Harvard College Investment Magazine Summer 2007 by Harvard College Investment Magazine

Investment Harvard College

Magazine Summer 2007

MUSICAL CHAIRS Which Will Be the Last Exchange Standing? STEPPING THROUGH THE COMPUTER SCREEN AN INTERVIEW WITH JIM COLLINS Leadership Advice from a Business Guru SPIRITUAL CAPITAL IN CORPORATE AMERICA THE CREDIT CRUNCH Subprime Loans, Corporate Credit, and the Stock Market

good to great

Moving up the value chain

All in a dayâ&#x20AC;&#x2122;s work.

Youâ&#x20AC;&#x2122;ll grow here. Youâ&#x20AC;&#x2122;ll shine with your team. Lehman Brothers is both entrepreneurial and collaborative. Whether you are interested in a career in investment banking, capital markets, investment management or any of our corporate areas, visit us online at www.lehman.com/ruready.

lehman.com/ruready

Today you affected tomorrowâ&#x20AC;&#x2122;s financial headlines.

| SUMMER Lehman is anCOLLEGE equal opportunity employer M/F/D/V. The Firm and its affiliates do not discriminate in employment because of race, religion or belief, gender, national or 2 Brothers HARVARD INVESTMENT MAGAZINE 2007 ethnic origin, disability, age, citizenship, marital or domestic/civil partnership status, sexual orientation, gender identity or gender expression.ÂŠ 2007 Lehman Brothers Holdings Inc. All rights reserved.

"#$ % % &

! ' % ( ) ) * +, #$&$$ - .&$$ / (

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

hcim HARVARD COLLEGE INVESTMENT MAGAZINE

Summer 2007

Not Over the Hedge

By Zachary Rosenthal

w w w.har vardinvestmentmagazine.org

ADVERTISING

EDITORS-IN-CHIEF

% 0 1 *+ "$ !*"+, ',(

EXECUTIVE EDITORS

(0 '' * + * / ."+

SENIOR EDITORS

, '% 1 !" '

'*1 (( ('' .*1

! *1 (+ ',! %

() &"'" ' " ! % % *2

* %" "% $(. ,*(+ ' * ( 3 * &+(' ( *, -'' ,, & ',! ' & " "++ ! 1%" * ' "+ (' ,! ' * '+, "'

". $ -' ! & * ! ' "1"' ! *% + "' "&" ! %+ ! ' ' "%"'+$1

EDITORS

Phone 617-875-9137 E-mail advertising@harvardinvestmentmagazine.org

INSIDE SCOPE

The Harvard College Investment Magazine (HCIM), a student-run organization at Harvard College, is a semi-annual publication devoted to presenting the significant and current topics of investment and finance. Blending professional articles, interviews, and academic research, the magazine offers a comprehensive array of commentary to the investment field, serving as a platform of intellectual exchange between the professionals and the Harvard academic community.

Hiring the Best

What Mathematics Gave Finance

US $20 US $24 US $30

Phone 510-717-9058 E-mail subscription@harvardinvestmentmagazine. org

PUBLISHER

.%( ('(' '$(

WEB ADMINISTRATOR

*2 (*2 " *2

EMERITUS ALUMNI BOARD

ARTICLE SUBMISSIONS Phone 510-717-9058 E-mail editor@harvardinvestmentmagazine.org

(1 "'

(. ' +, *

FACULTY ADVISORS

- '1+! ,1* $(. !& ' *(,! *+ " ! % -+ !"% ", % '. +,& ', *(-) *" ' (2%(/+$" ' * 1 ''"4 * ' **"%% 1' ! '# &"' "!-' "' ' ( '' "+" - ", % '. +,& ', *(-)

Harvard College Investment Magazine Harvard University University Hall, First Floor Cambridge, MA 02138

COPYRIGHT 2007 (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 not necessarily shared by the editors. All editorial rights reserved.

The Harvard name and VERITAS shield are trademarks of the President and Fellows of Harvard College and are used by permission of Harvard University. Printed by Michael Buckley, Harvard Media Ventures

Lost in Taxation

By Sarah Wang

Corporate Governance

By Donna Ivry

(!' &) %% * &1 , "'

JOIN HCIM E-mail join@harvardinvestmentmagazine.org

GLOBAL OUTLOOK

US $12 US $15 US $20

EXECUTIVE DESIGNERS

By Hagop Taminian

INVESTING TODAY

United States Canada International

INSTITUTIONAL

By Jan Zilinsky

ONE-YEAR SUBSCRIPTION PERSONAL

Investment Harvard College

Table of Conte nts

Exchange Traded Funds

By Jonathan Greenstein

Magazine

Driving Passion

By Sergali Adilbekov

FEATURES INSIDE SCOPE

Musical Chairs The Vista Effect

By Robert Andrew Davis

By Robbie Dunnette

A Sunny Day for Tax Havens

By Chelsea Zhang

Stepping Through the Computer Screen By Charles Yin

Rising Dragon

An Interview with Jim Collins

Securitization

Spiritual Capital in Corporate America

By Samantha Fang

By Roxanne Bras

By Mike Weglarz

By Rika Christanto

Hedging Against the Heat

The Credit Crunch

By Kylie Francis

By Alex Bayers

Letter from the Editor

Investment Harvard College

Magazine

Past issues of HCIM are full of stories about the economy, markets, corporate strategy, and business leaders getting it right or wrong. Following the teachings of HCIM’s interview with business guru, Jim Collins, on what it takes to go from “good” to “great”, this Fall 2007 issue of HCIM offers something a little bit different. We have still preserved our mainstay articles, which offer insights on understanding individuals, companies and the markets in which they operate. Scattered throughout this issue are articles that offer tips on succession planning and recruitment (“Hiring the Best”), the historical roots of modern finance (“What Mathematics Gave Finance” and “Driving Passion, Driving Markets”), and ongoing hot-button issues such as corporate governance, real estate securitization and exchange traded funds. What makes this issue “great” is that not only are we attempting to present an array of both the here and now, but also of the near and very practical future. This fall, HCIM explores the ideas and trends that arise from the increasing integration of world markets, as exemplified by the consolidation of stock exchange (“Musical Chairs”), and common technological platforms (“The Vista Effect”). This issue also re-evaluates what it means to be multinational—including the responsibilities, risks, and rewards—and the implications for future strategic direction. Our articles take a stance on the increasing relevance of religion in the workforce (“Spiritual Capital in Corporate America”); the essential role of offshore tax havens (“A Sunny Day for Tax Havens”); and the current and future Asian economic powerhouses, China and Vietnam, respectively. In addition to the broad corporate and management strategies we aim to cover, this issue informs our readers how to invest in the phenomena of nature (“Hedging Against the Heat) and in Hollywood (“Not Over the Hedge”). In this and in all issues of HCIM, we go beyond the meeting room and attempt to decode the economic, political, social, and cultural dimensions of the business community that is both intriguing and contradictory. Enjoy.

Musical hairs C

Which will be the last exchange standing?

By Robert Andrew Davis

uring the past year, it has become trendy for stock market exchanges to merge and forge partnerships amongst each other. Accompanying this trend has been a debate between experts regarding the benefits of these mergers and partnerships. By creating pan-continental exchanges and even global exchanges, do the users of these new conglomerates benefit or will the lesser number of exchanges instead reduce competition and create higher trading fees? Are the exchanges actually helped by their mergers in terms of cost savings or do

Rika Christanto

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Features the exchanges’ CEOs simply not want to be left out of the consolidation spree? While only the future will answer these questions, preliminary analysis suggests that the benefits from the exchange mergers are limited and that the current uptrend in mergers will prove to be the precursor for the future of trading, in which a few global exchanges will control financial trading.

TRANSITIONING TO PUBLIC COMPANIES

The history of stock market exchanges spans to the 12th century in France. From that time until the current decade, most of the exchanges around the world were privately held, as seats on the exchanges were bought and sold for prices that depended upon demand. In 2000, the Chicago Mercantile Exchange (CME), the largest futures exchange in the United States, set a precedent by demutualizing and becoming a for-profit organization. In 2002, the CME became the first American exchange to issue shares and become publicly traded. These precedents proved to be very encouraging to exchanges across the world, as a great number have become publicly traded companies since the CME became the first to do so. Most notable among

shares and the merged company became the NYSE Group Inc. Another advantage of the merger was that the NYSE went from being a stock exchange that used continuous auction floor trading to an exchange that uses both an electronic trading platform and floor auctions. As exchanges have recently become for-profit organizations, many have developed electronic trading platforms in order to reduce costs and increase efficiency. Since most exchanges are now electronic and publicly traded, the process of merging exchanges has become much easier. The recent slate of mergers of exchanges has been led by the union of the NYSE Group and Euronext, a pan-European stock and derivatives exchange. The combination will create a $29 billion company named NYSE Euronext Inc. The merging of the two exchanges seems sensible because they offer different products in different countries. While the NYSE is largely known as the preeminent exchange for trading equities and bonds, CEO John Thain has clearly stated that he wants to gain market share in derivatives trading. By merging with Euronext, the NYSE will be able to take advantage of Euronext’s Life exchange, which is a

The proposed merger between the Chicago Mercantile Exchange and the Chicago Board of Trade (CBOT) valued CBOT at $9 billion and would create the world’s biggest

derivatives exchange, valued at $29 billion. By closing the

trading floor at the CME and combining the electric trading platforms of the two exchanges, the merger anticipates savings of $125 million per year.

the exchanges that have gone public is the New York Stock Exchange (NYSE), now the world’s leading stock exchange. On December 6, 2005, the NYSE approved a proposal to acquire Archipelago Holdings Inc. By doing so, the NYSE’s 1,366 seats were transformed into publicly traded 8

derivatives exchange based in London. The NYSE Euronext merger seemed to be initiated due to timing. The NYSE was forced to negotiate with Euronext when the Deutsche Börse exchange became interested in merging with Euronext to create a dominant European exchange.

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

Creating a trans-Atlantic exchange appeared to be a better option for both the NYSE and Euronext however. Now, the merged exchange can encourage companies to list their shares on both the NYSE and Euronext. This will help attract more international listings, which have recently been lost by the NYSE to the LSE due to stringent U.S. regulatory policies. Also, by merging the two exchanges’ technology systems and data centers, the trans-Atlantic exchange will realize an expected $250 million in savings by 2009. As the NYSE and Euronext pursued their merger, the NASDAQ stock market became interested in acquiring the London Stock Exchange in order to create its own trans-Atlantic exchange. In its attempt to acquire the LSE, the NASDAQ purchased nearly 29 percent of the publicly-traded shares of the LSE. The NASDAQ then made a hostile bid for the rest of the LSE’s shares, which valued each LSE share at about $24. On the February 11, 2007 deadline for LSE shareholders to accept the tender offer, only 0.41 percent of the remaining shares had been tendered, which left the NASDAQ with far less than the 50 percent barrier required to take control of the LSE. LSE shareholders felt the NASDAQ’s offer undervalued the company but the NASDAQ refused to raise its offer price, claiming that the recent bids for the LSE had artificially raised the value of its shares. In recent years, the LSE has been approached by Deutsche Börse, Macquarie Bank, Euronext, and the NASDAQ regarding mergers. Under United Kingdom takeover laws, unless another bid is made for the LSE from a company other than the NASDAQ, the NASDAQ must wait a year before making another bid for the company. In the meantime, the NASDAQ will have to decide what to do with its 29 percent stake in the LSE, especially since it took on a large amount of debt to purchase the shares. While trans-Atlantic mergers have been popular of late, several mergers of American exchanges have been taking place as well. The biggest proposed American merger has been between the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT), which

PRIOR TO 2000

2000

2002

Most of the exchanges around the world are privately held, as seats on the exchanges were bought and sold for prices that depended upon demand.

The Chicago Mercantile Exchange, the largest futures exchange in the United States, sets a precedent by demutualizing and becoming a for-profit organization.

The Chicago Mercantile

(ICE), a primarily electronic exchange for trading futures and energy. The offer from ICE values the CBOT at $9.9 billion, 10 percent more than the CME offer. While the CME-CBOT would create a combined exchange in control of 85 percent of futures trading in the United States, the ICECBOT combined exchange would control only 33 percent of futures trading in the United States. This would leave the CME much less powerful and with a smaller market value of $20 billion, equal to the market value of the ICE-CBOT exchange. The new bid from ICE is likely to lead to a bidding war between itself and the CME for control of the CBOT. While some exchanges have pursued mergers, others have attempted to create strategic partnerships. The Tokyo Stock Exchange (TSE) has created two such

partnerships with the NYSE and the LSE. Little has been said about what these partnerships will involve but it is assumed that the NYSE-TSE partnership will share new trading technology. The TSE computers malfunctioned earlier in 2007 because they could not handle the amount of trading that occurred during an especially volatile day. Since then, the TSE has put aside $500 million for technological investments and has upgraded its system so that it can handle 14 million orders per day, twice as many as before the problems occurred. The partnership between the TSE and the LSE is likely to lead to new trading products that will be jointly available on both exchanges. Other partnerships have involved small stakes being purchased in emerging exchanges. The NYSE paid $115 million

are the two largest derivatives exchanges in the country. This deal valued CBOT at $9 billion and would create the world’s biggest derivatives exchange, valued at $29 billion. By closing the trading floor at the CME and combining the electric trading platforms of the two exchanges, the merger anticipates savings of $125 million per year. This deal developed quickly after a merger between the CBOT and the Chicago Board Options Exchange (CBOE) was broken off, a result caused by a disagreement over how much of a stake the CBOT already held in the CBOE. Now with the CME-CBOT deal gaining traction, the CBOT-CBOE merger appears moot. What has complicated the CMECBOT merger is a competing bid for the CBOT from IntercontinentalExchange

Exchange becomes the first American exchange to issue shares and become publicly traded.

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Features

in January to purchase a 5 percent stake in the National Stock Exchange in India. In February, Deutsche Börse purchased a 5 percent stake in the Bombay Stock Exchange for $43 million. It is expected that these small stakes will create long-term relationships between the exchanges, which will lead to mutual cooperation in the vital Indian market.

THE PURPOSE OF CONSOLIDATION

For the NYSE and NASDAQ, who have pursued consolidations with European exchanges, the goal of their intercontinental mergers has been to overcome market share losses that have resulted from the SarbanesOxley Act. This U.S. federal law was passed in 2002 in response to the accounting and corporate governance scandals of the late 1990s and early 2000s. The stricter corporate governance that is required due to Sarbanes-Oxley means that companies in the U.S. must spend more money to stay in compliance with the Securities and Exchange Commission (SEC), having a detrimental impact on smaller companies and start-ups. As a result, companies are no longer as willing to list their shares on American exchanges because foreign exchanges require much less stringent enforcement. By merging with a European competitor, American exchanges could serve companies who wish to list on their exchanges without being held to the stern Sarbanes-Oxley requirements. Merging with European exchanges would also allow the American exchanges to gain the trading fees of companies who wish to avoid the National Market System, which links all of the American exchanges. This system assures that a buyer is matched with the cheapest seller in the U.S., no matter where the trade is initialized. This has caused large trades to be split into multiple smaller trades, which increases costs and makes trades take longer. Institutional traders and brokerages prefer to make large trades that occur rapidly and thus wish to avoid the National Market System requirements. While trans-Atlantic mergers have taken place in order for American exchanges to gain more foreign listings, pan-European and pan-American exchanges are forming in order to gain pricing power. In Europe, the mergers of the exchanges in Paris, Amsterdam, Lisbon, London, and Brussels

“

The recent merging spree for exchanges seems to be the beginning, rather than the end, of a trend. JeanFrançois Théodore, the CEO of Euronext, recently predicted that within years there will only be two or three global exchanges that will dominate trading.

formed Euronext. More recently, Deutsche Börse has looked to consolidate with other European exchanges. Economists believe that there is an impetus to consolidate in Europe because there are far too many currently existing exchanges there, especially considering the dominant presence of the European Union. By reducing the number of European exchanges, the clearing and settlement processes of trading would be dramatically improved. In the United States, the pending merger of the CME and the CBOT would create an ultra-competitive exchange with extreme pricing power in the exchangetraded futures market. More importantly, a combined CME-CBOT would be able to better compete with Wall Street firms who privately negotiate 80 percent of the global derivatives contracts. As a global futures

force, CME-CBOT could attempt to standardize trading of many derivatives and become better positioned to gain a portion of the current over-the-counter derivatives market. Gaining this market share would allow the company to grow even faster than the 30 percent annual growth of the derivatives market as a whole. Due to the position a CME-CBOT merger would establish, ICE initiated a bid for the CBOT in order to prevent increased trading and clearing costs. Even if only 20 percent of the global derivatives contracts are publicly traded, a company with 85 percent of that market would greatly reduce pricing competition. As a result, the ICECBOT merger has gained much support from derivatives traders and Wall Street firms alike, who both stand to lose money if the CME-CBOT merger is realized.

”

GLOBAL EXCHANGES ON THE HORIZON: A GOOD THING?

