they are simulated by students from the business school who have done recruiting for a variety of firms.

They have actually already gone through this. They give you lots of pointers on what things to highlight and what things to talk at length about in interviews.

During the internship, I learned so much that was not taught anywhere in a Harvard classroom.

These mock interviews are really helpful because you do not want to walk into an interview having never practiced. The first interviews will always be a little off because once you walk in, the sense of realness hits you. So if you prepare with mock interviews, it will definitely give you a head start on things.”

Meredith Finn ’05 will be working with Citigroup’s investment banking division immediately after graduation.

Jeff Jeff ’05, an economics concentrator from Boston, first heard about the financial recruiting world through his “roommate who was pretty into finance. I knew I was interested in economics and making money, so I started asking more friends about the process and began looking into things at OCS.” Jeff ended up interviewing for companies like Morgan Stanley, Credit Suisse First Boston,

student’s perspective Deutsche Bank, Citadel, and DE Shaw. With the area of Fixed Income as his main career and intellectual interest, Jeff prepared for the interviews by “trying to keep abreast of the Dow, the recent market developments, and long term interest rates.

The night before the interview, I would do research for a specific company and try to identify any recent developments for that company. The interviewers will ask, ‘Do you follow the Wall Street Journal or New York Times; What is your favorite section in these papers, etc.’ It definitely pays off to be prepared and to be able to come back with upto-date information. The interviewers may even ask about their own company, so you do not want to look like you do not know anything about the company you are interviewing for.”

In the beginning, Jeff said he felt nervous. But as he began interviewing for more and more companies, the anxiety started to subside. Jeff says, “Once you get past the first 5 minutes, the nervousness passes.

When you get that first offer, the nervousness completely washes away, and you learn to take charge in your own interview.

It is kind of like being nervous at the beginning of an exam. Once you actually start doing the problems, then the anxiety passes.”

Jeff recalls the first round interviews taking place in “waiting rooms that were just like fishbowls.

There was glass on two out of four sides. Everyone is anxious and nervous and ready to get it over with.

Some people are lounging and waiting, while some people are intently studying a paper they wrote so that they can talk about it. The interviewers I got, it was luck of the draw. Some were nice, some were mean. I have never really been caught off guard with questions, but there are some tricky questions that pop up every once in a while. Those tend to be the brain-teasers. In Fixed Income, they are often quantitative questions. They are fun though. In one

Harvard Investment Magazine :: 12

student’s perspective

Jan Szilagyi

interview, I got asked nothing about finance the entire interview. They just asked me what position I would play in soccer, what is the riskiest thing I have ever done, etc. Once, one of my friends got asked if he were greedy. He thought about it and said yes, which turned out to be the right answer.

My first interview was pretty tough, but what I think is the hardest part about an interview resides in the resume. It takes you two to three years to build up a good resume and transcript. It is a really long and tedious process. Companies have cutoffs for GPAs which they let you know about.

They may not say it but they do, so sometimes mediocre grades plus a lot of extracurricular activities do not cut it. Also, depending on the field you are interested in, especially for the quantitative positions, course selection matters, which you cannot go back in time and change” Jeff believes that in order to decide whether a career in the financial world is something that you want, a student should intern and experience the whole environment first-hand. As a junior, Jeff interned at a boutique middlemarket investment bank. Jeff says, “I actually did investment banking that summer and I turned out to not like it that much. It was very boring work at low levels because all you do is plug numbers into models, create PowerPoint presentations, use Excel, etc. In the end, I did not think it was something that I wanted to do. It was very menial work.

Nonetheless,

my experiences showed me that I like working at smaller firms. I got more responsibilities and at board meetings, I was actually invited to participate. They would ask me things like, ‘what do you think of the deal? In larger firms, they ease you in. In smaller firms, they throw you in the lion’s den because they cannot afford to spare extra people. In the end, I enjoyed this kind of aggressive hands-on experience for my internship.”

After graduation, Jeff ’05 will be working for Deutsche Bank in Global Capital Markets.

Jan Szilagyi

Jan Szilagyi, a mathematics major at Yale ’01, is a Kirkland House resident tutor from Slovenia. Szilagyi entered the financial recruiting world after he heard from a good friend working at Goldman Sachs that it was a great place to be employed. Therefore, Szilagyi ended up interviewing for McKinsey, JP Morgan, Goldman Sachs, and Morgan Stanley. After receiving an offer from Goldman, Szilagyi decided to turn it down to head back to school. However, after a couple weeks of graduate school at Harvard, he decided at that point, school was not what he wanted to do. So Szilagyi left to go work for the hedge fund Duquesne Capital LLC. After working there for two years, Szilagyi left the financial world again to pursue a Ph. D. in Economics at Harvard University.

At Duquesne, Szilagyi found that “Duquesne has a special type of ease-in process. It is a small company so there is no formal training. They only hire one person every now and then so they assigned me to a couple of senior guys. The guys taught me important things, but I also had to do things they did not want to do, like write computer models, so that they could focus on the big picture while you did the little things. I feel that if you have someone who wants to take on a mentoring role, and not just give you an assistant’s role, you will learn a lot more about the company.”

One of the most important lessons that Szilagyi learned from working in the financial world is that “there are no extensions at work. You cannot email the Teaching Fellow for an extension on a deadline. In the real world, if something had to be done by a certain date, it had to be done. This really teaches you to keep your focus. Working

student’s perspective

for a year before coming back to school really gave me a different perspective on life. It showed me what I was working towards. It let me see what skills I am lacking so that when I came back to school, I was able to target the specific areas in which I knew I needed to learn more about.”

Back when Szilagyi went through the interview processes, he felt that the best way to prepare for the interviews was “going to those informational dinners and events which bring analysts who are recent graduates. Talk to them about what is going on at the company, about what they do, and why they wanted to be there. Most of the time they are the ones who do the first round interviews, too. When you go in for the actual interviews, definitely learn the basic terms for finance. Some companies had online interview aids that tell you what terms you need to know. Go and read up on each firm, know things about the company you are interviewing for. ” As for the actual interviews, Szilagyi feels that, “confidence improves from one round to another. Once you get past one round, it gives you confidence because you know you got that far. The first round interviews are brief. They are just asking general questions to reduce the applicant pool down. This is where they weed out people who did not prepare for the interviews at all and people who are very generic candidates.

Some interviews are filled with puzzles and math questions.

They want to see how you think, not necessarily whether you can solve it. For example, they will present scenarios to you; sometimes they have nothing to do with finance. A company once asked me how much paint I would need to paint a Boeing 747. Most questions just deal with general knowledge, like how well you estimate certain things. Some questions are more

technical like: can you compute the present value of something?

For example, a friend of mine was once asked to solve a puzzle that dealt with a chessboard with each side missing a square. They asked him if he could still cover it with dominoes because a normal chessboard can be covered perfectly with dominoes. It is a challenging puzzle, but you should not freak out. If people freak out and cannot solve it, then they just show the firm that they would not perform well in tough situations. The hardest questions are the ones that ask you to list your strengths and weaknesses like ‘why are you good for this job?’ You do not want to come across as arrogant, but at the same time, you do not want to present yourself as a guy with a bunch of weaknesses either. Those answers are always the trickiest. Nonetheless, companies often decide ahead of time who they want, but the interviews are used to confirm their original opinions.”

Szilagyi felt that two of the most important things that anyone going into an interview should be prepared for are knowing your resume and having prepared questions of your own. Szilagyi warns students, “You do not want to contradict your own resume. Know it very comprehensively. You do not want to say that you are good at languages and that you know seven of them, but then list one of your weaknesses as learning languages. Also, when they ask you towards the end whether or not you have questions, do not ask, ‘how do you like working at Goldman?’ That is such a generic question and it will not make you stand out at all. You should come up with two or three creative questions to ask them, so they see you as an intelligent and interesting candidate worthy of remembering.”

After graduation from Harvard with a Ph. D. in Economics this summer, Szilagyi looks forward to re-entering the financial world.

Ashley Ma Ashley Ma ‘05, an economics concentrator, grew up in New York City. Because she grew up in one of the biggest financial centers of the world, Ma was “always somewhat

Harvard Investment Magazine :: 14

student’s perspective

Ma believes that “one of the key things in an interview is to stay calm. The interviewers want to see how you will act if you are sitting with them in a board room meeting for eight hours a day. You have to be a likable person because the interviewers are the people who will be working with you in the future.

Most companies send Harvard alumni to interview candidates, so that could either be good or bad. You can be comfortable discussing things with them, but not too comfortable because they are your interviewers.”

Ma felt the best way to prepare for an interview is to “just know what is going on in the financial world.

You do not have to know the Wall Street Journal cover to cover, but have a good sense of what is happening in the industry. Also be aware of who your competition is. The company and the interviewers will know about you because most of their employees are Harvard graduates, so do not come off sounding too normal or bland or that your life is based around investment banks. If your GPA is lower comparable to other students, you should spend extra time justifying why you deserve the position. Knowing your resume is one of the most important things you can do to prepare, too.

Talk about what has been most significant to you, what has prepared you for this job, etc. The resume is the first thing they see about you, so you need to bring life to your resume.”

When confronted with a weird question, Ma feels that the best way to approach this is to “take a deep breath.

Think about what seems like the most natural response. Do not let what they ask you shake you, definitely keep your composure. One of the weirdest questions I ever got was ‘tell me something that has nothing to do with your resume.’ It was a trick question, but I just took a deep breath and worked my way through it.”

As for the actual internship experience, Ma interned for Smith and Barney the summer after freshman year. “The program provided really good training. They will interpret your abilities and place you in the best place possible for you. I worked with private client groups and got a really good education in terms of what I saw first-hand. I saw how the director interviewed with the clients and it just added to a greater picture for me. It is really useful to be there and see how the different parts of an investment group work. Something that I wish more Harvard students were aware of is job-sites like Monstertrak.com. You have to put the effort into it by posting your own resume, drafting letters, contacting the places. But if you take the initiative, this is a great opportunity because you are not competing with all Harvard students anymore. The companies will see you in a different light and pay more attention to you. It also might be hard because you know these companies are not specifically looking for the Harvard-type student or else they would have come on campus. But it is really

Companies want a candidate who knows about the company and their expertise and is interested in what the company does.

aware of the process. I always had friends who were going through interviews or already working in the industry. I comped the business board of The Crimson freshman year which helped me out a lot.

I made a lot of connections when I worked alongside juniors and seniors who were going through the process. People would find out about information sessions and then the word would get around. It really helped always being around that kind of environment. The information sessions I ended up attending were not helpful in explaining the delineation between the different areas of finance and how companies differed from each other. I believe that in order to find out more about each company and their culture, you really need to speak to people who are working or have worked there.”

Ma ended up interviewing for companies like Merrill Lynch, Boston Consulting Group, McKinsey, Alexander Hamilton, and other smaller hedge funds. Going into the final interview processes for these companies, Ma relied on her experiences from previous internships and interviews to help her. “After sophomore spring, I did a couple of interviews and applied for a few jobs. I did not get those because I was a sophomore competing against juniors and seniors, but I learned so much. It was a really steep learning curve. In the first interviews, I had no idea of what to say. But towards the end, I learned what to say and how to tell my story.

The first interviews are about learning as much as possible.”

15 :: Harvard Investment Magazine

worth a try.”

Ashley Ma ‘05 is will be banking at Jeffries Broadview after graduation.

Una Kim Una Kim, Cornell ’97, is currently a Ph. D. candidate and a resident tutor for Kirkland House. When in college as an undergraduate, Kim was not sure if the Ashley Ma financial world was what she wanted to be involved with. Kim entered the whole process “almost by accident. I was not really looking in the finance direction. I went into it as an adventure. I did not know anyone in those areas. But I knew that if I did not interview for finance firms then I would never do it again. It was almost like the most extreme thing I could do at the time. I ended up doing all of my interviews off-campus and through network searches because I missed the on-campus recruiting season. I used the alumni network and called hundreds of

student’s perspective people, used tons of websites, and ended up interviewing for many consulting firms before I ended up with an interview and then an offer from Solomon Brothers.”

Going into the interview process, Kim “did not know anyone who worked in business. I ended up giving mock interviews to myself. I wrote down answers to questions that might pop up.

I developed lots of stories based on things I have done, wrote them out, and practiced for months before interviews. This really helped because once they asked a question, I felt really comfortable talking about myself. The actual interviews turned out to be varied. The environments can be aggressive. When you have interviews with multiple interviewers, it is really hard because you cannot form a one-on-one relationship with the interviewer.”

On the actual internships, Kim felt that students who enter the financial world need to know what they want to do and why they are doing it. “The students need to be clear about the goals that they want to accomplish. It is easy to get lost and to lose your center because it is an industry with a lot of money, a lot of egos, and a lot of young people which skews the personalities and the values. Most people in the financial world are between 25-35 years of age. In order for someone to do well, they need to know what they want out of it and to have a strong support network outside of the financial areas. You need to ask people to keep you in check because you cannot stray too far from your own values. People get in trouble for illegal things, fired for expense fraud and corruption. Remind yourself why you are doing what you are doing and have people close to you force you to question yourself.”

For students who are just getting into the financial recruiting sector, Kim recommends that “students go to OCS. Speak to alumni. Put in early on research because it will really help you. Learning in different areas will help you with lots of firms. Also put in extra work in finding companies that do not come to campus. Most companies do not participate in on-campus recruiting, and this is especially true of industry (versus professional service) positions and smaller firms. Many companies that students would enjoy working for do not come to campus so students need to look for them by themselves.

The smaller companies do not have time to recruit, so if you present yourself, they are more likely to accept.”

In interviews, Kim recommends that the “most helpful thing is to know what you are talking about.

You may not know the details, but show that you have done your homework. Show that you have thought it out. Companies want a candidate who knows about the company and their expertise and is interested in what the company does.”

After completing her Ph.D. in organizational behavior and sociology, Kim plans on entering teaching.

Harvard Investment Magazine :: 16

Jeff Bezos

An Interview With When you decide to start your own company, you should pick an area that you have a lot of passion for. Too often, I see people chasing the latest hot trend, whatever that might be, and that very rarely works out well.

