WSJ and others (9/12/03)
FOR THE VAST MAJORITY of mutual-fund shareholders who are buy-and-hold investors, the rapid-fire traders who rush into and out of those funds may be Public Enemy No. 1.
The frenetic trading by such fund "timers" runs up portfolio operating costs and cuts into profits of long-term investors, making the timers unwanted company in most mutual funds. Fund firms have been preaching this gospel for years, of course, making it all the more disturbing that the New York state attorney general has charged that some fund firms cut special deals allowing timers to make frequent trades, despite stated fund policies to the contrary.
Still, it's possible for buy-and-hold investors and rapid-fire traders to coexist happily in the same portfolio -- at least when that portfolio is a mutual-fund cousin called an exchange-traded fund. ETFs are portfolios of securities like mutual funds, but unlike mutual funds, they are traded throughout the business day on various exchanges.
If you are a long-term holder of an ETF, trading in that fund by timers "should not affect you at all," says Robert Levitt, a Boca Raton, Fla., financial adviser who in recent years has shifted to using ETFs far more than ordinary mutual funds in his clients' portfolios.
There are 114 ETFs in the U.S., with combined assets of $117 billion as of July. Financial advisers say these investment vehicles are worth a look for many investors, although ETFs certainly aren't a perfect fit for all people or in all situations.
ETFs are similar to index mutual funds in that the baskets of securities making up their portfolios aim to track the performance of a market benchmark as broad as the Standard & Poor's 500-stock index or as narrow as measures that track only networking stocks or stocks listed in Austria. But in other ways, there are more differences than similarities between ETFs and ordinary mutual funds, says Timothy Jares, an assistant professor of finance at the University of Northern Colorado in Greeley who has done research on mutual funds.
With ordinary "open end" mutual funds, investors' orders to buy or sell fund shares are directed to the fund itself, which fulfills those orders once a day. When an investor buys fund shares, the fund takes in cash and the manager invests that money in stocks or other securities. Funds handle redemption orders from investors by maintaining a cash cushion or by selling securities.
But short-term traders rushing into and out of a mutual fund can trigger substantial transaction costs for a fund selling securities to raise cash for share redemptions. A fund manager who holds assets in cash trying to avoid the transaction costs involved with rapid-fire trades can end up hurting fund performance as well by missing out on rising markets. And there sometimes are negative tax consequences for investors stemming from portfolio sales forced by rapid withdrawals of assets by timers.
With ETFs, in contrast, most of the buying and selling of fund shares take place directly among interested buyers and sellers who connect through an exchange where the ETF shares trade all day long. ETFs do create and redeem shares in certain transactions with institutional investors. But in those cases, the funds take in or distribute securities that are proportional slices of their portfolios rather than cash.
The net effect is that "trading [of ETF shares] does not impact current shareholders," says Lee Kranefuss, president of the iShares group of ETFs sponsored by Barclays Global Investors. The design of ETFs makes them "a very useful tool for a lot of diverse communities -- and they don't get in each other's way," he adds.
The basic structure of ETFs also helps those portfolios avoid problems with traders exploiting "stale" prices of international-stock funds, one of the most appealing targets of fund timers. In particular, the ETF design provides "an elegant solution" to the challenge of accurately pricing a U.S. portfolio that holds Asian stocks that don't trade during U.S. market hours, says Gus Fleites, president of SSGA Funds Management Inc., a State Street Corp. unit that is another major ETF sponsor.
Shares of open-end funds typically trade once each day based on the funds' net asset value, or the calculated per-share value of the portfolio holdings as of 4 p.m. Eastern time. The problem is that some international-stock funds set those NAVs based on closing prices in Asia where markets ended trading many hours earlier.
Market timers have exploited that opportunity by placing buy orders for shares near the end of the U.S. trading day when news events or a big upward move in the U.S. stock market suggests Asian shares are poised to move significantly higher. They then sell the fund shares the next day, taking profits out of the portfolio and eating into the returns of the mutual fund's long-term holders.
That fund-timing game doesn't work with Asian-stock ETFs, such as Barclays' iShares MSCI Japan Index Fund and iShares MSCI Hong Kong Index Fund. That's because ETFs don't trade at a calculated NAV. Rather, the prices of ETFs change during the course of the U.S. trading day as market participants adjust their expectations for the next round of trading overseas.
Some open-end mutual funds have looked to shut down the fund-timing game by setting "fair value" prices for their Asian-stock funds that reflect late news and U.S. market action, reducing the chances for stale prices that attract timers. While those fair-value decisions may be made by a small committee of fund personnel, Mr. Fleites says the marketplace pricing of ETFs reflects the opinions of a far broader group of market makers and investors.
Indeed, when open-end foreign funds set their fair-value prices, one logical indicator to include in the decision is the trading of foreign-stock ETFs, Mr. Jares and Angeline Lavin, an associate professor of finance at the University of South Dakota in Vermillion, wrote in a paper last year.
Various features of ETFs may appeal to long-term investors, traders, or both. The ability to buy and sell all day long is crucial for short-term traders, for instance, but it appeals to some other investors as well.
Tim Walker, an engineer in Overland Park, Kan., doesn't actively trade his ETF holdings but still appreciates the fact that "if you want to trade them at 11 in the morning, you don't have to wait for the market to close to set your NAV." Mr. Walker also likes the fact that some ETFs have lower expense ratios than comparable open-end mutual funds and can be more tax efficient.
