Does Targeted Investing Make Sense?

Does Targeted Investing Make Sense?Author(s): Ronald D. WatsonSource: Financial Management, Vol. 23, No. 4 (Winter, 1994), pp. 69-74Published by: Wiley on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3666084 .

Accessed: 15/06/2014 21:16

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].

.

Wiley and Financial Management Association International are collaborating with JSTOR to digitize, preserveand extend access to Financial Management.

http://www.jstor.org

This content downloaded from 91.229.229.13 on Sun, 15 Jun 2014 21:16:19 PMAll use subject to JSTOR Terms and Conditions

http://www.jstor.org/action/showPublisher?publisherCode=black

http://www.jstor.org/action/showPublisher?publisherCode=fma

http://www.jstor.org/stable/3666084?origin=JSTOR-pdf

http://www.jstor.org/page/info/about/policies/terms.jsp


Does Targeted Investing Make Sense?

Ronald D. Watson

Ronald D. Watson is President Chairman and CEO of Custodial Trust Company (a wholly-owned subsidiary of The Bear Stearns Companies Inc.), Princeton, NJ. In 1993, he chaired the U.S. Department of Labor's ERISA Advisory Council.

Economically targeted investments (ETIs) are capital projects that are expected to

provide economic benefits to the economies of the regions in which they occur. Pension plans have been encouraged by both public officials and other constituencies to factor these collateral benefits into the decision-making process when selecting investments. Detractors see this as social investing that constrains portfolio choice, compromises the integrity of the pension fiduciary, and results in suboptimal financial

performance. Proponents agree that investment performance standards should be kept at a high level. However, they point out that externalities, such as new jobs, broader tax bases, and stronger local economies, are real and that they can be important to a

pension plan's participants and beneficiaries under the right circumstances. This article argues that carefully selected ETIs may improve the overall performance of a

portfolio of pension assets and benefit plan participants in the process. The critical

prerequisite to considering an investment's externalities is assessing whether the project will probably be financed by another investor if turned down by the pension fund (the relatively efficient market model) or will fail to find a suitable investor (the inefficient market model).

0 Marr, Nofsinger, and Trimble (1993) argue that the

practice of seeking investments with specific "local attributes" -economically targeted investments

(ETIs)-poses a threat to the private pension system. They deride the financial performance of these investments and

disparage the notion that there is any economic rationale to a policy that encourages pension funds to invest in ETIs. The historical track record of ETIs is, as these authors contend,

undistinguished. However, it does not necessarily follow that all ETIs lack financial merit or that they cannot represent valuable components of a pension plan's investment

portfolio. This article makes the case that carefully selected ETIs can add value to a pension portfolio.

As the nation's pool of pension assets passes the $4 trillion mark, the investment practices and portfolio management strategies of these institutional investors are

attracting increased political scrutiny. Fiduciary prudence and financial performance are always critical issues when

looking at pensions, but the impact of investment decisions on the economy or market of the plan sponsor is garnering an increased share of the questioning. Unlike the "1social

investing" concerns of the late 1970s and early 1980s, which

sought to discourage investors from holding assets associated with politically incorrect behavior (South Africa, tobacco, pollution,...) regardless of any underlying financial

merit, ETI proponents focus on the positive aspects of

investing-especially investing in projects that benefit the investor's community. Job-creation, small-business

development, low-income housing, and tax-base expansion can be benefits associated with an ETI.

The underlying premise is that pension investment

managers have an obligation to consider both the financial attributes of an investment and its multipliers and externalities-positive and negative. To the extent that the

ripple effects of an investment produce economic wealth directly or indirectly for the participants in a pension plan, those effects should be factored into the investment allocation decision. Ignoring their existence suboptimizes an investment portfolio in much the same way that ignoring covariances of financial returns suboptimizes traditional investment portfolios.

Modern portfolio theory is currently ill-equipped for this dimension of the decision process. MPT focuses on financial returns and ignores externalities. The MPT marketplace is

basically efficient, but ETIs are bred of inefficient markets. In theory, the financial and nonfinancial interests of the

participants in any given pension plan could be enhanced as a result of externalities owing to a direct investment made by the pension fund in its own community. These benefits might even be reflected in higher returns for other local

Financial Management, Vol. 23, No. 4, Winter 1994, pages 69-74.