By: Michael Hauschild

Jeff Bezos is the founder and CEO of Amazon. com. After graduating from Princeton summa cum laude, Phi Beta Kappa, in Electrical Engineering and Computer Science in 1986, Mr. Bezos joined FITEL, a high-tech start-up company in New York. In 1988, Mr. Bezos joined Bankers Trust Company, New York, leading the development of computer systems that helped manage $250+ billion in assets and becoming their youngest Vice President in February, 1990. From 1990 to 1994, Mr. Bezos helped build one of the most technically sophisticated and successful quantitative hedge funds on Wall Street for D.E. Shaw & Co., New York, becoming their youngest senior Vice President in 1992. In an interview with HCIM, Mr. Bezos shares with us his experiences founding Amazon.com.

17 :: Harvard Investment Magazine

HCIM: Can you describe your experiences founding Amazon. com and growing it into a retailing giant in less than 10 years?

When I started out, World Wide Web usage was growing at 2,300% a year. That was the wake-up call that told me there is something interesting going on and suggested the kind of business opportunities there might be. I have always been interested in computers and computer science. So I started looking at what different business plans might work in that kind of environment because industries that are growing 2,300% a year are very rare.

HCIM: What are the lessons that you have learned about the

retail industry, the Internet and consumers?

The one thing that we started out with and have developed more and more over the years is our obsession over customers. We are a very customer-focused company. What is interesting is that despite all the changes in technology and adoption of the Internet, the primary drivers of great customer experience have not changed much over the past ten years. The big drivers for us are selection, low prices and convenience – making it easy for people to get products quickly and at the right price. Our customers are not computer experts; they are ordinary people who want to get things done. So, for each of these variables – selection, price, convenience

Harvard Investment Magazine :: 18

interview: Jeff Bezos

and availability – we have been striving to improve all the time.

Not so long ago, we introduced Amazon Prime, which is our latest project to make it easier for shoppers to get their products faster while still doing that at a low cost.

HCIM: Do you see Amazon.com as a traditional retailer?

The skills and competencies you need to be an effective

The only way to do that is to continue to improve customer experience, which is what we focus on every day. We have been relentlessly pushing for greater efficiency and productivity so that we can give back the same efficiency to the customers. We are constantly working on increasing selection and in-stock availability.

This allows us to have the products closer to the customers and enables quicker product delivery to the buyers. These are the kinds of things that you have to do as you continue to earn and generate new business from customers.

HCIM: 5 to 10 years is a long time in the Internet space.

Where is Amazon.com headed in the long-term?

For us, what is in a way most interesting is the stability of the primary drivers that I mentioned earlier – convenience, price and selection. When we devise our strategy, we try to build it around things that we know will not change much over time. A lot of things will change dramatically in the next five to ten years, and a lot of these changes will be good for our business. People will start to have multiple computers at home, with very capable mobile devices that enable them to shop when they have moments of downtime, such as PDAs that wirelessly connect to the Internet. But the things that will not change are in some ways the most important. Ten years from now, people are still going to demand low prices; they are going to want convenience, rapid availability and a big selection of products. We are not going to wake up ten years from now and have customers think that it would be even better if things were a little less convenient.

HCIM: Amazon’s international segment is a very important part of the company. Can you talk about your recent expansion into China with the acquisition of Joyo.com?

online retailer are really quite different from what you need to be a great physical retailer. Our business is driven by technology. My background is in computer science, and that is what our company is focused on, making sure that we have outstanding technology.

The core and essence of physical retailing is the old saying that the three most important criteria for success are location, location, location. And that is true; real estate is very important for the physical retailing business and the physical retailers are experts at that. For us, real estate is not a very important consideration.

Instead, technology takes the place of real estate. So, there are a lot of differences. If you look at our financial model, you will see that we can turn our inventory much faster because we have such an efficient inventory system and we do not have to keep many copies of the same book in a network of 500 stores. So, when you look at the details, the two businesses are actually quite different.

HCIM: How do you ensure that Amazon.com is the preferred shopping location for millions of online shoppers?

19 :: Harvard Investment Magazine

Last year, we acquired the Chinese online retailer Joyo. com. The rapid adoption of the Internet in China, coupled with rising incomes, is very promising for Amazon.com from a long-run perspective. The Joyo team is already very successful at drawing in customers in China, and we will continue to improve the customer experience there by broadening the selection and lowering prices as we have done in many of our other international properties.

HCIM: Amazon.com launched A9.com in October 2003. What is A9.com and how does it fit into your strategy?

A9.com is a website that does web search. It is personalized, and it greets you by name the way Amazon.com does. It keeps track of all your searches and makes all the searches you have ever done searchable. This means that if you did a search a year ago, you can go back in time and easily find what you were searching for.

You can also drag-and-drop bookmarks. In addition, we recently added a new ‘BlockView’ feature for our A9 Yellow Pages. We had trucks equipped with GPS and digital cameras drive all over the US and take pictures of streets and buildings so that users can search for an address or a business and see the street they are on before they even get there. A9.com is all about innovation in and around web search.

HCIM: You have long held the view that in the long-run, the interests of customers and shareholders are aligned. But it seems that in the most recent quarters, Amazon has been rewarding customers more than shareholders. How would you communicate your long-term strategy to shareholders?

Eight years ago, we went public at a split-adjusted price of $1.50 a share. In eight years the stock has gone up by a factor of more than twenty, and the long-term return to investors at Amazon.com has been very healthy. At the same time, we have been relentlessly working to improve the customer experience in every way we possibly can, even if it is expensive for the company in the short-term. This is the right strategy and approach for our business, and it is the strategy that we are going to continue to pursue. Amazon Prime, which we launched in February, is a great example of this. Amazon Prime allows customers to get free unlimited 2-day shipping for any order and next-day shipping for only $3.99. Amazon Prime will be very expensive for the company in the short-term, but in the long-term, we expect it to help us earn more business from our current customers, as they value the increased convenience and look to Amazon.com for more of their everyday purchases. As a result, it will drive larger amounts of free cash flow, which is what will help shareholders. Therefore, in the long-term, we genuinely believe that the interests of customers and shareholders are perfectly aligned.

HCIM: What is the biggest threat to Amazon.com’s long-term success?

I think that one thing that will keep us in good stead over the long-term is this obsessive focus on the customer. I think that it is always tempting for companies to get competitor-focused. We pay attention to competitors; we look at them, but we are never

competitor-obsessed. Instead, we try to be customerobsessed. We will look at competitors to see if they are doing good things for their customers and whether or not we can learn from it. We try to stay heads down and focused on our customers. In the Internet space in particular, where the rate of change is so great, by being focused on customers we get to do things for them more quickly than we would be able to if we had closely followed our competitors. We really like the position we are in. If you look at the people who are attracted to Amazon, they are very innovation-focused.

We get a lot of satisfaction out of inventing new ways to do things for our customers. Not only is being customer-focused a good business strategy, but it also happens to be very fun.

HCIM: What is the craziest thing you have ever done as the CEO of Amazon?

In some ways, one of the craziest things we ever did at Amazon was to start the company selling over a million different books.

Many people we talked to certainly advised us that this would be very hard to do. And they were right, it was very hard. But I also think that, with hindsight, this was one of the best things we ever did, because in the early days, many people bought books that were extremely difficult to find from us. We kept that same strategy over time. When we go into a new category, we try to have the ultimate selection, not only the best sellers, but also the products that are very hard to find – be that in our kitchen store, tools store or electronics store. We pursue that strategy relentlessly. It was one of those things in the early days where the prudent course might have been to start with a smaller selection and then work your way up.

But taking this broad-based approach did work out well for us.

HCIM: What advice would you give to graduating college students who are thinking about starting their own business?

First of all, I would advise everybody who asks that question that it is a good idea to go work for several years in a best-practice company. It is very helpful to learn a lot of the things that you will learn in an already established company. The second thing is that when you decide to start your own company, you should pick an area that you have a lot of passion for. Too often, I see people chasing the latest hot trend, whatever that might be, and that very rarely works out well.

Harvard Investment Magazine :: 20

Kenneth C. Griffin is Chief Executive Officer and President of Citadel Investment Group, L.L.C. Mr. Griffin founded Citadel in 1990 and has led the organization’s evolution from a small Chicago hedge fund to a $12 billion global investment firm.

Mr. Griffin graduated with honors from Harvard College, earning a B.A. in Economics. While at Harvard, Mr. Griffin created investment partnerships for relative value trading. Upon graduation, Mr. Griffin joined Glenwood Partners in Chicago. The success of his early investment partnerships and his strong performance at Glenwood led Mr. Griffin to found Citadel one year later.

From its roots as a single-strategy investment firm, Citadel is now involved in a variety of asset classes, including equities, fixed income, energy products and foreign exchange. In addition, Citadel Derivatives Group, an affiliate of Citadel, is a leading market-maker in U.S. equity options. The firm employs approximately 1,000 professionals, with offices in Chicago, New York, London, San Francisco and Tokyo.

Citadel’s investors include corporate pension plans, families of wealth, leading university endowments, money center banks, global insurance companies and Wall Street investment banks.

In addition to Mr. Griffin’s responsibilities at Citadel, he is a member of the Boards of Trustees of The Art Institute of Chicago and the Museum of Contemporary Art. He also serves as a Director of The Chicago Public Education Fund and the Harvard Financial Aid Task Force.

By: Anna Haisi Yu

21 :: Harvard Investment Magazine

Movers and Shakers:

Kenneth Griffin

For me, an environment where I am learning, where I am challenged and where I am growing, is where I want to be.

HCIM: You started Citadel with no formal technical training and only a Harvard Bachelor’s degree. What is it that has brought you to where you are today? How do you survive and excel in an industry that is now overcrowded by Ph.D.s and occasionally Nobel Laureates?

The willingness to learn on my own and from others has been important throughout my career. I began trading options during my freshman year and really enjoyed the challenge of trying to find opportunities in the market. I realized quickly that I knew very little about the financial markets. Fortunately, Harvard had incredible resources; the Baker Library is one of them. I spent hours in Baker almost every day and read every book I could find on financial theory.

In addition, I learned early on in my career that people really enjoy developing and mentoring young people who are willing to listen. A number of people were instrumental in teaching me the ropes of business. I spent countless hours on the phone with market professionals from firms like Bear Stearns and Merrill Lynch who were willing to take me under their wing and share their insights, their expertise and their experience.

Today, some of the most successful individuals at Citadel have been able, early on in their careers, to build similar connections and establish similar relationships with other market professionals. The willingness and ability to listen are important factors in enabling young people to be successful in building rewarding careers.

HCIM: Many academics and finance professionals believe that there could be a bubble in the hedge fund industry. The discussion has been going on for a while, and the hedge fund industry seems to continue to do well. Do you see a bubble and what is your view of the future of the hedge fund industry?

Within the strategies that are employed by hedge funds, we have seen $600 to $800 billion of equity capital enter the space in the last 5 or 6 years. Whether you consider the dotcom sector, the telecommunications sector, even the railroad sector, I don’t believe any industry has attracted as much capital over such a short period of time throughout history. With that much capital flowing into the business, it is reasonable to conclude that the prospect for better than market returns going forward is pretty bleak. During the internet boom, many companies suffered not only stock price underperformance, but literally ceased to exist. I don’t see the same type of outcome for the hedge fund industry. Although we have seen thousands of hedge funds delivering mediocre returns, resulting in investor disappointment, we have not seen the type of value erosion experienced during the internet bubble.

HCIM: Size can be a blessing, but it can also be a problem.

With $12 billion under management, how do you make sure that Citadel ‘stays ahead of the curve’?

I think you have perfectly addressed the question. Size is a double-edged sword with great advantages and disadvantages.

Typically at small hedge funds there are a handful of smart investment professionals who are very good at making

interview: Kenneth Griffin investment decisions based on their intuition, their experience, their analysis and their understanding of the marketplace. Small hedge funds with small amounts of capital can enjoy the returns from these investors’ labor. However, as the manager wants to Our philosophy is built around finding exceptionally talented grow his or her business, success is no longer tied to the efforts of individuals and encouraging them to become great entrepreneurs. a few; it is about the performance of the institution and the team.

We look for people who have the ambition to become market If you look at the largest participants in the capital markets, leaders in a particular segment of the capital markets, who such as Goldman Sachs, Lehman Brothers and Morgan Stanley, understand how to work within a team and lead their teams to you can see that they have very impressive returns on their capital. leverage their collective skills. These professionals endlessly seek There is no indication that size is an issue for large investment to create competitive advantage and understand which investment banks. Many of them have grown significantly larger over the past processes will make them successful. When they find such a decade and their returns continue to be substantial. At the same process, they execute it relentlessly day in and day out. They also time, they have generated a competitive advantage. They are know how to leverage other market participants, capabilities from able to recruit teams of exceptional Wall Street, technology, analytics, people; they are able to put in place their relationships with corporate investment processes and in turn, America, and they use all of these My advice to every student who is generate exceptional results. They levers to compete in the global trying to make a decision for the years have built franchises that return markets. Citadel is very different value. from the gifted one-person shop I immediately after graduation: take It is difficult to transition between spoke about earlier. Our business the opportunity that in your mind these two extremes. Some managers is about talented people joining can generate very good returns on together with the mindset of is the most rewarding, that you are their own but don’t know how to building a great business. most passionate about and that you delegate or leverage themselves. find most interesting and save the As they grow, they get into trouble.

HCIM: There seems to be a We believe that the most successful convergence of the hedge fund and rest of your life for being risk averse. hedge funds will be able to organize the private equity industry. What do their teams and their capabilities in a you think of that trend? fashion similar to the big investment banks in order to create a sustainable long-term competitive There is no doubt that some of the largest hedge funds are advantage. making more and more investments in areas that were once dominated by private equity firms. The reverse is also true in that HCIM: You said that you see Citadel as an entrepreneurial some private equity firms are now building hedge funds. I believe project rather than a hot-shot money making machine when you that this trend will continue in the future. The largest firms will visited Harvard last year. What is your philosophy in running the attract some of the greatest individuals from both fields to take company? advantage of opportunities in the market as a whole, whether it is

interview: Kenneth Griffin the public or private markets.

HCIM: Is Citadel itself thinking of entering into the private equity business?

We certainly have it on our strategic road map, but we also see tremendous opportunities in the businesses we are in today. These areas will be our principle focus for a long time.

an unusual path for most college graduates. What is your view on risk-taking?

I certainly took an unusual path when I graduated. Importantly, one needs to understand that when students graduate from Harvard, they are very lucky because in those early years they are in a position to do whatever they want to do. No matter how wrong it goes, they can always get back on their feet and try again. When you are 35

HCIM: With offices in Tokyo and London, what are Citadel’s future plans for international expansion? And more specifically, what is your view on the opportunities in China?