Some other investors appreciate the fact that ETFs can be sold short -- meaning that investors can sell borrowed shares in anticipation of falling prices and then later purchase the holding at a hopefully lower price.
On the negative side, however, investors must pay commissions to buy ETF shares, just as they do with individual stocks. That can make ETFs uneconomical for people who are investing small amounts, including many investors who are systematically buying fund shares every month or every paycheck. The bid-asked spread of an ETF -- that is, the difference between what a market maker will pay to buy the security from an investor and what that firm will charge to sell it to someone else -- also can eat into returns during a short holding period.
Finally, the ETF menu of investment choices, at least for the moment, is still limited to index portfolios, rather than to portfolios that are actively managed by a stock picker. "ETFs are not going to take over the mutual-fund world," says Mr. Fleites, whose State Street subsidiary sponsors both ETFs and open-end funds.
Peaceful Coexistence Some key reasons why long-term holders of exchange-traded funds -- unlike those of ordinary mutual funds -- aren't hurt by "market timers" who jump in and out: -- With their different design, ETFs don't take in cash that has to be invested and don't sell securities to distribute cash. -- As a result, buying or selling by timers doesn't force an ETF to incur transaction costs or to stockpile cash. -- International-stock ETFs trade at changing prices, not "stale" ones.
It's back-to-school time, so let's start with a quiz. In what year did a cocky young dot-com CEO whose startup was threatening the old guard tell me that the Internet was the "next wave": (a) Just before Netscape's IPO in 1995; (b) At the filming of Netpliance's Super Bowl commercial in 1999; (c) In the midst of the continuing ugly environment for tech in 2003?
If you chose (c), you're either smart or lucky--or you work at one of the many venture-backed dot-coms that have been Wall Street pariahs over the past few years. Now wiser, more mature, and in many cases profitable, these firms are eyeing the emergence of another Internet era. The real kickoff, most agree, will be the IPOs of Google and Salesforce.com (whose founder, Marc Benioff, was the source for today's quiz).
A dot-com resurgence is long overdue. The Net's power as a business tool never weakened, even after stocks plummeted in mid- 2000. In the post-bubble wreckage, too many people dwell on the Razor scooters and irrational exuberance and ignore the Net's fundamental promise. Says Clay Corbus, senior managing director at investment bank W.R. Hambrecht & Co.: "What was ballyhooed during the bubble about the potential for hypergrowth has been tested, and it still holds. The Internet does allow companies to scale quicker."
The best examples are Google and Salesforce.com. Google, less than five years old, now powers more than 200 million web searches per day, employs over 1,000 people, and by many accounts (though not its own; it won't comment) is nearing $1 billion in annual revenues, with hundreds of millions in profit. Salesforce.com, the Siebel Systems competitor that makes online tools for managing the sales process, is younger than Google and smaller, but growing rapidly. Benioff says that the company is in its second profitable quarter and that sales, which have been doubling annually, are running at a $100-million-a-year clip. Neither company is allowed by the SEC to discuss it, but many investors and techies expect both to go public within a year.
There's no question that a new hunger for dot-coms is building. Revenues and stock prices are soaring for public stars of the Net like Amazon, eBay, and Yahoo. And though fewer than 15 venture- backed firms have gone public since mid-2000, roaming-Internet access provider iPass tested the market in July and lived to tell about it. It garnered a valuation of over $1 billion and has seen its stock rise from an opening-day $14 to a recent $19.50.
Lining up for their chance to cash in are classic dot-coms: Emode, which offers online personality tests and matchmaking, claims 35 million members and five quarters of profitability; MyFamily.com, which helps people research their family trees, is "very profitable," says investor Tim Draper of VC firm Draper Fisher Jurvetson; and gift site RedEnvelope is already in registration. Further down the line are companies like website marketer LinkShare and online print-and-delivery outfit Mimeo. Research firm VentureOne calculates that more than 400 private infotech startups now operate profitably. About 200 deal in software, and 25 still proudly wear the dot-com appellation.
Many of the companies planned to catch the last wave of IPOs but missed out--devastating at the time but clearly now a blessing in disguise. The delay allowed execs to manage their businesses rather than manage Wall Street. BizRate.com, which helps people research consumer purchases, bulked up to 250 people by 2000 even as it was hemorrhaging money. "I got carried away, just like everybody else," says chairman Farhad Mohit. "I'm still stuck in a ridiculous BMW lease. I didn't even negotiate. I told the guy, 'I want to be the fastest purchaser in this dealership, not the one who got the best deal.'"
Now, having cut back to just 95 employees, BizRate is "very profitable," he says. "We're not ready to go public. But we'll see what Google does." Meanwhile, rival DealTime recently bought Epinions.com and seems closer to an IPO.
Thankfully this wave of Internet IPOs will build slowly-- investors are smarter, and the hurdles higher. Says Benioff: "Not only do you have to comply with Sarbanes-Oxley, but you also have to decide about expensing stock options. You'd better have three quarters of profitability and be cash-flow positive. You'd better be of scale and have marquee customers and enough momentum to keep going for two or three years at the earnings growth rate you go out at. This market is unforgiving."
Those that meet the challenges will be much stronger than their bubble predecessors. Get over your skepticism and notice how much time you're spending online. We're only starting to see the real commercial promise of the Internet.
