Fitness of Use Criteria for Price Index Deflators in National Income Accounting A Case Study: Mutual Stock Fund Management

Transcription

1 Finess of Use Crieria for Price Index Deflaors in Naional Income Accouning A Case Sudy: Muual Sock Fund Managemen Michael Holdway U.S. Bureau of Labor Saisics Absrac: Mos saisical agencies in developed counries are working o expand he coverage of heir price indexes o beer represen he services secor. Relaive o he durable and non-durable goods producing secors, services ofen presen measuremen challenges ha are difficul o address in an operaional environmen. This paper presens a case sudy of how he Producer Price Index program concepualized and hen execued a price measuremen mehodology for he oupu of he Invesmen Advice indusry, while simulaneously esing he deflaion properies of is mehodology for finess of use in he naional accouns. Voorburg Group on Services Saisics Sepember 2002 The views expressed are hose of he auhor and do no reflec he policies of he U.S. Bureau of Labor Saisics.

2 Inroducion Saisical agencies coninue o expand heir coverage ino he services secor which has led o a consrucive dialogue wih naional income accouning praciioners. The dialogue has ofen focused on he finess of cerain price indexes for separaing price change from quaniy change. The deflaion properies of a price index are parly dependen on how saisical agencies respond operaionally o he concepually difficul price measuremen challenges presened by service indusries such as finance, consuling or medical care. Several crieria can be used o access he accuracy and relevance of deflaors ha vary according o he complexiy of he price measuremen challenge. Some of he basic enes followed by he Producer Price Index (PPI) program o review finess of use are lised below. I. Price measures are operaionally defined a. The PPI model is based on indusry revenue funcions holding inpu requiremens fixed. b. Consan qualiy indexes are a funcion of inpu requiremens II. Crieria used o es he assumpions in I. a. Modeling he relaionship beween he revenue funcion and he price mechanism used o quanify price change. b. Changes in oupu qualiy are relaed o changes in inpu requiremens relaive o a reference period. (Violaion of he fixed inpus assumpion require a valuaion adjusmen ha approximaes he marginal cos difference beween he curren and reference period inpu requiremens) The minimum framework in secion I and he validaing crieria in secion II may seem obvious, bu appropriae measures of oupu prices for many service indusries are widely recognized as problemaic in he price lieraure. The following review will explore some of he issues ha he PPI has confroned in is assessmen of he deflaion properies of a price index for he oupu of he Invesmen Advice indusry. Invesmen Advice was chosen as a case sudy parly because a reliable secondary daa source was idenified and available o empirically es he robusness of he PPI's chosen price mechanism using he crieria of secion II-a. The crieria in secion II-b, appropriae measures of qualiy change for Invesmen Advice oupu, are more difficul o quanify and es in a brief review and are herefore lef for fuure research. Concepualizing he Price Measuremen Problem The Producer Price Index (PPI) program has included Invesmen Advice (IA) among he indusries slaed for coverage as par is on-going expansion ino he services secor. Muual fund porfolio managemen, he focus of his review, is he mos imporan IA service, accouning for almos 70 percen of indusry revenues. 1 The Invesmen Company Insiue (ICI), an indusry rade associaion, defines he services provided by muual fund porfolio managemen as making invesmen decisions ha are based on exensive knowledge and research of marke condiions and he financial performance of individual companies and specific securiies. As economic condiions change, he manager may adjus he mix of a fund's invesmens o adop a more aggressive or defensive posure o mee is invesmen objecives. 2 1 The U.S. Bureau of Census esimaed oal IA (SIC 6282) revenues in 1997 were $53 billion. The Invesmen Company Insiue esimaed ha, in he same year, muual fund porfolio managemen revenues were $36.5 billion. 2 "Guide o Muual Funds", published by he Invesmen Company Insiue and available on-line a