The recent merging spree for exchanges seems to be the beginning, rather than the end, of a trend. Jean-François Théodore, the CEO of Euronext, recently predicted that within years there will only be two or three global exchanges that will dominate trading. The first stage of this global consolidation has already been completed as Euronext helped to consolidate exchanges within Europe and the NYSE, NASDAQ, and the CME have made acquisitions within the United States. The second stage is currently under way as trans-Atlantic mergers take place, which will be followed by the final stage in which global exchanges will be created. With the NYSE linking itself to Euronext, the TSE, and the National Stock Exchange in India, as well as partnerships between the LSE

and the TSE and between Deutsche Börse and the Bombay Stock Exchange, it appears as though the final stage of Théodore’s prediction may be coming to fruition sooner than expected. As global exchanges are formed, advocates claim that the purpose of these global exchanges will not be to use monopoly rents to reward shareholders, but instead to serve a unified trading community. Global exchanges allow the opportunity for all of the world’s largest companies to be listed on the same exchange amid an international pool of liquidity. However, exchanges are ultimately set up to serve traders and it is these users who will not benefit from consolidated exchanges, due to higher costs of trading. As global exchanges emerge, competition will decrease and amid pressure to consistently boost earnings for shareholders, these exchanges will be forced to raise prices. One of the major selling-points of the recent mergers has been that cost savings will result from the mergers and that these savings will be passed on to benefit customers. While it makes sense that combining technologies will create savings for exchanges, it makes less sense how the combined technology will create savings for users. Furthermore, the recent failure of an attempted global partnership between exchanges lessens the benefits of future global exchanges. In 2000, a partnership between ten exchanges, including the NYSE, Euronext, and the national exchanges in Mexico and Australia, was created. This alliance was called the Global Equity Market and was supposed to revolutionize the way in which stock markets function. Instead, within a year the Global Equity Market had ceased to maintain any real function. The global exchanges that are in the making will thus benefit users much less than shareholders. Even so, it has been said that the cost savings predicted from merging exchanges have been over-estimated, meaning that shareholders would not profit as much as is expected. All of these factors should create doubt in the minds of exchange executives when considering mergers. Still, as long as electronic trading platforms make it easier to consolidate equipment, the stock market continues to reward shareholders for acquisitions, and executives trust that partnerships are the best method for earnings growth, stock exchanges will continue to merge.

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Computer Screen Stepping Through the

A Look at the Applications of the 3-D Internet Revolution By Charles Yin

comfort of a desk chair. However, imagine going about all of this, still with the ease of being behind a computer screen, but actually being able to walk through the aisles of the supermarket, actually speaking face-to-face with the ticket agent, and actually being able to interact with your friends both verbally and physically with subtle facial expressions and exaggerated gesticulations. This is the world of Second Life.

A PLATFORM TO THE 3-D INTERNET

magine traversing through the eclectic stock of your local produce store, making the daily rounds,

and afterwards taking a brief detour to book discount air tickets to Bermuda, all while gossiping up a storm with half a dozen of your closest friends. Indeed, thanks to the marvels of the Internet, all of this is possible from the

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

Second Life is an Internet-based virtual world, combining fantasy and reality to allow immersion into a seemingly boundless online community almost entirely made up of usergenerated content. Users (not players – Linden Lab has been insistent on avoiding the characterization of Second Life as a video game) are transformed into avatars of almost any conceivable visual configuration through the use of a control panel, which allows for changes to height, eye color, bone structure, girth, and a bevy of other cosmetic variables. Avatars range from tattooed punk rockers, to stiff-collared office workers, to scantily clad Amazon warriors—the idea behind this has been to remove any and all barriers to creativity. After generating an avatar, the user can proceed to step across the interface between the real and virtual worlds at the click of a button. Navigation through the digital realm takes the form of the mundane, including walking (controlled by the arrow keys) and public transportation, as well as the unconventional, including scuba diving and even superhuman flight. The massive and immersive environment of Second Life is part of the reason for the platform’s success—users can explore sprawling metropolises, packed with an eclectic mix of stores, restaurants, office buildings, bars, and theaters. Also within Second Life are a plethora of golf courses, beaches, ski resorts, and even medieval fiefs designed for roleplaying enthusiasts. Of course, what makes Second Life a truly interesting place to be is the community: about 334,000 visitors make the sojourn to Second Life on a regular basis, and a total of 2.6 million individuals have tried out the platform since its inception in 2003. The popularity of Second Life

is growing at a frenzied pace, with more than 20,000 new users experiencing virtual immersion per day. Mark Anderson, author of the Strategic News Service newsletter predicts that “in two years I think Second Life will be huge, probably as large as the entire gaming community is today.” Second Life acts as an exceedingly social

“

Second Life offers the

potential to communicate with

prospective employees in a way that offers an interactive and

fun experience. And given that we are targeting people with skills in creativity, innovation and applying digital channels technology, Second Life is a good fit.

”

Richard Lord Hyro’s Chief Operating Officer

medium. It allows for individuals to meet under a wild array of social contexts, with an unfathomable number of possibilities for interaction. It is this potential for social interaction that many businesses are eager to harness, using Second Life as a platform into what is being called “the 3-D Internet,” which is made up of online environments that allow user interaction in a visually immersive context.

RECRUITMENT IN SECOND LIFE

Although Second Life is currently seen as a social forum, the virtual world is quickly becoming a platform for more practical endeavors. In early February 2007, digital services provider Hyro purchased an island in Second Life and created a

Features

virtual headquarters in order to take its recruitment operations into the realm of the 3-D internet. The online recruitment base spans four levels and aims to attract employees for the company’s real-world offices in Australia, New Zealand, and Thailand. Within Hyro’s “Recruitment Hub,” prospective applicants can do everything from learning more about opportunities at Hyro, to picking up an application, to submitting a completed resume and application form for review, and can even virtually interview with a Hyro representative’s avatar persona.The online facilities are being put to productive use, with a number of “showrooms” displaying the corporate history and philosophy of Hyro, in addition to past projects, awards, and continually updated company news. Thus far in 2007, Hyro has hired 27 people through Second Life and is trying to use Second Life to fill 35 more positions in Australia and New Zealand and around 20 in Thailand. Hyro’s Chief Operating Officer, Richard Lord, comments that Hyro is interested in “high quality web, mobile, and virtual design and development staff to keep up with its rapid growth and client demand in the real world.” He notes that “Second Life offers the potential to communicate with prospective employees in a way that offers an interactive and fun experience. And given that we are targeting people with skills in creativity, innovation and applying digital channels technology, Second Life is a good fit.” Joining Hyro in bringing recruitment to the 3-D internet is TMP Worldwide Advertising & Communications, the world’s largest independent recruitment advertising agency, which on February 12, 2007, announced that it would “bring new capabilities to corporate recruitment in 2007 via TMP Island, the company’s space within the popular Second Life virtual world.” Louis Vong, TMP Worldwide’s Vice President of Interactive Strategy notes that “virtual worlds like Second Life will allow for brand immersion like never before, from showcasing a company’s capabilities in a dynamic environment, to getting a better understanding of a candidate’s creativity, to the benefits of networking in real-time from disparate locations. TMP Island will

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

provide our clients with a multitude of capabilities—and we are just beginning to scratch the surface of what’s possible.” Big businesses have already begun to see the promise of TMP Island and virtual recruiting. Judy Wright, senior program manager of employer branding for TMobile notes that “we’re very excited about

and talent to fuel their continued success and growth. The application of the unbounded social potential of Second Life to recruitment could ease much of the burden that the financial services industry currently faces in recruiting new employees. The heated competition among rival institutions in

Finally, the business opportunities possible with Second Life, including the usage of the platform as a virtual marketplace are rife with potential profitability. Already, about $600,000 is spent daily throughout Second Life, equal to $220 million each year.

the possibilities TMP Island will offer, and we believe we’ll be able to connect with our candidate pool in a distinct way that is as entertaining as it is informative.” While interest in Second Life as a platform for recruiting continues to grow and as online recruitment projects and techniques become more refined, big businesses have demonstrated interest in Second Life not only as a creative means of reaching applicants, but also as a potentially powerful means of improving their daily operations and communications. This potential of the platform has a strong possibility of greatly impacting the financial services industry. The financial services industry is gated by recruitment, and it is the task of recruiters as gatekeepers to meticulously screen potential entrants, extending a handful of coveted offers only to the cream of the applicant crop. Of course, recruiters are concerned not only with selecting among applicants, but also with advertising in order to assemble an initial pool of applicants from which to begin selection. Combined, these dual roles of publicizing in conjunction with filtering constitute the means through which all financial institutions acquire human capital 14

recent years has engendered intense efforts towards acquiring a competitive edge, which in the financial services industry translates into developing a means of attracting the top available talent. The search is on for innovative approaches to effectively appeal to the target audience of skilled talent within the job market. Second Life may represent the greatest innovation that recruitment has experienced in decades.

CORPORATE INTEREST IN SECOND LIFE

A user inputs his account information, clicks confirm, and summarily logs into the online virtual world of Second Life. This particular user is perhaps not the typical Second Life user—he is Sam Palmisano, current CEO of IBM. More noteworthy is that this particular session of Second Life did not transpire in the confines of a dimlylit living room, but instead in front of an international assembly of thousands of IBM employees during a presentation held in Beijing in November 2006 regarding IBM’s initiatives in coming years. Included among a number of initiatives including digital storage and branchless banking, Palmisano announced a $10 million project to foster the “3-D Internet”

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

exemplified by Second Life. Palmisano articulated his views in an e-mail interview, declaring that “the 3-D Internet may at first appear to be eye candy, but don’t get hung up on how frivolous some of its initial uses may seem.” He considers virtual platforms including Second Life the “next phase of the Internet’s evolution” and predicts that they may have “the same level of impact” as the first Web revolution. Within IBM, one of the strongest proponents of Second Life, Ian Hughes, claims that “Second Life stimulates collaboration among a dispersed workforce.” Hughes states that “we’re all used to teleconferences, but in Second Life we gather and mingle before the meeting, and when it finishes, some people stop and talk again. We start to form social networks and the kinds of bonds you make in real life.” This facilitation of communication lies at the heart of Second Life’s application as an internal business tool, which constitutes yet another dimension in which the 3-D Internet could make a sizeable impact. Finally, the business opportunities possible with Second Life, including the usage of the platform as a virtual marketplace are rife with potential profitability. Already, about $600,000 is spent daily throughout Second Life, equal to $220 million each year. Thus far, this figure is composed mostly of land acquisitions and rentals, along with purchases from online entrepreneurs, who take the form of nightclub owners, jewelry makers, and even casino operators. The potential for an online retailer like Amazon.com to use Second Life as a means of allowing virtual shopping, of intimately examining and being able to interact realistically with merchandise, and of easily carrying out transactions using the in-game currency, Linden dollars (Linden Lab sponsors a currency exchange program between virtual and real currencies), is indeed worthy of corporate exploration. The technology of the 3-D Internet is poised to dramatically change the nature of business opportunities and internal corporate operations. The task now falls on innovators and entrepreneurs to explore the medium and take advantage of opportunities to harness the networking capabilities of this powerful but nascent technology.

Photo courtesy of rayng.com

Features

Interview with Bestselling Author

Jim Collins

Leadership Advice from a Business Guru By Roxanne Bras

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Features

Features Mr. Collins, in your research on top executives, have you seen a correlation between the educational background of leaders and their success?

The research has not shown a direct relationship between great leaders and their educations. In fact, the educational backgrounds are quite varied. The most prevalent academic background is law, as it trains people how to ask questions rather than just how to give answers. Most of the best executives didn’t come from an MBA track, but this trend may be changing as MBAs are becoming more prevalent. The one similarity is that all great leaders are learners. They learn from anyone they meet; they have a well cultivated ability to ask questions. Sam Walton [founder of Wal-Mart] is a great example. The lesson is, ‘don’t try to be interesting; try to be interested.’

ood is the enemy of great. This idea has been the foundation for Jim Collins’ research on thriving companies and their leadership. He asks the provocative question, “Why do some companies succeed?” In answering this question, Jim Collins has authored four bestselling books, built a research laboratory in Boulder, Colorado, penned a multitude of articles in publications such as the Wall Street Journal, Fortune Magazine, and BusinessWeek, and established a distinguished career at the Stanford Graduate School of Business. Jim Collins has worked relentlessly to study great companies and their leaders in order to discover what exactly distinguishes good companies from great ones and what transforms an average leader into an extraordinary executive. Jim Collins recently spoke with HCIM about business topics that are of particular interest to students hoping to embark on a successful business career. Regardless of your interest in business, Jim Collins’ work is applicable to leadership of all kinds—political, educational, and nonprofit. In his book Good to Great, Mr. Collins looks at natural experiments to determine what propels a company to greatness. For example, although General Electric and Westinghouse began in similar situations, GE grew into a great company while Westinghouse did not. What was the difference? These situations in which two companies begin in 16

After college, do you recommend starting your own business or joining an established company?

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

themselves and their business thin by working in different directions, hedgehogs figure out what they are good at and then channel all energy toward that unified goal. Finally, great leaders ask themselves three key questions, and use the answers to guide them in both their business and personal development. In the following interview, Mr. Collins addresses issues relevant to students and gives advice to those preparing to enter the workforce.

But Ivy League educations can also be very humbling. When I went to Stanford, I was thrown into a place where everyone was more talented than me. It was very humbling; but it helps you discover your particular talents; you can’t possibly be the best at everything.

The most important thing about education is realizing that it does not end at graduation. It begins when you get out of graduate school; you can learn about whatever you want as a lifetime quest...Learning should not be a means to a career; learning is an end.

That’s not really the question to ask yourself. Instead, answer three questions. 1. What are you passionate about? You can’t sustain excellent work if you aren’t really passionate about what you do. 2. What are you genetically encoded for? We can make ourselves good at a lot of things, but being great should be like a fish in the water. 3. What can I contribute that society will value enough to pay me for? When leaving college, everyone feels the great pressure of ‘what?’ What career path? What grad school? Instead of answering these questions, those who I’ve seen do really well have chosen their next move based on which choice gives them the greatest mentors. They focused more on picking a job with the right mentor, rather than picking the ‘best’ job. Ask yourself, ‘who will help me grow as a person?’ The other side of the coin is, ‘Are you a good mentee?’ Try to build a personal board of directors.

Photo courtesy of Joel Grimes

virtually identical situations and over time diverge in their level of success provide the empirical data for Good to Great. Much of the success of great companies is attributed to leadership. Great leaders, who Mr. Collins labels as Level 5 Executives, share common characteristics. These include putting their primary emphasis on people, which means getting the right people “on the bus” before deciding where to drive. They are also hedgehogs—instead of stretching

“

that they got. They wouldn’t assume that they deserved everything they achieved. The problem with being successful early on is that you attribute it all to your merits; but if it takes you a while to be successful, then you better understand the role luck plays.

Are leaders born or made?

My research would say that leaders come in many packages. There are people who are surprised to discover that they can lead. A great example is Katharine Graham. [She became head of The Washington Post after her husband’s sudden suicide and encouraged Bob Woodward and Carl Bernstein to continue investigating the Watergate scandal when few other news outlets dared challenge the Nixon Whitehouse.] She is a perfect example of someone being thrown into a leadership situation and then thriving. The question isn’t really if you are or are not a leader. Instead, it’s about whether you find something you care enough about. There is no real archetypal leader; often they are quiet and reserved.

Have you noticed anything specific about executives with Ivy League educations? For example, do these leaders have trouble relating to others or are they more confident than they should be?

I don’t know exactly what the numbers are but I would say that the best leaders were studious and did have a real streak of personal humility. They were often very willful but would acknowledge the good luck

The most important thing about education is realizing that it does not end at graduation. It begins when you get out of graduate school; you can learn about whatever you want as a lifetime quest. I read more now than when I was in college. Learning should not be a means to a career; learning is an end

What caused you to becoming interested in studying leadership?

I think I’m very lucky to have discovered the three circles; I run out of hours in the day to work. I’ve found something that fits my genetics and society values it. Part of it goes back to my exposure to mentors who all had this passion. These include Robert Waterman, author of In Search of Excellence: Lessons from America’s Best Run Companies, and junior researchers at McKinsey; I was very inspired by Peter Drucker. I realized that management is essential for a free society to work. We need well run organizations. This is especially true in a democracy; otherwise, we run the risk of tyranny. Excellent leadership is a noble cause—my mentors showed me the path of how to do it.

”

Along with your research on American corporations, you have done a lot of work on management in the social sectors. Can you discuss the differences and similarities between great executives and great social sector leaders?

There are significant differences between leaders in social sectors and leaders in business. The most important is that business leaders have concentrated executive power. If you are in social sectors, you don’t. You can’t simply decide what is going to happen. Instead, you need a coalition of points of power. If you aren’t able to establish this coalition, you lose power. The ability to lead in the social sectors depends on ‘legislative capability.’

Considering Harvard is transitioning to a new university president in the summer of 2007, are there any particular personal attributes that leaders in the social sciences need to help reign in this coalition?

Great leaders ask a lot of questions rather than just give answers. This is true in any field, but is particularly applicable to university management. The reality of managing a university is that you have to manage a faculty that is defined by a thousand points of ‘no.’ This certainly makes the task more difficult. So Harvard’s incoming president will have to figure out a way to reign in a diverse group and build a consensus. SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Features

When diversity is the norm and a selling point for the recruitment and retention of talented employees, it is becoming increasingly difficult to deny a place for religion in the workplace. Firms are beginning to support not only the promotion of minority groups but are making space for religious expression in recognizing their employees as Christians, Jews, Muslims, Buddhist, Hindus and Free Thinkers.

aith-based funds, corporate chaplains and online bible networks in the workplace are blurring the line delineating the secular and spiritual realm in business. In a bottom-line world in which a purely secular business ethics has been deemed to be irremediably deficient, scholars and business leaders have called for a spiritual audit of Corporate America. In light of Enron’s moral failures despite its 65-page “Code of Ethics”, Coca-Cola, Merrill Lynch, Ford Motor, Microsoft and many more are energizing their corporate mission statements by including spiritual or religiously oriented messages. These faith friendly firms are allowing their employees to bring religious values and “love thy neighbor” sentiments to work as an answer to moral lapses in commerce. As such, there appears to be a growing parallelism between perceiving employees in a more holistic sense, as productive assets to firms rather than expenses, and the greater accommodation of religious expression in the workplace. But does bridging the traditional disconnect between religion and business allow companies to effectively articulate a coherent and consistent set of business ethics? While it is undeniable that the corporate mainstream are moving away from their long-held “don’t ask, don’t tell” policy with regards to religion, can a Jesus-inspired corporate mission effectively set a higher moral bar than boardroom-generated ethics?