70 FINANCIAL MANAGEMENT / WINTER 1994

investments, more employment opportunities for pension plan participants who are still working, or lower taxes. The central issues for a conceptual analysis of this phenomenon are "what are the conditions under which these financial feedback effects occur?" and "what are the policy implications of finding that they might occur?"

I. The Traditional Pension Fund Management Process

Pension trustees must follow hallowed principles (originating in English common law) when they select investments for trust accounts. They are obligated to be loyal to the beneficiary's interest and to manage the trust for the exclusive benefit of the beneficiary. The "prudent man" rule

requires that they behave as a prudent man might when faced with protecting the interests of any beneficiary over the

prospective life of the trust. While allowed some discretion based upon the specific circumstances of the investment, the trustee is required to place high priority on preserving the

principal of the pension trust. Diversification across a variety of investments is the time-tested way to do this. Recently, this fundamental principle has been updated to reflect

evolving finance theory (and political correctness) into a

"prudent investor" rule. Over the last twenty years, a body of regulations, opinion

letters, and interpretive bulletins written by the United States

Department of Labor to explain the Employee Retirement Income Security Act of 1974 (ERISA) have clarified some of the managerial issues surrounding pension fund administration. In particular, they have made clear the

principle that such trusts can be managed as a whole, with the objective of optimizing the financial returns on the entire

portfolio. The prudent investor rule can only be evaluated in the context of the full scope of a fiduciary's investment decisions. This enables investment managers and fiduciaries to use finance theory to construct portfolios containing unusual investments to enhance the overall performance of the pool of funds. This principle is also being incorporated into general trust law at the state level (National Conference of Commissioners on Uniform State Laws (1994)).

While the theory of portfolio optimization is

straightforward, the implementation of that theory has not been. Historical means and covariances of financial returns are not necessarily the numbers upon which prospective investment decisions should be based. Some asset classes are too new to have the long track records upon which to base estimates. Some assets are not priced in efficient markets. In short, creating a reliable covariance matrix across the full array of asset classes and special direct investment

opportunities is not practical. So application of the theory falls back on risk management by quantitative approximation of prudent diversification (and ordinary judgment)-a process called asset allocation. However, all investment

performance (where quantified) is still based on the direct financial performance of the assets acquired. While

interrelationships among the direct financial returns of various investments are considered under the covariance term, second-order financial or nonfinancial returns (collateral benefits) are not incorporated into the

optimization analysis.

II. Returns in Inefficient Markets Implicit in the concept of an ETI is the assumption that

the market for ETIs is imperfect. If markets were perfect, there would be no reason for sound ETIs to be singled out for special attention. Critics caution that ETIs are more likely to be inferior investments that would only be acceptable if some ulterior "political" objective motivates the investment decision. This probably occurs in some cases. Sponsors might well emphasize the societal benefits of mediocre investments if that is what convinces public sector investors to select these projects. However, this is not the kind of investment described by proponents of ETIs, who generally agree that such investments must be structured to offer a

"prevailing rate of retum.1 I ETIs must be sound and competitively priced to be

appropriate pension investments in the first place. In a perfect market, the sponsors of a worthwhile project will be able to find qualified investors without inordinate difficulty. It is

only in imperfect markets that good investments may not be funded. A shortage of qualified investors, contracting rigidities, and information asymmetries can all contribute to market conditions where sound projects may be overlooked.

Financing any unique or unusual investment creates financial forecasting problems, which are potentially troublesome for pension plans. There may not be a track record from similar investments to use as a guide to future

performance. Risk exposures may be very concentrated. Covariances can only be imagined. Contract terms may be so unusual that pricing the asset becomes an educated guess. The norm is few players on either side of the market and high bid/ask spreads. Peculiarities embodied in federal and state tax codes may make the playing field between investors still more uneven.

1The U.S. Department of Labor's ERISA Advisory Council report (ERISA Advisory Council: DOL (1992)) attempted to clarify this definition further

by repeatedly referencing "prevailing rates" in terms of risk- and

liquidity-adjusted long-term discounted rates of return.



WATSON / DOES TARGETED INVESTING MAKE SENSE? 71

Limited market appeal is part of the definition of an ETI. To qualify as an ETI, an investment must have an economic

impact that is expected to be specific to a region, a

population, or an industry. The broader and more diffuse the

geographic market impact of any investment, the less appeal it has as an ETI. Therefore, ETIs are generally characterized as small to medium financings of "projects" (or groups of

projects) that are meaningful to a specific part of the

economy.