3 Prior o he publicaion of an IA price index he following concepual measuremen challenges should be resolved: Wha is he correc uni of measure for invesmen advice oupu? Wha is he correc uni of measure for invesmen advice oupu prices? A resoluion of hese quesions is complicaed by an indusry pricing sraegy ha ies invesmen advice revenue o changing porfolio asse values. In oher words, exogenous facors such as a volaile and unpredicable equiy marke have a poenially srong influence on nominal price and revenue change a he esablishmen and indusry level. The Relaionship Beween Muual Funds and Invesmen Advisors Muual funds are owned by shareholders ha elec a board of direcors o oversee operaions and deermine a fund's invesmen goals (described laer). The board of direcors has he responsibiliy of conracing for he services of a separae legal eniy known as an invesmen advisor (also called muual fund manager). 3 Invesmen advisors are paid by muual funds o selec and manage he securiies ha make up a fund's porfolio consisen wih is saed invesmen objecive. Invesmen advisors are currenly conraced by muual funds o manage more han $7.0 rillion in porfolio asses. The advisor's fee is usually he larges muual fund expense and he only one considered in his review. Muual Funds Broadly Defined A muual fund is an invesmen company ha pools money from shareholders o acquire a diversified porfolio of securiies. Muual fund porfolios are srucured o mee saed invesmen objecives ha carry an implied risk profile. Boh invesmen objecives and he mehods used o mee objecives vary according o he ype of fund. The ICI esimaes ha here were more han 8,000 muual funds in he year 2000 ha could be caegorized ino four basic secors. 4 They are lised by order of imporance in able 1. Table 1 Muual Fund Type Asses Under Managemen*. Sock Fund $3.962 rillion (57%) Money Marke Fund $1.845 rillion (26%) Bond Fund $0.808 rillion (12%) Hybrid (sock and bond) Fund $0.349 rillion ( 5%) *From ICI membership survey ha includes approx. 95% of domesic muual fund asses Because four secors are inadequae measures of fund diversiy, he ICI furher disaggregaes muual funds ino invesmen objecive caegories. For insance, sock funds are assigned by ICI o one of 33 caegories deermined by a porfolio's equiy composiion. Examples of several ICI invesmen caegories used o classify sock funds are lised below: Aggressive Growh Funds: Inves primarily in common socks of small companies. Growh Funds: Inves primarily in common socks of well-esablished companies Emerging Marke Funds: Inves primarily in companies based in developing regions of he world. Income-equiy Funds: Inves primarily in companies wih a consisen record of dividend paymens. 3 According o he ICI "Virually every muual fund is exernally managed and hus relies upon ouside businesses o provide services o shareholders." 4 The ICI esimaed he oal number of Open-end muual funds in he U.S. a 8,027 and he oal number of non-u.s. funds a 45,423. Ineresingly, he only counry wih more muual funds han he U.S. is Korea wih 11,677. In erms of asses, U.S. funds were valued a $7.26 rillion as of Sep while non-u.s. funds were valued a $4.88 rillion. 3