LIVING HISTORY

Spiritual Capital in

Corporate America By Rika Christanto

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

The intermarriage of religion and business is not a contemporary phenomenon. Dating back to the 18th century in American history, early missionaries had adapted business marketing techniques to attract a large following. Alexis de Tocqueville noted that spirituality and religious faith were instrumental in preserving the rights and duties of citizens while Max Weber’s The Protestant Ethic and the Spirit of Capitalism elaborated on the role of religion in entrepreneurial activity. Bruce Barton’s bestselling book, The Man Nobody Knows, encapsulated the materialism of the Protestant churches in the 1920s; he portrayed Jesus as “the founder of modern business” who “forged twelve men from the bottom ranks of business into an organization that conquered the world.” While debate persists on the spiritual dimension of commerce, it is difficult to dismiss the coincidence of America economic prosperity and strong Christian orthodoxy despite the secularizing trend among other industrialized

nations. The strong religious influences in business and transcendent grounding for corporate ethics has, however, diminished over time. Business in the 1990s has almost veered into being indirectly anti-religion. The oft preached religious values of helping the poor and less fortunate appears to be antithetical to the capitalist market system, making businessmen hesitant of

using religious values to shape their ethical decisions. In a pluralistic society, religion and even the various interpretations of one religion are seen as divisive; the imposition of religion in the workplace is de facto intolerant of non-believers. Others point at the failures of religious institutions to meet their own moral standards and thus, their secular counterparts would be no better off by encouraging increased religiosity.

Features RELIGION AT WORK, RELIGION IN THE MARKET

But the opposition to create working environments conducive for religion confuses a faith-based versus a faith-friendly business institution. While shareholders would look unfavorably upon a public firm that privileges one religion over another, there is room to be more accommodating of the religious beliefs and practices of employees. When diversity is the norm and a selling point for the recruitment and retention of talented employees, it is becoming increasingly difficult to deny a place for religion in the workplace. Firms are beginning to support not only the promotion of minority groups but are making space for religious expression in recognizing their employees as Christians, Jews, Muslims, Buddhist, Hindus and Free Thinkers. There is, for instance, increased awareness of religious holidays among the various faiths and donations to religious charities. Tyson Foods, the world’s largest processor of meats, worked with consultants to develop a faith friendly set of values, which reads, “We strive to honor God and be respectful of each other, our customers, and other stakeholders.” Results have thus far been robust. A McKinsey & Co. report indicated that spiritual awareness at work increased productivity while reducing turnover. The study also recognized that while there is still no place for traditional, organized religion in motivating employees, spirituality is the buzzword for creating a sense of purpose and ethics at work. Best sellers like God is my CEO and the emergence of spiritual gurus like Deepak Chopra present ways for incorporating a secularized spirituality into leadership and team building programs. Whether or not such techniques are merely the newest management trend to inspire employees, this trend is also driven by a demand for greater expression of faith at work. The raised stress levles and competition at work coinciding with more divorces and fewer support networks at home have driven people to search for emotional guidance at church. Faith at work has become the effect of people refusing to go to church on Sunday only to leave it behind when they go to work on Monday. In response, firms have found supporting faith at work as an effective and

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Features

cost-efficient means of raising productivity and reducing work-related problems like depression.

HEDGING YOUR FAITH

worship. Laura Nash of the Harvard Business School points at the need for not only practical problem solving and execution for success but also a time for reflection. In confronting a new situation, it makes sense to understand the various implications of a business decision, from the perspective of employees, customers, shareholders and competitors. Spiritual mediation and prayer have been empirically shown to provide useful means of contemplating and reflecting on one’s actions. In addition to the virtues of

Openness to religious faith, however, is not only limited to the office. Firms are also offering products that cater to the increased affinity for religiosity among the public. For example, the financial services, an industry that relies heavily on customer trust, readily allow religion in the workplace to encourage ethical values. But in addition, they have also extended their support for religion by providing faith based funds for their customers. Islamic funds like the Amana Trust Growth Fund avoid investing in businesses that are related to pork foodstuffs, liquor and gambling. Christian funds like the Ave Maria Catholic aura Nash of the Values Fund and the Timothy Plan Aggressive Fund Growth explicitly Harvard Business School points at the search for companies that do not need for not only practical problem support abortion or pornography and can either lean more liberally solving and execution for success but or follow a closer interpretation of the Bible. also a time for reflection. In confronting These religious criteria for investments do not necessarily a new situation, it makes sense to sacrifice investor returns. understand the various implications Morningstar, a fund research firm, reports that these faith-based of a business decision, from the funds have increased seven fold since 2000. In 2006, these funds perspective of employees, customers, consistently outperformed the S&P by 3.2 percent in average annual shareholders and competitors. returns. The growing demand for investments not only reflects the desire among investors to remain true to their religious beliefs but also an awareness that good corporate honesty and social capital, a less obvious governance principles may be behind the competitive advantage derived from solid returns. religious participation is the way in which faith appeals to entrepreneurs. Regardless “BE YE FRUITFUL, AND MULTIPLY” of religious denomination, there are So how does a religious and spiritual striking commonalities between religious framework play a role in securing business worshippers and entrepreneurs. Both require success? conviction even in the face of setbacks and First of all, religion can moderate the doubts. Certain selections of the bible also singular profit motive of businessmen. Labor appear to use material prosperity as an standards and fair wages are consistent with analogy for being virtuous. As Jesus says, Christian virtues that protect worker well “For to all those who have, more will be being and allow for a smoothly functioning given, and they will have an abundance; working environment. In addition, social but from those who have nothing, even capital in the form of integrity and what they have will be taken away.” Just loyalty can be promoted through religious as the Pilgrims sailed to North America

“

anticipating both freedom of religious and expression and commercial prospects, the modern day workplace is increasingly expected to cater to an employee’s desire for economic advancement as well as appeal to his or her core values. God’s blessing for material wealth, however, brings not answers but a slew of unanswered questions. For instance, how does management handle numerous requests for individualized religious services and allocate resources accordingly? How can atheists avoid feeling excluded in a faith-friendly firm? When is it ‘right’ to fire workers: to boost short term profits or only to prevent a bankruptcy? Despite these additional uncertainties, it would not make good business sense to neglect the role of religion in the business community. A global corporation requires greater sensitivity to religious views and the ways in which religion affects the market and the workplace. In face of the moral dilemmas that businessmen contend with each day, religion provides an additional perspective for analysis and decision making. And at a time when capitalism suffers from a crisis of moral bankruptcy, religion has become an increasingly valuable asset to legitimize and temper the self-seeking virtues of capitalism. Organized religion also has much to learn from business practices. America’s most successful churches in fact model themselves after corporations by catering to the customer first and using sermons to address practical problems instead of employing dogmatic rhetoric. The dialectic between religion and business is possible because contrary to the conventional view of capitalism as monolithic and exploitative, business comprises of human relationships that forces business practitioners to manage their inner emotions and motivations. Religious faith can be a source of strength and conscience for global entrepreneurs but first, it must be remolded a non-adversarial and ethical business culture that cuts across all religious denominations. All we need is a little faith.

”

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

INSPIRED COMMERCE

The Credit CRUNCH By Alex Bayers

Subprime Loans, Corporate Credit, and the Stock Market

he recent decline in the stock market has largely pinned on two things—subprime mortgages and quant funds. However, journalists fail to explain how the arrangements under which subprime mortgages and other complicated credit instruments work—an understanding that sheds light on why investor demand for subprime mortgages have dropped so quickly, and the results that ensued. Subprime, along with credit instruments known as collateralized debt obligations, explains much of the mortgage crunch and the aftermath in the equity market.

Other mortgage originators have replaced some banks as a source of mortgage lending. Instead of lending to borrowers with the intention of holding on to the mortgage, these originators have what are called warehouse facilities with a bank. With these warehouse facilities, banks lend money to originators to make loans, and in turn have previously originated loans as collateral for the loans. Once an originator has made a sufficient number of loans (and the definition of sufficient varies depending on how large the originator is), it will sell off these loans to a bank, insurance company, or other financial

institution, who can hold the mortgages or securitize them (Create a bond from the pool of mortgages). A financial institution can buy the loans simply to hold on to them. Fannie Mae, Freddie Mac, or Ginnie Mae could also buy the mortgages, and either hold the mortgages for their own investment or issue a security, like a bond, with the mortgages as the collateral. Since people who borrow with a mortgage can pay back the principal of the debt at any time, when borrowers pay back principal early the holders of these securities get some of the value of the security paid back early. However, an investor will receive the value of his investment if a borrower defaults because these firms will pay the investor the balance of the loan if a borrower cannot pay. Because of this guarantee (which is implicitly backed by the Federal government) these institutions can issue debt at only slightly more than the cost of a Treasury bond. The institution, in turn, can take the difference between the security and the underlying mortgages for the risk it takes. However, there are limits on the size of each individual mortgage and the overall size of these institutions’ investment portfolios. There has been political pressure to raise the limits on both of these to aid borrowers in the current mortgage crisis. A bank can also securitize the mortgages, issuing bonds to investors with the mortgages as collateral. However, the banks are not

federally backed, like Fannie Mae or Freddie Mac, and thus security holders can be hurt if the debt defaults. To protect these investors, the banks use two techniques for what is known as credit enhancement—tranching and excess spread. Imagine $100 portfolio of mortgages, with 10% interest. Further imagine three investors, but each with different risk appetites. The first person wants a lot of risk. He agrees to suffer the first $10 in losses. He also wants more return—maybe $3 interest for their $10. The next person wants less risk, investing $20. This $20 is protected for the first losses, but suffers the next $20 in losses, for which he will take $3 interest. The last person is happy to be able to take less risk. He can lose $70, but for that to happen the other investors have to lose their $30. He’ll also accept less return—only $4 on his $70. This system is called tranching. Excess spread works by receiving a higher interest rate on the mortgages than are paid on to the investors. In this case, the mortgages might pay 12% interest. So there is $2 of excess interest to protect investors against losses. Whereas the examples had 3 tranches, or groups with the same credit enhancement, many mortgage-backed securities (MBS) have 10 or 11. The first loss piece is called the residual. It gets money as borrowers pay off their loans, rather than a specified interest rate. Typically all the other tranches are rated by credit agencies and receive a specified interest rate. The more protection each tranche has the

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Features the higher its rating (The highest rating being AAA/Aaa); conversely, the riskier the tranche the more money it receives. Depending on the credit-worthiness of the mortgages backing the MBS, the bond tranching varies. So an MBS of prime mortgages will have a very small residual, perhaps 1% of the size of the security, whereas an MBS of subprime securities will have a larger residual, around 5% or 6%. Securitization used to be immensely profitable for investment banks, who could sell the resulting securities for more than the cost of originating the mortgages.

payments on some of these subprime MBS have reached 20% or more. If people cannot pay their debts, they likely cannot buy many consumption goods, potentially causing a recession. Similarly, real estate was one of the largest drivers of economic growth, and the number of delinquent payments suggests a lack of future new housing purchases, imperiling the jobs created by this explosion in housing. As this supply of houses increases, some borrowers may find it more prudent to default on their homes rather than have a mortgage greater than the value of their property. Such actions will only further hurt THE RELATION TO CORPORATE DEBT & the housing market, adding to economic woes. THE STOCK MARKET Additionally, some of the largest purchasers of There are a number of reasons why MBS were what are known as Collateralized mortgage problems should affect the stock Debt Obligations, or CDOs. market and other debt. First, delinquent Remember how banks use tranching to create AAA-rated securities from risky subprime loans? Banks can tranche a portfolio of MBS just like they tranched a pool of mortgages, to create a CDO. CDOs have been a major growth area for banks. Banks can assemble a group of assets and pool them together to remain that way for the life of the CDO, or an asset manager can use a CDO to get leverage for its investments that it can change at any time. Not only do CDOs invest in mortgages, but can also invest in other assets like auto loans, or more likely corporate bonds or loans. As the value of the securities in a CDO dropped, so too did the value of the CDO. Because of this s e drop in value, instead s u ho f of more CDOs being o y a pply rowers m u created, which would s or his ult As t es, some b nt to defa e help absorb the amount s of debt in the market, e v increa ore prud er than ha e the pipeline of new m h h t t CDOs stopped. find i r homes ra er than t h c at ei u e h A d d i n g r S t g n o rty. age e g t p t pressure to value of r r o u r o a m eir p further h o h CDOs t f o gt nly n i o was the d value l d l i s w market, a n fact that o i t ac ng i s as MBS u o the h ic woes. values m dropped, econo the banks

“

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

”

which lent money to originators demanded more collateral. The originators were unable to come up with this collateral, and consequently some, such as NovaStar Financial, were forced to file for bankruptcy. Since the collateral for the loans could be sold, this created an even larger supply of mortgages, driving prices of mortgages and the MBS created by investment banks down. Similarly, some banks run what are known as conduits. In a conduit, a bank creates an entity that holds a collection of assets, typically AAA- or AA-rated MBS. These conduits finance the purchase of these MBS with commercial paper—short-term debt that is not required to be registered with the SEC, unlike most securities. Typically money-market mutual funds buy this debt, which is known as asset-backed commercial paper (ABCP). Commercial paper typically does not yield much, and ABCP has attracted much attention because it yields more than corporatecommercialpaper(Verycreditworthy corporations also borrow in the commercial paper market). Under most conditions the mortgages yield more than the commercial paper, which the banks or sponsors take. They frequently have agreed to provide liquidity for the conduit, so if a conduit’s commercial paper has expired and investors are unwilling to buy more commercial paper the bank must buy all the mortgages—an expensive proposition, which felled two German banks, Sachsen LB and IKB Deutsche Industriebank. These failures can lead to the sale of more mortgages, driving values even lower. How, in turn, does this affect the equity market? Beyond the obvious firms directly hit by subprime and its economic ramifications, there are other factors. As the value of corporate debt drops, the value of that firm’s equity will drop unless the firm has become substantially riskier. New borrowers will have to pay higher interest rates, lowering their stock price. Additionally, many investors theorized that if their stock became “cheap” private equity funds would rush to buy it; however, as corporate credit dried up (because CDO issuance slowed) these private equity funds were less likely to buy the companies, eliminating this support which had lowered the risk of stocks. Equity market dislocations caused by this pressured selling by leveraged quantitative equity funds, causing the value of those funds’ existing investments to drop further.

NOT OVER THE

HEDGE S

Hedge funds and investment funds shower needy film studios with capital, but is the market any less risky? By Zachary Rosenthal

ince the establishment of the film industry, it seemed inevitable that a collaborative relationship would emerge between studios and independent wealth management companies. After all, like any other trade, filmmaking is fundamentally a commercial endeavor. Although film financing from outside sources has always been customary, these assets came directly from affluent individuals rather than hedge funds and investment banks. In recent years, however, that has changed dramatically, with hedge and private-equity funds supplying studios with as much as $4.5 billion—1/3 of the production costs of all motion pictures each year—since 2005. Yet because they are creative goods, the market for films is highly unpredictable and, as a result, potentially just as risky for investors as the overall market.

SOURCES OF COLLABORATION

The studios’ need for financial support from investment funds stems from the decline in global box-office revenues in 2005. Since the slump in returns, studios have been more cautious about autonomously financing productions with large budgets. The market is increasingly uncertain due to the sustained popularity of DVDs, video on demand, Internet piracy, and other sources of entertainment. On the other hand, the entertainment industry remains the United States’ largest exporter and consequently a shrewd investment for portfolio managers looking to diversify. Hedge funds and investment banks provide studios with a large amount of capital necessary to generate risky projects. The downside for the studios is the percentage of the grosses owed to the financiers that otherwise would have remained in their possession. As a result of market uncertainties and the desire to leverage risk, the studios have been more willing to accept outside funds for even their most highly anticipated projects. While these projects demand larger budgets

and thus carry the risk of losing money, they also exemplify the endeavors for a mutually advantageous relationship between the studios and financial institutions, which are otherwise suffering from declines in the real estate and stock markets. Regent Entertainment chairman and Chief Executive Officer Stephen Jarchow, whose company reached a $50 million financing agreement with Merrill Lynch, told Hollywood Reporter writer Stephen Galloway that in the past decade investors have preferred backing firms that produce tangible assets. In light of Relativity Media CEO Ryan Kavanaugh’s casual comparison of films to widgets, there exists the risk that hedge fund managers will ignore their unique properties as creative goods. It becomes necessary to recognize, then, that films exhibit what economist and author Richard Caves terms the nobody knows phenomenon: their consumption by worldwide audiences is a reflection of changing tastes and cultures. While the benefits to the studios are well-defined, then, the hedge funds risk pooling their assets in a market that is no less precarious, if not more so, than the overall economy.

CONSTRUCTING THE DEAL

The typical contract between a studio and an investment fund stipulates that the fund finance twenty to forty percent of the production and distribution costs of a film. The fund then receives a similar share of the profits. The Walt Disney Company provides one of the earliest examples, deriving assets from outside sources since the 1980s. In 2005, The Kingdom Films LLC agreed to cover forty percent of production and distribution costs for thirty-two upcoming Disney films in return for forty percent of the distribution fees and profits from theatrical and video releases.As is customary, Disney will recover its percentage of the distribution fees from each film’s revenue

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Inside Scope

before Kingdom Films collects its profit. Considering Disney suffered a $300 million loss in the fourth quarter of 2005—and was anticipating a split from Pixar that did not transpire—the corporate alliance was wisely deemed necessary. Some contracts reflect a tendency by companies to back projects along predetermined genre or budgetary lines. Merrill Lynch is supplying $50 million to Regent Entertainment, the Regent Releasing division of which produces independent films designed for a gay audience. Other wealth management companies finance the production of studio departments that pander toward a particular demographic, while still others back only independent features. Whatever policy is pursued, it is crucial that managers construct a diverse portfolio to minimize the risk in an industry dependent on consumer tastes that are difficult to measure and everchanging. At the forefront of the entertainment finance industry are law firms like Loeb & Loeb LLP, which handles investment in the television, music, and film industries. Loeb & Loeb’s participation represents a fixed cost for studios interested in negotiating with independent investors; nevertheless, the company has a history of representing the motion picture industry since the establishment of the Academy of Motion Picture Arts and Sciences. Its presence is necessary as funds carry significant bargaining power in providing the assets necessary for film production. The need for legal relations further attests to the evolution of the collaboration.