FOLLOW almost any Democratic presidential candidate around, and it won't be long before you hear this statistic. In 1980, the average CEO was paid around 40 times as much as the average worker; now the multiple is above 400. George Bush's tax cuts "for the rich", say the likes of John Kerry, who formally announced his candidacy this week, must be scrapped to help those of lesser means. Meanwhile, pundits, notably Paul Krugman at the New York Times, have argued that a new "plutocracy" is rising.
The idea that America is becoming a less egalitarian place seems to worry the Republicans too. On Labour Day, the country's only official salute to the proletariat (established in 1894 to be the first Monday in September to disavow any connection with May 1st), Mr Bush donned his working-stiff outfit and baseball hat and headed off to Richfield, Ohio, to reassure his union brothers that he was appointing a new tsar for manufacturing.
Does America really have an inequality problem? Statistically, the answer is "Yes, but". Much the same applies to the question of whether the Democrats can turn this into a winning political issue.
By whatever measure you use, the richest Americans have done very well over the past few decades. According to the Census Bureau, the share of national income going to those in the top fifth of earners rose from 44% in 1973 to 50% in 2000. The share going to the top 1% rose to 15% in 1998, higher than it has ever been since the second world war, according to a recent study of tax returns by two economists, Thomas Piketty and Emmanuel Saez.
Take wealth rather than income, and America's disparity is even more startling. The wealthiest 1% of all households controls 38% of national wealth, while the bottom 80% of households holds only 17%, according to the Economic Policy Institute (EPI). Around 85% of stockmarket wealth is held by a lucky 20%.
If the rich have been doing much better than other Americans in relative terms, the poor have failed to improve their lot as they did in the 1950s and 1960s. The wage incomes of the bottom 20% of households have barely grown in real terms since the mid-1970s. As for wealth, the bottom fifth has debts that exceed its assets, making its wealth a negative number. The bottom fifth's percentage of national wealth worsened from -0.3% in 1983 to -0.6% in 1998.
These depressing statistics, though, come with two caveats. First, poorer Americans are better off than they once were. The proportion of Americans in poverty now stands at 12%; in Mr Krugman's supposedly golden 1950s, it reached 22%.
Meanwhile, although real wages appear stagnant, poor people can buy far more with them. The combination of technology and globalisation - the very thing that has depressed some manufacturing wages - has put many more erstwhile luxuries within the grasp of poorer Americans. They now own better-quality cars and washing machines than rich ones did a generation ago; mobile phones and computers are now mass-market items.
Second, America is a remarkably mobile society. As this year's Economic Report of the President points out, 50-80% of the unfortunates in America's bottom quintile push themselves into a higher quintile after 10 years. There are worries about mobility; Chris Edwards of the Cato Institute complains that marriage patterns may now be reinforcing inequalities, since yuppies marry yuppies these days. Yet, in broad terms, the idea that America is a land of opportunity still stands.
Interestingly, Americans are usually over-optimistic about their chances of promotion. An opinion poll a couple of years ago found that 19% of American taxpayers believed themselves to be in the top 1% of earners. A further 20% thought they would end up there within their lifetimes.
Seen from an international perspective, America certainly looks an unequal country, but in a way that many of those optimistic Americans might be proud of (see chart on next page). According to the EPI, admittedly using figures from the late 1990s, the gap between the top and bottom tenth of earners in America is wider than that in almost any other rich country. Even so, America's poorest are (in real purchasing-power terms) only a tiny bit worse-off than their peers in Sweden, Finland and Denmark; and they are better-off than those in Britain and Australia.
The relative inequality in America comes from the people at the top doing unusually well. The top 10% of Americans are nearly twice as well off as the top 10% of Nordic households. They are also much further away from the mean.
How does this translate into politics? Most Americans seem to understand that inequality is not just to do with tax cuts for the rich. The introduction of new technology - ATM machines and the like - has done far more than anything else to throw Americans out of work. Inequality is also tied up with social problems, such as the rise of single-parent households (see Lexington). One reason, arguably, why real incomes for poor Americans rose at the end of the 1990s was because the welfare-reform law in 1996 forced them to find work.
Similarly, Americans, even in recessions, still tend to lack the deep-rooted class envy that still afflicts Old Europe. They tend to associate wealth with the people who make it rather than inherit it (hardly surprising in a country where the richest two people are Bill Gates and Warren Buffett, rather than the queen and the Duke of Westminster). As Mr Edwards points out, many of the visibly wealthy are self-made entertainers and sports stars.
This helps explain why Al Gore's "People v the powerful" campaign failed to catch fire in 2000. Yet, three years later, Mr Bush looks more vulnerable on two fronts. First, the current jobless recovery is hitting poor America particularly hard - and prompting comparisons with the golden years of Mr Clinton's presidency. Although the recession technically ended in November 2001, unemployment has risen from 5.6% to 6.2% since then. The EPI calls this the worst recovery for job creation since records began in 1939. For those still in work, real wages since the end of 2001 have fallen by about 1%, says the institute.
Second, the tax policies of the Bush administration will probably only exacerbate the already wide gap between rich and poor. The inheritance tax has been all but scrapped. Marginal rates on top incomes have come down. Most important may be this year's reduction in capital gains and dividends taxes which, by some estimates, will provide a windfall to just the top 20% of households.