4 The ICI s caegorizaion of sock funds are sill somewha general and may be furher refined o describe hose funds ha specialize in narrowly defined secors such as bioech, communicaions, or semiconducors. The proliferaion of invesmen objecives offered by he muual fund indusry coninues o grow o mee he requiremens of individual and insiuional invesors. 5 A fund s invesmen objecive deermines wheher he ype invesmen advice services paid for are acive or passive. An example of a passively managed fund is one wih a porfolio ha duplicaes he securiies underlying a racking or benchmark index such as he S&P 500. As you migh expec, passively managed index funds pay lower invesmen advice fees han acively managed funds. 6 In boh cases, he invesmen advice fee almos always is saed in erms of basis poins or a percenage of porfolio asses: IAFEE = * PV Where IAFEE is he invesmen advice fee, is basis poins and PV is porfolio value. I is he invesmen advice fee ha is of primary ineres o he PPI program. Some Requiremens for a Concepually Correc Price for IA Services In deermining he concepually correc price and subsequen measure of price change for IA services, he PPI's pricing framework mus be considered. The PPI is based on a fixed-inpu oupu price index (FIOPI) model. The FIOPI is designed o compare producer revenues in differen ime periods, holding inpus and echnology consan. In he PPI's Laspeyres formula, inpu requiremens are fixed by he reference period's revenue funcion. Because he PPI canno capure he universe of ransacions ha accoun for an indusry's revenue, individual ransacions are sampled. The preferred price in he PPI framework is one ha reflecs changes in indusry revenues holding inpus fixed. Therefore, one of he limus ess for a concepually "correc" IA price is ha changes in price are proporionae o changes in revenue, resriced by he aforemenioned assumpions of he PPI model. 7 Deermining he correc price for IA services also is dependen on he accurae idenificaion and measuremen of oupu. Implici in his requiremen is an undersanding of he indusry's basic producion process. The inpus ha flow ino he producion process and hen are ransformed o oupu subsanially deermine he naure of he service produced and he ransacion ha he PPI should sample. Many of he inpus provided by invesmen advisors o maximize oupu can be hough of as sof inpus, which include analyical skills and marke, indusry and company knowledge. 8 The relaive quaniies of sof inpus may change over ime as hey are used o develop porfolio sraegies ha bes respond o evens in he markeplace. As for oupu, indusry expers seem o have a consisen general definiion of he oupu services provided by invesmen advisors, which hey describe as creaing a porfolio ha blends differen ypes of socks and bonds o achieve he maximum reurn for a given level of risk. 9 The indusry definiion suggess ha porfolio values may be an appropriae opion for measuring relaive changes in nominal IA oupu. 5 According o ICI, from 1990 o year-end 2000, he number of muual funds grew from 2,900 o 8, Large index funds based on he S&P 500 end o pay porfolio managemen fees of 0.30 percen or less, while i is no unusual for acively managed funds o pay managemen fees of 1 percen or more. 7 The proper adjusmen for qualiy change or even wha consiues invesmen advice qualiy change will no be addressed in his review, bu qualiy change in he FIOPI model occurs only when he fixed inpus requiremen is violaed. Such violaions require an adjusmen equal o he change in marginal cos plus normal markup associaed wih he new inpu requiremens. The valuaion or idenificaion of changing inpu requiremens presen some ineresing concepual challenges for invesmen advice services ha may be explored in a follow-up review. 8 In his conex, maximizing oupu revenues is equivalen o maximizing he porfolio's yield or rae of reurn. This view is consisen wih he indusry pricing pracice of charging fees based on a percenage of porfolio asses. If he fee percenage is sable, nominal revenue for IA services change proporionally wih a porfolio's rae of reurn. 9 Morningsar and he Invesmen Company Insiue offer similar descripions of muual fund advice. 4

5 Availabiliy of Price Daa for IA Services Muual fund advisors generally can provide he PPI program wih he following ypes of informaion: The invesmen advice fee saed in basis poins. The rae of growh in he value of invesed asses over specified ime periods. The porfolio asse value as of specified poins in ime. Differen price relaives can be consruced using his informaion. The mos obvious measures are described in he examples below. Example A: If a change in he nominal price of IA services is defined as a change in basis poins hen a price PR can be saed as: 10 relaive ( ) PR = PR may no, however, capure he complee ransacion price ha he indusry has esablished as a rae imes a value. Because basis poins ofen are saic for exended periods of ime, PR is likely o deviae from he "price" implied by a rae imes a changing value. A recen GAO repor (see references) o Congress saed ha, "The fees ha he advisor and oher service providers deduc from he fund's asses represen he price of he services hey perform." The repor found ha from 1990 o 1998 muual sock fund asses grew 833 percen and muual fund advisor revenues grew 801 percen. Since invesmen advisors explicily price heir services hrough fees saed as a percen of asse values ha change proporionally wih asse growh raes, one can argue ha PR should be adjused for growh raes, as illusraed in example B. Example B. If a change in he nominal price of IA services is defined as he raio of basis poins adjused by he PR can be saed as: growh rae ( ) GR of a reference period porfolio, hen a price relaive ( ) 1 1 PR R = + ( 1 GR ) If he assumpions of he FIOPI model are no violaed, hen i appears ha example B passes he previously menioned limus es, namely, ha he relevan ransacion price is one ha has a proporional relaionship o changes in nominal revenue, holding inpus fixed. Alernaively, an explici valuaion of he advisor's fee could incorporae he acual porfolio values in wo periods as in example C. R Example C. If a change in he nominal price of IA services is defined by he raio of curren and reference period prices deermined by * PV PR could be saed as:, hen a price relaive ( ) V 10 The mos basic index of price change is expressed as a percenage ha shows how he curren price differs from a reference or base period price. The comparison price, c, is divided by he base price, b, o form he raio c b. This raio is he price relaive and a basic index number is obained by muliplying he price relaive by 100. The price change represened by an index number is usually expressed as a percenage change raher han a change in he level of he index as: [(Index c - Index b ) / Index b ] *100. 5