Adventure, left him an easy target for discharge. He was replaced by Relativity Media’s Ryan Kavanaugh. Nevertheless, the original contract for Poseidon reveals Waisbren’s poor judgment in cooperating with Warners on such a costly and ambiguously attractive venture that lacked contemporary youth appeal and significant star power. In addition, the arrangements confirm that the studios maintain the majority of control over their films’ revenues: According to the L.A. Times, although Virtual covered half of Poseidon’s production and marketing costs, it would not have earned any money until Warners collected the 12.5-percent distribution fee and interest, recovered its own marketing costs, and paid the film’s profit participants. Since the burden of the fixed

“

INTERNAL COMPETITION AND BLAME ATTRIBUTION

When Benjamin Waisbren, the head of Virtual Studios, was fired in 2006 after Poseidon lost $50 million and V for Vendetta returned much less than expected, his dismissal illustrated the career risks that come from investing in film production. Corporate conglomerates control the major studios, and their shareholders have the electoral power to vote for a CEO’s removal.In this case,Waisbren struck a six-picture deal with Warner Brothers that is costing Virtual, primarily backed by a hedge fund, Stark Investments, $528 million. Waisbren’s recalcitrant personality led to internal tensions, however, and the notable failure of Poseidon, a big-budget remake of a successful 1972 disaster film, The Poseidon 24

”

costs of production and distribution directly fell upon Stark’s investors, the Poseidon fiasco illustrates that an unfavorable investment cannot only cost a company millions of dollars, but it can also irrevocably damage relations with clients and reduce future investments. For concerned hedge fund CEOs, the answer might be to ascertain deals with subsidiaries of the corporate conglomerates that own their companies. Among the many hedge funds benefiting from backing film production is Dune Capital Management. The firm will invest more than $520 million in financing films for 20th Century Fox. The continued partnership between Fox and Dune, both subsidiaries of News Corp, follows the commendable achievements of Borat and The Devil Wears Prada, which together amassed more than $585 million worldwide, in 2006. However, the present fifteen-film deal comes on the heels of Universal Studios’ victorious $40-million-plus bid for the rights to Borat star Sacha Baron Cohen’s follow-up feature. Furthermore, although Borat and Prada represent Fox’s capacity to produce inexpensive and highly profitable comedies, among the

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

slate of films Dune is expected to fund are Die Hard 4 and Fantastic Four: Rise of the Silver Surfer. These potential tentpoles with built-in fanbases are nevertheless costly ventures that might fail to meet box-office expectations and consequently fail to benefit Dune. The overall uncertainty of Fox’s future stream of earnings reflects the fact that risk-averse studios typically want investment firms to cofinance their most expensive and venturesome projects rather than lesser gambles or surefire hits. Thus the problem of adverse selection— studios selecting their riskiest films to be externally financed—persists even when a single conglomerate owns both firms.

THE FUTURE OF FILM

Given the continued popularity of the film industry at large, the developing relationship between studios and wealth management companies indicates a structural change in the market for motion picture production. The studios are more willing to accept funds from outside investors in an attempt to film large-scale projects and alleviate risk. However, the terms of contracts favor the studios, which still connect creative artists and promote and distribute films. If studio executives fail to craft more agreeable arrangements with investment bankers and hedge fund managers, the best alternative for the latter parties will be to establish their own production companies directly, thus circumventing the studio system and reaping more of the profits. Such a move would require that managers take responsibility for the publicity and behavior of their stars. As of February 2007, Merrill Lynch was reportedly closing a deal with Tom Cruise to provide MetroGoldwyn-Mayer Inc.’s long-defunct United Artists unit with $500 million. Despite his questionable public conduct, which purportedly culminated in the termination of his production deal with Paramount Pictures, Cruise remains a superstar whose presence in a film guarantees higher revenues. Salma Hayek has also reached an agreement with MGM to head a production unit targeting Latin American and Hispanic demographics. MGM’s mobilization of reliable celebrities to front its subsidiaries while depending on third-party capital suggests that, for now, most wealth management companies will be able to craft effective deals with studios rather than compete against them.

Driving Passion, Driving Markets

The popular appeal of stock markets By Sergali Adilbekov

s it the corporate perks that attract them to work over a hundred hours a week? Is it the

power, influence, and happiness that they get with the money earned? Is it the higher social status that comes with working on Wall Street? Today, with the financial services industry is recruiting ever more extensively, each individual offers a different motivation for choosing to make a career of the stock market. But whether it is the thrill of the risk or monetary compensation,

the

dominant

incentive to pursue a life of trading equities and derivatives has still yet to be asserted.

The characteristic appeal of the stock markets is undeniably its inherent uncertainty. People want to know the future.The possibility of wild fluctuations in future prices keeps people awake at night, pondering the question: will we be ever able to develop the appropriate mechanism necessary to accurately predict price fluctuations? As things stand right now, the question remains the holy grail of financial economics. The quantitative answer goes back to Louis Bachelier, a French mathematician, who proved mathematically that stock option prices are virtually unpredictable in his 1900 Ph.D. thesis. Later, Alfred Cowles, inspired by the Great Economic Depression, investigated the same problem and came up with an equally ambiguous conclusion: “It is doubtful.” Mathematicians, statisticians, and economists alike confirm this finding by inferring trends and making extrapolations based on historical data. Our desire for prediction can provide perhaps a more relevant, qualitative solution where statistical analysis fails. Essentially, passion drives prediction. Curiosity for the future herds people towards the markets. As a result, the competition for financial analyst positions on Wall Street has risen dramatically. To become an analyst, one does not have to major in economics or finance. Recent graduates of the sciences, arts and humanities are all eligible to join the fray. The trend in recruiting practices within the financial industry has shifted from hiring those who base their decisions on monetary compensation to those who demonstrate a passion for their jobs. The elite tertiary institutions produce so many graduates who meet the required high level of analytical skills that these students have to compete on an additional criterion: their level of hunger for the position. In other words, employers on Wall Street do not only search for ability but also for passion.

Professional Opinion The Unique Ingredient

Joe Gregory, President and COO of Lehman Brothers Inc.

Recently, passion has taken on different forms that can be invented intuitively: passion for team work, passion for results, passion to challenge oneself intellectually, etc. The forms of passion that the companies are searching for in their prospective employees depend on the company’s profile, image, and style of work. One such form—optimism—was suggested by the President and Chief Operating Officer of Lehman Brothers Inc. Joseph M. Gregory. What is “optimism” for you?

It’s a fun concept to give over to. And I do, as I said in the talk that we gave [on Harvard campus]. It isn’t so popular, I think. And I do think as you go through an educational process that we tend sometimes to deal in things that are more absolute and less of a “touchy-feely” as they sometimes describe as optimism. There is actually a brain science associated with the concept of optimism. It bears out some of our mindset about being a unique ingredient. If you go through the life lessons about things that can’t be done, one good example is the Wright brothers trying to fly their plane. A whole bunch of people said [sarcastically]: “Yeah, that will work!” But I don’t think that was the case. So, what made them keep trying? Was it a divine wisdom that, absolutely, this would work? Or was it, perhaps, an intense optimism about the outcome? And I think that is what it was. Remarkable things can happen

when human beings really put their brain power to the wheel.

Do you think passion and optimism are the same things?

Only if you think it’s fun! …Such things mostly come out of things that you think are fun, intriguing, or necessities. The passion fortunately thrives in the work environment that we are engaged in, and is mostly about fun. Passion can also be about life and death; passion can be about being in difficult places of our world; and it can be about a passion to survive… so, fortunately for us, we are not in that state. …I think you do need that energized willingness, if not need, to perform. It is a tremendous motivator that gets into that state of using more brain capacity than one might ordinarily use by sort of just going at it. And passion about keeping people energized and interested is probably the right use of the word.

Inside Scope

Hiring the

Best By Jan Zilinsky

uch like the most prominent of universities,

claim that they attract the best.

This observation should come as no surprise as talent and skill matter a great deal today: news of the skill-premium, wage inequality, and the

Scholarly Opinion

companies

indispensability

technologically-savvy

employees clutters the business section each week.

We will never be able to accurately predict stock market prices Ken Stanley, Instructor of statistics at Harvard College Can we prove that passion is attracting people to work in stock markets?

The most direct way of obtaining that type of information would be an opinion survey targeted toward individuals who have recently accepted such employment. Consideration of the appropriate sampling frame and the development of objective questions will require considerable work. A pilot study that would test the draft survey method and questions would appear to be essential. In my opinion it is very likely that someone has previously done such an opinion survey. So did you try to look one up then?

Will we ever learn how to predict the stock prices correctly?

I don’t feel that we will ever be able to accurately predict stock market prices. Whatever tools (e.g. extensions of linear models) exist or will be developed will only be able to go so far. First, you are talking

about trying to predict human behavior (buying and selling). Second, whatever prediction models can help predict will probably soon be public knowledge and will be factored into the overall base price (value). Thus what will be left is the unpredictable human noise. I would make the analogy here with multivariate linear models. The model would provide the basis for predicting the general pattern, but it is the “residuals” (the noise) that is really the heart of what you want to understand. The “model” provides information on overall trends (which would soon become public knowledge) so the unpredictable part (the residuals) would end up being what you try to predict. Regardless of how much one learns about the overall pattern and the influence of related factors, the key will be trying to predict the residuals (noise) that are left over. Even if the models expand their abilities to predict, the unpredictable human behavior will always yield a small noise at the end that will ultimately frustrate the model builders. SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Inside Scope

“

Willingness to work hard and the ability to perform specific tasks are no longer the sole characteristics that employers consider in the hiring process. While flexibility, reliability, and loyalty are difficult to find—and even harder to measure—they are essentially priceless.

”

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

A company’s quality of staff is the primary key to its success. Globalization has intensified competition as markets continue to expand. Willingness to work hard and the ability to perform specific tasks are no longer the sole characteristics that employers consider in the hiring process. While flexibility, reliability, and loyalty are difficult to find—and even harder to measure—they are essentially priceless. It has traditionally been the role of the human resources division to seek and hire the brightest, but it is now expected that management employ people upon considering their potential. This aspect of leadership is so crucial because some characteristics are invisible to the naked eye. Employers need to rely on intuition in judging whether a job candidate genuinely wants to be involved in the industry (the motive factor) and whether he or she will be the right fit for the company (the matching factor). When hiring decisions are not fully rational and explicable, business ethics come into play. The company’s human resources department should actually consider ethical matters even before the first deal is struck. Companies need to ask themselves tough questions: does affirmative action have a place in the firm’s philosophy? Should it ever rely on quotas? While a company needs to look for the most qualified, it must also remember the disadvantages of a team that is not diverse. In terms of serving different sorts of clients or representing the company, a homogenous group will hardly succeed. But there are more reasons why firms should increase the amount of attention they pay to human resources. The incentives lie partly in our improved understanding of spillover effects. People who are motivated, hard-working, or simply happy indirectly influence others and inspire them to act in the same way. Although it might not be easy to learn to be self-reliant or to lead, it helps to see coworkers who have these skills in the workplace: their presence is a constant reminder that improvement is possible. Nancy Rothbard, assistant professor of management at Wharton Business School, says that what “people bring with them to work is not all bad for the organization.”The divide between personal and professional life can indeed be harmful. Corporations

What really matters [in time of crisis] is whether there are men and women who will step up despite sleep deprivation, devoting themselves to solving the problem and doing all in their power to help—or even save—the company.

are realizing today an employee will only be happy in the workplace if she is happy at home. When onsite health services, childcare, and fitness centers are provided, employees are generally less stressed and more resistant to mood change. However, in order to significantly increase productivity, simple and traditional measures or benefits, such as giving out free gym memberships, will be only partly effective. Firms ultimately need to transform attitudes. If an employee feels guilty about taking an hour to exercise (because there is too much work) then the company has failed at improving the mental and physical health of the workforce. Fortunately, there is still room for creativity: companies can apply incentive models to activities that are beneficial for the employees. For example, by rewarding healthy eating habits or exercise with cash bonuses, firms can inherently alter the habits of their employees—an invaluable achievement. Other healthy attitudes should be actively encouraged as well. A smile is contagious; good mood spreads from one person to another, so firms should not only look for friendly people but also insist on a working environment devoid of

unnecessary conflict. Companies should incorporate their newest findings and research. Recent studies have shown that an employee’s mood at the beginning of the day has the most significant impact on his overall performance. It would therefore be wiser to make sure that employees begin each day with a positive attitude than to protect them from any possible harmful scenarios throughout the day. Allowing casual conversations or a little music during early hours (8-9:30) would generally have positive effects on productivity. Employee attitudes are the real cornerstone of a company’s success because every business will deal with an unexpected situation or even a crisis. What really matters at that time is whether there are men and women who will step up despite sleep deprivation, devoting themselves to solving the problem and doing all in their power to help—or even save—the company. Undoubtedly, all that effort to accommodate irregular demand for work as well as the ability to maintain a positive outlook needs to be recognized; again, incentives matter. Sigal Barsade, associate professor of management at

Wharton, recently wrote that employees “are not sufficiently recognized by their organizations for the work they do.” When the workforce feels unappreciated, it will under-perform, and the best professionals will be lost to competition. In other words, talent management should be a priority: companies need to retain the best people by keeping them satisfied. That includes not only a competitive salary and benefits, but also reasonable working hours. A study by a Harvard Business review recently found that more than one half of male executives and approximately 80 percent of female executives say they will be unable to maintain their hours and lifestyle for more than a year. Setting up an efficient system for the provision of incentives is a challenge. It is as difficult as hiring the right people, but companies need to make every effort to excel at both. Simply put, it is worthwhile to look for employees who have unobserved social skills and exhibit loyalty. Sensible employees will approach conflict and problematic incidents in a rational way, saving their employer money that would otherwise be lost to the inefficiencies caused by office politics or poor performance.

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Inside Scope

The

Vista Effect By: Robert Dunnette

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

hen Microsoft’s Windows Vista was released for manufacturing on November 8, 2006, it was a momentous day for the software giant. Over five years in the making, Vista was the biggest software launch in Microsoft’s history, and was backed by a flashy marketing event as well as a massive advertising campaign. However, there was never really any question as to whether Windows Vista would be adopted. The

release was supported by every major system vender, with the notable exception of Apple, and the operating system was virtually guaranteed to become ubiquitous within a few years. The real reason that the launch of Windows Vista was so closely watched was that its success carried enormous implications for the entire IT industry. IDC, a technology research firm, estimated that for every dollar spent on Windows Vista, industry revenue would increase by

$18. By the end of 2007 Windows Vista is expected to generate 157,000 new jobs and create $70 billion in additional revenue, in a boom termed the “Windows Vista Effect.” The Winners and Losers However, not all sectors of the industry will benefit equally from this growth. The single greatest benefactor will be the hardware manufacturers who will see demand for their product rise as consumers rush to make their computers “Vista Ready.” Unfortunately, as with any revolution, Windows Vista will result in some losers. Third party security applet producers will be hit hardest as their entire market is transformed. For a system to be certified “Vista Premium Ready” it must pass a set of demanding hardware requirements. These requirements have led Hans Mosesmann, a chip sector analyst with Nollenberger Capital, to identify Vista as a “disruptive technology,” and the first modern OS update to “tax the current hardware that goes into a PC.” According to Mosesmann’s calculations, these increased system requirements will result in PCs with 15% to 20% more semiconductor hardware. This increased demand for power can be divided into two broad categories: system memory and graphics processors. The largest hurdle for a home user attempting to prepare their PC for Vista is the Premium Ready requirement of 1GB (1024MB) of system memory. According to a recent Citigroup report published in September 2006, the average computer shipped with 750MB of system memory. If every new system was upgraded to meet Microsoft’s requirements, the result would be a 33% increase in industry wide demand, and supply will struggle to keep up. As the demand for system memory increases, it is likely that flash memory will increase in popularity. Today, flash memory is primarily used as storage for MP3 players and digital cameras. However, Windows Vista introduces ReadyBoost, a technology that allows users to utilize flash memory to augment their system’s performance. Numerous studies point to this development to increase the flash

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Inside Scope

memory market between 10% and 15% in 2007. This surge in demand will likely prove a windfall for memory manufacturers. As they switch to the new 70nm process they will be able to cut costs while increasing production. Krishna Shankar, Senior Analyst with JMP Securities singles out Micron Technologies for praise. Given the Vista upgrade cycle and Micron’s expansion into specialty memory, she expects the stock value to skyrocket “50% to 100%.” The second hurdle that upgraders face concerns the graphical requirements of the new operating system. While previous iterations of Windows did not stress the graphics processor, a Windows Premium Ready system requires a DirectX compatible graphics card with 128MB onboard memory. This is significant since business machines designed to process spreadsheets and send email, do not require a discrete graphics processor. These same systems will now require a graphical overhaul to run the new operating system. This requirement will allow graphics chip makers NVIDIA and the AMD subsidy ATI Technologies to expand beyond their traditional market of gamers and graphics designers. Jen-Hsun Huang, President of NVIDIA, told shareholders, Vista “creates a lot of opportunity for us,” and cited Vista as one of the most promising sources of growth. The increased system requirements of Windows Vista will clearly prove a boon for hardware manufacturers, and the demand will quickly spill over beyond the two industries mentioned. For example, computer builders such as Dell and Hewitt Packard are projecting strong sales as consumers race to replace older PCs that cannot support the new operating system. Windows Vista may be the “killer app” that the hardware companies have been waiting for. Unfortunately, not all sectors of the industry will be as lucky. Third-party developers have traditionally feared operating system upgrades. At best they will face a host of new compatibility issues, and at worse they could find their industry segment completely transformed. This was the fate of Netscape when Microsoft released Windows 95 OEM. This new operating system contained a little applet called Internet Explorer, and as a result 32

Netscape watched its market share of over 80% dwindle. While not all Microsoft applications achieve this level of success, their inherent advantage of being bundled with the Windows operating system makes them serious contenders. During this upgrade cycle, the security software sector will face the brunt of the impact. In January of 2002 Microsoft Chairman Bill Gates declared Microsoft’s Trustworthy Computing Initiative which placed security as the software giant’s top priority. Windows Vista is the first fruits of this effort and includes two significant improvements over its predecessor, an improved Windows Firewall with two-

“

While Windows Vista is not necessarily a death sentence for security companies, it is clear that security companies will face a difficult position as Vista grows in popularity.