We have been very successful in terms of our own international efforts. Furthermore, we have a long history of investing in foreign countries. In the early 1990s, we generated almost half of our profits in Japan. In Europe, our London office provides us with a phenomenal vantage point from which to invest across the entire region. Asia is more difficult because of the cultural differences and geographic dispersion. In Europe, it is possible to get from one country to another within two hours. In Asia, that is simply not the case.

Strategically, as we build our business in Asia, we will have to be on the ground The willingness and ability in more countries. As such, our strategy is years old, with a family, children to listen are important different between the US, Europe and Asia. We and additional responsibilities, are looking to establish multiple locations in you are not in the same position factors in enabling young Asia in the years to come. to take risks as when you are 22 people to be successful in In terms of opportunity, China is important or 23 years of age. So my advice to understand because of its impact on the to every student who is trying building rewarding careers. global capital markets. The country is a huge to make a decision for the years consumer of natural resources as well as a huge immediately after graduation: producer of consumer and industrial products. take the opportunity that in your The growth of China’s economy impacts all of our businesses mind is the most rewarding, that you are most passionate about simply based on its size. Having said that, capturing investment and that you find most interesting and save the rest of your life opportunities in China remains challenging from my perspective. for being risk averse. Whatever you want to do, this is the time to There are a number of changes that need to take place in pursue it. Twenty years from now, your freedom to take risks will China in the years to come in order for it to become a market be limited. where foreigners are able to be successful as passive investors.

It is important to distinguish between direct foreign investing, HCIM: What is the next step for you? such as building a factory, and passive investment. As China has opened its markets, people have had great success with foreign I truly enjoy what I do. More importantly, I enjoy my direct investment over the last few years. As a passive investor, colleagues. I am fortunate to work with many individuals who are profitability comes from owning stocks or bonds. The opportunities incredibly brilliant, ambitious and who keep me on my toes each for foreign investors in this area remain scarce. The market is and every day. For me, an environment where I am learning, where small, there are restrictions on many activities, and it is a difficult I am challenged and where I am growing, is where I want to be. market to succeed as a foreign investor in public securities.

We have experienced a huge period of growth, a huge period of creativity and innovation, and from my vantage point this is HCIM: You run a business that deals with risk. At the same exactly the job that I want and the environment in which I want time, you also took a lot of risk in your personal life and picked to live.

25 :: Harvard Investment Magazine

Where Will Russia Go? A Look at the Future Prospects of Russia’s Economy By: Oleg Bibergan

In 1886, Russian poet Fedor Tyutchev wrote a famous poem on the complexity of understanding Russia: Russia cannot be understood with the mind Nor can she be measured with an ordinary yardstick There is in her a special stature You can only believe in Russia 120 years later, foreign investors are still faced with the dilemma of “understanding Russia with the mind.” Is Russia on the way to becoming a global investment powerhouse, or is it closing itself, returning to the frosty times of suspicious, inwardlooking authoritarianism?

On one hand, Russia was and remains a country where investment opportunities are spectacular. It is the nation with the largest domestic market in Europe with 143 million people, lowest personal income taxes at 13%, and an educated, cheap workforce with an average salary of $4000 a year.

One can get an idea of the country’s progress from its cell phone usage, which doubles every year; close to 55% of the population now owns mobile phones. The government, at least publicly, is eager to attract foreign investment, and sometimes it succeeds in doing so: in 2003, British Petroleum, one of the largest oil producers in the world, bought 50% of TNK, a private Russian oil producer, to form a TNK-BP partnership. In another example, in 2004, ConocoPhillips invested in a minority stake in Lukoil, another private oil company in Russia.

Overall, for 2004, Foreign Direct Investment (FDI) in Russia soared to US$9.4 billion, which is 38.9% higher than in 2003, according to the Russian statistical agency Goskomstat. Recently,

Harvard Investment Magazine :: 26

global outlook: Russia Jim O’Neill, a chief economist at Goldman Sachs, estimated that Russia, along with Brazil, China and India, will overtake the overall GDP of the six largest industrial powers in the world by 2050. Furthermore, the Russian Center of Macroeconomic Analysis projects that in the next four years, investors around the world will bring to Russia another US$83 billion.

Domestic investment in Russia is rising as well. For example, the management team of MMK, a major steel producer, bought out 17% of the government share in MMK for US$790 million. Numerous Russian companies conducted IPOs, among them AFK Sistema, one of the major national telecom holdings, and NPO Irkut, an aircraft producer. These developments illustrate that both domestic and foreign investors are confident in Russia’s potential as a place where money can be made. These investors are eager to enter the burgeoning environment before their competitors by investing billions of dollars into the developin Russian economy, which grew by more than 7% in the last several years.

There is, however, another side to this picture. Many investors are discouraged by the arbitrary and capricious bureaucratic system in Russia. Courts are rarely considered independent and prudent institutions like those of the US and other Western nations. Indeed, investors’ trust was shattered by a series of murky court processes against Yukos, formerly Russia’s largest and most transparent private oil producer.

Lord Owen, a prominent British statesman who became the chairman of Yukos International UK in 2002, once said, “Yukos is one of Russia’s most innovative and dynamic companies.

It is at the vanguard of new modern Russia and is adopting global best practices across its businesses.” Yukos was worth US$40 billion in October 2003 before the arrest of its CEO, Mikhail Khodorkovsky, on the counts of tax evasion and money laundering. Russia’s Federal Tax Services (FNS) also unleashed a series of tax raids and investigations on the company to verify its tax accounting for the time period 2000-2003. In 2004, FNS fined Yukos and its subsidiaries US$27.5 billion for violations during those years. Despite the efforts of Yukos’ lawyers, the courts quickly rubberstamped these charges made by the FNS.

This made the government the biggest holder of Yukos’ debt, and allowed it to subsequently acquire Yugansk (abbreviation of Yuganskneftegaz), Yukos’s major oil subsidiary, in a rather shady auction with only two participants: the state-owned Rosneft and a mysterious Baikal Finance Group (BFG). The latter, which won the auction with a bid of US$10 billion (which was only negligibly higher than the original starting bid), turned out to be a virtually asset-less company officially located on the second floor of an apartment building in the small provincial town of Tver. Nevertheless, this unknown company somehow managed to borrow US$3 billion from a state-owned bank and used it to buy out Yugansk. The absurdity of the situation was reinforced when Rosneft later bought BFG, and hence Yugansk, for 10,000 roubles, equivalent to US$400.

Once the new owners from the state stepped in, earlier tax fraud charges against Yugansk were soon dropped in successful appeals to the court.

Yukos, torn apart and ravaged, is now worth less than US$1.5 billion. Interestingly, it is well-known that all Russian oil companies use loopholes in laws to minimize taxes, mainly through offshore zones and gross abuse of tax exemptions.

For example, the oil company Sibneft used the so called “handicapped” tax minimization scheme. Under this plan, Sibneft would set up a number of companies, each having employees which, peculiarly, would be physically handicapped in one form or another, with blindness, deafness and muteness among many of the disabilities found in the workforce. The rationale for this ploy was that under Russian laws, companies

Many investors are discouraged by the arbitrary and capricious bureaucratic system in Russia.

27 :: Harvard Investment Magazine

that hire a large number of employees with disabilities receive tax breaks. While many other firms like Sibneft cheat the Russian system, not a single company was hit and punished as hard by the government as Yukos was. Public opinion believes that Mr. Khodorkovsky violated the unofficial agreement that the President of Russia, Vladimir Putin, struck with the oligarchs after the presidential election in 2000. The agreement was simple: “you don’t mess with politics, and I won’t mess with economics.” In essence, if the richest Russians do not attempt to fund opposition and criticize the government, then the government in power promises to be benevolent to the dubious privatization schemes in the 1990s. However, if the bounds are crossed, the ruling power will ruthlessly punish the businesses. Whether that is true or not, this example illustrates the Russian bureaucrats’ arbitrary use of law, which is hardly attractive for foreign investors.

The tax fraud charges against Yukos were overwhelmingly viewed as political in nature. The real question is whether the Yukos case was unique, or whether investors should anticipate further crackdown against other private companies. On one hand, the evidence is quite pessimistic. In the past year and a half, the FNS made a number of high-profile charges against companies such as Vympelcom, the leading Russian mobile phone provider, TNK-BP, another private oil company, and a whole array of other firms. Are the charges made by the FNS a simple enforcement of a much needed tax discipline, or are these the government’s deliberate efforts to strip the assets of major companies that have stood in its way?

The case of Gazprom highlights the ambiguous and mixed signals that the current Russian government delivers to businesses. A government-controlled gas fuel company,

global outlook: Russia Gazprom is the direct heir of the Ministry of Gas Industry in the former USSR. In 2004, it was decided that Gazprom will acquire Rosneft, a state-owned oil company, to form a statecontrolled natural resources behemoth. Investors were optimistic about the deal, since the government promises to liberalize the trading of Gazprom shares once the merger goes through. While the government’s offer may appear appealing, a closer look at the deal reveals a much less attractive scenario. Years earlier, Rosneft had made a costly acquisition of another company that raised its own liabilities by US$10 billion. In addition, while the heads of the two corporations, Gazprom and Rosneft, entered into behind-the-scenes warfare on the conditions that the companies will merge under, their motivation, sadly enough, was not in the interest of the shareholders, but rather focused on their own bureaucratic power.

There is a growing understanding both among politicians and businessmen that government pressure on businesses is debilitating the country’s recently improved investment climate. In his 2005 address to the parliament, President Putin demanded that the bureaucrats cut red tapes and stop “terrorizing businesses” with dubious tax charges. He also made many other highly encouraging remarks about protection of private property, freedom of speech, and democracy. Unfortunately, these words have to be taken with caution, because they come from the leader who, among other things, promised that Rosneft would not take part in the Yugansk auction, and then concluded that its participation was completely legitimate. President Putin was also the one who noted that there was no need to change the regional governor elections law, but then changed

global outlook: Russia it to indirect elections. In addition, he had said that the country needed independent courts, but then proceeded with the Yukos case, in which government pressure undermined the court’s independence in an unparalleled magnitude.

In the end, the primary concern for both foreign and domestic investors alike is what the government’s economic intentions are. Because the government displays both positive and negative signals to businesses, its true motives are hard to gauge. And while investors are optimistic about investing in Russia, they are less confident about keeping their money there long-term. Net outflow of funds reached US$27 billion in 2004 as businessmen, worried that their companies will become the next Yukos, rushed to hedge against political risks by transferring money abroad, mainly to Britain and Switzerland.

With these concerns in mind, how can investors hedge against the government’s unpredictable involvement in businesses? John Brown, the chairman of BP, believes that the best way to protect investments in Russia is to strengthen close relationships with people in the Russian government. If investors go to Russia ready to play by Western rules, they will have to face serious disappointments. It is, after all, important to be on the bureaucrat’s good side to get things done. The power of the bureaucrats rose significantly under President Putin’s rule, and as their resources grew, so did their greed. Russian government needs to realize that protecting property rights, curbing corruption, and upholding independent courts are needed to strengthen the economy and make Russian markets more efficient. There are tremendous opportunities for foreign investment in Russia, but whether they will be realized depends on future government policies and the government’s willingness to reverse its repressive cycle.

Because the government displays both positive and negative signals to businesses, its true motives are hard to guage.

HSA CASE STUDY COMPETITION October 2005

* Participate in an exciting day-long team competition * * Practice case interview skills with judges from recruiting financial firms * * Use and develop your analytical, problemsolving and communication skills *

Awarding Cash Prizes!

For further details visit www.hsa.net/cfe/ YOUR EDGE FOR THE RECRUITING SEASON

Constructing Credibility in China By: Anna Haisi Yu Professor Ming Huang received his PhD in Finance from Stanford University and PhD in Physics from Cornell University. He is now the Vice President and Professor of Finance at Cheung Kong Graduate School of Business in China and an Associate Professor of Finance at Stanford University. Prof. Huang has also taught at the University of Chicago and is the recipient of a number of awards for his outstanding achievements in research and teaching.

What impact does corporate credibility have on the financial market? How can a strong Chinese credit rating system be built? In an interview with the Harvard College Investment Magazine (HCIM), Prof. Huang talks about building a strong credit system in China, the world’s fastest-growing economy.

HCIM: How does corporate credibility play a role in the proper functioning of the financial market?

Huang: First of all, we can consider the financial market as having three important participants: issuers, investors, and intermediaries that facilitate the transaction of capital between those who have excess capital and those who are in need of capital. Companies raise capital to invest in profitable projects, and the cost of this capital is based on their level of credibility; the higher the credibility, the lower the cost. To attain a high credibility, companies must operate their businesses responsibly and protect the investors’ interests. Here, I want to emphasize the difference between corporate bankruptcy and jeopardizing investors’ interests. Under normal market conditions, a company may have to file for bankruptcy and liquidate for different reasons. However, bankruptcy does not necessarily imply that management was involved in illegal practices. After all, any time a company raises capital, it bears the risk of becoming insolvent. As a result, there are insolvent companies even in a well-developed financial market, and a system in which there are no bankruptcies is an unhealthy one, because it implies that either investors are not taking enough risks or the market is covering up problems in unhealthy companies. Companies becoming insolvent at a healthy rate is one of the most important characteristics of a financial market with a well-developed credit rating system.

Now let’s consider the role of investors. With a well-functioning credit rating system, investors only need to make a utility maximizing decision about investment risks based on company ratings from the rating agencies. Therefore, with the help of the credit rating system, issuers and investors each have clear and distinct functions in the financial market:

Harvard Investment Magazine :: 28

issuers should actively improve businesses and keep investors up-to-date on the companies’ operations; investors, in turn, must analyze the risk-return tradeoff and adjust the amount of capital invested accordingly.

Intermediaries such as investment banks, accounting firms and credit rating agencies take on the third role in the financial market.

Their job is to reduce misinformation between companies and investors and improve market transparency through professional research. Intermediaries resemble issuers in the sense that they also strive to improve credibility and trustworthiness. The heavy reliance on credibility by all three parties constitutes a network of trust that pushes the market to greater efficiency.

HCIM: How would the financial market behave if there were no credit system?