It is these "giveaways" that the Democrats are now concentrating on. But raising marginal tax rates, the Democrats' traditional solution to inequality, usually hits many people who regard themselves as middle-class, and does nothing to reduce the vast fortune of true plutocratic families, such as, well, Mr Kerry's.
Indeed, is the Harvard-educated Mr Kerry, who is married to a Heinz heiress worth $600m, any more an homme du peuple than George II, as some Democrats like to call Mr Bush? Howard Dean, the Democratic front-runner, may stress his occupation as a humble doctor, but he grew up in the Hamptons and Mr Bush's grandmother was a bridesmaid to his granny. As long as the presidency remains the shuttlecock of different scions of the north-eastern aristocracy, Americans may have a hard time thinking of any party as the champions of the poor.
It is as vital a ritual as the ringing of the opening bell, but no celebrities are present, save one -- Richard A. Grasso. At about 7:30 every morning, the chairman and CEO of the New York Stock Exchange is handed a set of papers at his desk on the sixth floor of 11 Wall St. This 57-year-old, wiry, bald man is the best-known -- and notoriously the best paid -- stock market executive in the world. Ever since it was announced on Aug. 27, his $140 million compensation package has been a subject of intense criticism -- and an investigation by the Securities & Exchange Commission. But no matter how bad the sniping from that and other crises, the numbers on those daily pages are solid, consistent -- and reliably glorious.
The papers have no special name -- ``my overnights,'' he calls them -- but they explain why Grasso is Wall Street's $140 million man. They are market-share statistics for each of the top 100 NYSE-listed stocks. For years, the NYSE's share of trading in its listed stocks has been 80% or better -- an extraordinary performance, considering the growing number of competitors that face the NYSE. The comparable figure for the NASDAQ market is just 16.4%.
To Grasso's detractors, what matters most is not his financial performance but his moral leadership -- and in that realm, they maintain, Grasso is sorely wanting. On Sept. 2, SEC Chairman William H. Donaldson fired off a letter demanding that the NYSE explain, in detail, how it determined Grasso's pay package. And as if to drive home the point, the SEC released the letter, which contained an extraordinary public bawling-out of a sitting NYSE chairman. ``In my view,'' Donaldson wrote, ``the approval of Mr. Grasso's pay package raises serious questions regarding the effectiveness of the NYSE's current governance structure.''
Even before the paycheck bombshell, institutional investors were going public with long-festering complaints about improper practices on the NYSE trading floor. Criticism was mounting over the NYSE's lack of transparency and unique version of governance, under which Citigroup Chairman Sanford I. Weill, then under regulatory scrutiny, was offered a seat on the NYSE board of directors -- not in his role as a financier but as a representative of the ``public.''
As a ``private entity with a public purpose,'' to use a phrase often employed by Grasso, the stock exchange is expected to take the high moral ground -- to set standards. Since becoming chairman in 1994, Grasso has firmly staked out that ground and parlayed that into unparalleled financial success. ``He has waved the flag often enough to persuade investors and the world and public opinion that the NYSE is an American icon,'' observes former SEC Chairman Arthur Levitt.
Somehow, the high ground has slipped away. How did it happen? Interviews with NYSE insiders, the exchange's competitors, critics, and allies -- and Grasso himself -- paint a picture of a complex institution that is superbly managed as a private enterprise yet is, as its critics contend, a parody of corporate governance. Far from serving as the gold standard for Corporate America, Grasso instead presides over an institution that has only grudgingly and belatedly engaged in reform of its internal governance -- despite its public responsibility as a regulatory body.
Grasso's NYSE has an uneven record as a regulator, nabbing insider traders with admirable alacrity but often criticized for not adequately regulating the behavior of its floor traders and member firms -- such as the specialists who manage trading of NYSE stocks. To be listed on the NYSE, companies must meet certain standards of governance, giving the exchange a voice in the national dialogue over corporate reform.
At a time when public policy is tilting toward stronger, more independent boards, the NYSE's board of directors falls short. The board -- which includes such non-Wall Street luminaries as Avon Products CEO Andrea Jung, Viacom President Mel Karmazin, and former Secretary of State Madeleine K. Albright -- is virtually handpicked by Grasso, who essentially determines the board's composition despite a supposedly ``independent'' nomination process. Indeed, Grasso's assertions that the board member-selection process is independent -- even more independent than that of most public corporations -- have been so vociferous that he appears to have provided incomplete or even misleading testimony on that subject to the Senate Banking Committee in May.
So what did Grasso do to earn his $140 million? Simply put, he took good care of his primary constituency -- the 1,366 men and women who own memberships, or ``seats,'' that enable them to trade on the NYSE floor. Even though some seat holders say they were stunned when they learned of the pay package, most appear to have accepted it with equanimity. Robert W. Seijas, ex-CEO of Merrill Lynch Specialists and an exchange veteran, says the reason is simple: ``The seat holders are the [NYSE's] shareholders, and they've seen an extraordinary increase in the value of their shares.''