”

way filtering and Windows Defender, an anti-spyware product. These features will directly compete with established thirdparty applications. The security and information management market is currently a $3.6 billion per year industry. However, Windows Vista is projected to “reduce the threat of malware by over 95 percent” according to a Yankee Group report. It is clear that the market is about to undergo a dramatic transformation. While it is unlikely that the $2.6 billion per year antivirus industry will be seriously affected, the $440 million per year anti-spyware and still bigger firewall businesses will struggle. A Yankee Group report recently suggested that vendors “abandon the desktop firewall market”

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

Companies in the security and information management market have thus far denied that their particular sector is in danger. David Moll, CEO of WebRoot Software, has publicly expressed doubt that “lumbering Microsoft” would be able to survive in the quickly evolving anti-spyware market. John Thompson, CEO of Symantec, has been blunter telling shareholders, “We know more about security than [Microsoft] ever will.” Thompson backs up his bravado with a recent study conducted by Symantec which characterized Vista’s security improvements as too little, too late. The study states that in spite of Vista’s improvements “attackers had already moved on [to other vulnerabilities].” Andrew Jaquith, Security Analysist for the Yankee Group, acknowledges that these studies may prove “[Third-party] products still have relevance in the new world of Vista,” however he points out “free and good enough beats costly and elegant.” For most budget conscious customers, “what comes with Vista might be just good enough.” This appears especially true in the firewall and anti-adware markets where the convenience of Vista is hard to beat. However, the outlook is not universally grim. The Yankee Group report acknowledges that “companies that can focus on manageability and scalability, even if those products overlap with Vista, will continue to do well.” In the end companies can succeed in spite of Vista’s improved security because issues will persist. In other words “third parties will always have a rich and robust aftermarket available to them to serve.” While Windows Vista is not necessarily a death sentence for security companies, it is clear that security companies will face a difficult position as Vista grows in popularity. As their target market shrinks, they will be forced to evolve or fail. As a result, even software powerhouses like Symantec face an uncertain future. In conclusion, the launch of Windows Vista is poised to transform the computing industry. While Vista may or may not be a boon for specific sectors, there is no question that its influence will expand beyond Microsoft’s bottom line. Without understanding this momentous piece of software and vendor’s reactions to it, it is too easy for an investor to get burned by the “Windows Vista Effect.”

What

athematics

Gave

inance

The Story of Derivatives from Thales to LTCM By Hagop Taminian

In October of 2006, the world witnessed the largest consolidation of financial exchanges when the Chicago Mercantile Exchange (CME) bought out the Chicago Board of Trade (CBOT) for $8 billion, giving the new behemoth a book value of assets close to $26 billion. The merger sets the stage for a new era in the trading of derivatives—contracts that derive their value from the prices of other assets, such as stocks and bonds. Slightly over 30 years ago,

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

derivatives were almost unheard of. But in 2005 alone, a mammoth 10 billion derivative contracts were bought or sold worldwide.

DERIVATIVES: A COLORFUL HISTORY

The first derivative contract is often attributed to the 6th century B.C. Greek philosopher Thales. Berated by fellow Greeks for his poverty, considered to be a consequence of his occupation, Thales set out to prove them wrong. One year, he predicted that the olive harvest would be especially bountiful the following autumn. Confidently, Thales made agreements with olive-press owners to give them what little money he had in exchange for the right to use their olive presses when the harvest was ready. Because the harvest was in the future and hence uncertain, Thales negotiated low prices for the right to use the presses. When autumn came, the harvest was as exceptional as Thales had predicted. He was thus able to rent out the presses he had an exclusive right to use at a nice premium, making a tidy profit and proving his skeptics wrong. Hence, more than two millennia ago, Thales exercised the first known options contract, a derivative which gives the owner the right, but not the obligation, to buy the underlying asset (the olive harvest) upon the contract’s maturity (autumn). The trading of derivatives, however, was not always a success story. A popular anecdote of the disaster that derivatives can spawn is the case of the tulip and bulb craze in 17th century Holland. In the late 1500s, the Dutch were introduced to tulips by Ottoman traders, and were immediately captivated by their beauty. Around the time, tulips contracted a virus— called “mosaic”—which altered the color of the tulips’ petals to give them exotic flame-like patterns. As interest in these exotic tulips grew, so did their demand, and tulip prices began to rise. Eventually, people started speculating in the tulip market, forecasting future shortages or demand patterns and responding to these forecasts by altering tulip inventories. Within one month, the average price of tulips rose twenty-fold, and people began selling land and liquidating savings to buy more tulips. Soon, tulips—which once cost about the same as an onion—were being exchanged for entire tracts of land. As any self-respecting arbitrageur knows, these prices were hardly a true reflection of the value of the tulips—they were, after all, just flowers. Be that as it may, people increasingly took speculative contracts in tulips, believing that the price would still rise higher. However, just as some investors began selling their tulip 34

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

positions to lock in a profit, others followed suit. As the price of tulips plummeted, traders began reneging on their contracts, wreaking havoc across Holland despite an attempt by the government to intervene. Thousands of people lost their life savings and homes, and the ensuing depression hurt even those who locked in profits early. The tulip craze is testimony to both the power of derivatives and the madness of the masses. Fast-forward 350 years.The CBOT was founded in April of 1973, listing less than 20 call options on stocks (the right to buy a stock at a future time), with a first-day trading volume of only 911 contracts. One year later, daily trading volume rose to 20,000 and then eventually reached 200,000 contracts. What brought derivatives from their early days of lunacy to being today’s most sophisticated financial instruments? While several factors contributed to this turn of events, perhaps the most essential was the use of mathematics to price derivatives.

Bachelier was the first person to come up with such a method for pricing bonds. His was also the first paper to study finance using advanced mathematics. Bachelier’s thesis concluded that

“no arbitrage” argument is that if your net investment is worth zero today, then it must be worth zero tomorrow. Otherwise, there would be an “arbitrage opportunity” that would soon

Hence, more than two millennia ago, Thales exercised the first known options contract, a

derivative which gives the owner the right, but not

THE OPTIONS PRICING PROBLEM: A MATHEMATICIAN’S FORTE

Derivatives generally come in three classes: futures (or forwards, which have a minor distinction from futures), options, and swaps. All of these contracts involve an element of uncertainty, and thus are risky. For example, if someone were to buy a call option on a stock, then there is an uncertainty because the price of the stock could rise or fall in the future, and this affects the value of one’s position. From a mathematical point of view, the question that hundreds of 20th century arbitrageurs and mathematicians wanted to answer was: how much is that risk worth? Solving this “options pricing problem” would lead to the coveted solution of how to value an option. Finding the elusive answer took the brilliance of some of the best mathematicians of the 20th century. In 1900, French mathematician Louis Bachelier wrote a PhD thesis entitled The Theory of Speculation. In his work, Bachelier studied the movement of bond prices on the Parisian bourse, and was able to derive a relationship between the probability distribution of prices and the flow of heat, both of which are random processes. Such models are called “Brownian motion models,” and

the obligation, to buy the underlying asset upon the contract’s maturity. between any two points in time, the change in bond prices was a normally distributed random variable. His work, however, went unnoticed for decades. In the 1930s and 1940s, an eccentric MIT mathematician, Norbert Wiener, formalized the mathematical treatment of Brownian motion models in what he called “Wiener processes.” Japanese mathematician Kiyoshi Ito then contributed a method by which to perform calculus on Wiener processes, discovering the seminal ideas of the now ubiquitous field of stochastic calculus. This mathematical work would be instrumental in coming up with the final solution for the options pricing problem. Myron Scholes and Fischer Black, the two mathematicians who would ultimately find the answer, are now immortalized in the field of finance. Their idea to solve the problem was to create a small portfolio consisting of a stock, an option on the stock, and a risk-free bond. Their argument, an approach known as “no arbitrage,” was subtle but elegant. It worked as follows: start by borrowing some money (for example, by selling a bond) and invest the proceeds in a stock and an option on that stock in a given ratio that minimizes risk. Notice that your net investment today is zero, because you borrowed an amount which you invested in a stock and an option. Furthermore, note that the values of your stock, bond, and option might be completely different tomorrow. However, the gist of the

be exploited until it disappeared. Thus, since there are no arbitrage opportunities, your portfolio is going to be worth zero tomorrow and you can deduce the value of your option given that you have the price of your stock and bond. Instead of deducing the value of the option through a today-tomorrow model, however, one can use shorter time intervals by deducing the change in value of the option every hour. This logic can be taken a step forward, whereby using the aforementioned stochastic processes allows for continuous revaluation of the price of the option. This process yields an accurate value of the option and is the essence of the famous Black-Scholes model, which was and still is widely used as a derivative-valuation and “dynamic hedging” model.

FROM MATHEMATICS TO MONEY: THE CASE OF LONG-TERM CAPITAL MANAGEMENT

Robert Merton was one of the mathematicians who applied the idea of continuous-time revaluation to the options pricing model of Black and Scholes. In 1994, Merton, along with Scholes and a number of prominent Wall Street personalities, founded Long-Term Capital Management (LTCM). The hedge fund planned to take investment to a new level of sophistication and, in the words of Scholes himself, LTCM expected to be a “gigantic vacuum cleaner sucking up nickels from around the world.” LTCM was a

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Inside Scope tremendous success in its first three years, when it delivered returns of 20, 43, and 41 percent, respectively. Fortunes were literally doubled within an unprecedented time period. LTCM’s investment strategy specialized in fixed-income arbitrage trades known as convergence trades. The idea behind such trades was that the value of long-term maturity bonds issued within small time periods would converge over time. The key was that the rate of convergence to this long-term price was different for each bond, depending on its liquidity and its volume of trading. LTCM specialized in making bets on how quickly this convergence would occur. Because the spreads in bond prices were ordinarily quite narrow, LTCM had to take on highly-leveraged positions in order to make any considerable profits. A leveraged position is one in which you borrow money at a given interest rate and reinvest it under a certain strategy that expects to earn higher returns. If the bet is successful, then one returns the borrowed money plus interest and keeps the difference in interest rates as a profit. LTCM used a certain kind of derivative, known as an interest rate swap, to leverage its investments in convergence trades. Awrinkleinthisseaofsophistication was that LTCM’s highly leveraged trades were based on the premise that even if some of its investments ran into trouble some of the time, it was nearly a statistical impossibility for all of them to fail simultaneously. Yet such is the world of finance that in 1998 this is precisely what happened. Although there are various dimensions to LTCM’s collapse, it is generally agreed that the breakdown began in the second quarter of 1998, when a slump in the mortgage-backed securities market inflicted losses on hedge funds and forced them to liquidate some of their emergingmarket positions. Meanwhile, the Treasury market was undergoing an upturn; together, these two factors led to a divergence in credit spreads. As LTCM’s convergence trades were essentially based on selling short Treasury bonds, the fund soon found itself in the first hints of trouble. This dilemma was exacerbated by the exit of Salomon Brothers from the arbitrage business. Salomon, a firm known for its strong 36

presence in proprietary trading, was one of Wall Street’s most formidable investment banks in the 1980s. LTCM knew that the exit of a firm like Salomon would affect the markets in which it was heavily invested, but it misjudged the extent of the effect. LTCM incorrectly believed that Salomon’s positions would be picked up by other hedge funds—a prediction that never transpired. This excess supply further drove down the value of many of LTCM’s investments. The final straw for LTCM came in

The full disclosure of derivatives positions in financial statements is crucial, as is the development and application of sound riskmanagement policies at the individual firm level. While some may scoff at the proposition, the discipline of market mechanisms can control even our most complicated creations.

August of 1998, when Russia announced a “restructuring” of payments on its so-called “GKO” bonds. Effectively, the restructuring amounted to a default, causing investors everywhere to panic and triggering a “flight to quality” whereby investors sold Russian and other emerging market bonds en masse and bought more secure U.S. Treasury bonds. As the price of Treasury bonds rallied and that of lower quality debt plummeted, the world witnessed an unprecedented divergence in spreads. This was reflected in spreads on the aforementioned interest-rate swaps: while swap spreads usually moved one or two basis points daily, they moved 21 basis points in a single day in the aftermath of the Russian default. On August 21st of the same year, LTCM sustained a single-day loss of $550 million. The first three weeks of September

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

saw the value of LTCM’s equity fall from $2.3 billion to $600 million. As a result, LTCM found its leverage ratios at unsustainable levels.All over the world, fears transpired that as LTCM liquidated its positions to cover its enormous debt, prices in the asset classes it liquidated would crash. This would put the portfolio positions of other hedge funds and institutional investors in trouble, causing further sell-offs and precipitating a global financial meltdown. To avert this disastrous course, the Federal Reserve Bank of New York, along with a consortium of American and European banks, organized a $3.6 billion bail-out of LTCM in return for a 90 percent stake in the firm.

A Sunny Day for Tax Havens By Chelsea Zhang

“FINANCIAL WEAPONS OF MASS DESTRUCTION”?

LTCM was only one firm among many that collapsed as a result of the misuse of derivatives and a misunderstanding of the risks associated with them. Barings Bank, Orange County, and more recently Amaranth all collapsed for similar reasons. In his 2002 annual shareholder report, Warren Buffett—in typical tongue-in-cheek style—called derivatives “financial weapons of mass destruction.” Was Buffett’s hyperbolic assessment of derivatives justified? Generally, critics of derivatives contend that the instruments are poorly understood and that they create unmanageable risks which will one day bring the world’s financial system to its knees. Unfortunately, these same people pursue too naïve a solution to the problem: stricter regulation. Regulation would simply distort efficiency by interfering with the market’s optimal allocation of risk. In other words, rigid and standardized government regulation would simply weaken the ability of institutions to effectively manage the risks they face. Instead, as is always the case in economics, the most ideal solutions to our problems are marketbased. In this regard, the full disclosure of derivatives positions in financial statements is crucial, as is the development and application of sound risk-management policies at the individual firm level. While some may scoff at the proposition, the discipline of market mechanisms can control even our most complicated creations.

Redemption is possible in world markets—even for tax havens.

n years past, the phrase “tax haven” might have conjured an image of a sunny, idyllic island where taxevading, money-laundering businessmen take shelter under the secrecy granted to business transactions, and the tropical breeze whispers of shady dealings. That image is now obsolete. The widespread criticism of tax havens seems to have blown over as recent reports have cast a more favorable light on them.

Tax havens, which comprise 15 percent of all countries, belong to a group more formally known as offshore financial centers (OFCs)— small, wealthy economies like Bermuda and Jersey whose business relies on capital flows

from abroad. A special report in the February 24, 2007 issue of The Economist weighs the muchpublicized drawbacks of OFCs against their less well-known advantages and concludes that OFCs can benefit world financial markets.The article, by Joanne Ramos, argues that “although international initiatives aimed at reducing financial crime are welcome, the broader concern over OFCs is overblown.” Several academic studies have drawn conclusions in favor of OFCs as well. Now praised for improving their governance, encouraging business investment, and introducing healthy competition, OFCs are overcoming the longheld stigma that they damage the economies of neighboring countries and facilitate illegal

activity.

HISTORY

Jersey, an island off the French coast, is renowned for its financial services. According to The Economist’s report, the island houses 46 banks, 1,055 investment funds and over 200 trusts. The island has been helped due to its maximum income tax rate holding steady at 20 percent since 1940. Jersey’s success stems from the fact that it provides the services of an OFC, which may include little or no taxation, lenient financial

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Global Outlook regulation, and privacy in banking. More recently, OFCs have evolved to offer services besides banking, such as insurance and fund management. The increasing sophistication of these jurisdictions has blurred the distinction between what qualifies as an OFC and what does not. Despite this uncertainty, the rapid growth of OFCs in the past decades is indisputable. The Economist’s report cites several statistics: whereas the world economy grew at an annual rate of 1.2 percent per capita, on average, between 1982 and 2003, the economies of OFCs grew at an average rate of 2.8 percent. Offshore assets have quintupled over the last two decades and now stand between $5 trillion and $7 trillion. Bermuda, which tops the list of wealthy countries, has a per capita GDP of nearly $70,000, while the U.S.’s figure is only $43,500. The Economist’s article offers an explanation for the ascendancy of OFCs: the loosening of financial regulations, the explosion in international financial services, and the Internet have promoted the global dispersion of capital. Perks offered by OFCs besides low tax rates also keep the capital flowing in. These perks include simpler tax systems, less costly regulation of businesses, legal systems that protect businesses, and a location near profitable economies, as listed by the International Monetary Fund. Of course, the main use of OFCs is for companies to relieve their tax bills. According to a 2005 study by Mihir Desai and C. Fritz Foley of Harvard Business School and James Hines of the University of Michigan, tax havens reduce taxes in two ways: first, firms can transfer income from high-tax jurisdictions to low-tax jurisdictions; and second, firms can defer the taxation of income that would occur when income is repatriated to the U.S. Larger tax haven countries tend to serve the first purpose, while smaller countries tend to serve the second. The study also found that firms that employ tax havens tend to be larger, more foreign-oriented, and technology-intensive, with higher levels of intrafirm trade.

war on honest U.S. taxpayers” because they cost the U.S. up to $70 billion a year. Other countries face similar losses in tax receipts from corporations and individuals alike. The Rolling Stones, for instance, took advantage of the Netherlands’ lenient tax policy toward royalties for artists and athletes. According to a February 4 article in The New York Times, the rock group paid a meager tax rate of 1.5 percent on $450 million in profit. In addition to censuring tax diversion, critics of OFCs often maintain that OFCs lack the oversight to investigate money laundering, monitor banks, and prosecute financial crime, especially because they profit from attracting more capital. The Economist’s report cites the common perception that OFCs help channel funds to “terrorists, drug traffickers and rogue

“

STIGMA

As a result of OFCs serving the purpose of lowering tax liabilities, they fell into disrepute because they divert tax revenues from other countries. U.S. Senator Carl Levin has said that tax havens have “declared economic

The Economist’s report cites several statistics: whereas the world economy grew at an annual rate of 1.2 percent per capita, on average, between 1982 and 2003, the economies of OFCs grew at an average rate of 2.8 percent.