Huang: In the absence of a credit system, companies will lose the channel through which they raise capital because investors will not have information about the businesses and their trustworthiness, thus making it difficult to evaluate the investments. This results in a significantly higher cost of financing and may even paralyze capital flows. In China, for example, there is virtually no corporate bond market because of its weak credit rating system. Although some companies manage to issue debt with guarantees from the government, this is still not “real” corporate debt financing.

From the investors’ perspective, the absence of a credit system limits their investment opportunities. This cripples the economy’s ability to efficiently channel resources to where they are most needed and puts to waste vast amounts of resources that could be used to add value and generate returns. China is a big country and there are many talented entrepreneurs with creative ideas and strong technical skills. The malfunctioning capital market, unfortunately, makes it extremely difficult for these bright individuals to raise money and carry out their ventures. Ideas are thus left unutilized, and this is a huge loss for our society.

HCIM: China has its own credit rating agency, but why do investors distrust their ratings?

31 :: Harvard Investment Magazine

Huang: The Chinese government works very hard to develop the corporate bond market, which relies heavily on a fair and well-developed credit rating system. The current situation in China is very simple: almost all the companies are AAArated, but their ratings in the international capital markets are far from being good. This is because Chinese companies bribe the credit rating agencies and every AAA-rating becomes a profitable source of income for these agencies. Even if the good companies are reluctant to follow this practice, the bad ones will, which then puts the good companies at a disadvantage.

Ironically, Chinese credit rating agencies do have the ability to accurately evaluate a company’s financial conditions. These agencies have a good understanding of the markets and are well aware of the factors that apply to China’s economic environment. Sadly, the credit rating agencies, driven by profit, are hardly reliable.

HCIM: Given the problems that you mentioned, how can China establish a healthy credit rating system and deter bad practices like bribery, which you mentioned above, from occurring?

Huang: When China imported foreign technology two decades ago, the technology sector ended up being taken over by foreign companies. This example illustrates the reason why China’s credit rating system should not be a simple importation of foreign credit rating agencies. This does not mean, however, that China should not invite US agencies to help her. Indeed, rejecting foreign intermediaries is equivalent to rejecting the credit system altogether. After all, the entrance of US companies will help Chinese c r e d i t rating

intermediaries build up their reputations in a shorter period of time than if they were left on their own. While Chinese agencies can benefit from the presence of foreign institutions, we must also ensure that foreign companies not take over, but instead simply play the role of assisting domestic agencies.

Economists sometimes define credibility as the accumulation of all past information about an entity. Because the market infers a company’s future based on its past, it will take a long time for Chinese agencies, known for their history filled with scandals, to build up their reputations. Having said that, what is the key to constructing the strong credibility that these Chinese agencies need?

The answer is simple. Think about why investors trust Moody’s ratings and not a nameless agency’s. This is because Moody’s values its own reputation very highly. If they accept bribes and in return give out an inaccurate AAA rating, investors will lose faith in Moody’s and its business will fail. Chinese rating agencies need to place the same kind of emphasis on their own reputation. Credibility itself, after all, is the most important attribute for credit rating agencies.

HCIM: How can the Chinese government support the development of trustworthy credit rating agencies?

Huang: Standard & Poor’s and Moody’s received a lot of support from the U.S. government when they first started. The government often adopts very strict rules to ensure that financial agencies acting on behalf of investors invest only in companies above a certain level of rating. This encourages companies looking to raise capital to invite agencies to conduct credit ratings. Investors, at the same time, are also in great demand of credit reports for potential investment targets. With needs of credit ratings from both investors and companies, driven in part by the government, a market based on credibility is naturally born. Currently, the Chinese government has very good opportunities to support and build a strong credit system because financial resources are mostly controlled by the government or government related agencies.

HCIM: From what you are saying, if the government regulates that all issuers must have credit ratings, this will generate huge demand for credit reports. Won’t the credit rating agencies then have even more opportunities to profit from bribes and in the process further undermine their credibility?

Huang: In the long-run, we cannot rely solely on the government to build a healthy credit system; both issuers and investors must act as judges of the credit rating agencies. The government can also adopt a policy that closes down one or several poor performing agencies each year based on investors’ feedback; the vacancies can then be filled with newly founded and hopefully better agencies. This policy is applicable to the current situation in China because the companies that are investing in the bond market are large and well-structured institutions with very high levels of expertise. They can accurately assess the performances of the

global outlook: China rating agencies, and their judgments will have an impact in the voting process mentioned above.

If Chinese corporations can establish solid reputations for themselves, they will have more business and generate greater returns.

HCIM: Finally, what are the longrun consequences of having a poor credit system in China?

Huang: An obvious drawback in the current Chinese capital markets is that all the business opportunities that need credible companies are taken by foreign businesses.

One such example involves the construction and maintenance of financial data systems. Large financial institutions with hundreds of thousands of clients often assign the task of processing client information to outside specialists. Such outsourcing is necessary because it is costly and inefficient for each institution to set up its own data storage and processing system. Finding a trustworthy agency for this job, however, is very difficult in China. After all, the agency may sell the information to competitors for profit.

While a well-developed credit market does not have such problems because the only corporations that can take on data processing jobs are those with excellent reputations, this is not the case in China.

The poor credibility of Chinese agencies causes these jobs to be outsourced to more trustworthy foreign companies like Thomson One, and profitable opportunities are thus taken away from local businesses by foreign financial institutions.

In the end, if Chinese corporations can establish solid reputations for themselves, they will have more business and generate greater returns. This, in turn, will benefit the shareholders, who will then have more capital to invest. Credibility is thus the key to driving the Chinese economy.

Harvard Investment Magazine :: 32

Interview with Mr. Kairat Kelimbetov

Minister of Economy and Budget Planning of the Republic of

By: Kuanysh Y. Batyrbekov

Kazakhstan

HCIM: Please, tell us about yourself.

What are your responsibilities as a Minister and what is the mission of your ministry?

How did you become a Minister and did you encounter any difficulties in your career path?

I was born in Almaty, the ex-capital of Kazakhstan. I specialized in mathematics in secondary school, and this subject played a crucial role in my career. I graduated from Moscow State University with a degree in applied mathematics and started to think about a career in academia and science. At that time the President of Kazakhstan, Mr. Nazarbayev, created a unique system for enrolling young professionals into public service agencies in the country. So I enrolled in the program and in 1996, after graduating from the National Higher Academy of Public Administration under the President of Kazakhstan, I joined the team of Higher Economic Council, which developed the Kazakhstan-2030 national strategy.

When working in various governmental agencies, we tried to bring into Kazakhstan the best practices from all over the world, and one of the main reforms that we successfully implemented was the coordination of strategic, economic and budget planning. So I have the privilege of being the first Minister of Economy and Budget Planning of Kazakhstan, which was created in 2002. Throughout this time, I continued to further my education, the highlight being my taking of the 5-month advanced economics course titled “Leaders of the 21st Century” at Georgetown University in 1999.

The scope of our ministry’s responsibilities is very broad: formulating the state’s economic, budget, and fiscal policies, managing administrative reforms, and overseeing territorial development, to name a few. But our main mission is to provide an integrative framework for all policies as well as other government initiatives.

I cannot imagine anyone developing his or her career without

33 :: Harvard Investment Magazine

any obstacles. In my career there were a lot of difficulties, and as my position rose I felt that the obstacles became more and more complicated. This is normal – I cannot say that I like them, but I know that I have to go through them.

HCIM: President V. Putin promised to double the GDP of Russia by 2012. When do you think Kazakhstan will double its GDP and what are the growth rates of Kazakhstan’s economy in the last ten years?

According to the Strategy of Social and Economic Development of Kazakhstan, the government is planning to double the year 2000 GDP figure by 2010. The good news is it seems that we can achieve this target ahead of schedule. While in the 1990s Kazakhstan’s economy was going through a period of stagnation, since 2000 it has been on a positive trend of high growth rates.

In 2004, the real GDP growth rate was 9.3 percent. By the end of 2004 the economic potential of the country exceeded the 1990 GDP by at least one percentage point, and by 2007 we expect to exceed that by 26.8 percent. Over the last three years Kazakhstan’s GDP increased by 36.6 percent, while the target was 31.9 percent.

In 2005 the real GDP is expected to grow at a rate of 7.9 percent.

Thus, the economy of Kazakhstan is already ahead of its schedule by 10 percent, which means that by 2008 its GDP will double the 2000 figure, meaning that we will be two years ahead of schedule.

global outlook: Kazakhstan

HCIM: How can you explain such a rapid economic development? And can you talk about the potential for financial market development, in particular M&A and IPO? It is not a secret that Kazakhstan’s recent economic growth was mainly due to high world prices for petroleum, which is our main export commodity. But it would not be right to say that this is the only reason.

Since declaring independence, Kazakhstani authorities have been executing sound economic reforms, with clear targets and an emphasis on the consistency and continuity of economic policies. During its development, the economy of Kazakhstan faced and overcame difficult periods of post-USSR collapse and the Asian financial crisis. Through this, we better understood the need to diversify our economy away from extraction sectors, and the importance of managing inflows of liquidity in the growing exports. We have sound economic fundamentals, including the most advanced banking system in the CIS (Commonwealth of Independent States), a growing pension fund system, the National Oil Fund, and a strong network of development institutions, which opened new opportunities to channel public and private savings into local and foreign investments through a risk-sharing structure.

The next set of economic development is the implementation of the State Program for Industrial and Innovation Development:

Kazakhstan: Real GDP Growth Rates for the Last 10 Years (in percent) 1995 1996 1997 1998 1999 2000 2001 2002 2003 -8.2 0.5 1.7 -1.9 2.7 9.8 13.5 9.8 9.2

modernization of the stock market, and the creation of a regional financial center in Almaty, which, we hope, will bring us to a higher stage in terms of the quality of financial services and to a new level of stock market capitalization.

As for IPO’s, we think that it is one of the most attractive ways for our corporate sector to raise capital in international and local markets, and to benefit from our current macroeconomic development. Up to now some banks from Kazakhstan have already issued ADRs (American Depository Receipts) and have experience in this area. But in order to bring our companies to the market we need to set up stronger principles of corporate governance and adopt the International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS). For small- and medium-sized companies, conditions for local IPO would be created in the Almaty Financial Center, a place where large corporations, including state-owned enterprises, have access to international capital markets.

As for Mergers and Acquisitions (M&A), it has become an important financial activity in recent global development. For Kazakhstan, M&A is one of the essential tools for upgrading the quality of our financial system, and to further promote M&A, we need to create financial and industrial groups in Kazakhstan. There is the possibility in the near future of selling a part of government owned stock in large state-owned enterprises to well-known international companies and portfolio investors. Indeed, I believe that we need to fortify our position in international markets while the market situation is favorable for our issuers.

2004 9.3

Working in the public sector brings together a professional career, prestige, stability, and the chance to work on interesting projects.

Harvard Investment Magazine :: 34

global outlook: Kazakhstan Let me also mention that Kazakhstan, within the last few years, has substantially improved its macroeconomic environment, and we see a favorable macroeconomic situation as a prerequisite for the effective implementation of industrial and innovative strategies. In addition, we are taking steps to improve the business climate as a part of the ‘Kazakhstan Competitiveness Initiative’.

HCIM: Can you please tell us about the project of creating a financial center in Kazakhstan’s ex-capital, Almaty?

The project “Creating a Regional Financial Center in The new generation Almaty” is being implemented under of young professionals the guidance of the should be multilingual.

Ministry of Economy They need to know how and Budget Planning and administered by to speak English and the think-tank of the other foreign language.

Center for Marketing and Analytical Research. We are also working closely with The Boston Consulting Group (BCG), which acts as a consultant and helps us align the project with the best international practices.

The main goal of the project is to ensure economic feasibility by creating an international and regional financial center in Almaty, and to study its potential. Many tasks remain to be done in the project, such as the development of the model and structure of the center, including its instruments, players, regulation, marketing policy and infrastructure.

Presently, the project has entered the third phase. The first two stages involved research on the best international practices, assessment of the domestic and target countries’ financial markets, and looking into two alternative locations for the financial center. At the end of the second stage, the decision was made to build a center that will integrate domestic and international markets. We still need to lay out a detailed plan that will be presented to the Kazakh authorities.

The plan will consist of additional measures and stipulations needed to improve the existing financial market.

Lessons from the past experiences of Singapore, Dubai and Dublin tell us that a country’s overall environment, infrastructure and business credibility form the critical foundation for success. This foundation, however, requires long-term development. Dubai’s financial center is still a work in progress, but the deliberate actions undertaken by the Dubai International Financial Centre have already yielded encouraging results. The elements that account for Dubai’s success can be found in Almaty as well: a diverse and educated workforce, a committed financial community and strong support from the government. Like Singapore, Almaty has a relatively well-developed infrastructure when compared to other cities in the region. Singapore, Dubai and Dublin have

35 :: Harvard Investment Magazine

also established developmental agencies dedicated to attracting foreign companies and investment while also responsible for expediting all necessary approvals and procedures in the process.

This is something that we should also look into.

HCIM: Why did you choose to work with Boston Consulting Group over other companies on the Almaty project?

The work on creating a financial center in Almaty started more than a year ago. After looking into and thoroughly analyzing similar international financial centers in Dubai and Dublin, the government decided to work on the project with an international consulting company that has rich experience in financial market strategy development. Based on independent analysis of the consulting services market and consultations with various interested counterparts within the country and abroad, the choice of which firm to work with was short-listed to two consulting companies: The Boston Consulting Group and McKinsey & Company.

Both these companies are leaders in creating business strategies in different countries, especially in financial sector development. The most important selection criterion was that both companies had a lot of experience working on similar projects in a number of different countries; the most successful ones were in Dubai (UAE), Singapore, and Thailand. The two companies also had experience in the CIS market. However, preliminary negotiations with the companies’ representatives

global outlook: Kazakhstan

revealed that McKinsey & Company was not able to take part in the project at that time, while The Boston Consulting Group expressed a strong interest in the project with the commitment to fulfill it within a tight timeframe.

It should also be mentioned that The Boston Consulting Group is one of the best consulting companies on finance issues in the world. BCG undertook financial market development projects in a number of countries, including Hungary, Argentina, France, Germany, Canada and USA, acting as a consultant to governments.

The company is a real pioneer and international leader in creating and developing business strategies. It developed new analytical instruments that are used today in business practices worldwide (for instance, the Boston group matrix, time competition, experience curve etc…). Based on these solid credentials, BCG was selected as the project’s sole consultant.