That's because Grasso is an undeniably talented manager. Early in his tenure as chairman, he made the NYSE into a powerhouse for initial public offerings, grabbing business that once belonged to NASDAQ. Even his sharpest critics agree that Grasso's has almost single-handedly built up the exchange's public image -- which, along with an intense detail-oriented approach, has helped maintain the NYSE's superb market-share numbers. In 1999, seat prices reached an all-time high of $2.6 million. Even today, despite a three-year bear market, exchange seats are selling for $2 million -- the same as they were during the tail end of the bull market in 2000. By contrast, seat prices were as low as $760,000 when Grasso took over the NYSE in 1994.
Few investments outside of the NYSE -- and fewer stocks of listed companies -- can boast such impressive results. Former NYSE board compensation committee chairman Kenneth R. Langone, who owns two NYSE seats, notes that he leases out both of his seats -- and that, with annual lease prices in the $200,000 range, the rate of return from the leases is a healthy 10% or better, even for seats that were purchased at the height of the market. Indeed, for longtime NYSE members -- in the 1970s, seats could be bought for as little as $35,000 -- owning an exchange seat is a real gold mine.
With seat sale and lease prices so healthy, the exchange's intense public-relations campaign under Grasso generated little controversy even though it irritated some traditionalists who disliked Grasso's PR stunts. Grasso's leadership on September 11 -- when the exchange swiftly resumed trading despite fearsome damage to Lower Manhattan -- cemented his reputation for crisis management, as did his performance during the recent blackout. Unfortunately for Grasso, September 11 was followed by a wave of corporate scandals that focused attention on the NYSE's weak spot -- its corporate governance.
If ``governance'' at the NYSE were to be judged solely on the basis of its CEO's relationship with his shareholders, Grasso's could hardly be better. Grasso has a special relationship with the floor: He meets with seat holders often, in sometimes tempestuous informal gatherings and also in one-on-one meetings -- no difficult feat, considering the manageable number of seat holders and the fact that most of them work in his building. They are not just his corporate overlords and ultimate bosses. They are his friends -- in a sense, his family.
Grasso's hardscrabble early life has, if anything, burnished his reputation on the trading floor -- a blue-collar stronghold where college degrees are strictly optional. Grasso's father left the family when Richard was an infant, and he was raised in a working-class neighborhood in Queens, N.Y., by his mother and two unmarried aunts. Young Grasso, like many traders at the exchange, was a ``street kid.'' An indifferent student at Newtown High School, he dropped out of New York's Pace University and subsequently served two years in the U.S. Army in the 1960s. It is the stuff of internal folklore how he landed a clerk's job in the NYSE's stock lists department two weeks after leaving the army in 1968, adapted rapidly to the NYSE's arcane procedures, and quickly became a rising star.
Grasso made friends easily and became a favorite of the floor community. In the early '80s, he even had a chance to become a specialist, in the employ of his good friend, veteran specialist William Johnston. But Grasso turned down the job because of an even more promising alliance with the man who became his mentor and patron -- and, in later life, his neighbor in Long Island's fashionable Locust Valley. The taciturn ex-Marine and second-generation specialist John J. Phelan Jr. became president of the Big Board in 1980 and then chairman, and Grasso rose along with him. In 1988, Grasso became president of the exchange.
Phelan's successor was Donaldson, educated at Yale University and a founder of the brokerage firm Donaldson, Lufkin & Jenrette. In an ironic twist -- given Grasso's recent conflict with Donaldson -- Grasso owes his career to the current SEC chairman. The working relationship forged between these two very different men was a tribute to the political savvy and the pragmatism of both. Grasso had considered resigning when Donaldson got the appointment in 1991 but stayed on after meeting Donaldson for a leisurely dinner at a Manhattan restaurant. Donaldson offered Grasso what the latter describes as a ``partnership.'' Grasso accepted.
As managers, the two men were polar opposites -- Donaldson detached and aloof, a delegator. ``Bill Donaldson brought a more professional, CEO-kind of management,'' says Catherine R. Kinney, now co-president of the NYSE and executive vice-chairman of the board of directors. ``Bill delegated to Dick. He was the advocate, the visionary, the outside person, and Dick was very much the chief operating officer and ran the exchange,'' says Kinney.
The two men differed in ways that had important internal symbolism. Grasso came to the trading floor almost every day, glad-handing and slapping backs, and almost never missed a retirement dinner -- whereas Donaldson rarely could be seen at such occasions. It's not just ``shareholder relations,'' say friends. Grasso genuinely enjoys these events, posing eagerly for photographs with retirees as eagerly as he appears in daily photo opportunities during the ritual ringing of the opening bell.
Grasso brought the same hands-on approach to the NYSE's external relationships, at the same time as he intensely focused on the nitty-gritty of market share and competition for listings. He raised the exchange's public image, gaining free publicity by persuading celebrities to ring the opening bell -- and engaging in publicity stunts such as a charity boxing match and appearing in an episode of the HBO series Sex and the City.
Grasso also mended Donaldson's uneasy relationship with Arthur Levitt's SEC. Indeed, the difference in the two men's approach to the SEC is instructive, particularly in light of recent events. As NYSE chairman, Donaldson had wanted to encourage overseas companies to list on the exchange by pressing the SEC to relax rules requiring the application of generally accepted accounting principles (GAAP) to non-U.S. companies. Levitt refused, straining relations with the NYSE. But instead of irritating Levitt and the SEC by pushing that losing cause, Grasso and Levitt agreed that the SEC chairman, a former chairman of the American Stock Exchange, would join him in a campaign to attract overseas companies. Levitt said the deal was that ``the two of us will go around the world attracting listings.'' After all, he told Grasso, ``I'm a pretty good listings salesman.'' Grasso agreed, avoiding a nasty political battle.