VINDICATION

Desai, Foley, and Hines put a dent in the stigma against OFCs with the release of their 2004 paper, which concluded that tax havens benefit neighboring non-haven countries. The researchers found that the existence of a tax haven is associated with greater growth in nearby countries, “implying a complementary relationship between haven and non-haven activity.” Because havens lessen the tax liabilities of a company’s operations in a region, they also encourage growth of the company in other countries of the same region. Just as the regional effects of tax havens may be misjudged, it is also the case that the governance of OFCs may be better than previously thought. The likelihood that a country will become a tax haven increases with the quality of its political institutions, reported a study by Hines and Dhammika Dharmapala in 2006. In the study, governance quality was found to hinge on several measures: political stability, quality of regulations, and corruption, among others. It may be that as tax havens compete for capital, the better-governed ones survive, while the ones with corruption and financial crime are weeded out. A strong justification of OFCs is their effects on competition. First, OFCs allow firms to escape bureaucratic regulations and to optimize their financial operations across nations with different tax policies. The result: companies stay competitive. Second, with the exception of poor countries, tax competition initiated by OFCs may be healthy, as it prevents governments from imposing excessive taxation and from growing too big. Third, OFCs also force banks in surrounding countries to stay competitive, which may improve overall welfare. According to a 2005 paper by Andrew Rose of the University of California and Mark Spiegel of the San Francisco Fed, the closer a

”

nations in need of cash.” OFCs do, in fact, have a tainted history. Dubai, an emerging OFC, provided a place for terrorists to transfer funding for the September 11 attacks. Cyprus is notorious for illegal activity: supplying Saddam Hussein with weapons in the 1990s, illegally profiting from sales of Iraqi crude oil, and accepting money from the Russian mafia for tax evasion, as detailed in the article “Fantasy Island” in the April 24 issue of Forbes. However, Cyprus has taken steps to improve its financial reputation. In May 2004, it adopted regulations that cracked down on money laundering and enforced transparency in business. Various other objections are raised against OFCs. For one, their low tax rates may spur tax competition, in which countries vie to cut tax rates until they’re unable to fund government spending. The burden of this “race to the bottom” falls heavily upon poor countries. A

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

report by Oxfam estimates that developing countries lose at least $50 billion in revenue to tax havens—the same as the amount of aid they receive. A second complaint is that financial turmoil may spread easily from OFCs to onshore economies, especially as hedge funds and obscure derivatives expand operations in OFCs. Finally, the influx of workers into OFCs due to friendly business policies raises the cost of living for the original inhabitants of the OFC and results in overcrowding.

Top economies by GDP per person

country lies to an OFC, the more competitive its banking system is.

2006 Estimate (in thousands)

SMOOTH SAILING AHEAD?

The recent reports, which approve of OFCs and justify their policies, bode well for their future. Still, suspicions of unscrupulous activity in OFCs persist. Such suspicions have inspired international efforts to clean up operations in OFCs—imposing regulations on bank supervision, money laundering, and so on—with rising costs of compliance. The Commonwealth Secretariat,a group of nations in the former British Empire, priced the cost of regulations at $45 million for Barbados and $40 million for Mauritius during 2006. Similarly, the Virgin Islands have suffered a drastic reduction of business since the Internal Revenue Service enforced new regulations and began audits of tax abuse in early 2005. The number of firms there declined from 100 to under 60 in two years, causing local leaders to complain that the new regulations have seriously threatened their economy. It is ironic, and perhaps unfortunate, that the higher costs of running OFCs may overwhelm the investment encouraged by their business-friendly policies—for this investment underlies the benefits that proponents of OFCs now stress.The criticisms of the past should cease, ushering in a new era of healthy competition in which OFCs and non-OFCs not only coexist, but also mutually benefit from each other.

10 20 30 40 50 60 70

BERMUDA LUXEMBOURG EQUATORIAL GUINEA UNITED ARAB EMIRATES NORWAY GUERNSEY CAYMAN ISLANDS IRELAND UNITED STATES JERSEY BRITISH VIRGIN ISLANDS ICELAND DENMARK HONG KONG CANADA Source: CIA World Factbook

References Ramos, Joanne. “Places in the sun.” 24 Feb 2007. The Economist. Vol. 382, Issue 8517. IMF Background Paper on OFCs. 23 June 2000. HYPERLINK “http://www.imf.org/external/np/mae/oshore/2000/eng/back.htm” http://www.imf.org/external/ np/mae/oshore/2000/eng/back.htm Desai, M.A., C.F. Foley and J.R. Hines. “The Demand for Tax Haven Operations.” March 2005. Downloaded from Social Science Research Network. Browning, Lynnley. “Gimme Tax Shelter.” 4 Feb 2007. The New York Times. Freedman, Michael. “Fantasy Island.” 24 Apr 2006. Forbes. Vol. 177, Issue 9. Oxfam. “Tax Havens: Releasing the Hidden Billions for Poverty Eradication.” Desai, M.A., C.F. Foley and J.R. Hines. “Economic Effects of Regional Tax Havens.” Sept 2004. NBER Working Paper No. 10806. Dharmapala, D. and J.R. Hines. “Which Countries Become Tax Havens?” Dec 2006. NBER Working Paper No. 12802. Rose, A.K. and M.M. Spiegel. “Offshore Financial Centers: Parasites or Symbionts?” 13 May 2005. NBER Working Paper No. 12044. Sharman, J.C. “Developmental Implications of Anti-Money Laundering and Taxation Regulations.” Commonwealth Finance Ministers Meeting, 12-14 Sept 2006. Matthews, R.G. “Tax Haven Wants its Welcome Mat Back.” 27 Dec 2006. The Wall Street Journal.

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Lost in Taxation

By Sarah Wang

China’s Taxation Policy and What Every Investor Should Know

n recent years, China has taken center stage in the discussions on global economies. Predictions of China eclipsing the United States as the world’s dominant economy by as early as 2041 have caught the attention of the investment world and made “China” a truly global buzzword. And for good reason. Since the late 1970s, when Deng Xiaoping opened up the country to international trade, China’s GDP has increased tenfold, and in 2006, measured on purchasing power parity basis, China stood second only to the US as the world’s largest economy. China’s entry into the World Trade Organization in 2001 proved a watershed, as it opened up this emerging market to foreign investment. Given the vast market potential and expensive labor pool, China offers exciting investment opportunities to U.S. investors. However, more than a simple language barrier stands between investors and investment in China—understanding the relatively new and complex Chinese taxation system is critical for any interested enterprise or individual. This comprehension may even provide insight behind China’s recent phenomenal economic growth. 40

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

As certain as death and taxes.

Personal Income Tax

—Daniel Defoe

Grumbling about taxes seems to be a national pastime in America, but in comparison to the personal income taxes on foreigners residing in China or deriving China source income, American income tax woes become less compelling. Rather than being computed annually, the Chinese individual income tax rate progresses from 5% to 45% based on a monthly income. In figure 1, we see that the Chinese Individual Income Tax Law, adopted in 1993, is more progressive than that of the United States, where the highest marginal tax rate is 35% on annual income over US$ 168,275 (based on taxable income for a married couple filing joint returns). Figure 1 reveals the Chinese income tax rate based on monthly income in Chinese RMB (roughly equal to US$ 0.125). Moreover, in contrast to the United States, Chinese tax laws do not distinguish between married and single taxpayers; nor is there a deduction for dependent children. Instead, there is a standard flat deduction of RMB 1,600 each month in computing taxable income. Foreigners are allowed an additional RMB 3,200 per month. Of particular importance to anyone interested in working in China is the fact that a foreigner’s income subject to the Chinese income tax depends on the length of his/her stay in China. Figure 2 highlights the changes in taxable income as a foreigner’s stay in China increases.

Nuclear physics is much easier than tax law. It’s rational and always works the same way.

—Jerold Rochwald

Corporate Taxes And Tax Incentives

In addition to foreign individuals paying taxes, all foreign businesses with establishments in China are also subject to various forms of corporate taxes under the Chinese law. Corporate taxes applicable to foreign investment enterprises include corporate income tax, value added tax, business tax, and various other business taxes. But what is perhaps more interesting than the various and relatively predictable corporate taxes are the multiple tax incentives issued by the Chinese government.

One of the first taxes all foreign investment enterprises must pay is the Corporate Income Tax, which is an effective rate of 33% (including a national tax rate of 30% and a local tax rate of 3%). Foreign investment enterprises, both wholly foreign owned entities and joint ventures, are taxed on their worldwide income, though a foreign tax credit is allowed for income taxes paid to other countries. Enterprises must also pay a tax not familiar to many Americans: the VAT (Value-Added Tax). VAT is levied on the import of goods, the sales of goods, and on the processing, repair, and replacement services. The standard Chinese VAT rate for most products is 17%. Interestingly, export sales are exempt from VAT, which reflects the Chinese government policy of encouraging export sales. VAT is paid by the seller of goods, provider of service, and the importer. However, it is a pass-on tax and is born by the consumers. Therefore, it is not directly charged to corporate income. Other corporate taxes that businesses must pay include the business tax (see figure 3), consumption tax, stamp tax, and land value added tax. In order to attract foreign investment, the Chinese government has introduced some truly impressive tax incentives for foreign investment. These incentives are available subject to qualifying conditions such as the location of the enterprise, the nature of the business, and the duration of operations/ investments. Major tax incentives include reduced tax rates and tax holidays. Specifically, foreign investors can enjoy a reduced tax rate of 15% if the foreign investment enterprises and foreign enterprises are located in one of the five Special Economic Zones. The 15% rate also applies to foreign enterprises engaged in production and manufacturing activities located in Pudong New District in Shanghai, Suzhou Industrial Park, Economic and Technology Development Zones, Free Trade Zones, Export Processing Zones, and other specified investment zones, reflecting a government effort to stimulate production in these areas. On the top of the reduced tax rates, foreign investment enterprises that are production-oriented (their annual sales from production activities exceed 50% of its total annual income) may qualify for an incredible five year tax holiday, which entails a twoyear tax exemption and a three year 50% tax reduction beginning from the companies’ first profit-making year.

Figure 1 Monthly taxable income (in RMB) 0 – 500 500 – 2,000 2,000 – 5,000 5,000 – 20,000 20,000 – 40,000 40,000 – 60,000 60,000 – 80,000 80,000 – 100,000 Over 100,000

Tax rate 5% 10 % 15 % 20 % 25 % 30 % 35 % 40 % 45 %

Figure 2 Length of stay Income subject to in China Chinese income tax Income paid by Less than a employer in 90 days in China services a calendar actuallyfor performed year in China Income for services 90 – 364 performed in days in a China regardless calendar paid by a Chinese year employer or a foreign employer Income earned in China foreign 1 – 5 years incomeand remitted to China Worldwide income including interest, Over 5 dividends, and years rent, regardless whether they were remitted to China

FALL 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

“

Rising Dragon

The growth of the Chinese economy has been matched and perhaps even stimulated by a

complimentary tax law that is highly encouraging for foreign export-oriented and technologically

advanced industries, dividend reinvestment, and foreign investment in general.

The tax incentives do not end with foreign production stimulation. To encourage foreign investors to reinvest their dividends in China, the Chinese government offers a dividend reinvestment refund. Foreign investors who reinvest their dividends in China for at least five years are entitled to a 40% refund of the tax they paid on the dividends. This tax refund increases to a whopping 100% if the reinvestment is in an export-oriented or technologically advanced enterprise. In order to further fuel its booming trade surplus, the Chinese government also offers a further 50% tax reduction at the end of the five year tax holiday for those in export-oriented and technologically advanced enterprises. The deduction for export-oriented enterprises (which exports over 70% of its output in a given year) is only for that year, while the deduction is extended for three years for the so-called “technologically advanced enterprises.”

In addition to the previous concessions for corporate income tax, the Chinese government has also introduced a range of other preferential incentives on value added tax, business tax, and custom duty. For example, income from technology development and related consulting services are completely exempt from business taxes. Furthermore, importation of raw materials, parts, and certain equipment are also exempt from value-added tax and customs duty if the produced goods are exported.

The nation should have a tax system that looks like someone designed it on purpose.

—William Simon

Final Considerations

The progressive personal income taxes, intense corporate taxes, and purposeful tax

”

By Samantha Fang

incentives combine to form one interesting tax policy in China. The growth of the Chinese economy has been matched and perhaps even stimulated by a complimentary tax law that is highly encouraging for foreign export-oriented and technologically advanced industries, dividend reinvestment, and foreign investment in general. Of course, tax regulations in China are ever changing. One proposed new tax law would unify the tax codes for foreign investment enterprises and domestic enterprises into one enterprise tax law. The proposed reform would focus on the development of businesses in certain industries as opposed to in specific locations (such as Special Economic Zones). With the Chinese tax regulations continually changing, one aspect remains constant: the need for investors to understand the different categories of taxes and tax incentives before investing.

Figure 3 Taxable Services

Rate

Construction, transportation, telecommunication, cultural and sport activities

Entertainment

5 – 20 %

Banking, insurance, transfer of intangibles (such as copyrights)

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

IT Investment and Economic Development in Vietnam

ith all the hype surrounding China’s rise as an economic and political superpower, it is easy to overlook the potential of other emerging markets in the region. Despite the spotlight on China, Vietnam has emerged as the next hotspot for investment, fueled by expanded international trade, increased flexibility for foreign investors, and--perhaps most importantly for the future--a penchant for IT technology. In the three decades since Vietnam transitioned from communism to a more liberal socialist market, the country has surpassed most of its neighbors in economic development and growth. With a GDP growth of 8.4%, it is Asia’s secondfastest growing economy, following only China’s. In fact, a recent Merrill Lynch report urged its investors to strongly consider Vietnam, estimating that Vietnam “will be the fastest-growing Asian country in the next 10 years.”

Vietnam’s economic reversal began in the 1990s through the Doi Moi, or Reconstruction, program. A result of the government’s efforts to confront widespread poverty and to stimulate its stagnating economy, Doi Moi effectively abandoned Marxist economic planning and introduced market elements to the Vietnamese system. The government has abolished price control, devalued the Dong, legalized private ownership, freed the private sector, and opened the country for foreign investment. To stabilize the domestic SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Global Outlook situation for foreign investment, it has begun to introduce a modern legal framework and to pursue monetary and fiscal policy. Describing the nature of the reforms, Le Dang Doanh, its primary architect, stated, “The reform is definitely irreversible. Any attempt to come back to a centrally planned economy, to overplay the state sector, is economically irrational, inefficient, and psychologically counterproductive.” Determined to be an industrialized nation by 2020, Vietnam seems determined to forge on and cut itself from its socialist past. While it has traditionally exported agricultural goods and natural resources, Vietnam is beginning to become a center of manufactured and technology products. The shift from resource-rich to labor-rich products marks the country’s commitment to long-term, sustainable growth. This transition into more labor-intensive products has been facilitated by the normalization of relations with the US in 2004 and Vietnam’s recent entry into the WTO, and has profound implications for Vietnam’s future economic growth, foreign investor confidence, and the social wellbeing of the Vietnamese people.

INTEL AND THE IT INFLUX

In November 2006, Intel surprised the investment world by choosing Ho Chi Minh City as the site for two of its production plants, choosing over seemingly more lucrative options in Cambodia, Thailand, and China. Intel’s billion-dollar investment was an upgrade from the company’s original 300million-dollar investment for a semiconductor assembly and test plant. The move effectively committed Intel, the world’s largest chipmaker, to Vietnam and placed the country on the global high-tech map, signaling its ambitions to keep up to pace with its more lucrative Asian counterparts. Intel’s decision to move operations to Vietnam has been fueled by the factors that have made investment in Vietnam so desirable: a fast growing economy, strategic location, strong emphasis on education, skilled workforce at a competitive cost, and strong government commitment and support to grow in the information technology market. Furthermore, Vietnam’s recent entry into the WTO has minimized tariffs and barriers to free trade, while ensuring intellectual property protection--a key factor in Intel’s decision. Intel’s proven preference for sourcing locally 44

creates opportunities for the hundreds of local Vietnamese technology companies, whose growth will make the country more conducive to further investment by other IT companies. “Vietnam is where the action is now--it’s like a gold rush,” said Than Trong Phue, the manager of Vietnam Intel, “You’ll be foolish if you miss out.” Other companies have taken notice. Already, Intel’s move has raised concern among its competitors, particularly the integrated circuits producer AMD, who has just opened a new plant in Dresden, Germany. The Japanese electronics giant Canon recently committed to invest an additional $110 million in Vietnam, increasing its total investment in the country to $370 million and making Vietnam the largest base for manufacturing Canon printers outside Japan. Alcatel, Fujitsu, and Siemens have also followed suit, while Bill Gates’ recent April 2006 visit to Prime Minister Phan Van Kai has raised intimations that a Microsoft deal is in the works.

