Diversification too Narrowly Defined

By Herbert Whitehouse

Why do institutional investors exclude from their portfolios the very companies that loan officers in community banks are working hard to supply with capital? Do pension and other fund managers have higher standards and less risk when they invest in the “efficient” public markets?

Many pension funds claim to have conservative investment standards; but these standards assume a restricted investment universe, and therefore only marginally reduce the inherently risky task of picking stocks. These funds have lost billions of dollars during the last two years. For example, the New Jersey State Pension Fund lost more than $10 billion in the fiscal year ending June 30, 2001. Those losses appear to have continued in the current fiscal year. On June 30, 2001, the New Jersey fund held almost $4 billion in the stock of just three companies: General Electric and Microsoft have declined about 30% since then, and AOL Time Warner has declined by over 60%. Investing billions of dollars in a few large companies has completely overwhelmed and defeated the conservative tendency of the fund’s other policies.

In 1992 I warned that “these risks have been mitigated while pension savings continued to increase. So long as this trend holds, the narrow band of the economy on which this money is focused will continue to have an artificial advantage.”

Diversification means not putting all your eggs in one basket. But pension managers do put all their eggs in one basket. They don’t have all their money in just one stock, but a large fund will risk many billions of dollars on just a few large companies. These managers have a funny rule: They invest only in public companies.

But most Americans don’t work for these public companies, they work for small businesses or are self-employed. Ninety-nine percent of U.S. businesses are small, and only a few are public companies. Fifty-one percent of American GDP and a higher percentage of job growth comes from small businesses.

Look at the 401(k) investments of my neighbor: Duncan and his wife work for a small, privately owned computer company. All the 401(k) investments—derived from the income and productivity of this private company—are put into the public market. The same thing happens with the taxes Duncan pays to fund the New Jersey State Pension Plan. None of that pension money is invested in the company that Duncan and his wife work for—or in any private company. This pattern is part of the explanation for strong institutional investor performance in the last decade.

One risk comes from the demographics that control the flow of funds into and out of pension and 401 (k) plans. America’s retiree population is growing as a percent of the population. But more significantly, beginning in the year 2002, America’s saving population—ages 35 to 54—will stop growing and begin to shrink as a percentage of the population. Thus, the failure of pension funds to embrace real diversification may accentuate the flow of funds out of the public markets over the next decade. Pension managers choose to increase risk by avoiding diversification into the whole economy because real diversification is difficult and expensive. Pension managers leave this dirty work to someone else, usually a bank. Most pension funds buy and sell stocks like day-traders.

The decision not to diversify gives the fund manager an advantage. The one-way flow of monies from Duncan and people like him increases the demand for public company stock, and that increases the price of the stock. Which makes the pension manager—who has all his eggs in this one basket—look good.

The fantastic increases in public market stocks over the last decade were not “irrational exuberance.” The increases were structural, reflecting a steady but artificial subsidy from the rest of the economy.

Today, pension fund managers do not even compare the value of public companies with investment opportunities in the rest of the economy. For example, Roland Machold, who was New Jersey’s fund manager in the early 1990s and later State Treasurer, once stated that investing in the kinds of small businesses that banks invest in would be too risky for the State Pension Fund, a rationale that may surprise New Jersey’s banking regulators!

The question is how long pension and 401(k) investment managers can refuse to engage in the hard investment work necessary for economic development. Perhaps we are already seeing the consequences for failure to diversify throughout the economy as a whole.

Ten years ago, I quoted a former colleague, Henry Bethe, from my days as secretary of a Chase Manhattan Bank board of directors committee: “Ten loan officers will do more good for our economy than any one institutional investor.” Original lending is the key to economic growth.

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