HCIM: Turning to another topic, what do you think about the role of women and national minorities in the government? What is the extent of this problem right now in Kazakhstan?

In our country there are equal rights for everybody in all areas.

This is something that has long been enshrined in the constitution.

In Kazakhstan today, both male and female leaders from different regions and different parts of the community are playing key roles in the country’s political, economic, and cultural arenas.

I would say that our ministry is a good example in this regard.

Most of the top managers are women; our staff is multinational and I think that everybody feels very comfortable here. I must note that Kazakhstan has about 120 ethnicities that peacefully coexist. This ethnic tolerance is reflected by the composition of the government, where ethnic and gender barriers do not play a role in career advancement.

HCIM: What do you think about the US budget deficit and its impact on Kazakhstan and its currency exchange rate?

The US economy continues to be fuelled by credit from the rest of the world, as evident

by America’s alarming levels of current account deficit. Some have even commented that the world is essentially relying on a ‘banker’ who may not pay up. I personally feel that the situation is not as dire as some have predicted, but there are still reasons to be concerned. For us, the decline of the dollar against most currencies is compounded by the appreciation of tenge (Kazakhstan’s currency), which would have occurred regardless of the dollar’s current woes. In Kazakhstan, there is consensus that our currency will continue to appreciate as FDI (foreign direct investment) continues to flow into the country. In such an environment, we believe that we need to help the country’s non-extractive exporters stay competitive; otherwise, the President’s stated goal of ‘diversification’ in the exporting sector will be in peril.

When we talk about the US budget deficit, we should also be aware of the market views. Not long ago, the dollar-to-euro rate reached the highest historical level of 1.3640. After market corrections, it is again showing signs of moving up. In my opinion, however, we also need to take into account the quality and structure of US government debt. If somebody tells me that Kazakhstan could owe government debt with a yield curve up to 30 years and with the average yield around 2% like the current US debt, then I would say that this is the ideal scenario that many countries dream about. We do not think that the US budget deficit, with such an efficient structure, is a subject of high risk for the US economy.

As for the impact of this issue on the economy of Kazakhstan and exchange rate volatility, I would say that first of all we are exposed to interest rate risk, since we have dollar denominated liabilities with floating rates, as well as dollar investments in fixed income instruments. Nonetheless, we believe that our managers will do their best to eliminate this particular risk by using interest rate swaps (IRS) or other structured derivative products and strategies. Meanwhile, exchange rate volatility could take place with a certain lag after prices of export commodities rise. Should this happen, we will prepare a number of measures to keep the exchange rate within the permitted range, and we will be ready with measures to minimize possible external shocks.

HCIM: Finally, what advice would you give to students planning to pursue a career in civil service?

The public sector today needs people who understand modern management, modern technologies, and public administration.

Young people planning to join the public sector must meet certain requirements. Aside from a degree, young people should have personal qualities such as diligence and discipline. Moreover, they should be able to write well, a skill much needed when writing policy papers. The new generation of young professionals should also be multilingual: besides their native language, they need

Harvard Investment Magazine :: 36

global outlook: Kazakhstan to know how to speak English and other foreign languages.

Indeed, having civil servants with multilingual skills is one of the conditions for a competitive state, economy and nation to thrive, and the government should actively look for the best graduates to join the public sector.

What kind of opportunities make students want to work in the public sector?

For one, working in the public sector brings together a professional career, prestige, stability, and the chance to work on interesting projects.

In addition, young people will acquire a

37 :: Harvard Investment Magazine

number of valuable skills as well as the understanding of their place and role in an organization. This experience can be very useful in business companies if they decide later to change their careers. From civil service, you can also learn about the process of decision-making. You will understand macroeconomic issues and acquire the ability to think at a global level. A civil servant, finally, knows and understands tax and corporate laws as well as the civil code. Civil servants therefore acquire not only management experience, but also how to build ties and relationships that can be useful in the future.

I also want to say that we have carried out a number of public service reforms in Kazakhstan. The purpose of these reforms is to increase the effectiveness and efficiency of our public administration, and to improve the living standards and social status of the civil servants. Young people who want to pursue a career in public sector need to know that their knowledge and skills is much needed.

In the end, I believe that working in the civil service sector today can offer great opportunities for young, vigorous and innovative people.

Aggregate Short Interest and Market Valuations By: Owen A. Lamont & Jeremy C. Stein Owen A. Lamont is a Professor of Finance at the Yale School of Management.

His research interests include imperfect capital markets; short selling; security prices, expected returns, and reaction to news; diversified firms and internal capital markets; and macroeconomic fluctuations and investment. He is a Faculty Research Fellow at the National Bureau of Economic Research, and previously held positions at the University of Chicago, Princeton University and The Boston Company Economic Advisors.

Jeremy C. Stein is a Professor of Economics at Harvard University, where he teaches courses in finance in the undergraduate and PhD programs. Before coming to Harvard in 2000, he was for ten years on the finance faculty of M.I.T.’s Sloan School of Management, most recently as the J.C. Penney Professor of Management. Prior to that, he was an Assistant Professor of Finance at the Harvard Business School from 19871990. He received his AB in economics summa cum laude from Princeton University in 1983 and his PhD in economics from M.I.T. in 1986. His research interests include behavioral finance and stock-market efficiency; corporate investment and financing decisions; risk management; capital allocation inside firms; financial intermediation; and monetary policy.

The spectacular rise and fall of stock prices during the recent dot-com bubble period has been accompanied by a surge of interest in the topic of short-selling. For the most part, this work is cross-sectional in nature, examining the causes and consequences of short-sales constraints at the individual-stock level, and it suggests the following two broad conclusions.

First, consistent with the notion that short-selling is undertaken by rational arbitrageurs, the demand for short positions is greatest among stocks that appear to be overvalued—e.g., stocks that have high ratios of prices to book value. Second, because of frictions in the market for borrowing stock, as well as various institutional rigidities, arbitrage by would-be short-sellers is incomplete. Thus those stocks where the demand for shorting is greatest (as measured, say, by a high premium paid to borrow the stock for the purposes of shortselling) tend to have abnormally low future returns.a Less attention has been paid to variation over time in aggregate short interest, and to the role that this might have in countering marketwide sentiment. Casual intuition might suggest that short-selling-based arbitrage would be more effective along the aggregate dimension than it is in the cross-section. After all, while it can be difficult at any point in time to short a minority of very overpriced stocks, most stocks are easily and cheaply shorted. Moreover, there are other ways to get a short bet down on the aggregate market—for example, by purchasing put options on various indices.

It turns out that this intuition is off the mark. We examine some basic data on the evolution of aggregate short interest, both during the dot-com era, and at other times in history. In a striking contrast to the patterns seen in the cross-section, total short interest moves in a countercyclical fashion. For example, short interest in NASDAQ stocks actually declines as the NASDAQ index approaches its peak. Moreover, this decline does not seem to reflect a substitution away

Short-selling does not play a particularly helpful role in stabilizing the overall stock market.

Harvard Investment Magazine :: 38

Jeremy C. Stein from outright short-selling and towards put options: the ratio of put-to-call volume displays the same countercyclical tendency. As we discuss below, the evidence is perhaps most consistent with Andrei Shleifer and Robert Vishny (1997), who argue that the openend nature of most professional arbitrage firms (i.e., the fact that investors can withdraw their funds on demand) makes it difficult for these firms to buck aggregate mispricings. The evidence also suggests that short-selling does not play a particularly helpful role in stabilizing the overall stock market.

I. The Data A. The Dot-Com Bubble Figure 1 tells our basic story for the dot-com period. We plot three series on a monthly basis over the interval 1995-2002: i) the NASDAQ index (CRSP’s total return index); ii) the valueweighted short-interest ratio (100 times the market value of shares sold short, divided by the value of shares outstanding) for all NASDAQ companies; and iii) the 60-day moving average of the Chicago Board Options Exchange’s (CBOE) daily put-call ratio.

The put-call ratio is the total CBOE trading volume in puts— including both index options as well as options on individual NASDAQ, NYSE and AMEX stocks—divided by the volume in calls, and we use it as an admittedly noisy proxy for the magnitude of shorting done via options. This ratio averaged about 0.7 during the period; we have multiplied it by four in the figure so as to fit it on the same scale as the short-interest ratio.

As can be seen, both the short-interest ratio and the putcall ratio decline substantially as the NASDAQ index explodes upward from mid-1998 to its peak in March of 2000; they both then rebound sharply as the index collapses over the subsequent two years. Some simple statistics confirm the visual impressions from the figure. The return on the index over the prior twelve months has a correlation of –0.54 with the short-interest ratio; and a correlation of –0.63 with the put-call ratio. (The short-interest ratio and the put-call ratio are themselves highly positively correlated, at 0.58, suggesting that these two measures are capturing similar information.)

Aside from these time-series patterns, it is also worth noting

39 :: Harvard Investment Magazine

Owen A. Lamont that remarkably little short-selling takes place at any point in the cycle. In the case of the NASDAQ, the short-interest ratio averages 2.53 percent over our sample period, and never breaks four percent.

B. Short-Selling on the NYSE, 1960-2002 For a longer historical perspective, we examine NYSE data from 1960 to 2002. Because of both data availability and institutional differences, we use an alternative measure of shortselling. One issue is that we have better data here on short-selling volume than open interest. A second is that on the NYSE, unlike the NASDAQ, a large fraction of shorting is due to specialists, who are engaged in high-frequency hedging. So the measure we use is total shares sold short by public investors (as opposed to by NYSE member firms) divided by total share volume, which we term the short-sales ratio, and which we can calculate on an annual basis.

The NYSE short-sales ratio trends sharply upwards during this period (rising from 1.2 percent in 1960 to 6.6 percent in 2002), perhaps reflecting the growing popularity of hedge funds and other long-short strategies. Thus we look at the change in the shortsales ratio. In Figure 2, we plot this change against the annual return to the value-weighted NYSE stock index. The two series move strongly counter to one another—the correlation coefficient is –0.51, which is highly statistically significant. So overall, this longer stretch of history tells much the same story as Figure 1 does for the dot-com era.

II. Implications The evidence suggests that aggregate short interest displays extrapolative behavior—i.e., it looks like fewer investors are willing to bet on the market going down after a period in which it has been rising. But this characterization raises a puzzle. Recall that at the individual-stock level, short interest appears to be contrarian in nature, with high-priced stocks attracting more attention from short-sellers. So why does the cross section of shorting seem to reflect the actions of rational arbitrageurs, while the aggregate time series seems to reflect the actions of naïve trend-chasers?

One potential answer has to do with the open-end nature

at countering market-wide sentiment shocks than it is at enforcing rational pricing in the cross section. This can be true even though the most obvious direct impediments to arbitrage (e.g., individual stocks being hard to borrow) arise in the cross section.c Of course, this line of discussion raises another question: if open-ending is such a handicap for arbitrageurs when it comes to dealing with marketwide sentiment, why is the open-end form so common?

On the one hand, it seems clear that open-ending is a natural response to problems Figure 1 NASDAQ Index, NASDAQ Short Interest Ratio, and CBOE Put-Call Ratio, of agency and asymmetric January 1995 – December 2002 information. Investors worry about turning over their money of professional money management. Consider an example in the to somebody who may turn out to be incompetent or crooked, spirit of Shleifer and Vishny (1997). Suppose there are a set of and so attach value to an early-liquidation option. Yet it does not hedge funds that specialize in short-selling. The managers of these follow that the degree of open-ending that we observe is one that funds are rational arbitrageurs, so at any point in time, they will use serves investors well. Stein (2003) argues that competition among the capital they have to target a portfolio of the most overvalued money managers for investors’ dollars creates an externality, and can lead to a socially excessive amount of open-ending. When any 1.5 one fund open-ends, it compromises its own ability to undertake 1962 certain kinds of arbitrage (which is both a private and social cost), but it makes itself more attractive to investors, and thereby steals 1 business from other funds (which is a private, but not a social 2002 1990 1970 2001 gain).

1974 1966 1995 This general perspective on the constraints faced by .5 1996 professional money managers is helpful in thinking about the 1968 1973 Change in Short Sales Ratio 1982 1993 1994 1985 1988 1986 arbitrage role played by non-financial firms. In contrast to the 2000 1998 1989 1977 0 1980 behavior documented above, non-financials were, effectively, 1997 1984 1965 1978 1964 1979 1969 1983 1981 enormous short-sellers during the bubble period, via issues of 1987 1999 their own shares—the dollar volume of initial public offerings and 1972 -.5 1976 1961 1991 seasoned equity offerings peaked at roughly the same time as the 1992 1967 NASDAQ index. In rationalizing this fact, one probably does not 1975 -1 want to take the position that non-financial managers are shrewder or better-informed than, e.g., hedge-fund managers, particularly 1963 1971 with respect to market-wide movements in prices. A more plausible -402 Changes-20 0 20 40 Figure in NYSE Short-Sales Ratio vs. NYSE explanation has to do with a comparative institutional advantage.

NYSE Return Return, 1961-2002 A non-financial manager who issues equity at the time of a market companies—hence the pattern of shorting in the cross section. But peak does so in the closed-end corporate form, and without being when the market rises, the short-selling funds will lose money, and subject to mark-to-market accounting. So if the market continues hence will face redemptions from their clients. These redemptions to go up, she will not record a loss, and she will certainly not be (i.e., the well-known “performance-flow” relationship) may have faced with the threat of liquidation. their roots in either rational updating about hedge-fund-manager As a final point, our data shed some light on the tendency for ability, or in some degree of irrational trend-chasing on the part of short-sellers to come under political attack in the aftermath of large end investors. But in either case, the result is that fund managers market declines. Jones and Lamont (2002) discuss the crackdown have less capital to work with in a rising market, and are forced to on short-selling after the crash of 1929, and note that numerous scale back their aggregate short positions. anti-shorting regulations stem from this period, including the The broad message is that because of the pervasiveness of uptick rule, as well as the Investment Company Act of 1940, which open-ending, professional arbitrage may be even less effective placed severe restrictions on the ability of mutual funds to go

Harvard Investment Magazine :: 40

short interest and market valuation short. It is clear from Figures 1 and 2 that aggregate short-selling tends to increase in bear markets, which perhaps makes it all the easier for people to blame the messenger.

However, according to our interpretation of this evidence, the problem is not too much shortselling in falling markets—recall that the aggregate volume of short interest is always quite small in absolute terms—but rather, too little in rising markets. If this view is correct, any regulatory efforts to constrain shortselling are likely to be misguided.