FACTORS BEHIND RECENT GROWTH

The driving factor for Intel’s--and probably the rest of the IT world will follow-choice of Vietnam lies in its relatively low labor costs. As capital poured earlier into China and India, the corresponding rise in worker productivity and wage has made Vietnam a much more attractive option. According to Business Week, while it takes about $125 a month to hire a factory worker in China, the same wage for a Vietnamese worker would be $65; similarly, a skilled software engineer in India would cost $750 a month while a similar manager in Vietnam would earn $350. Furthermore, the government’s incentives to promote IT investment allow IT companies such as Intel to capitalize on the market and maximize their profits. With a little risk and a much lower cost, Intel stands to earn on its investment in Vietnam, and would certainly be followed by other companies. Furthermore, Vietnam’s human resources, as well as its political and social stability, ensure that foreign investment in Vietnam will be more stable and sustainable. In its annual report, the Political and Economic Risk Consultancy in Hong Kong ranked Vietnam the most stable of all countries in the region, citing its relative lack of religious, cultural, and ethnic clashes. Furthermore, Vietnam’s young population--over half the population is under 25--is the ultimate labor resource for incoming

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

IT companies and foreign investment. Over thirty thousand graduate from Ho Chi Minh City universities every year; education is comparable to that of China’s, while English proficiency is on a sharp increase. In addition to educational improvements within the country, overseas Vietnamese--many of whom now live in the US-have returned, transferring knowledge and capital to contribute to the growth of Vietnam’s economy. Furthermore, the government has shown itself committed to drafting necessary reforms and building infrastructure. Changes in the legal framework, such as the Unified Enterprise Law and the Common Investment Law, now offer foreign investors greater legal protection than before, allowing them to secure their assets. The government has also expanded the range of business models available to foreign businesses, allowing for foreign firms to completely own businesses in Vietnam, as well as participate in joint stock companies. In addition to the whopping $125 billion the government has set aside for infrastructure development, Vietnam is calling for an additional $25 billion in foreign direct investment to aid efforts. For a small country in Southeast Asia, the numbers are unbelievably huge: the overhaul and modernization of infrastructure will increase growth in Vietnam’s construction materials sector by 15% and its building sectors by 9%. The growth requires $28.8 million in power projects, $38.9 million to upgrade railroads and bridges, $12.8 million in broadband development, and the construction of 6 new international airports. A latecomer in the Southeast Asian region for attracting investment when compared to earlier foreign influxes into Malaysia,Thailand, and Singapore, Vietnam nevertheless now has issued 4,047 licenses with $41.5 billion worth of capital. A more telling sign, seventy-three

different countries and economies are invested in Vietnam, and the country has attracted over 100 transnational companies, many of whom are listed in Fortune’s Top 500 list. Asian countries have noticed Vietnam’s potential sooner than the West, accounting for 64% of Vietnam’s foreign direct investment, but European investors are catching on to the craze, holding a solid 21% of Vietnam’s foreign capital share. The country’s increasing exports to fellow ASEAN (Association of Southeast Asian) countries--along with bilateral trade agreements and most-favorednation assurances signed with members of the European Union, the United States, India, and China--boost the country’s already dramatic growth, increasing incentives for further foreign investment and interest. The most interesting aspect of this foreign investment influx is its self-perpetuating cycle of growth: foreign companies place their assets in Vietnam because of its various benefits;

the wealth that accrues from these assets is then used to develop additional benefits that will attract further investment. Foreign direct investment has helped modernize management and corporate governance, creating a new generation of dynamic managements. In a 2002 report on the effects of foreign investment, Doanh claimed that investment has triggered the success of the Vietnamese economy, training or re-training some 300,000 workers, 25,000 technicians, and 6,000 managers.The simultaneous growth of physical capital and human capital is laying the foundations for projected solid and steady future growth.

ECONOMIC DEVELOPMENT

For this very reason--that foreign investment propels growth--the Vietnamese government has been extremely ardent in its efforts to attract foreign companies and to create a climate conducive to investment.

In an interview with The Hindu, Pham Gia Kiem, Vietnam’s Foreign Minister, appealed to Indian--and global--investors, bluntly stating, “I would like to call upon investors to do business in Vietnam. The Vietnamese Government will grant you maximum incentives.” In addition to the economic growth that such foreign assets can bring, they are also instrumental in alleviating poverty and modernizing the country’s infrastructure. Indeed, since the beginning of the Doi Moi reform and its corresponding influx of foreign investment, poverty has been reduced to less than 20 percent of the population. The recent IT influx is a fitting example in which Vietnam has coupled with foreign companies to improve the social conditions of the poor in rural regions while advancing with cutting-edge technology. Recently, with Intel’s support, the Vietnamese government has been running pilot programs with WiMAX (worldwide interoperability for microwave

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

“

The driving factor for Intel’s—and probably the rest of the IT world will follow—choice of Vietnam lies in its relatively low labor costs. As capital poured earlier into China and India, the corresponding rise in worker productivity and wage has made Vietnam a much more attractive option.

access), technology that transfers wireless data in a manner similar to WiFi, but with higher speeds and longer ranges. While the success of the program could serve as a marketing tool for Intel, the Vietnamese government seeks to use WiMAX to connect rural areas with public access to the Internet. Officials envision that the WiMAX project could be used to more efficiently deliver public services and provide information that could lower poverty in rural areas. Information on issues such as farming and health would raise the productivity of those in rural areas, while connection could make the government more responsive to the public’s needs. The ultimate goal of the project, however, is much more ambitious, seeking to educate rural populations about technology and perhaps even outsource operations from the cities to the villages. Such programs show the Vietnamese government’s commitment to using the resources of foreign investment-such as the recent IT influx--for social and economic development.

THE FUTURE: HOPES AND ROADBLOCKS

Despite the euphoria surrounding the opportunities in Vietnam, there are many salient problems that must be addressed

and considered by investors. First, Vietnam’s authoritarian government has been called “even more opaque than China,” making it difficult for foreign investors to gauge the progress and deliberation of reforms; perhaps, reforms could even be derailed. Corruption is a widespread problem: just last year, the government stopped a large-scale project to build a highway across northern Vietnam, uncovering a graft scandal that led back to the Transport Minister. It is also possible that the recent hype surrounding Vietnam is the loss of investor interest in Thailand following the September 19th military coup that replaced Thaksin. Some analysts predict that foreign investors will turn away from Vietnam and towards Thailand again, once the Thai government proves itself committed to foreign investment. Furthermore, in spite of efforts, Vietnam’s infrastructure still remains significantly inferior when compared to its ASEAN counterparts. The communist government has been

”

trying to rectify these issues. In light of growing corruption, it has been issuing clearer policies and implementing them more reliably than the democracies in the region. Infrastructure--especially with the influx of information technology--has become one of the government’s top priorities. As IT in Vietnam grows at a rate of 30% a year, it would be interesting to see the effects of Vietnam’s modernizing economic growth. It could be a powerful statement of how foreign investment and technology work together to spur economic development and reduce social ills.

Resources Lan, Nguyen Phi. Foreign Direct Investment in Vietnam: Impact on Economic Growth and Domestic Investment (2006). Centre for Regulation and Market Analysis, University of South Australia. Official Website of ASEAN. hyperlink “http://www.aseansec.org/4810.htm” http://www.aseansec.org/4810.htm. “Merrill Lynch Upbeat on Investing in Vietnam” (Feb. 9, 2007). Vietnam Business Forum. hyperlink “http://vibforum.vcci.com.vn/news_detail.asp?news_ id=5715” http://vibforum.vcci.com.vn/news_detail.asp?news_id=5715. Balfour, Frederik. “Why Intel’s Stacking the Chips in Vietnam” (Feb. 15, 2006). Interview with Craig Barnett, Chairman of Intel. Business Week Asia Online. Fulbrook, David. “Vietnam’s High-speed IT Rise.” Asia Times Online. http://www.atimes.com/-atimes/Southeast_Asia/HK29Ae01.html

CORPORATE GOVERNANCE DIAGNOSING THE PROBLEM & PRESCRIBING THE CURE BY DONNA IVRY

he past several years have witnessed a multitude of large corporate fraud cases and increasing media attention to a variety of seemingly extravagant corporate perks. With each new tide of scandals, investors were severely hurt in the stock market. The most prominent example: Enron Corporation stock plummeting from prices as high $85 to $0.30 in the post-fraud sell-off. Enron became the seventh largest company in the U.S. by creating shell entities to keep hundreds of millions of dollars worth of debt off its books while recording fictitious revenues. On October 17, 2001, the corporation reduced its shareholders’ equity by $1.2 billion, precipitating an incredible stock drop. Enron executives, however, practicing insider trading, sold off their own shares prior to the accounting correction. Arthur Anderson, Enron’s auditor and the fifth leading accounting firm in the world at the time, participated in the scandal by shredding thousands of documents. The outraged public demanded accountability and federal legislature responded by passing the Sarbanes-Oxley Act. The Act was aimed to prevent corporate sector meltdowns such as those witnessed by Enron, Tyco International, Peregrine Systems, and WorldCom by creating greater transparency and accountability. Its provisions included greater disclosure, certification of financial statements, reports by CEOs and CFOs, increased criminal and civil penalties for misstating financial statements, and more, creating further incentive for managers to act in accordance with prescribed guidelines.

Baruah, Amit. “Rise of India, China an Opportunity for Vietnam and Asia” (Mar. 1, 2007). Interview with Pham Gia Kiem, Vietnam’s Deputy Prime Minister and Foreign Minister. The Hindu. hyperlink“http://www.hindu.com/2007/03/01/stories/2007030103571100.htm”http://www.hindu.com/2007/03/01/ stories/2007030103571100.htm. Doanh, Le Dang. Foreign Direct Investment in Vietnam: Results, Achievements, Challenges, and Prospects (Aug. 16, 2002). Presented to the International Monetary Fund, Conference on FDI in Hanoi.

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Investing Today

“

WRAP UP AND OTHERS BEGIN, IT IS PERTINENT TO CONSIDER WHAT CORPORATE GOVERNANCE CONSISTS OF AND, MORE IMPORTANTLY, HOW TO GET IT RIGHT.

As trials of fraudulent executives wrap up and others begin, it is pertinent to consider what corporate governance consists of and, more importantly, how to get it right. The underlying issue within corporate governance is the principal-agent problem. This quandary arises when one party—the principal— contracts an agent to act on its behalf, but is hindered in its ability to monitor. The agent will act in his own self-interest, which cannot be guaranteed to match that of the principal. When ownership of the company is separated from its control, the principal-agent problem naturally arises. And corporations have an additional layer of complexity: the board of directors. This governing body’s purpose is to maintain the interest of the disparate stakeholders, combating the principal-agent problem. Even this institution, however, experiences conflict-of-interest crises when contracting management is not conducted at an arm’s-length. Board members have certain incentives to cooperate with management. Board compensation is influenced directly by the CEO, as well as business contracts with the members’ firms. Along with a financial impetus, there are physiological effects that increase compliance with managers. Many directors have social connections to the management which makes oversight more difficult. Several public scandals have illuminated the undeniable existence of a principal-agent problem in the corporate world. Recent research into corporate governance has primarily focused on resolving the incentive misalignment issues. For example, it has been 48

TRIALS OF FRAUDULENT EXECUTIVES

proposed that if managers had substantial stake in the company, their own incentives would be exactly those of the shareholders— maximizing the firm’s profits. Yet this incentive scheme does not hold in reality. Michael C. Jensen and Kevin J. Murphy estimate that CEO wealth increases by only $3.25 for every $1,000 rise in shareholder wealth. They attribute this low pay sensitivity in part to public pressure, such as media criticism, which does not allow for large payoffs. Aside form pay sensitivity, several other tools are available to promote healthy governance. Remember that the principalagent problem subsists due to hindered monitoring ability. If the principal can perfectly observe the agent’s behavior, it can curb any activity misaligned with its own interests, thus eliminating the dilemma in the first place. Monitoring, however, becomes a heavier burden with diffuse shareholders; as a public good, this type of observation will not provide equity holders the incentive to undertake the activity as they already reap the benefits at no cost. One way to minimize this free rider problem is to encourage the presence of a large shareholder—a shareholder with 10 to 20 percent of the stock ownership. Such an entity would have ample incentive to monitor management, but also have enough control to pressure management to respect its interests. Nevertheless, this type of majority shareholder is uncommon in the United States. Another actor possibly involved is the large creditor, who again has the proper incentives to monitor management. Monitoring for debt

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

”

holders may also be easier as they can lend short-term and have firms reapply for loans contingent on performance. Debt holders, unlike shareholders, have the additional right to take control of the company if it defaults on the loan. Similar to large creditors, even diffuse lenders may add sufficient control mechanisms when a substantial amount of debt is entailed. When loaded with debt, the manager must undertake only those projects that are particularly valuable to the company in order to prevent financial distress. If insolvency persists, creditors seize control of the company and propagate changes in management. On a more basic level, increasing the amount of debt decreases the scope of funds managers can redirect for their own benefit. When internal controls such as oversight by the board of directors are not sufficient, there is a market for external control in the form of takeovers. This extreme form of discipline takes control away from the existing managers; but perhaps more importantly, the threat of such action often forces managers to align their actions with shareholder value maximization. However, this type of an external check is not absolute either. Managers have the ability to diminish the potential risk of takeover via mechanisms such as the poison pill, which gives shareholders the right to common stock if anyone acquires a set amount of the company’s stock. Converting this right dilutes the ownership by any possible acquirer, making the takeover more expensive. External monitoring does not only occur due to market forces. The media often takes on a substantial monitoring role. The press affects

the managers’ and board members’ reputation in the eyes of shareholders, future employers, and society at large, curbing some undesirable behavior. Subscribing to societal norms can nevertheless hurt shareholder wealth when managers, for example, act according to environmental protection ideals that deviate from the firm’s profit maximizing behavior. The above-mentioned methods to combat the principal-agent problem work ex-ante, preventing managers from acting in their own selfishness by creating an incentive

scheme to align the interests of the managers and shareholders. But the problem still persists. And although several cases have been revealed, the degree at which managers act in their own self-interest to the detriment of investors outside of these publicly denounced instances is impossible to gauge. As government legislature works to create even harsher penalties for managers acting in accordance to their own profit maximizing incentives, it may lull the individual investor into thinking the problem has become a non-

issue. According to Alexander Dyck, Adair Morse, and Luigi Zingales, however, only 6% of frauds are revealed by the SEC and 14% by the auditors. Thus, it primarily falls to the media, industry regulators, and employees to bring these cases to light (14%, 16%, and 19% of the time, respectively). Perhaps the biggest disincentive to f raud is the knowledge that a vigilant public anticipates such acts and that escaping oversight is ultimately impossible.

References: Bebchuk, L., and Jesse Fried, “Pay without Performance: Overview of the Issues”, Harvard Law School Olin Discussion Paper No. 528, November 2005. Dyck, A., A., Morse, and L., Zingales, “Who Blows the Whistle on Corporate Fraud?” (2006) Working paper, University of Chicago. Dyck, A., and L., Zingales, “The Corporate Governance Role of the Media” (2002) Working paper, University of Chicago. “Enron: Timline.” BBC News. 23 March 2007 <http://news.bbc.co.uk>. Fama, E. F., and M., C., Jensen, “Separation of Ownership and Control,” (1983a) Journal of Law and Economics 26, 301-325. Jensen, Michael C., and Kevin J. Murphy “Performance Pay and Top Management Incentives,” Journal of Political Economy, 1990, 98: 225-264. Shleifer, A., and R. W., Vishny, “A Survey of Corporate Governance,” (1997) Journal of Finance 52 (2) Shleifer, A., and R. W., Vishny, “Value Maximization and the Acquisition Process,” Journal of Economic Perspectives (1988) 2 (1) 7-20. “Summary of the Provisions of the Sarbanes-Oxley Act of 2002.” The American Institute of Certified Public Accountants. 23 March 2007 <http:// thecaq.aicpa.org>. Wruck, K. H., “Financial Distress, Reorganization, and Organizational Efficiency,” Journal of Financial Economics 1990, 27: 419-444.

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Investing Today

Securitization

EXCHANGE TRADED FUNDS

A Major Driver of the Commercial Real Estate Market

By Mike Weglarz

Tracking Mainstream and Exotic Benchmarks

ommercial real estate has experienced a welcomed boom in recent years. The market—which includes office, retail, multifamily, and industrial properties—has witnessed consistently high rates of return relative to other asset classes and it is expected to continue growing at an exceptional pace. Not surprisingly, capital has surged into the market from banks, insurance companies, and institutional investors. Wachovia’s commercial real estate alone comprises over 10% of its assets as the industry is expected to continue growing at an exceptional pace. The market’s success story can be attributed, in part, to the onset of mortgage-backed securities. THE ORIGINS OF SECURITIZATION Securitization as a practice has quite humble origins. In his book Liar’s Poker, Michael Lewis recounts the history of an illiquid residential mortgage market. With no penalty for early prepayment on residential mortgages, banks were reluctant to finance the loans. They feared that, in order to evade costly interest payments, their borrowers would repay the loan in full before the term expired. This unpredictable behavior created an illiquid mortgage market, in which borrowers faced greater constraints in financing their residential needs. Enter securitization: the pooling together of relatively illiquid assets into more diversified financial products rejuvenated the market. These securities reduced the risk for the lender and were sold off to investors. The impact of securitization on residential real estate was profound and provided the market with an unforeseen opportunity to flourish, infusing it with new demand. THE DEVELOPMENT OF COMMERCIAL MORTGAGE-BACK SECURITIES The practice of securitization offered lenders the ability to finance and exchange relatively illiquid assets. Institutions, therefore, found no trouble in applying the concept from residential to commercial mortgage-back securities (CMBS). In no time, the commercial real estate market was transformed much in the same way. The reduced risk securities provided lenders forced down interest rates. As a result, the investor base for commercial mortgages expanded and created an avenue for lower-cost financing. These effects generated benefits for all three parties involved in securitized transactions. The borrower was able to take on more capital at lower interest rates. The lender was able to access a new, previously illiquid market with the products. Finally, the investor received attractive and credit-worthy, tailored products. The recent boom in commercial real estate can be understood as a byproduct of the added liquidity and diversification offered by CMBS. JUMPING ON THE SECURITIZATION BANDWAGON Despite a coinciding boom in CMBS and the development of new and original investment products, the CMBS market in the United States has cooled as of late. The cause tends to elude even the most brilliant of industry research and analysis, but very well may be due to a corresponding simmering of real estate in general. Indeed, the true casual interplay between securitization and real estate has yet to be fully explained. Nevertheless, a growing portion of commercial mortgages underwritten in the United States will be securitized in one form or another. THE FUTURE OF CMBS While CMBS in the United States has been on the decline, the Canadian market has been performing well. A strong Canadian real estate market as of recent years, as well as low interest rates and a knowledgeable investor base, has allowed CMBS to establish a firm presence within the country. Nonetheless, CMBS growth in Canada has been less than expected, and the market is still tiny relative to its American counterpart. An emerging CMBS market so close to home holds large implications for American investment. Expansion of American business into Canada is almost certain. Already, banking institutions within the United States are looking for lending opportunities within Canadian CMBS. Pension funds and insurance companies may very well find the Canadian CMBS to be a wise investment opportunity as well. Indeed, as the U.S. CMBS market cools, it is likely that business and investment in the commercial real estate market will compensate by relocating to Canada. 50

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

By Jonathan Greenstein

hile the mutual fund industry, with nearly $9 trillion in assets, dwarfs the $500 billion in assets held in the Exchange Traded Funds (ETFs), the inherent advantage of ETFs leads financial experts to predict a seismic shift to ETFs over the next decade. The increasing popularity of ETFs is evidenced by the more than 475 ETFs on the market as of April 2007, a dramatic increase from the 80 ETFs that existed as of the end of 2000. ETFs run the gamut from plain vanilla Standard and Poor’s Depositary Receipts (SPDRS) or also known as “Spiders”. SPDRs are units of an ETF that holds shares of all the companies in the Standard & Poor’s 500 Composite Stock Price Index (S&P 500), and are thus designed to mimic the S&P 500 index, to specialized funds that track regions, countries, industries and asset classes.