III. Externalities in Project Finance Regional economists presume that investment decisions

have multiplier effects as the income resulting from the first spending decision leads to additional spending and then additional income, gradually rippling through the economy to create additional economic activity, jobs, and wealth. In some cases, the analysis can be refined to distinguish the job multipliers associated with one kind of investment from those of another. However, there is a big difference between

believing that these externalities exist and accurately forecasting how they will affect the wealth of a specific subgroup of investors.

These collateral benefits can be of two types. There can be broad-based, general benefits to the region most affected by the investment. Assuming that there are no harmful side-effects (such as pollution), these benefits are a pleasant by-product of the investment and can be considered a "plus" from the pension management's point of view. However, no matter how valuable these benefits are to the community at

large, they cannot be used to justify below-market financial returns on the investment.

Alternatively, some of these collateral benefits can flow

directly to specific employees, employers, real estate markets, or industries. Their impact may be amenable to analysis and quantification. From the point of view of a

pension plan trustee, collateral benefits (externalities) from ETIs are relevant in analyzing potential investments only in the second case--where they result in greater wealth for the actual participants and beneficiaries of the pension plan. General goals of "benefiting society" or "benefiting the

regional economy" may appeal to some as a justification for the investment, but they will seldom satisfy the legal "exclusive benefit" and "loyalty" rules imposed by ERISA.

Investing in an ETI must produce a direct stream of expected financial returns that enhances the plan's capacity to pay benefits at least as much as any alternative investment of comparable risk. These returns must be financial, predictable, and trackable-no easy task. If these collateral benefits are real enough to be quantified, it should be possible

to add them to the projected direct financial returns on the investment to calculate an overall rate of return. Assuming that its overall rate of return meets or exceeds those available in the market for assets of similar risk, the ETI should be viewed as a legitimate investment alternative. Then the only question that remains is how this return stacks up against other targeted and nontargeted alternatives.

Imperfect markets are the place where such feedback

opportunities are most likely to be traceable to the investment decision of the pension. Investments in both inefficient and efficient markets create collateral benefits. Under the right circumstances, those benefits could be tracked back to the

plan participants. However, if a sound investment meets the criteria for being funded in an efficient market, economists

presume that it will be financed and undertaken. The

resulting collateral benefits will flow to the plan and its participants whether their pension actually supplies funding for the investment or not! The only collateral benefits that will not flow to the relevant plan beneficiary are those from investments that are never undertaken, so the willingness of a major institutional investor to consider ETIs may be quite important to both the funding of the investment and to the creation of relevant collateral benefits.

IV. Examples of ETIs The argument that both direct financial returns and

indirect collateral benefits should be considered may seem reasonable, but a few concrete examples will help clarify the issue. One example concerns an underfunded pension fund for a building trades union. Such funds are often tempted to direct a significant share of their resources into financing new construction projects, because they hope to stimulate demand for their members' skills. Nothing is certain in the construction business, and the decision to invest in new projects might be viewed as increasing the risk of the portfolio by overweighting asset classes with high covariances and with the plan participants' other sources of income.

Nevertheless, if the multi-employer contract that governs contributions to the union pension fund is designed to make up past underfunding, the pension plan will ultimately receive two sources of income: one from the direct financial returns on the investment and another in the form of new

pension fund contributions whose discounted present value is greater than the discounted value of the liability associated with the new hours of creditable service logged by workers on the construction project. The net additional contributions to the fund to reduce the unfunded liability are a direct collateral benefit to the existing pension plan's participants




and beneficiaries. And tracking this collateral benefit is not

especially difficult. A second example concerns the assistance provided by a

pension plan for venture capital and technology development in the same industry as the plan sponsor. Presumably, pension plan participants are not indifferent to the long-term health and vitality of the industry from which they earn their

living. Investments can produce jobs, tax revenues, and a

competitive advantage that will ultimately benefit the industry and its work force. The argument that an industry whose technology is fundamentally competitive will

eventually attract the requisite investment capital without

targeting really characterizes a long-run equilibrium; but not all industries operate in perfect markets, and not all market

adjustments are frictionless. Any inefficiency creates

opportunity. Low-income and multi-family housing is another area

that generates interest from proponents of ETIs. The deterioration of major cities and the flight of industry and

upper middle class workers to suburban locations has created numerous social problems and real social cost. There is also

strong evidence that private lending institutions have avoided extending credit in these locations whenever they viewed the risks of further deterioration to be too high. A

capital gap is created, where creditworthy borrowers find their access to credit restricted by factors not directly related to their ability to repay the loans.