References Brunnermeier, Markus and Nagel, Stefan. “Hedge Funds and the Technology Bubble.” Journal of Finance, 2004, forthcoming.

Chen, Joseph, Hong, Harrison and Stein, Jeremy. “Breadth of Ownership and Stock Returns.” Journal of Financial Economics, November 2002, 66(2-3), pp. 171-205.

D’Avolio, Gene. “The Market for Borrowing Stock.” Journal of Financial Economics, November 2002, 66(2-3), pp. 271-306.

Dechow, Patricia, Hutton, Amy, Meulbroek, Lisa and Sloan, Richard. “Short-Sellers, Fundamental Analysis and Stock Returns.”

Journal of Financial Economics, July 2001, 61(1), pp. 77-106.

Griffin, John, Harris, Jeffrey and Topaloglu, Selim. “Investor Behavior Over the Rise and Fall of Nasdaq.” Working paper, Yale University, 2003.

Jones, Charles and Lamont, Owen. “Short Sale Constraints and Stock Returns.” Journal of Financial Economics, November 2002, 66(23), pp. 207-239.

Lamont, Owen and Thaler, Richard. “Can the Market Add and Subtract? Mispricing in Tech Stock Carve Outs.” Journal of Political Economy, April 2003, 111(2), pp. 227-268.

Meeker, J. Edward. Short Selling. New York: Harper Brothers, 1932.

Ofek, Eli and Richardson, Matthew. “DotCom Mania: The Rise and Fall of Internet Stock Prices.” Journal of Finance, June 2003, 58(3), pp. 1113-1138.

Shleifer, Andrei and Vishny, Robert. “The Limits of Arbitrage.”

Journal of Finance, March 1997, 52(1), pp. 35-53.

Stein, Jeremy. “Why Are Most Funds Open-End? Competition and the Limits of Arbitrage.” Working paper, Harvard University, 2003 Footnotes a See, e.g., Joseph Chen, Harrison Hong and Jeremy Stein (2002); Gene D’Avolio (2002); Patricia Dechow et al (2001); Charles Jones and

41 :: Harvard Investment Magazine

Owen Lamont (2002); Lamont and Richard Thaler (2003); and Eli Ofek and Matthew Richardson (2003). b Going further back in time, Jones and Lamont (2002) discuss the crash of 1929. Although quantitative data is scarce, anecdotal evidence indicates that as stock prices rose in the late 1920’s, short-selling declined. According to J. Edward Meeker (1932), prior to the crash “few had the hardihood to sell short” and so “the panic of 1929 descended on an inadequate short interest.” c See also Markus Brunnermeier and Stefan Nagel (2004), and John Griffin, Jeffrey Harris and Selim Topaloglu (2003).

Both papers focus directly on the actions of large institutions, and find that they actually had substantial long positions in high-priced tech stocks during the period in which the NASDAQ index was approaching its peak.

Managing University Endowments By: Benjamin Y. Lee

Endowments are important to a university for a number of reasons. For one, a large endowment offers stability by providing a reliable flow of income to the university’s operating budget. It reduces the institution’s dependence on external funding, allowing it to maintain autonomy in its financial decisions. A heavy reliance on outside funding, after all, places the university under the mercy of the donors and exposes the institution to the risk of outside benefactors having a significant voice in its activities. A substantial collection of assets also renders the university less dependent on student tuition charges as a source of income; instead, it enables the institution to offer a better financial aid program, thereby allowing the university to attract a more diverse and talented pool of students. A large endowment further allows the faculty and the administration to develop a strong educational foundation. It provides advanced equipment, affords superior facilities, attracts brighter intellectuals, and better funds cutting edge research. Finally, endowment assets provide a buffer for the university in the event of an adverse financial shock. By paying out distributions that are larger than normal, endowments offer the university the resources needed to address such financial predicaments.

The goal of endowment management is thus twofold. The endowment managers must ensure that the real purchasing power of the endowment assets is preserved. Such pursuit of purchasing power preservation is a long-term goal that spans generations. At the same time, the endowment must provide a substantial flow of resources to the university to support its operating budgets. This marks the intermediate-term goal of endowment management: that the assets must provide stable operating support to the institution. While a high-risk, highreturn investment policy best serves the goal of maintaining real purchasing power, this policy is detrimental to the intermediate-term goal of the endowment: to generate reliable distributions for the institution’s budgets. A high-risk, high-return portfolio produces the superior long-run returns that beat inflation. However, the exceptional returns come at the cost of short-run performance volatility, which does not fit the low volatility, low-risk environment that is most desired when the goal is to provide predictable spending flows.

Unfortunately, low-risk investment portfolios generate returns that are insufficient for purchasing power preservation. Therefore, a clear trade-off exists between the long-term and intermediate-term goals of endowment management. Fiduciaries thus face a challenge

Harvard Investment Magazine :: 42

university endowments

investment managers must make. To preserve the real purchasing power of endowments and at the same time support the institution’s in balancing the conflicting nature of supporting current spending spending, the assets must be allocated efficiently, in such a way as while preserving assets. to provide superior returns with reasonable volatility. The task is especially challenging for a university; the nature of the expenses Spending Rule incurred by the university causes it to experience a rate of inflation One way to alleviate the tension between the conflicting higher than that reflected by the CPI. goals of endowment management is through sound spending Despite the challenge, the principle of diversification drives policies. The choice of an appropriate spending rule, that is, the the asset allocation decision process. While diversification cannot decision of how much should be budgeted for deduction from the reduce the inherent market risk associated with the investments, endowment to support current spending and how much should be it can significantly reduce the nonsystematic risk of the portfolio. left to provide for future spending, is extremely important. For a Therefore, to create a portfolio with high returns and low spending rule to be deemed appropriate, it must be linked to the volatility, the institution must allocate its assets into different asset investment and allocation of endowment assets. After all, the classes that exhibit little correlation with one another in terms of amount of funds available for investment is given by the amount performance. left over from spending distributions. Furthermore, the spending Modern portfolio theory, namely Markowitz mean-variance rule must generate distributions that grow by at least the rate of optimization, plays an important role in the asset allocation inflation experienced by the institution over time. This prevents decision process. The model produces a set of efficient frontiers the university from losing real purchasing power and enables it to that gives the lowest possible variance that can be attained for support the same set of activities, if not more. a given portfolio expected return. The optimal portfolio is then Current practice tends to link the endowment distribution identified by specifying which of the institution’s utility functions rate, or the target spending rate, to the average long-term returns produces a tangency point with the efficient frontier. However, it is of its portfolios. This maintains, on average, the principal of the often difficult to apply the theoretical model in practice and to link endowment. A more complicated spending rule does not involve the the model’s optimal portfolio with the institution’s spending policy. long-term average; rather, it sets the target rate to be proportional Given the limitations of mean-variance analysis, the portfolios to a moving average of generated must be combined with simulations tests to endowment values, for assess the effectiveness of the investment and spending instance, that of the past policies in a number of different scenarios. Nonetheless, Fiduciaries face a chalfive years. This provides a even this combination of simulations and quantitative smoothing mechanism for analysis is not fault-free, as it rests on the assumptions lenge in balancing the the institution’s spending, made about future returns and risks. When care is taken conflicting natures as averaging reduces the to ensure that the assumptions made are reasonable, of supporting curfluctuation of year-tothe quantitative models drawn from them provide year changes in the value a powerful tool for the institution’s rent spending while of endowment assets. endowment managers. preserving assets.

Furthermore, the degree of Once asset allocation targets smoothing can be controlled are made, it is crucial that they be by averaging the time frame; maintained. This rests the endowment a longer period can be used on a solid foundation of policy targets, to decrease volatility in the spending amount. This policy can and increases the chance for portfolio be contrasted to a spending rule based on a fixed proportion of success. Disciplined rebalancing year-end endowment value. Under this mechanism, the university techniques are therefore essential will receive a large distribution of resources from the endowment to ensure that target allocations are in a year when the market offered exceptional returns, and yet maintained. After all, deviations the amount will be dramatically reduced the following year if from the desired asset targets lead the markets performed poorly. Such a scenario contradicts the to outcomes that are less likely to endowment’s goal as the provider of a stable stream of income, satisfy the investment goals set and therefore highlights the importance of designing a spending by the university. rule that allows for smoothing. However, in pursuing a stable spending flow, volatility will inevitably be introduced to the Asset Classes real value of endowments. Hence, while a sound spending At the heart of asset policy can reduce the tension between asset preservation allocation is the ability of and stable income distribution, it cannot eliminate the different asset classes to inherent conflict between the two goals. enhance the portfolio’s riskadjusted returns. Traditional Asset Allocation asset classes, namely Aside from spending policies, the allocation marketable equities of endowment assets is the other key decision that and bonds, provide

43 :: Harvard Investment Magazine

the fundamental building blocks for constructing institutional portfolios. Private equity, real estate and absolute return define the alternative asset classes. When invested together with the traditional asset classes, alternative asset classes contribute to performance by pushing back the efficient frontier, allowing the construction of portfolios with higher returns for a given level of risk. In addition, alternative assets are priced much less efficiently than traditional asset classes. Therefore, there are more arbitrage opportunities for the managers to exploit and, in the process, add substantial value to the assets. At the same time, because markets for alternative assets are less efficient, investments made in these markets must be managed actively, as average returns fall short of comparable traditional securities. To facilitate better understanding of the roles that each asset class plays in the investment process, they are examined individually in more details below.

Marketable Equities Equities, or marketable securities, are central to endowment investment, as they generate the high returns that support institutional activities. As the fundamental institutional asset, marketable securities provide the reference frame from which all other allocation decisions are made. As the US equities market is extremely efficient, however, selecting securities that will outperform the market is often a daunting task.

To facilitate asset allocation and portfolio management, securities are often classified in several different manners according to their characteristics, one of which is into domestic and foreign equities.

In today’s global economy where firms tend to be multinational, domestic and foreign securities, in essence, represent the same investment opportunities. Nonetheless, the distinction lies with the currency risks associated with investing in foreign equities. At another level, equities are also divided into developed and emerging markets to highlight the different levels of risk tied to each category. While emerging markets offer higher potential returns as a result of their less developed market structure, they also exhibit a higher degree of performance variability. Some managers further classify securities according to region, capitalization size, and other criteria. These categorizations allow for a clearer

university endowments understanding of the characteristics of different equity portfolios.

More importantly, they offer a certain degree of diversification.

Thus, even when limited to traditional asset classes, a thoughtful combination of different equity classes, together with bonds, can still generate satisfactory results with reasonable volatility.

Fixed Income Fixed income, namely bonds, plays a central role in diversifying the institutional portfolio. In contrast to marketable equities’ volatile performance, bonds provide a steady and reliable stream of income to the portfolio. This level of security is especially important during financial crises, when bonds tend to perform better than riskier investments. The cost, however, is that bonds offer lower average returns than marketable equities and alternative assets.

Bonds are not immune to economic fluctuations. Their performance is tied closely to the rate of inflation. Fixed income investments perform poorly during periods of unanticipated inflation, when higher price levels eat into the value of fixed nominal coupons and future principal payment. This setback is often mitigated by equity positions, which usually perform well as inflation drives the existing value of corporate assets upward. On the other hand, during periods of deflation, the institution benefits greatly from the increase in bond value and the protection that it provides.

This justifies the allocation of assets to fixed income investments, which should contain only long-term, highquality, non-callable bonds that perform well in periods of deflation. It is also important to note that many other riskier investments, including equities, correlate with inflation rates as well. Hence, although it is the primary tool for diversification, the bond’s diversifying power is somewhat limited.

Finally, cash is often included under fixed income investments.

It is usually invested in instruments that mature within one year.

Contrary to popular belief, cash does not play a significant role

Harvard Investment Magazine :: 44

university endowments in well-constructed endowment portfolios. This is because other streams of income, such as stock dividends, coupon payments, and funds from the natural turnover of assets, offer the institution the same type of liquidity that cash and money market instruments provide.

Real Estate Investments in real estate provide the most effective protection against unanticipated inflation. Prices of well-located and highquality properties correlate nearly perfectly with the rate of inflation. During periods of rising prices, income from leases also increases as new contracts take into account the effects of inflation.

To be most effective, real estate investments should embody both equity characteristics from the residual value of the property (which is quite variable by nature) as well as bond characteristics from lease obligations, which provide a fixed stream of cash flows similar to that of a bond.

A popular form of real estate investment is the Real Estate Investment Trust (REIT). REITs use the pooled capital of many investors to purchase and manage either income property or mortgage loans. Like securities, REITs are traded on major exchanges, providing a higher degree of liquidity than traditional real estate. REITs also enable sharing in non-residential properties such as malls, hotels and other industrial properties, and are given special tax considerations provided that most of the dividends are paid to investors. While REITs performed on average better than appraisal-valued real estate index, they are nonetheless more volatile and correlate highly with small-capitalization stocks.

Like the other alternative asset classes, investments made in real estates require careful monitoring and active management.

Value-adding opportunities remain in the operation of real estate assets; inefficiencies in the pricing of real estate can also be exploited. Finally, while bonds and real estate generate similar

levels of return, fixed income assets suffer in the event of unexpected inflation, whereas real estate positions benefit. Hence, it is important for a well-constructed endowment portfolio to contain sufficient exposures to both fixed income and real estate.

Absolute Return Although a member of the alternative asset classes, absolute return consists of investments made in the traditional marketable securities. However, investments are made to exploit inefficiently priced marketable securities, and the positions taken exhibit little or no resemblance to traditional stock and bond investments.

While absolute return strategies offer equity-like returns, they are able to greatly diversify the institutional portfolio. Market risk is reduced through investments made in value-driven or event-driven scenarios, which tend to behave in manners unaffected by market forces.

Value-driven opportunities involve identifying overvalued and undervalued securities, establishing positions, and lowering the associated risk through hedging activities. Performance therefore depends entirely on stock picking ability. Event-driven investments, on the other hand, stem from predicting the likelihood of a corporate finance transaction, such as a merger deal, its probable timing, and the expected value of the assets after the transaction.

Since the strategy involves holding both long and short positions, market movements have little influence on the returns.

Since absolute return ultimately involves predicting and taking advantage of arbitrage opportunities, successful performance depends largely on manager skill. Qualified managers are able to generate high levels of return while using hedges to reduce systematic risk and market exposure. Absolute return thus provides a powerful diversification tool for endowment management.