Grasso's hands-on approach to the exchange's management extends to its highest echelons. The NYSE board of directors, unlike most corporate boards, does not nominate its own members. Theoretically, that makes it more independent than corporate boards -- a point Grasso has repeatedly emphasized in his public statements and in his appearance before the Senate Banking Committee on May 7, in which he was questioned sharply by Senator Paul Sarbanes (D-Md.) on his role in the Weill affair. He has explained time and again that the exchange has a nominating committee, independent of the board, that appoints members of the board. Nominating committee members, a mix of financial and public representatives, are not allowed to serve on the board. The current committee includes such prominent members as Prudential Financial President Arthur F. Ryan and New York University President John Sexton. The committee has a long history, dating back to the early 1970s, and in theory it should insulate the board from Grasso and provide a genuinely independent source of board members, who serve two-year terms.
In practice, it doesn't quite work that way -- something that is of more than academic interest in the wake of the Weill fiasco and the selection of homemaking guru Martha Stewart to the board not long before her recent travails. Even though the nominating committee picked Weill, Grasso concedes that the idea for selecting him -- and all other board members, for that matter -- was actually his. In his interview with BusinessWeek, which took place prior to recent pay imbroglio, Grasso explained that he has an annual ``audience'' with the nominating committee, in which he provides names of potential board members from which the nominating committee makes its selections.
The nominating committee is not obliged to accept Grasso's choices, but it invariably does so. ``We have a dialogue every spring,'' Grasso told BusinessWeek. ``I lay out usually five to seven candidates. And they're not compelled to listen to those five to seven. They can do whatever they want.'' By contrast, Grasso's Senate Banking Committee testimony emphasized the independence of the process and testified that ``there is separation of the chief executive from that nominating process.'' An NYSE spokesman, Ray Pellechia, denies that Grasso was misleading in his testimony and says that time constraints prevented a fuller explanation. He also pointed to an Apr. 3 press briefing in which Grasso briefly mentioned, without elaboration, that he has an ``audience'' with the nominating committee.
Although CEO ``audiences'' with the nominating committee long predate Grasso, the practice -- and the committee's failure to make independent choices -- ensure that the board is not exactly a hotbed of dissent. Or, as board member William B. Summers Jr. puts it, ``people have great collective respect for one another.'' Indeed, the NYSE board appears to be almost entirely free of strife and factionalism -- and according to Langone, the board's votes on compensation issues have been unanimous for years. Langone, a former chairman of Home Depot, served as head of the human resources and compensation committee from 1998 until June, 2003. He is a close friend of Grasso, so close in fact that Grasso served on the Home Depot Inc. board until adverse publicity caused him to resign. Langone left the NYSE's compensation committee as a result of the controversy. Grasso's earlier term on the board of Computer Associates International Inc. had also drawn fire, in part because of that company's lavish executive compensation.
Blessed with such a harmonious board, filled with friends such as Langone, it was little wonder that Grasso wound up with a sweet pay package when his contract was last negotiated in 1999. The compensation committee, based on recommendations from the consulting firm Hewitt Associates, used as benchmarks the pay of financial-services executives. Grasso was given the option, which he exercised, of deferring his pay and bonuses at a risk-free rate of 8% a year -- although Summers and Langone say they do not know whether that interest was yielded by an investment contract with an independent investment manager, or was simply paid by the NYSE.
According to Summers, the pay package that was provided to Grasso in 1999 -- and its controversial interest rate for accrued pay -- reflected the soaring prospects of the exchange and the fact that Grasso was not eligible to receive the stock options that were all the rage at the time. There was, he maintained, no sentiment for pegging Grasso's salary to the pay scale of regulators. That would have cut his pay -- which includes but is not limited to a base salary of $1.4 million and an annual bonus of $1 million -- to just a fraction of its current level. (Donaldson, by contrast, earns about $140,000 a year at the SEC.)
Summers could shed no light on the combination of pay and previous bonuses that led to Grasso's $140 million accumulated pay, which he will receive in a deal that extends his contract expiration from 2005 to 2007. ``It was put in place at a time when 8% did not raise eyebrows,'' says another person familiar with the board's decision. The exchange has declined to elaborate on the composition of the package -- or how much Grasso was paid each year -- beyond saying in a statement that $40 million was from ``his savings account balance,'' another $51.6 million consisted of a ``previously accrued retirement benefit,'' and another $47.9 million were ``relating to prior incentive awards.''
The decision to extend Grasso's contract through 2007 -- although only recently announced -- actually took place in late 2002, according to a person familiar with the chain of events. Harvey Pitt was leaving as head of the SEC, Paul H. O'Neill was departing as Treasury Secretary, and Grasso was widely named as a possible successor to both of them. That led the compensation committee -- then under Grasso's pal Langone -- to send a member to approach Grasso to discuss a possible extension of the contract. Grasso was agreeable to extension of the contract -- but only for two years. Thus Grasso's decision to stay at the stock exchange was actually made long before the contract extension was announced. People familiar with the decision vigorously deny that Grasso cashed out his deferred compensation -- thereby ending his 8% interest bonanza -- because of the potential for adverse publicity. But if that were the motive, it backfired, judging from the vociferous reaction.