It is not only possible, but likely, that there are more "efficient" ways to finance projects with such externalities. This example clearly poses a free-rider problem. However, the issue is not whether ETIs are the optimal financing vehicle, but whether any collateral benefits exist that could be considered by an investor choosing to do so.

Without arguing the rationality or irrationality of the lenders' collective behavior, the existence of imperfect markets seems indisputable. In such circumstances, the

multipliers, externalities, and collateral benefits from

improving the housing stock can clearly accrue to the local

community. Whether these benefits are significant (in the

long-run financial sense) or are likely to accrue to the

participants and beneficiaries of a pension plan that provides the needed funding is an empirical question. The answer depends on the degree to which the pension participant pool and the residents of the affected community overlap. However, it is possible that feedback effects exist.

In this case, it may be desirable to structure the funding to place any significant downside risk on another entity (like a governmental development authority) and to use the pension fund only as the long-term source of capital rather than as a primary risk-bearer. If a pension plan is willing to

provide the long-term funding in a properly-structured deal, projects that would have floundered without the pension plan's participation may become feasible. This asset may meet all the basic investment requirements of a pension fund, but it is not a readily marketable security of the type pensions normally favor.

It is apparent from these examples that the decision to invest within the plan sponsor's own region or industry may create a potential for conflict of interest. Even if the investment is free of self-dealing in the form of excessive fees or mispriced exchanges of assets, there is an inherent risk of bias in the form of overly optimistic estimates of future cash flows and investment risks. The estimation process is subjective when the investment opportunity exists within an inefficient market, so tracking systematic bias would be difficult before the fact.

A pension trustee's legal responsibility to the participants and beneficiaries of the trust is quite clear, but the difficulty in determining the prudence of an investment still troubles regulators. The fact that any given investment proves to be unsuccessful is not sufficient to establish that the investment manager or trustee made an imprudent decision. When considering ETIs that might benefit the plan sponsor, pension funds subject to ERISA use a combination of independent advisors and formal exemption opinions from the Department of Labor to protect themselves from charges of self-dealing.2

In the public pension plan arena, the rules are rooted in trust law tradition and in specific state or local laws. The

pressure for marshaling all of a government's resources to address a social problem or to revitalize a business (tax) base can make objectivity in evaluating the collateral benefits of ETIs even more difficult to achieve in the public sector. The notion that a defined benefit plan need not be fully funded if backed by the full faith, credit, and taxing power of a government unit also tends to muddy the tradeoff between supporting and stimulating the local economy now and providing benefits many years in the future.

V. Risk Characteristics of ETIs The final issue that should be addressed in examining

ETIs as a pension asset is "how should these assets be treated

2One of the difficult problems of investing in ETIs is the risk of violating the "prohibited transactions" rules of ERISA. Under ERISA, a "party in interest" in a pension plan is any fiduciary, employer of covered employees, services provider, or other related party. Plan fiduciaries are prohibited from engaging in a variety of transactions that may benefit such a party in interest. ETIs are, by definition, expected to create collateral benefits not only for plan participants but also for other related parties. If they are successful in doing so, they may create a technical violation of this provision of ERISA, which is intended to protect plan participants and beneficiaries from self-dealing transactions.



WATSON / DOES TARGETED INVESTING MAKE SENSE? 73

in a portfolio analysis?" The ERISA Advisory Council's 1992 report posits that the relevant rate of return on any investment made in an ETI should be calculated as the discount rate, r, that satisfies the equation:

n

Investment = C [ (C + e] /(1 + r)i i=1

where i is a single cash flow measurement period, n is the term of the investment, C is the after-tax cash flows, e is the

equivalent "net" value of externalities, and the only collateral benefits estimated are those realizable by the plan participants and beneficiaries.

