ACTUARIALLY-DRIVEN INVESTORS & FINANCIAL FADS Summary: No matter…

    ACTUARIALLY-DRIVEN INVESTORS & FINANCIAL FADS

Summary: No matter how wild they get, financial markets don't impose upon the
calculation of mortality rates. Unfortunately, the ivory tower culture of actuarial work is
vulnerable to the vast but recurring changes in fashions in stocks, bonds, real estate, and
(shudder) now in commodities.
Recently, HSBC estimated that by the end of 2006 institutions will hold some US $100
billion in commodity indexes. This compares to US $10 billion held at the end of 2003
and very much less at the cyclical low for commodities in late 2002.
This is the first direct venture by such funds in history and marks a remarkable departure
from "The Prudent Man Rule" into the fad de jour.
In the past, the clash between the aloof long term view and undeniable market forces has
resulted in corporate damage.

Observations: In this article, the term actuarially-driven investors refers to insurance
companies and almost anything related to pension funds. These, of course, include
sponsors and pension fund managers, with the connecting theme being long term studies
by actuaries on mortality rates as well as projected investment returns. Obviously, so-
called federal government pension plans are not included as falling under a heading of
electorally-driven promotions.
In contrast with a rapidly changing financial world (particularly with volatility exceeding
that typical of previous new financial eras), mortality rates change at a glacial pace. Often
this culture of a virtual constant state sets itself up as removed from the variable nature of
investment markets. At other times, it locks on to investment fads.
It is one thing to be detached from shorter term fluctuations, but the pedestal of the
"dignified long term perspective" has, in a number of cases, been isolated ­ particularly
from the remarkable financial volatility typical of great asset inflations.
For example, at interest rate lows in the 1940s and 1950s, insurers were very comfortable
with the fashion to favour fixed income investments over risky equities.
Regrettably, the unthinkable was building and that was soaring CPI inflation which, in the
early 1960s, was considered a plague that could only happen in inferior countries.
Looking back on it, the irony is exquisite. As bonds were being trashed, salvation was
found in equities which, in turn, were soon trashed by soaring alternative investments in
commodities or real estate, which eventually turned disappointing as well.

Some History: As with generals always fighting the last war, the complacency that seems
to go with many large funds leaves them vulnerable to the inevitable major changes in
investment fashions. Since the late 1600s, insurance companies have been the largest
investors, but this review is limited to North American life insurers since the 1860s. One
observation is that the financial violence found with our period of asset inflation occurred
in two previous examples. Another is that the steadiness of mortality calculations may




ACTUARIALLY-DRIVEN INVESTORS & FINANCIAL FADS ­ UPDATED JUNE 16, 2006                       1
foster a complacency vulnerable to the extraordinary events that attend great asset
inflations.
In the mid-1800s, some insurers in England had shown a long success of operating
conservatively, providing full protection for their policyholders, with a return of 3% on
their funds. In Canada and the U.S., this was about half the return from first class
securities.
Businessmen in Canada, for example, saw the opportunity that, with a wider margin of
safety, they could charge lower premiums and show a good return to shareholders.
The Sun Insurance Company of Montreal was incorporated in 1865 and initially the Board
of Directors reviewed each policy applicant and investments. Disqualifying rules were
complex and included sailing on ships crossing the Atlantic and travelling too far south
into the U.S. Malaria and a variety of enteric diseases in the hotter climates were a real
risk.
Of interest, the fine print also forbade payout on death due to suicide, dueling, or at the
"hand of justice".
Sun, which became a global giant, is a suitable representative of the industry. Actuarial
review by a consultant was first engaged in 1876 and a full-time actuary was appointed in
1881.

The New Era That Ended In 1873: While our review is by no means thorough, the
sampling is random as to which reports were readily available. For example, the Pacific
Mutual Life Insurance company started in Sacramento had their operations reviewed in
1871 by an actuary from Boston. In 1873, one was hired who had the only calculating
machine in the West.
This was an "Arithmometer of Sir Thomas de Colmar" and the company's history describes
it as a big brass machine that, in accomplishing astonishing feats, "its wizardry brought in
many visitors". Unfortunately, it required frequent trips to San Francisco for repairs by an
expert watchmaker.
In the 1870s' boom, the Northwestern Mutual Life Insurance Company extrapolated
confidence and took "long term" positions in higher yielding but lower grade securities.
The "new era" climaxed with a bubble in 1873 and narrowing quality spreads reversed to
widening in the consequent distress and collapse of liquidity. Chagrined, the investment
committee discontinued the policy of trying to obtain high returns through risky
investments. The 1873-1895 contraction was called "The Great Depression", which
became an enduring illustration of risk forcing prudent investing.