Private Equity Private equity consists of leveraged buyouts and venture capital. While these investments offer little diversification to the

portfolio because of their fundamental ties to marketable equities, well-chosen private holdings can contribute dramatically to the portfolio’s performance. The exceptional returns generated by private equity, however, also come with higher levels of risk, as assets are exposed to operating uncertainty and greater financial leverage.

The nature of venture capital and leveraged buyout deals render investments made in private equity long-term and illiquid. In fact, a part of private equity’s high returns stem from investors’ expectation for a liquidity premium. The bulk of private equity returns, however, arise from valueadded investing. In the case of leveraged buyouts, simply adding leverage to a company increases expected returns but also boosts risk levels; no increase in risk-adjusted returns is made in the process. For venture capital deals, late-stage investors supplying only cash in the hopes of benefiting from the earlier efforts of others are often disappointed, since sale prices are determined efficiently in an extremely competitive market. Therefore, to generate superior returns from private equity deals, leveraged buyout managers must make fundamental improvements in the company’s operations.

Venture capitalists, on the other hand, must develop and exercise sound and profitable business plans, thereby creating value for the project in the process.

The importance of value adding in private equity allows managers to earn handsome compensation only by adding significant value to the investment. As a result, management of private equity deals shares the same goals and objectives as the owners; interests are aligned and agency problems largely reduced in well-established private equity investments. To the institutional investor, establishing strong and mutually trusting relationships with top-flight managers is thus essential to building successful private equity programs for its endowment portfolio.

The 60/40 Rule: Should Endowments Hold Bonds?

Although many institutions like Harvard and Yale have managed their assets with great success, the field of endowment management is not without debates and unresolved issues. There have been, for instance, numerous disputes about whether or not endowment portfolios should have large holdings of bonds as dictated by the traditional “sixty-forty rule.” Some even argue that

university endowments portfolios should be invested close to, if not at, 100% equities.

Bonds, as mentioned above, provide stability and protection to an endowment portfolio, especially during times of financial crisis.

The steady stream of income from bond coupons offers a “smoothing effect” to spending.

Bonds historically have been less volatile than marketable securities; however, fixed income has also generated lower returns over the long run. Indeed, during the 75 year period from 1926 to 2000, bonds generated an average annualized compounded return of 5.07% with standard deviation of 7.34, as compared to an annualized return of 10.84% for stocks, which also had a much higher standard deviation of 20.24.

Proponents of higher equity holdings primarily target bond’s low returns, arguing that if the goal is to maintain the purchasing power of the endowment for prosperity, the real value of the endowment principal must be preserved. Fixed income investments do little to contribute to the cause; spending the coupon while leaving bond principal intact during periods of inflation will undoubtedly erode the purchasing power of the assets. They note that while stocks are more volatile than bonds, stock returns are almost guaranteed to outperform bonds as the investment horizon lengthens. Since endowment investments should have an infinite horizon, they believe that higher equity holdings in place of bond investments are needed.

While those who favor little or no bond holdings acknowledge the bond’s ability to smooth out spending, they point out that yearto-year spending can be smoothed with almost any averaging approach. They warn that an emphasis on spending rules may shorten the investment committee’s planning horizon, thereby causing the committee to neglect successful strategies for long-term investing.

Stock returns based on S&P500 index. Bond returns based on 25%/75% composite of Lehman Bros. Intermediate-Term Treasury Index and Lehman Bros. Long-Term Treasury Index. For additional comparison, the average stock return from 1926-2000 was 12.81% while that for bonds was 5.31%.

1

Harvard Investment Magazine :: 46

university endowments They conclude that the cost is too high to hold fixed income in an endowment portfolio, and note that the problem is exacerbated as more bonds are often purchased during rebalancing. (Rebalancing is needed because stocks on average outperform bonds. Therefore, to maintain the desired asset allocation, stocks are often sold to purchase bonds.)

The effects that bond holdings have on portfolio returns and spending distributions can be examined in more detail with a simple model. Two portfolios, each with $10, are invested starting in 1926, with one holding 100% equities and the other investing in the traditional 60% equities, 40% bonds.

Spending policy each year is dictated by distributing 5% of the average yearend endowment value of the previous three years.

Figure 1 shows the year end endowment values for the two portfolios during the period. Starting in 1950, the endowment invested entirely in marketable equities experienced much greater growth, having a value of $590.03 at the end of the century, as compared with $169.84 for the endowment portfolio invested 60% in stocks and 40% in bonds. The endowment value of the all equities portfolio, however, is more volatile; this is especially evident in the late 1990s when the stock market blossomed under the technology bubble. Figure 2 displays the distributions made by the endowment over the 75 year period, assuming that the distribution is 5% of the average year end endowment value of the previous three years.

Once again, the endowment invested in all equities was able to make larger distributions than the 60/40 portfolio. However, it is worthy to note that the dramatic increase in spending distributions in the 1990s is unlikely to be maintained.

Of course, at the heart of endowment management is the preservation of purchasing power and the ability of spending distributions to at least keep up with the rate of inflation. Figure For all calculations, the S&P500 was used for stock returns while a 25% Lehman Brothers Intermediate-Term Treasury Index/75% Lehman 2

Brothers Long-Term Treasury Index mix was used for bond returns. This is because institutions mainly hold long-term bonds; the composite is therefore a better reflection of bond performance in an endowment portfolio.

45 :: Harvard Investment Magazine

3 shows the value of the endowments invested under the two strategies adjusted for inflation. As expected, the portfolio invested 100% in equities displayed a significant degree of volatility, especially in the period from 1950 to 1975. Furthermore, the bear market during the 1970s dropped the real value of the endowment below that of 1926 for the following decade. The erosion of real value is even more striking for the 60/40 endowment portfolio. The real value of the 60/40 portfolio was below the initial investment level for much of the time between 1926 and 2000. Finally, Figure 4 displays the real value of the spending distributions.

Although the model is oversimplified and lacks many of the complexities associated with endowment management, it does illustrate clearly the stock-bond tradeoff: while equities produce higher endowment returns than a portfolio of equities mixed with bonds, it also introduces a substantial amount of volatility to the real portfolio value.

Meanwhile, although bonds provide a smoothing effect, the erosion of principle is a serious concern for an endowment invested 60% in equities and 40% in bonds.

A possible alternative is to continue holding bonds, but in a proportion less than that dictated by the traditional 60/40 portfolio.

Indeed, larger endowments have utilized from 65/35 to 85/15 stockbond mix over the last decade.

The NACUBO 2003 Endowment Study, for instance, shows that institutions managing over $500 million in assets have on average moved away from fixed income allocations into alternative asset classes, allotting around 20% of the portfolio to fixed income (which includes cash). This exposure to alternative asset classes boosts asset returns while reducing risk; at the same time, the bond holdings allow the universities to hedge against unanticipated deflation. For this reason, universities mainly own long-term, high quality, non-callable bonds, which do well in a deflation.

Interestingly, as total assets under management decrease, the average percentage of assets allocated to equity and fixed income increases, such that the portfolio resembles more and more like the traditional 60/40 portfolio. For instance, universities with less than $50 million worth of endowments have on average invested approximately 60% in equities and more than 33% in bonds in 2003. Some of the impediments faced by these institutions are Inflation for the general consumer was taken from the Bureau of Labor Statistics. Since universities have in the past experienced on average an inflation rate approximately 1% higher than that for the general consumer, an additional percent was added for real value calculations.

3

university endowments structural. Their investments are smaller and as a result, they have trouble accessing the best alternative asset managers and difficulty building an adequately diversified portfolio of alternative assets.

[1] Bodie, Zvi, Alex Kane and Alan Marcus, Investments 5th Ed. New Unlike large endowments, smaller endowments don’t have the York: McGraw-Hill, 2002. investment staff to work on alternative asset portfolio holdings.

[2] Brealey, Richard and Stewart Myers, Principles of Corporate Finally, some of the institutions with smaller endowments are not Finance 7th Ed. New York: McGraw-Hill, 2003. prepared psychologically for the risks associated with alternative [3] Dobbins, Richard, John Fielding and Stephen Witt, Portfolio assets and the volatility Theory and Investment Management 2nd Ed. associated with higher equity London: Blackwell Publishers, 1994. holdings such as that of an [4] Dybvig, H. Philip. “Using Asset Allocation The heart of endowment 85/15 portfolio. In fact, since to Protect Spending.” Financial Analysts Journal, smaller endowments cannot Jan/Feb 1999, pp. 49-62. management is the preservadiversify their equities as [5] Swensen, F. David, Pioneering Portfolio tion of purchasing power and much, their 85% equity Management: An Unconventional Approach to the ability of spending disholding will be more volatile Institutional Investment. New York: The Free than a similar mix of a larger Press, 2000. tributions to at least keep endowment. up with the rate of inflation.

Conclusion Managers of university endowments must preserve the endowment’s real purchasing power while ensuring that the assets are able to provide a steady stream of income to the institution’s budgets. Sound spending policies and the use of quantitative models to determine the allocation of assets help mitigate the conflict that exists between an endowment’s longterm and intermediate-term goals. The availability of alternative asset classes have enabled many portfolios to generate higher riskadjusted returns, and a number of institutions with large assets under management have addressed the debate around the traditional 60/40 portfolio by moving away from fixed income positions and toward holding alternative asset classes. Still, many unresolved debates await answers. For instance, should endowments engage in tactical asset allocation? Should an Investment Committee made up of trustees or an internal professional staff be in charge of the endowment? And what is the appropriate spending policy in today’s low-return world? Successfully addressing these issues to allow for better endowment management will be the upcoming challenge for both the professional managers and the academia.

References

The 2004 Presidential Election & the Municipal Bond Market By: Ying Sun The most distinctive characteristic of municipal securities is their tax advantage. Historically, the yield spread between taxable and tax-exempt bonds has always reacted to changes in current and future tax policies. Tax policy was an important component of each candidate’s campaign platform in this past 2004 presidential election. This article investigates whether there was a statistically robust relationship between daily yield spread of taxable and tax-exempt bonds and daily estimate of each candidate’s chance of winning. The article also examines how efficient the bond market was with respect to changes in the election outcome.

If the municipal market adjusts slowly, investors should be able to profit from this delay by trading based on previous election information.

Previous Research:

Many studies have been done on the relationship between taxable and tax-exempt yields. Traditional models such as those used by Fama (1977) and Miller (1977) predict that one minus the implicit tax rate will equate the after-tax yield of a taxable bond to the yield of a similar tax-exempt bond. According to this model, at equilibrium, a taxable investor should be indifferent between holding the two kinds of bonds because they will have the same after-tax yield. In real life, however, investors have different tax rates; those with higher tax rates will benefit more by investing in the municipal market. Most studies that make use of this implicit tax model have focused on the effect of changes in tax policies that apply to various groups of municipal bond investors: insurance companies, bond funds, and individuals with higher tax rates. They predict that the yield spread should move with current and future

49 :: Harvard Investment Magazine

tax rates. Fama (1977) focused on how the spread should react to tax arbitrage opportunities of commercial banks. Poterba (1986) showed that both personal and corporate tax changes influence the yield spread through analyzing the reaction of individual investors, banks, and insurance companies.

Historically, banks and financial institutions were the major holders of municipal bonds. However, since the late 1980’s, there has been a shift towards individual investors. As a result, significant changes in personal taxes have stronger influences over the yield spread. Poterba (1989) provided evidence that expected individual tax rate is likely to become the primary determinant of the future yield spread between taxable and tax-exempt interest rates. This article will investigate the significance of a potential change in individual tax rate to today’s yield spread.

Due to the lack of available data that estimate the probability

of changes in future tax policies in a continuous manner, previous studies used monthly data that focused on the occurrence of isolated tax-related events over long periods of time. Their evidences do not clearly present a picture of how fast the municipal market reacted to the changes in the likelihood of future tax policies. The article addresses this problem by examining the relationship between the daily yield spread and a daily market price that approximates the probability of occurrence of a candidate’s proposed tax policy.

Tax Policies: If re-elected, President Bush will continue his current tax policy outlined in the Economics Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003. According to these tax cuts, the wealthiest individuals have a marginal tax rate of 35 percent, giving them 50% of the total amount of the Bush tax cuts. During his campaign and in the current administration’s FY2005 Budget Proposal, President Bush proposed to extend these expiring tax-cuts beyond 2010, or even make them permanent.

Senator Kerry ran on a platform that would repeal the Bush tax cuts for people with income over $200,000. According to “Senator Kerry’s Tax Proposals” by Burman and Rohaly of the Urban Institute, Kerry’s proposed plan would “restore the top two marginal income tax rates to 36 and 39.6 percent (from 33 and 35 percent now).” “Taxpayers in the top two brackets would also face the same marginal tax rates on capital gains and dividends as they did under prior law.” Since municipal securities investors in recent years are generally individuals in the top two tax brackets, the tax policy of the candidates should have great impact on the relative tax advantage of municipal securities, and thereby influence the demands of municipals.

Data: The first problem to tackle is how to best approximate the

municipal bonds probability of a candidate winning the election at any given day.

In recent years, online sports trading markets have expanded to include political betting. Prior to Election Day, individuals are able to bet on the outcome of this election on Intrade.com, an online betting market, through buying and selling contracts for each state as well as the whole nation. The price of a contract reflects the expected outcome of the election. The article utilizes the daily price for the national contract of Bush being re-elected from July 1 to November 1 from Intrade.com. These prices are comparable to the prices on the Iowa Electoral Market. Several papers have discussed the accuracy of these markets, and the betting market prices are indeed a reliable source for the analysis.

The main securities that reflect the yields of taxable securities are Treasury bonds and corporate bonds. According to Mankiw and Poterba (1996), most studies on the determinants of the yield spread between taxable and tax-exempt bonds have compared newly issued Treasury securities with prime grade municipals of similar maturity, so both types of securities are close to riskfree. However, problems arise when Treasuries are compared with municipals. Treasury is very liquid and will never default.

This is unlike municipal bonds, which are illiquid, and even the highest grade municipal bonds have a slight risk of defaulting.

We believe that the highest grade corporate bonds better compare with the highest grade municipal bonds of the same maturity, since they have similar default risk and liquidity. Thus, in this paper, the highest grade corporate bonds will be compared to the highest grade municipal securities of the same maturity.

