Resolving the Shortage of Equities: Other Ideas for Innovation in Capital Markets.
learning Module 
Innovation
Some Ideas for Innovation
Analysis of the development of the American capital market in the 1980s and 1990s, shown in the flow of funds accounts, suggests a few areas in which the 'health' of the market might be improved.
These areas call for innovation in products, institutions, and policy.
However, as already mentioned , any change will be and should be contested so as to ensure that the market institutions emerge stronger.
Change is inevitable, but the direction and nature is uncertain.
The ideas that follow are not recommendations of things to do but rather suggestions of what might be done and an intimation of how hard it is to effect change in capital markets.
Resolving The Shortage of Equities
Unless safe long-term investment vehicles become available in a form that provides protection of financial assets against inflation with reasonable growth of principal, the social problems of an aging society will be intensified.
So far there is little recognition that this problem exists.
Here are some lines of inquiry that might be pursued:
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Government annuities: In the 17th century, the city of Amsterdam raised funds by selling government guaranteed annuities — one of the first government securities.
Government sponsored annuities could make retirement saving more efficient.
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The advantage of annuities for retirement planning is that less savings are required to guarantee income to sustain a certain standard of living.
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In the U.S., annuities are issued by insurance companies, regulated at the state level, subject to rather heavy expenses and without federal guarantees.
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If the federal government used annuities as securities to finance the deficit, giving tax exemption and indexing against inflation, the shortage of equities would be less serious.
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Abolish 'Shareholder Democracy': The NYSE and other institutions support rules that require public companies to issue voting common shares to earn listing privileges.
'Shareholder Democracy' offers little to the average shareholder.
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This sounds good but has negative consequences for small shareholders:
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During takeovers and mergers, stocks can become over-valued because the element of control becomes confused with investment merit for non-controlling shareholders.
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Fund managers, voting shares held in portfolio, and hired corporate executives, develop short-term interests that differ from the interests of indirect investors.
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The costs of compliance and requirements for proxy solicitation, at the corporate and fund level, are disproportionate to any benefit to small shareholders.
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By revoking 'shareholder democracy' ordinary investors would be given a pure long-term investment play, not distorted by mergers, acquisitions, and takeover speculation.
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Promote Fully Participating Preferred Shares: Non-voting, fully participating preferred shares can be used by family-controlled firms to go public without losing control, while providing enhanced protection for small shareholders.
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This system, used successfully in Brazil for decades, involves preferred shares with a coupon set as a percent of par value and with first claim (after debtors) on assets on liquidation.
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The rules require that corporate profits that are not distributed as dividends be incorporated into capital, pro-rata, thereby increasing par value on the preferred shares and providing for regular increases in dividends.
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After common shares receive dividends at the same rate as the preferred, further dividends are distributed equally to common and preferred.
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Promote Preemptive Rights on Capital Increases: In some places in the world, stockholders have preemptive rights to subscribe to capital increases, pro-rata to their holdings.
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These rights can be bought and sold on the stock market.
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In the U.S., investment bankers turn livid at the idea of preemptive rights because such rules allow public companies to raise additional funds year after year without going through an underwriter.
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Fund managers also hate preemptive rights because, although such rights protect the interests of long-term investors, the practice may temporarily reduce short-term performance.
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From the point of view of issuers, by offering rights issues at below market (the normal practice), additional capital can be raised with less commissions, faster than going through an investment banker.
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Prohibit Buybacks Unless Pro-Rated; Remove Taxes on Dividends: This would remove the element of price manipulation from buybacks and illicit incentives for using them.
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A pro-rated buyback is essentially the same as a dividend and should be be conducted at the same price for all shareholders.
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Prohibit Executive Remuneration Linked to the Market Price of Stock, including Stock Options: Instead, executives could be rewarded on the basis of the five-year average rate of growth of dividends.
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Such a provision would encourage management to improve the intrinsic value of stock, rather than to focus on market price.
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To increase dividends usually calls for increasing long-term investment, which would tend to bring more equities to the market, improving dividend yields and reducing the amounts needed for retirement savings.
Participating preferred shares enhance protection for small shareholders.
Preemptive rights protect long-term shareholders and owner-managers.
Clarifying Roles of Fund Managers
Although most investors have long-term goals, fund managers are rewarded and judged by short-term stock price performance.
Incorporating funds adds expense, without increasing investor protection.
The use of the corporate format for open-end mutual fund only adds expense without increasing investor protection, since there is no more need for a board of directors to supervise a fund management company than than there is for a grantor of a private trust to require a board of directors to supervise a bank trustee.
At the same time, the cost of fund management does not increase in proportion to the size of the fund, providing incentives for fund managers to try to boost short-term price performance, at the expense of long-term improvement in intrinsic value.
Some changes that might help to improve this situation are as follows:
- Eliminate Required Distribution of Mutual Fund Profits: Mutual funds should be exempt from income tax, whether or not income is distributed.
- Capital gains and dividends could be retained in the fund indefinitely, if this was the objective of the fund.
- Funds would be required to have a declared dividend policy consistent with its fundamental investment policy.
- Require Mutual Funds to State a Time Horizon: In order to allow investors to choose a mutual fund with that is appropriate to their needs, as part of the 'fundamental investment policy' there should be a declared time horizon for eventual liquidation and distribution of fund assets (which might even be in installments over a number of years).
- Require Mutual Funds to Limit Size and Management Fees: The cost of managing a mutual fund does not increase in proportion to size .
- Funds that become too big may find it increasingly difficult to find good investments that will have a significant positive effect on results. Big funds are not necessarily better than small funds.
- Require Fund Managers to Publish Information About Intrinsic Value of the Portfolio: Funds should be required to publish weekly the weighted average price-earnings ratio and current dividend yield of the fund portfolio, to supplement net asset value.
- Semi-annual reports should present even greater information, such as weighted average dividend coverage, corporate leverage, dividend growth rates, and current ratios.
Capital Markets In Evolution
There a many other areas for reform and innovation that might be mentioned, such as redevelopment of closed-end funds, reform and federalization of the private annuities market, industrial policy, improvements in cross-border trading, 24-hour trading with immediate settlement, and accounting reforms to deal with derivatives and complex group structures.
This final lesson calls attention to the continued evolution of capital markets — a basic premise of Capital Flow Analysis — and suggests that through the study of national flow of funds accounts, the analyst will come up with ideas of how the market and its institutions may be improved, and perhaps may be better prepared to engage in the struggle to advance the market.
The ideas for change suggested in this lesson are meant to be controversial and to stimulate thinking about market evolution, with consequent advantages, pitfalls, and opposing interests.
Institutional change, in itself, can have a profound effect on long-term price movements of market instruments, as was the case of the mass marketing of open-end mutual funds in the 1950s and 1960s.
By entertaining ideas of institutional change, the analyst is more likely to perceive when such change is occurring and anticipate its effects on underlying price trends.
Before proceeding, check your progress:
Self-Test
Annuities may help retirees meet income goals because:
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The author says that 'shareholder democracy' is:
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In the U.S., preemptive rights to subscribe to new issues of common stock are:
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