The New Era That Ended in 1929: The next new era developed in the 1920s and Sun
became one of the great companies in the world. T.B. Macauly was both an actuary and a
visionary who had, at the end of WWI in 1918, sensed the coming of a new era of
industrialization. As history records, he didn't understand the risks of the subsequent great
financial boom. His way to participate was through equities, with selection the key, and no
investments were to be made for early sale or making a quick profit. In the mid-1920s,
Macauly wrote, "We are conservative in our selections and we retain our holdings



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indefinitely, regardless of market fluctuations.". The rationalization was, "We have
enlisted the brainiest and most experienced men on the continent to manage the
investments.". (This compares with the boasts from a hedgefund in March, 1998 that their
staff included "a disproportionate number of the world's leading computer scientists,
system architects, and financial engineers". The fund became insolvent in September,
1998.)
With the benefit of hindsight and the duress of the early 1930s, this policy came into
question and was rejected.
But, in foresight, this was an impossible view as the 1920s progressed and Sun's aggressive
approach to equities was unique in North America and was matched by only a few life
companies in England. In 1927, 55% of their investments were in various classes of
corporate bonds and some 30% was in common shares which, at the top in 1929, amounted
to 52% of the company's assets. This was well appreciated by speculators as the stock
soared from 560 in January 1927 to 4100 in September 1929. The low on the consequent
debacle was 145.

Infatuation With Fixed Income At Secularly Low Interest Rates: A 1971 history of
the company observed that if the wagon is hitched to the star it must follow the star. Sun's
business contracted with the bust and no dividends were paid for four years. In the mid-
1930s, management proudly announced that since 1931 they had exclusively invested in
"fixed interest-bearing securities".
This, of course, brings us around to the regard in the 1940s for fixed income that pushed
long treasury yields down to less than 3% as concerns for risk in equities had investment-
grade shares at a 6% dividend yield. Since the early 1700s, there have been six "new eras".
Typically at bear market lows, investment-grade stocks traded at a 6% dividend yield and
with the enthusiasms at bull market tops at 3%. On the credit cycle, interest rates for
senior government bonds typically traded around 3% at an economic trough and at the
height of a boom near 6%. (Over 300 years, the 15% in 1980 was the exception.)
By the late 1960s, widespread concerns about another depression were dispelled by a
wonderful bull market. As that one was peaking, the popular projection claimed there
would be so much institutional money coming into the stock market that there would be a
"shortage of equities". Expanding earnings multiples and new issues were also featured.
Despite this allure, the policy at a large life company was that any investment that
fluctuated in value had no value because the actuary could not match with any certainty the
sanctified 30-year forecast of mortality rates. Investments, therefore, required fixed
income. All bonds were held to maturity. Even if the issue was rated as junk, it qualified
as an "in" investment while equities and real estate were "out". In the early 1960s, equities
were restricted to 15% of investment funds and undesirable real estate was kept at 1%.

Infatuation With Real Estate At Secularly High Interest Rates: The greatest bear
market in history for bonds accelerated in the 1960s, making fixed income investments
unpopular. As the rate of inflation was getting well beyond most coupons, actuarial
assumptions suddenly forced direct investments in real estate. Pension funds bought a
wide variety of properties at inflated prices.



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Out of the speculative real estate collapse in the early 1980s, another great bull market for
common shares started. With this, another cult of equities developed with actuaries
eventually recommending a 60%+ weighting. Despite the collapse of radical speculation
in techs, this has maintained. This compares with the aggressive 52% weighting by Sun
Life in 1929.
Using the DJIA, equities didn't break even until 1955. This, so to speak, is an actuarial
life-time and, although there was little change in mortality rates, the investment culture had
changed to minimize rather than celebrate equities.
More recently, equities are very much in fashion, real estate again has been wonderful, and
confidence in the Fed's ability to depreciate the dollar "forever" is so strong that former
champions of fiduciary responsibility are speculating in commodities.
Recent changes in the yield curve and credit spreads are indicative of the financial stresses
that accompany the culmination of any great boom. This review starts with the asset
mania that blew out in 1873 when the leading New York newspaper editorialized that
nothing could go wrong because, without a central bank on a gold standard, the Treasury
Secretary had ample powers to prevent a contraction. It lasted from 1873 to 1895 and
senior economists called it "The Great Depression" until as late as 1940.
However, as history has shown, institutional infatuation with a fashionable asset class
provides a reliable indicator of a paradigm change.
For around 150 years and despite an august dedication to the long term, financial
institutions have flocked to fashion and then suffered chagrin. This ranged from being
overweight in bonds at a 3% yield in the 1940s to being overweight equities in the late
1960s when the S&P started a 66% decline in real terms.
If Sun Life, for example, suffered considerable remorse in being overweighted in stocks in
1929 at a 3% dividend yield, is a similar remorse possible with being overweight now at a
1.84% dividend yield?
Taking this line a little further, what is the potential for chagrin when positioned in
commodities with no coupon, let alone dividend?
The history of the investment behaviour of financial institutions provides an answer.




                                                         BOB HOYE, INSTITUTIONAL ADVISORS
                                                           E-MAIL bobhoye@institutionaladvisors.com
                                                            WEBSITE: www.institutionaladvisors.com




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