The Bloomberg Fair Market Value indices (BFV) were chosen as the source of these yields. The BFV indices are derived from data points on Bloomberg’s option-free fair market curves. These indices are either consistent or closely correlated with other industry benchmarks, including Moody’s and S&P indices for

20-year AAA Y ield Sprea d

are considered. First, the change in yield spread and betting price between the same days of the week 1.00 are computed. For example, the data point on July 12, a Monday, is the 0.80 difference between the yield spread on July 12 and the yield spread on the Bu sh Winni ng O dds 0.60 previous Monday. Since the market closes on weekends, weekends 0.40 are simply omitted. The result is a strong correlation even taking into consideration the auto-correlation in 0.20 the residuals. The coefficient on the weekly changes on Bush winning 0.00 200 4 -07 -01 200 4 -07 -16 200 4 -08 -02 200 4 -08 -17 200 4 -09 -01 200 4 -09 -16 200 4 -10 -01 200 4 -10 -18 200 4 -11 -02 odds is -0.635 with at least 99% confidence. The second kind of Figure 1 week-to-week changes is the change in weekly averages. A regression corporate bonds, and the Bond Market Association 11-bond and using these averages shows strong 20-bond benchmarks. negative correlation as well. The coefficient on changes in weekly average of Bush winning odds is -0.727. Together, these results support the hypothesis that the yield spread reacts to changes in Empirical results: Bush winning odds, making the regression above robust on the As seen in Figure 1, there is a general negative correlation differences level. between the probability of Bush being re-elected and the 20-year When comparing OLS regression results with Newey-West AAA yield spread. Two small dips in the yield spread occurred correction for standard error using bonds with 5, 10, and 20 year on August 24 and September 7, 2004. Since there was no sudden maturities, we find that 20 year bond yield spreads correlate with increase in the probability of a candidate’s change of winning just the odds of Bush winning the most, with coefficient -0.841, t-value for a day, these dips are unlikely to be related to the election, but -7.990, and R-squared 0.423. 5 year bonds, on the other hand, were probably due to noises in the corporate bond market which changed the least, with coefficient -0.178, t-value -1.481, and Rcan be observed from the 20-year AAA Corporate bond index. squared 0.024. This result agrees with the conclusions of Poterba’s Next, regression analysis was performed on this set of data. study: that longer maturity bonds react to change in future tax policy There is no reverse causality problem since it is unlikely that more than bonds with shorter maturities. Since households are the the yield spread could influence the dynamics of the presidential primary holders of long term municipal securities, and the personal campaign. It was found with at least 99% confidence that a 1% income tax policies affect households the most, it makes sense that increase in the likelihood of Bush winning leads to a 0.84% the changes are reflected in long-term bonds. In addition, longer decrease in the yield spread. A check for autocorrelation up to term bonds are less liquid and generally have a greater premium.

9 lags shows insignificant first to ninth sample autocorrelations A change in potential tax policy makes longer term tax policies of the residual. OLS regression using a Newey-West variance less predictable, thus a shift in longer term municipal yield created estimator is a means to correct for any autocorrelation in the by the tax rate will be more relative to shorter term yields. Since residuals of a time-series regression. The resulting standard error the taxable yield is unaffected by future tax policies, the spread on the coefficient increased slightly, but the p-value is still close between taxable and tax-exempt yields should change more when to 0. This result is equally robust when a time trend is added to the the maturity is longer. regression to test if there is another significant factor moving each of the variables along the same trend.

Discussion on market efficiency: The residual of the OLS regression could include day-toThe betting market is only an approximation of the true winning day trading noises in the two markets. Regression analysis using probabilities of the candidates. We have shown that the municipal weekly averages of yield spread and Bush winning odds shows an market adjusts its prices according to the potential outcome of even stronger correlation: R-squared increases from 0.43 to 0.70, the election. The two markets are essentially parallel, as their while the standard error decreases from 0.1052 to 0.05899. prices reflect the likelihood of Bush being re-elected. Assuming We then investigate how much the spread changed as a that the players in both markets have equal access to news of the response to changes in the future tax rates implied by Bush winning presidential campaign, how efficient were the markets at reacting odds. Regressing the daily yield spread change on the daily Bush to the news? To be efficient “with respect to an information set” winning odds change did not show any significant correlation. This means “it is impossible to make economic profits by trading on is perhaps once again due to the day-to-day noise in both corporate the basis of that information set” (Makiel, 1992). Thus, market bond and municipal bond trading. efficiency can be measured by the profit made from trading on Regression using week-to-week changes should help overcome information. We test for efficiency by constructing hypothetical these noises. Two kinds of measurements for week-to-week changes trading strategies, and test if they could earn superior returns based 1.20

51 :: Harvard Investment Magazine

municipal bonds on an explicitly specified information set.

To see if the bond markets were efficient with respect to the election news, we make the information set include historical yield Not surprisingly, the profit does correlate almost perfectly with the spreads (testing the weak-form efficiency) and the odds of Bush change in Bush winning odds from today to tomorrow. Regression winning (a proxy for all public campaign-related news, testing analysis also show that profit has no significant correlation with the semistrong-form efficiency). The strategy (called Strategy the yield spreads or betting odds known at the end of the previous 1) is a spread position in the day. Therefore, there is no profit to be made bond markets: going long on based on the information set in the betting municipal bonds and short on market using Strategy 2; the betting market is corporate bonds; any gain or weak-form efficient. loss in this trade will come from changes in the yield Discussion on noise and other factors: spread. If we only use the At best, the R-squared value of our information set known as regressions is about 0.7. Many factors other of yesterday night to decide than the tax rate could influence the municipal whether or not to use Strategy market, among them the 1 today, and we find that we FED interest rate, the could gain superior return, general economic cycle, then the market is inefficient. liquidity, and default risk .

We have calculated the Like any other security, price of the 20-year municipal and corporate bonds from municipal security prices the yields, assuming a 5% coupon rate distributed semiare strongly influenced by annually. We then computed the profits from buying $1 interest rates. During the worth of such municipal bonds today and selling them time period of the analysis, tomorrow, and financing this purchase by short-selling the FED went through a the corporate bonds. The profit is regressed against the series of rate hikes to raise the yield spreads and betting market prices known by the end interest rate from a historic of the previous day. low of 1.25% to 1.75%.

From the results of the regression, there is no This results in a general rise significant correlation between today’s profit and yield in the yield of municipal spreads and Bush winning odds known as of yesterday. bond prices. However, The profit from the spread strategy only correlates strongly theoretically, taxable bonds with the current day yield spread and betting market price. should be equally affected These results imply that trading based on historical yield by the rate hike; the two spread and historical Bush winning odds cannot generate changes should cancel each abnormal profit. The bond markets are weak-form other out in the yield spread, efficient with respect to historical prices or returns and and any change in yield semistrong-form efficient with spread should not reflect the respect to election news known impact of the rate hike. We to all market participants. have regressed the spread There is no significant on both the Bush winning A similar test for the odds and the interest efficiency of the online political correlation between to- rate set by the FED to confirm this prediction. betting market was performed. there is no significant correlation between day’s profit yield spreads Indeed, We have computed the profits the yield spread and the interest rate. from buying $1 worth of Bush Default risk also influences the yield spread. and Bush winning odds contracts today and selling If there are events that changed the default risk known as of yesterday. of the highest grade municipal bonds relative to them tomorrow, and financing this purchase by borrowing at the highest grade corporate bonds during the time the short-term rate (Strategy period of analysis, then default risk is a factor that 2). Since the short-term rate strongly correlates with the FED was overlooked in the regression analysis. Municipal defaults are fund rate, and the FED fund rate changed only two times over very rare. A Moody’s study found that only 18 out of the 28,000 the four months leading to the election, any profit generated with agency-rated municipal issuers defaulted on their public debt Strategy 2 would come from an increase in betting market price. obligations in the past 30 years. In 2004, there were little neardefault events reported; the perceived risk of municipal securities 1 The Wall Street Journal Prime Rate was chosen as the short term rate did not change much over the course of the four months analyzed. since it moves up or down in lock step with changes of the FED fund rate, and is the underlying index for most credit cards and personal loans. In addition, the bonds data used were rated AAA/Aaa. These bonds The choice of short-term rate should not matter much as it rarely changes over night.

The sections on default risk, liquidity risk, and change in investor demand draws facts and data from Schonbrunn’s article.

2

Harvard Investment Magazine :: 52

municipal bonds are usually insured in the case of a default, so taking default risk into consideration should not hinder the results of this study.

Liquidity risk is another factor that impacts the yield spread.

The current trading volume in the corporate bond market is more than ten times that of the municipal market. In addition, individuals tend to hold municipal bonds to their maturity. This difference in liquidity risk (even for bonds with the same ratings) explains a fraction of the yield spread between corporate bond and municipals.

We should look for the occurrence of events that changed the relative liquidity of AAA long-term tax-exempt and taxable bonds. From July to October, the average daily trading volume of municipal bonds increased steadily by 9%, while that of municipal bonds rose by 11 percent. This does not constitute a dramatic change in relative liquidity of the bonds. Although liquidity risk is part of the noise in the regression analysis, the influence of future tax policy on the yield spread overpowers any impact liquidity risk might have had.

In Poterba’s study, he suggests that unemployment rate is another explanatory factor for the change in yield spread. If the unemployment rate rose by one percentage point, this would induce a one to two percentage point reduction in the yield spread.

Unemployment rate declined steadily from 5.6% to 5.4% from the beginning of July to the end of August. This should translate to two to four tenths of a percentage point increase in the yield spread.

However, there was an overall gradual reduction in the yield spread over this time period. We suspect either the unemployment rate did not make a significant impact on the yield spread over this short period of time, or its effect was countered by the outcomes of the presidential election campaign.

Looking at factors outside the fixed income market, Mankiw and Poterba (1996) suggest that equities play a role in determining the yield spread between taxable and tax-exempt securities. Their model predicts that the yield spread between taxable and taxexempt bonds should be an increasing function of the dividend yield on corporate stocks. It is difficult to perform empirical analysis of the yield spread on aggregate dividend yield over the course of a few months, since there is no appropriate dividend yield index calculated on a daily or weekly basis. However, according to Standard and Poor’s announcement on year-end dividend changes, dividend activities increased steadily in 2004, with a 20.4% average increase in payment amount and 2% increase in the number of dividend payers. According to Mankiw and Poterba’s model, there should be an increase in taxable and tax-exempt yield spread.

Clearly, the yield spread in the graph does not follow such a trend.

If there were upward influences on the yield spread by changes in

53 :: Harvard Investment Magazine

stock dividend yield for the time period analyzed, this only implies that the effect of the presidential election campaign on yield spread was stronger than what the empirical results suggest.

Conclusion: Evidences from daily market data show that the yield spread had a significant negative correlation with the probability of Bush being re-elected from July 2004 to Election Day. This result is consistent with the view that potential upward adjustments in expected personal tax rates can increase the yield spread between taxable and tax-exempt yield.

The correlation was strongest in the 20-year yield spread, and weakest in the 5-year yield spread. The municipal market adjusted to changes in potential tax policies rather efficiently, as there was no abnormal profit to be made by hypothetical trading based on historical yield spread and the likelihood of Bush winning. We have also shown that expected future tax rate implied by the election news was the main determinant of the spread between taxable and tax-exempt yields.

References: [1] Burman, Leonard E. and Jeffrey Rohaly, 2004, “Senator Kerry’s Tax Proposals,” The Urban Institute, July 23.

[2] Fair, Ray C. 2004, “Predicting Electoral College Victory Probabilities from State Probability Data”, unpublished manuscript, Yale University, November.

[3] Fama, Eugene F., 1977, “A pricing model for the municipal bond market,” unpublished manuscript, University of Chicago Graduate School of Business.

[4] Kaplan, Edward H., and Arnold Barnett, 2003, “A New Approach to Estimating the Probability of Winning the Presidency,” Operations Research, 51 (January/February), 32-4.

[5] Malkiel, Burton, 1992, “Efficient Market Hypothesis,” in Newman, P., M. Milgate, and J. Eatwell (eds.), New Palgrave Dictionary of Money and Finance, Macmillan, London.

[6] Mankiw, N. Gregory and James M. Poterba, 1996, "Stock Market Yields and the Pricing of Municipal Bonds," National Bureau of Economic Research Working Paper N0. 5607, June.

[7] Miller, Merton H., 1977, "Debt and Taxes," Journal of Finance, 32 (May), 261-75.

[8] Poterba, James M., 1986, “Explaining the yield spread between taxable and tax exempt bonds,” in H. Rosen, cd., Studies in State and Local Public Finance (Chicago: University of Chicago Press), 5-48.

[9] Poterba, James M., 1989, “Tax reform and the market for taxexempt debt,” Regional Science and Urban Economics 19, 537-562.

[10] Public Securities Association, 1990, Fundamentals of Municipal Bonds, 4th ed.

[11] Schonbrunn, Bob, 2004, “Why Municipal Bonds are Attractive,” ING Investment Weekly, 47 (November).

[12] Wolfers, Justin, and Eric Zitzewitz, 2004a, “Prediction Markets,” Journal of Economic Perspectives, 18 (Spring), 107-126.

ml.com/careers

SATISFACTION IS GOOD

PRIDE IS BETTER Whether you look at us in terms of people, culture, products or our virtually limitless possibilities, Merrill Lynch defines “exceptional” in every sense of the word. It’s a source of pride for all of us who work here. And a source of exceptional careers for those eager to share in our passion for doing great things.

EXCEPTIONAL WITHOUT EXCEPTION Merrill Lynch is an equal opportunity employer.

C

H

I

C

A

G

O

•

S

A

N

F

R

A

N

C

I

S

C

O

•

L

O

N

D

O

N

•

T

O

K

Y

Stay ahead of the curve At Citadel, we work every day to gain an edge in the global financial markets. With world-class analytics, risk management capability, state-of-the-art technology and a global footprint, we see what others cannot see.

Founded in 1990, Citadel is a world leader in alternative investments. Our team of more than 600 professionals excels in relative value, event-driven and fundamental investment strategies.

Determined, focused, and passionate about winning, our team members capitalize on their individual and collective expertise to identify and seize market opportunities.

At Citadel, we work every day to gain an edge in the global financial markets.

Opportunities for university graduates include positions in: • Investment Management and Trading • Information Technology • Quantitative Research We welcome applications via your university’s on-campus recruiting process.

For more information visit www.citadelgroup.com

CTAD184

O