Grasso himself has long been mum on the subject of his compensation, saying that he has had no input into his pay and that the only words he has given the board on the subject are ``thank you.'' He is likewise serene on the other hot-button subjects concerning his tenure, including the age-old debate over whether the NYSE provides better service to his customers than the competition. His competitors' business models are, he says, ``very compelling.'' His deadpan expression hardly changes, not even into the second hour of a three-hour interview with BusinessWeek, but his words are laced with sarcasm. ``I guess they should feel pretty happy about that,'' he says. ``That must mean they think they're going to put us out of business.''
Grasso has seen to it that even after he is gone, change at the NYSE is likely to be incremental at best -- with the interests of his seat holders remaining a matter of paramount importance. Elimination of the exchange's floor-trading system, as urged by some exchange critics, would be the equivalent of burning the wallets of those 1,366 members -- and it is not about to happen. The specialists are the exchange, and the exchange is Grasso. ``Some people say: 'The exchange will die in 100 years. Kill yourself tomorrow.' Forgive me if I don't elect that strategy,'' he says.
Specialists and floor brokers are likely to continue to hold sway at the exchange, for the simple reason that they own it and dominate its corporate culture. When Grasso became chairman and CEO, he appointed his specialist friend and would-be employer Johnston as president. After Johnston's retirement at the beginning of 2002, Grasso elevated two longtime insiders whose careers, like his own, had been spent entirely at the exchange: Kinney and Robert Britz both hold the title of president -- exchange officials eschew the term ``co-presidents'' -- and their experiences and temperaments dovetail as neatly as Donaldson's and Grasso's. The outgoing Kinney, who began as a regulatory trainee in 1974 and moved into marketing under Grasso's tutelage, is the ``Ms. Outside.'' The more taciturn Britz, a 30-year exchange veteran who began in the Grasso manner as a listings rep, is the ``Mr. Inside.'' The two complement each other while not, as it happens, posing anything resembling a threat to Grasso.
When it comes to threats, Grasso is an old and seasoned warrior. Internal threats? Not very likely, with Grasso effectively controlling the board. Competitive threats? Asked about them, Grasso's reaction is reminiscent of George W. Bush on the subject of Iraqi guerrillas -- Bring 'em on. ``We learn from them,'' he says of his competitors. ``I think we're very good at adapting technology.'' But Grasso is more than just an apt pupil. His attitude toward competitors is a combination of bemusement and condescension. Asked about one upstart named Liquidnet, a computer system that joins the trading desks of institutional investors electronically, Grasso is suitably restrained. ``What are they doing? About 6 million shares a day?'' asks Grasso. ``If they're good, they'll draw liquidity. What draws liquidity is better pricing.'' Investors who believe they can get better prices elsewhere, he maintains, should go elsewhere.
Many institutional investors contend that Grasso is wrong. Traders, they maintain, flock to markets where they can most easily find a buyer or seller -- even when pricing is not the fairest. And indeed, they charge that at the NYSE, large block trades get worse prices than smaller ones. Sam Lek, a vocal Grasso critic whose Lek Securities has 15 seats on the exchange floor, says being the No. 1 exchange ``doesn't give you the right -- nor is it smart -- to antagonize your customers and say: 'If we're not so good, don't come here.' Because that's going to become a self-fulfilling prophecy.''
Only Bill Donaldson can make such prophecies a reality. Dick Grasso's ability to deal successfully with Donaldson's SEC is likely to be the biggest test of his career. Grasso could go a long way toward defusing this crisis by redefining the composition of the compensation committee to ensure that no executive of a company regulated by the NYSE can have a say in his paycheck. He could also ask the board to use more modest compensation benchmarks than Wall Street's executive payroll. He might even consider giving back some of the money.
Grasso has managed to charm his way out of vexing difficulties before, dating back to the days when he was a fatherless boy in Queens. Traders are avid gamblers, and -- while there are no formal odds on the subject -- the betting on the trading floor is that in a one-on-one match, Grasso vs. Donaldson, the guy who went to Yale loses to the guy who went to Newtown High. Period.
That would be a smart wager if not for one thing -- the public's patience with the NYSE is growing short. For years, Dick Grasso has been the undisputed overlord of a private entity that all too often has paid lip service to its public purpose. It's a long-running act. But an experienced showman like Grasso ought to know better than anyone when a long-running act is starting to wear thin.
Half Full or Half Empty? GRASSO'S ALLIES CREDIT HIM WITH: -- Maintaining a prosperous exchange, with 1,549 of its 2,800 companies joining on his watch, and a consistent 80% market share of the trading of NYSE stocks -- Showing strong leadership, particularly in times of crisis such as September 11 -- Burnishing the NYSE's public image as the world's leading stock market -- Expanding the exchange's global listings WHILE HIS CRITICS FAULT HIM FOR: -- Taking home a $140 million pay package that has become a huge source of embarrassment -- Failing to reform the NYSE's internal governance -- Neglecting large institutions, which complain of poor treatment and bad pricing -- Showing poor judgment by serving on the boards of both Home Depot and Computer Associates Data: BusinessWeek
Eliot Spitzer, New York State's attorney general, is at it again. Like Batman out to save a sordid Gotham City, he continues to pursue and torment the professional investment community, vowing to end everything from fraud to conflicts of interest that affect investors. Now, he's taking on the mutual-fund industry.
