Viewpoints on Current Issues

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As institutional investors grapple with seismic shifts in their strategies and needs, investment managers will also be undergoing profound change, including:

• More intense regulation and compliance
• Greater scrutiny of business practices and capital resources
• Potentially tighter strategic relationships with clients, but with corresponding pressure for lower fees
• Higher standards for risk management and disclosure
• Special requirements for credit research, given the diminished credibility of rating services
• Adjustments dictated by the cultural implications of increased hostility to financial services
• Potentially greater opportunities to provide solutions rather than merely products for clients

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The financial panic has changed the investment landscape. For institutional investors, the implications may be: More liquidity, better management of cash flows, reduced leverage, selected alterations in asset allocations, more contingency planning, different spending policies and stabilization reserves, especially acute stress for foundations, changes in governance, challenges in the investment consultant business model, and in general, a seismic shift in investment management practices.

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Does the recent meltdown in the financial markets drive a silver stake through the heart of the efficient markets hypothesis (EMH)?  No.  The meltdown killed the bad ideas, but they were dead already.  And the good ideas are as alive today as they were before the meltdown.

The EMH combines three myths (the bad ideas) with two insights (the good ideas). The central myth is that investors are totally rational. The insights are that there are no risk-free profits and markets are unpredictable. These insights then get confused with two other myths. “Return requires risk” gets confused with “risk generates return,” and unpredictability gets confused with randomness.

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Cash was supposed to be the low-risk, low-return asset. And then everything changed.

During the financial crisis that developed after the Lehman bankruptcy and the AIG rescue, cash became the high-risk, high-return asset. Today’s cash is not your grandfather’s cash. In this Viewpoint, Robert A. Jaeger and Cyrus Taraporevala of BNY Mellon Asset Management examine how this happened and what it tells us about the role of cash in investors’ investment portfolios. Without enough liquidity, they note, even investors with extremely long time horizons can end up as forced sellers during a panic. Cyrus and Bob conclude that cash and other forms of liquidity have to be built into the foundation of a portfolio.

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American taxpayers today own a significant chunk of Citigroup, American International Group and other financial institutions, thanks to the Troubled Assets Relief Program. Therefore, they also own, indirectly, a slice of the toxic assets that reside on the balance sheets of those institutions. And now taxpayers will end up owning even more of these troubled assets, thanks to the Public-Private Investment Program recently announced by Treasury Secretary Timothy Geithner. The question, though, is will they have the chance to benefit from these investments on the same terms as Wall Street? Probably not. Unless we take certain steps.

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In this paper, Robert A. Jaeger, Ph.D., Senior Market Strategist for BNY Mellon Asset Management, examines some of the broad themes driving the current financial meltdown and the housing bubble that preceded it. This includes a focus on leverage, with special attention to three sources of trouble: no-money-down mortgages, over-leveraged investment banks, and the selling of credit default swaps. He also reviews how flawed regulation and "free market fundamentalism" contributed to the mess, and the recent environment of self-reinforcing fear and downward momentum. Bob concludes with a look at the perspectives of both growth- and value-oriented investors in today's investment environment.

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Over the past few months, voice of the client has been largely missing from the ongoing discussion about the root causes and cures for the financial crises. In this report, Cyrus Taraporevala, Executive Director, North American Institutional Sales, Client Management and Marketing of BNY Mellon Asset Management, pens an imaginary letter outlining some of the pressing concerns expressed by a number of our institutional clients.

Cyrus describes how corporate pension plans are wrestling with the problem of being underfunded in the wake of the market’s slide, which may require companies to increase cash contributions to their plans. Additionally, a broad range of institutional investors are struggling with diminished cash flow and illiquid fixed income portfolios. The upshot could be a growing number of plan terminations and the potential for more pension obligations in the lap of taxpayers.

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Last year a prominent financial service executive announced his company was exiting the investment banking business by saying “I’ve had about all the fun I can stand.” While the past few weeks may be causing some to approach the same conclusion about the financial markets, panicking is clearly the wrong answer for long-term investors.

At BNY Mellon Asset Management our multi-boutique model generates divergence of thought, presented by experts in their specific asset classes. In this report, Phil Maisano, BNY Mellon Asset Management Chief Investment Strategist, and selected CIOs from our investment boutiques share some of their current thinking with you. We believe we have identified some of the challenges and opportunities as they relate to those asset classes and how they may impact your portfolio.

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Critics of the government's financial rescue plan are rightly concerned about taxpayers getting stuck with a $700 billion tab that benefits Wall Street bankers. In this paper, Ronald P. O'Hanley, Vice Chairman, The Bank of New York Mellon and Charles J. Jacklin, Ph.D., President and CEO, Mellon Capital Management Corporation, argue that a properly structured plan will strike the right balance between protecting taxpayers and encouraging participation by the financial industry. Ron and Charlie outline six principles that they believe can help the plan achieve its ultimate objective:

• The More Buyers, the Better
• The More Auctions, the Better
• Allow Smaller Bidders to Participate By Pooling Funds
• Disclose Total Treasury 'Buy-in' Prior to the Initial Auction
• Begin With the Larger, Widely-Held Issues
• Provide Transparency

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