The uncertainty involved in projecting financial returns for nonstandardized, local-projects has already been noted. The need to identify, quantify, and track collateral benefits (net of collateral costs) for any investment that would not meet a minimum hurdle rate3 of direct financial return, further complicates the evaluation process. The process is made even more difficult by the need to assess the likelihood that any given investment will be financed somewhere else if this pension fund rejects it. The only collateral benefits that can be counted as part of the overall return are those that will accrue to the fund if it is the sole feasible source of funding for the investment. In effect, the existence of alternative investors negates a fund's right to impute a financial value to collateral benefits and reduces these benefits to the level of subjective factors, which may cause a pension fund to favor one investment over another only if their direct financial terms are essentially equivalent.

The other traditional dimension of portfolio analysis is risk estimation. Most portfolio mathematics begin with a

long history of price movements from which returns, variances, and ultimately, covariances are calculated. This

practice is difficult for any class of investments that lacks the

homogeneous legal and financial structure that facilitates collection of comparable data for analysis. Some ETIs are similar to project finance investments, which may resemble in certain respects other assets for which historical data exist but are nevertheless sufficiently different that

generalizations about expected returns and variances are

only educated guesses. Almost no published work exists analyzing covariances

between ETI returns and returns from other asset classes. The

absence of reliably constructed historical data series for ETIs is the primary obstacle. However, there is one study that addresses questions of portfolio risk impact. It finds that ETIs show some promise of having risk characteristics that are sufficiently different from more traditional portfolio assets that they might reduce overall risk. This study, by the

Equitable Life Assurance Society's real estate division, is based on a relatively small data sample and must be

replicated many times before we can draw firm conclusions (DeLisle and Wright (1992)).

Despite the weakness of the evidence, however, the

preliminary conclusion supports the notion that ETIs have the potential to reduce risk just as any other asset class might. This hypothesis is defensible. Many ETIs are similar to more traditional assets, but they are not identical. If they were, the market would be too nearly efficient to exploit. One can

imagine ETIs as sufficiently different that their underlying cash flows and asset values will respond to economic cycles or random shocks differently from the rest of an investor's

portfolio. If that were the case-and the differences could be

documented--determining the "prevailing" risk-adjusted rate of return benchmark for these investments would be even more difficult. Attempts to determine appropriate hurdle rates would necessarily be tempered by judgments about prospective covariances. In any case, economists

routinely conclude that more research is required before firm conclusions are possible. In the case of ETIs, I agree.

VI.Conclusions ETIs can be treacherous investments. An analytical case

can be made that investments that are negotiated and priced in inefficient markets offer higher potential risk-adjusted rates of return than standardized, liquid securities. Variances of ETI returns may be higher than those of similar investments, but that should be reflected in the pricing terms. In addition, the externalities and multiplier effects of ETIs

may have sufficient local added value that they should be considered in a decision to invest.

However, the ability to capitalize on the higher returns

presumably available in inefficient markets requires a rational, objective investor. Returns might not be higher if:

1) risks are misunderstood-unintentionally or otherwise, 2) conflicts of interest cause the buyer and/or seller to bias the negotiation, or 3) political pressure causes more money to flow into the inefficient market than can be absorbed by ETIs that meet the current-market-returns test.

The task for policymakers is to lower the artificial barriers against ETIs and to facilitate the flow of investment capital

3The appropriate hurdle rate for any pension investment is the risk adjusted expected yield of the best investment opportunity not undertaken because of a lack of available funds.




into inefficient sectors of the economy-without biasing the

negotiation of price and nonprice terms in ways which create new inefficiencies or impose indirect costs on the beneficiaries of the nation's pension system. M

References DeLisle, J.R. and K. Wright, 1992, "Economically Targeted Investments:

Real Estate Strategies for Pension Funds," Equitable Life Assurance Society White Paper Series: Volume 5 (August).

ERISA Advisory Council, 1992, "Economically Targeted Investments: An ERISA Policy Review," Report of the Work Group on Pension Investments, Advisory Council on Pension and Welfare Benefit Plans, U.S. Department of Labor, (November)

Marr, M.W., J.R. Nofsinger, and J. Trimble, 1993, " Economically Targeted

Investments: A New Threat to Private Pension Funds," Journal of Applied Corporate Finance (Summer), 91-5.

National Conference of Commissioners on Uniform State Laws, 1994, "Uniform Prudent Investor Act," with prefatory note and comments, (August).



Documents

Does Targeted Investing Make Sense?