On Sept. 3, in an energy-infused press conference, Spitzer said ``illegal trading schemes'' allowed at least one hedge fund to buy mutual-fund shares at prices that were not available to most other investors. The attorney general announced a $40 million settlement with the hedge fund, Canary Capital Partners LLC, and its managing principal, Edward J. Stern. Stern, the son of real estate magnate and billionaire philanthropist Leonard Stern, did not admit or deny wrongdoing. Spitzer continues to probe mutual funds on the other side of its trades. ``It's the first shock to the fund industry in 60-some years,'' says John Collins, a spokesman for the Investment Company Institute, a Washington (D.C). fund industry trade group. ``If these charges prove true, there has been a breach of law that cuts close to the heart of what protects all mutual-fund shareholders.''
But while Spitzer continues to grab headlines, many wonder: Where is the Securities & Exchange Commission? The SEC has made clear it wants mutual funds to give investors more information about fees, portfolio turnover rates, revenue-sharing payments to brokerage firms, and the compensation of portfolio managers. In January it proposed some new regulations, and in June it put out a 120-page report on the industry's practices. In late July, the House Financial Services Committee passed a bill that would make most of those changes and more. Now, expectations are high that Spitzer's big splash will spur the SEC to adopt those measures quickly, and perhaps more.
But if greater transparency is always helpful, that alone is unlikely to stop the sorts of illegal practices Spitzer alleges. And probing mutual funds hasn't been a top priority at the SEC, although its caseload is up. Says Mercer Bullard, a law professor at the University of Mississippi and founder of Fund Democracy, a mutual-fund advocate: ``The real failure has been on the enforcement side. The SEC has done nothing to show that it really means business.''
Spitzer's case against Canary was based on a tip that came his way -- and he was able to move fast because he faces fewer procedural hurdles than the SEC does. ``Spitzer continues to trump the SEC in major new areas of investigation.... He's making an obvious effort to beat the SEC to the prosecutorial deadline,'' says Seth T. Taube, a former SEC prosecutor who now chairs the securities litigation practice of McCarter & English, a Newark (N.J.) law firm.
The SEC applauded Spitzer's big score -- but wondered why he pursued the case without clueing them in. ``We've been looking at mutual-fund sales practices for a number of months,'' says one official. ``Collectively, we have limited resources in which to look under every rock; perhaps we could be more efficient with a little more coordination.''
Spitzer's complaint against Canary Capital should put to rest any idea that the mutual-fund industry is a pristine, ethical world in which little watchdogging is needed. The complaint alleges that Canary was allowed to trade certain mutual funds after the market closed, exploiting market swings. ``Late trading,'' as it's sometimes called, is prohibited by New York State's Martin Act and SEC regulations because it allows select investors to take advantage of events that occur after the market has closed and are not figured into the funds' net asset value (NAV). Spitzer described the practice as ``being permitted to bet on yesterday's horse race.''
The hedge fund was also allowed to engage in ``timing'' mutual funds -- doing short-term ``in and out'' trades, based on previous NAVs. This harms buy-and-hold investors. Spitzer called this type of trading ``akin to playing a casino with loaded dice.''
What was in it for the mutual funds? Plenty. Canary plowed millions in assets into the mutual funds in exchange for the right to engage in timing. The hedge fund also offered to pay higher management fees than other customers. And it invested in accounts called ``sticky assets'' -- typically long-term investments in other financial vehicles managed by the mutual fund, such as bond funds, ``that assured a steady flow of fees to the manager,'' according to the complaint.
Mutual-fund firms named in Spitzer's complaint are among some of the most respected: the Bank of America's Nations Funds, Strong Capital Management, Bank One, and Janus Group. All say they are cooperating fully with the AG's office. Says Russel Kinnel, Morningstar's director of fund analysis: ``One of the reasons that funds are so popular is the perception that they're very ethical -- they supposedly treat the little guy like the big guy. But clearly, they haven't done that here.''
Ironically, hedge funds have taken most of the heat from regulators and in the press of late. Some insiders say that to take the focus off them, hedge-fund managers have been ``ratting out'' their mutual-fund brethren. ``Hardly anyone has a clue about all the games mutual funds play -- it's all about the big bad hedge funds,'' says one manager.
Spitzer would not comment on any pending settlement with the mutual-fund firms and no charges have been filed. But Canary will be required to return $30 million in profits reaped from illegal trading and pay an additional $10 million fine. Moreover, the AG says this issue is far from over: ``There are many other institutions involved in timing. It's just Day One of this investigation.'' Given Spitzer's track record, it could be remembered as D-Day for mutual-fund companies.
Anatomy of a Fraud In exchange for large investments in fee-generating funds, mutual-fund companies allowed hedge funds to: -- Trade mutual-fund shares illegally on after-hours, market-moving news -- Get in and out of mutual-fund shares throughout the trading day, called timing -- Profit from artificially low share prices the fund companies maintained in their own funds at the market's close But that meant big costs for investors: -- Timing created transaction costs that were passed on to long-term investors -- Gains were limited since managers held more cash to pay profits to the hedge funds -- Timing forced funds to use costly hedges to keep volatility down -- Redemption fees for timers were waived, depriving the mutual funds of revenue Data: New York State Attorney General's Office