THE ETF ADVANTAGE

An ETF is a basket of securities that allows investors to track a domestic or international index in a highly efficient manner. Unlike mutual funds, ETFs do not sell individual shares directly to investors, rather they package

shares in creation units,generally consisting of 50,000 shares each. These units are bought with a basket of securities that mimics the ETF’s portfolio, and the units are then split up and sold to investors on the secondary market. In effect, ETFs are index-oriented mutual funds that trade on exchanges like stocks. ETFs have many advantages over traditional mutual funds including market pricing, trading liquidity and flexibility, transparency, efficient portfolio management with its stable asset base, tax efficiency and the ability to leverage. ETFs give investors the best of all worlds by combining the benefits of diversification much like a mutual fund investment, but with the flexibility (e.g. shorting, hedging, leveraging) of stock trading. For example, certain ETFs use leverage to allow investors to double the daily performance of an ETF’s underlying market index. While the price for a mutual fund is determined at the close of the market based on a portfolio’s net asset value (NAV), an ETF’s purchase price is determined by supply and demand throughout the trading day.

Sander Gerber, Chairman and CEO of XTF Advisors, noted that in an era when news has an immediate impact on the market, ETFs have the benefit of trading at prices that reflect today’s events rather than yesterday’s news like mutual funds. While closed-end funds trade at prices that may vary widely from its underlying NAV, ETFs’ market price trades in very close range to its NAV. Further,since ETFs are designed to mimic indices rather than be actively managed, their expense ratios are low. Investors purchase the shares on the open market from brokers, and thereby avoid a myriad of expenses, expenses with which mutual funds have to contend like extensive regulations, servicing clients, and maintaining corporate and shareholder records. ETFs also have important tax advantages. To satisfy shareholder redemptions, traditional mutual funds need to sell shares of stocks held in the portfolio, triggering capital gains. This problem is eliminated by ETFs because the underlying portfolio shares are not sold when a holder sells his secondary ETF shares. ETFs

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

Investing Today are similar to index funds in that they typically have low portfolio turnover, which further limits potential capital gains.

THE BEGINNINGS OF THE ETF

ETFs first appeared on the Toronto Stock Exchange in 1990. In 1992, the American Stock Exchange made use of the SEC’s “Super Trust Order” to request use of the first authorized stand alone index-based ETF. When the petition was approved, the way was paved for the release of the S&P Depository Receipts Trust Series 1, more commonly known as SPDRs. Other early ETF adaptations included the Nasdaq 100 Index tracking stock (“Cubes”), first issued in March 1999, which used Nasdaq as its underlying index, and the Diamonds Trust Series 1(“Diamonds”), first issued in January 1998, which used the Dow Jones Industrial Average as its underlying index. Today, the major issuers of ETFs are Barclays, Vanguard,

Rydex, Claymore, and Deutsche Bank. The variety of ETFs has mushroomed since their debut. The ETFs on the market today employ broad market, fixed income, large/medium/small cap, commodity, specialty, emerging markets, industry and sector, and global and international indexes. ETF domestic equity assets have increased to approximately $455 billion, and currently there are 475 U.S. listed funds. Some of the new niche ETF’s include those focusing on companies dealing with cancer treatment, patents, spin-offs, social indexes, and high dividends. However, the rush to bring ETFs to market has resulted in some glitches. Rather than perfectly tracking the returns of a particular index, some ETFs are falling short. The tracking error measures the difference in total returns between an ETF’s NAV and the tracked index. It generally increases when ETFs try to mimic more specialized or niche

indices, which have larger positions in fewer or illiquid stocks. While the average tracking error in 2006 for U.S. major market ETFs was .29%, Morgan Stanley research reveals tracking error for U.S. sector/industry indices and international stock baskets was more than twice as high, at .61% and .72% respectively. While a shakeout of the flawed ETFs is inevitable, so is the prospect of the ETF market overtaking the mutual fund industry. The efficient portfolio management tools made possible by the ETF structure of investing in indices has already made ETFs the tool of choice for portfolio managers. The future of ETFs will undoubtedly include actively managed stock ETF and fund of fund type products. When individual investors are educated as to the advantages ETFs hold over mutual funds and the wide variety of product offerings they will no doubt make ETFs the preferred investment vehicle in coming years.

HEDGING AGAINST the HEAT

By Kylie Francis “The trouble with weather forecasting is that it’s right too often for us to ignore it and wrong too often for us to rely on it.”

—Patrick Young

or years, weather has been the hot topic of much small talk. And why not? The uncertainty of weather affects not only the layman who forgets to bring his umbrella out on a rainy day, but also the various corporations within the energy, agriculture and tourism industries. For these companies, profitability and revenues depend heavily on the vagaries of weather. The risks associated with weather are somewhat unique in that they affect volume and usage instead of price. An unusually warm day in the middle of winter can leave energy companies with an excess supply of oil or natural gas since people require much less heat for their homes. An unusually cold day in the middle of summer, on the other hand, reduces electric power sales for residential and commercial space cooling, leading to idle capacity which raises the average cost of power production and reduces demand for natural gas and coal. Although prices change consequently, they do not necessarily compensate for lost revenues due to unseasonable temperatures. Where previously insurance was the main tool of protection from unexpected weather conditions, new developments in financial instruments are offering businesses novel ways to mitigate the risks associated with changing weather patterns. As the world’s weather grows more volatile, interest in trading in the risk has grown too and the market has seen a rising demand in weather-risk contracts. According to a survey by PricewaterhouseCoopers, the Chicago Mercantile Exchange (CME) total notional value of weather-risk contracts increased to $45 billion last year, up from about $9 billion. Three instruments have been particularly favored by hedge funds: weather derivatives, catastrophe bonds and sidecars. Used primarily to hedge against unexpected swings in climatic conditions, weather derivatives based on Heating Degree Days (HDD) or Cooling Degree Days (CDD) are the most commonly traded, accounting for 98 to 99 percent of all contracts. An HDD is defined by the number of degrees the day’s average temperature falls below a base temperature (usually 65 degrees Fahrenheit, which is the baseline for heating needs). The CDD, the counterpart of the HDD, is the number of degrees by which the day’s average temperature is above a base temperature. Payoffs are defined as a specified dollar amount multiplied by the differences between the strike HDD (CDD) level specified in the contract and the actual cumulative HDD (CDD) level, which was measured during the contract period. An investor purchases a call option to receive the payoff if the recorded HDD (CDD) for the season is greater than the strike price, while an investor with a put option will receive the payoff if the recorded HDD (CDD) for the season falls below the strike price. A weather swap is a combination of a call and put option with the same strike and on the same underlying location, providing revenue stability. The remaining one percent of contracts are based on precipitation, measured by the

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

SUMMER 2007 | HARVARD COLLEGE INVESTMENT MAGAZINE

# ( ) # ! ' / s . % 7 9 / 2 + s 3 ! . & 2 ! . # ) 3 # / s , / . $ / . s 4 / + 9 / s ( / . ' + / . ' # ( / / s .s . % 7 9 / 2 + . . & 2 ! ! . . # # ) 3) 3 # # / / s ,s / . . $ $ / / . . s 4s 4 / / + + 9 9 / / s ( / / . . ' ' + + / / . .' ' # )( # ) ! # ' ! ' % 7 9 / 2 s+ 3s ! 3 ! & 2 , / s (

Investing Today amount of rain, or snowfall, measured by the amount of snow (including sleet) over a given time period. The most common users of weather derivatives are energy companies (or hedge funds trading energy risk), which account for 46% of the market. Suprisingly, the agriculture industry only accounts for 12% of the derivatives market, but recent protectionist policies may explain this effect as they dampen demand. The full role of weather derivatives within general investments strategy has yet to be discovered. One possible strategic allocation of this instrument is portfolio diversification as research has shown that the correlation between stock market indices and local temperatures is typically very low. Catastrophe bonds, meanwhile, are high yield debt instruments typically used by insurers as an alternative to traditional catastrophe insurance by reallocating narrowly defined risks onto secondary markets. The narrow scope applies to extreme natural disasters that cause a certain loss level. Investors, usually hedge funds, buy high coupon bonds that are often divided into tranches. If no catastrophes occur over the designated loss level during the life of the bond, investors get back their principal and a premium. These bonds allow the insurance industry to spread the risks from extreme natural disasters to capital markets. Their independence from the stock market and economic conditions coupled with their high yield make catastrophe bonds an increasingly attractive asset to investors, as demonstrated by their growing demand, with issuances of about $2.1 billion in 2005, up 75% from the prior year. The third type of alternative weather risk tool is in the form of sidecars. Like catastrophe bonds, sidecars offer reinsurance by issuing debt to investors. But sidecars typically involve a bigger investment (at least $200m) than the catastrophe bonds and are shorter-term: they mostly self-liquidate or renew in two years or less. According to the Economist, hedge funds put more than $3 billion into sidecars in North America alone between November 2005 and July 2006. For weather derivatives to work, there must be differing views or expectations of the weather. A put or a call option will only be issued if the issuer thinks that the expected payout from his options is less than the expected revenue from issuing the options. For catastrophe bonds to be attractive, investors must take the view that the higher bond premiums justify taking on the risk of a disaster. Option prices and bond yields would become prohibitively expensive if weather predictions were similar across investors. Weather will remain the hot topic for small talk for years to come, but the next time an unexpected blizzard leaves you stranded, you can at least take comfort in the knowledge that someone is profiting from it. 54

HARVARD COLLEGE INVESTMENT MAGAZINE | SUMMER 2007

3TAY AHEAD OF THE CURVE #REATE THE FUTURE 3TAY AHEAD OF THE CURVE #REATE THE FUTURE 3TAY AHEAD OF THE CURVE #REATE THE FUTURE !T #ITADEL WE WORK EVERY DAY TO GAIN AN EDGE IN THE GLOBAL !T #ITADEL WE WORK EVERY DAY TO GAIN AN EDGE IN THE GLOBAL !T #ITADEL WE WORK EVERY DAY TO GAIN AN EDGE IN THE GLOBAL FINANCIAL MARKETS 7ITH WORLD CLASS ANALYTICS RISK MANAGEMENT FINANCIAL MARKETS 7ITH WORLD CLASS ANALYTICS RISK MANAGEMENT FINANCIAL MARKETS 7ITH WORLD CLASS ANALYTICS RISK MANAGEMENT CAPABILITY STATE OF THE ART TECHNOLOGY AND A GLOBAL FOOTPRINT CAPABILITY STATE OF THE ART TECHNOLOGY AND A GLOBAL FOOTPRINT CAPABILITY STATE OF THE ART TECHNOLOGY AND A GLOBAL FOOTPRINT WE SEE WHAT OTHERS CANNOT SEE WE SEE WHAT OTHERS CANNOT SEE WE SEE WHAT OTHERS CANNOT SEE 3INCE ITS FOUNDING IN #ITADEL HAS GROWN INTO ONE OF THE WORLD S MOST SOPHIS 3INCE ITS FOUNDING IN #ITADEL HAS GROWN INTO ONE OF THE WORLD S MOST SOPHIS 3INCE ITS FOUNDING IN #ITADEL HAS GROWN INTO ONE OF THE WORLD S MOST SOPHIS TICATED ALTERNATIVE INVESTMENT INSTITUTIONS /UR TEAM OF MORE THAN ONE THOUSAND TICATED ALTERNATIVE INVESTMENT INSTITUTIONS /UR TEAM OF MORE THAN ONE THOUSAND TICATED ALTERNATIVE INVESTMENT INSTITUTIONS /UR TEAM OF MORE THAN ONE THOUSAND PROFESSIONALS IS LOCATED IN #HICAGO .EW 9ORK 3AN &RANCISCO ,ONDON 4OKYO AND PROFESSIONALS IS LOCATED IN #HICAGO .EW 9ORK 3AN &RANCISCO ,ONDON 4OKYO AND PROFESSIONALS IS LOCATED IN #HICAGO .EW 9ORK 3AN &RANCISCO ,ONDON 4OKYO AND (ONG +ONG 7E ALLOCATE OUR INVESTMENT CAPITAL ACROSS A HIGHLY DIVERSIFIED SET OF (ONG +ONG 7E ALLOCATE OUR INVESTMENT CAPITAL ACROSS A HIGHLY DIVERSIFIED SET OF (ONG +ONG 7E ALLOCATE OUR INVESTMENT CAPITAL ACROSS A HIGHLY DIVERSIFIED SET OF PROPRIETARY INVESTMENT STRATEGIES IN ALL MAJOR ASSET CLASSES PROPRIETARY INVESTMENT STRATEGIES IN ALL MAJOR ASSET CLASSES PROPRIETARY INVESTMENT STRATEGIES IN ALL MAJOR ASSET CLASSES #ITADEL IS BUILDING ITS ORGANIZATION FOR THE LONG TERM BY ATTRACTING AND RETAINING IN #ITADEL IS BUILDING ITS ORGANIZATION FOR THE LONG TERM BY ATTRACTING AND RETAINING IN #ITADEL IS BUILDING ITS ORGANIZATION FOR THE LONG TERM BY ATTRACTING AND RETAINING IN DIVIDUALS FROM AROUND THE WORLD WITH TREMENDOUS INTELLECTUAL CURIOSITY INNOVATIVE DIVIDUALS FROM AROUND THE WORLD WITH TREMENDOUS INTELLECTUAL CURIOSITY INNOVATIVE DIVIDUALS FROM AROUND THE WORLD WITH TREMENDOUS INTELLECTUAL CURIOSITY INNOVATIVE IDEAS AND A RELENTLESS COMMITMENT TO EXECUTION IDEAS AND A RELENTLESS COMMITMENT TO EXECUTION IDEAS AND A RELENTLESS COMMITMENT TO EXECUTION /PPORTUNITIES FOR STUDENTS INCLUDE /PPORTUNITIES FOR STUDENTS INCLUDE /PPORTUNITIES FOR STUDENTS INCLUDE s 3UMMER )NTERN )NVESTMENT 4RADING 3UMMER )NTERN )NVESTMENT 4RADING s s 3UMMER )NTERN )NVESTMENT 4RADING

#ITADEL IS VISITING (ARVARD THROUGHOUT THE SCHOOL YEAR #ITADEL IS VISITING (ARVARD THROUGHOUT THE SCHOOL YEAR #ITADEL IS VISITING (ARVARD THROUGHOUT THE SCHOOL YEAR 0LEASE REFER TO E2ECRUITING FOR MORE INFORMATION 0LEASE REFER TO E2ECRUITING FOR MORE INFORMATION 0LEASE REFER TO E2ECRUITING FOR MORE INFORMATION ON OUR KEY RECRUITING DATES ON OUR KEY RECRUITING DATES ON OUR KEY RECRUITING DATES

4O LEARN ABOUT #ITADEL INCLUDING A DAY IN THE LIFE 4O LEARN ABOUT #ITADEL INCLUDING A DAY IN THE LIFE 4O LEARN ABOUT #ITADEL INCLUDING A DAY IN THE LIFE OF NEW COLLEGE HIRES PLEASE VISIT OUR WEBSITE AT OF NEW COLLEGE HIRES PLEASE VISIT OUR WEBSITE AT OF NEW COLLEGE HIRES PLEASE VISIT OUR WEBSITE AT WWW CITADELGROUP COM WWW CITADELGROUP COM WWW CITADELGROUP COM

focus

to the world’s economy?

You’ll shine with your team. Lehman Brothers is both entrepreneurial and collaborative. Whether you are interested in a career in investment banking, capital markets, investment management or any of our corporate areas, visit us online at www.lehman.com/ruready.

lehman.com/ruready

Are you ready to bring your

You’ll grow here.

Lehman Brothers is an equal opportunity employer M/F/D/V. The Firm and its affiliates do not discriminate in employment because of race, religion or belief, gender, national or ethnic origin, disability, age, citizenship, marital or domestic/civil partnership status, sexual orientation, gender identity or gender expression.© 2007 Lehman Brothers Holdings