6 PR V PV = PV The asse value of PV includes he porfolio growh rae relaive o PV 1 as in example B, bu does no conrol for inflows or ouflows, which i seems clear should be excluded from measures of price change. 11 Because flows of funds are included, PR V has he undesirable propery of enangling oupu change wih price change. Deflaion Properies for Nominal Measures of IA Price Change The price relaives described in examples A, B and C were consruced from he ypes of daa ha can be provided o he PPI by he IA indusry. Measures of real oupu will differ depending on which measure of price change is used o deflae nominal revenue in he naional accouns. To summarize, hree price relaives ha can be calculaed using informaion readily available from indusry reporers in he PPI s monhly producion environmen are: A raio of basis poins: PR A raio of basis poins adjused by growh in he value of funds invesed a he sar of he period: PR R A raio of basis poins adjused by porfolio growh including inflows and ouflows of funds: 1 1 PR V To illusrae he deflaion properies for each of he price relaives assume ha he services provided by he IA indusry are limied o a single porfolio. Hypoheical daa are presened below o esablish a reference poin for differen measures of IA revenue change. Reference Period (-1) Comparison Period () PV = $ 10, 000, 000 PV = $ 11, 000, 000 = 25 (0.0025%) = 25 (0.0025%) GR = (6%) NFF = $ 400, 000 The reference and comparison period daa are used in example D o consruc price indexes based on he hree measures of price change. Noe ha is unchanged, bu he comparison period porfolio value has grown $1 million due o a growh rae (GR) of 6 percen and a ne flow of funds (NFF) equal o $400,000. Relaive o he reference period value, ne flow of funds may represen new accouns or addiional share purchases from curren shareholders or boh. 12 Example D. I PV = I R = ( 1+ GR) I V = 1 1 1PV 1 = 1.00 = 1.06 = 1.10 Nominal revenue is deflaed by an appropriae price index o esimae a measure of real oupu. Deflaion should answer he quesion, how much of he change in IA revenue, PV 1PV 1, is due o price change and how much, if any, is due o oupu (real) change? The deflaion properies for each of he price indexes are compared in example E. Example E. 11 Relaive o he reference period porfolio, flow of funds represen more or less invesmen advice oupu (new inpu requiremens) depending on wheher he flows are posiive or negaive. 12 Shareholder redempions also influence he ne flow of funds value. 6

7 Reference Period IA Revenue 1PV 1 =$ 10, 000, 000* = $ 25, 000 Comparison Period IA Revenue PV = $ 11, 000, 000* = $ 27, 500 Deflaor C$/Deflaor) = DC$ I = ,500/1.00 = 27,500 I R = ,500/1.06 = 26,000 I V = ,500/1.10 = 25,000 Real Change in Revenue I : DC$-R$=2,500 I R : DC$-R$=1,000 I V : DC$-R$=0 C$=nominal comparison period revenue; DC$=deflaed comparison period revenue; R$=reference period revenue Because is unchanged beween -1 and, he I deflaor reas any change in IA revenue as change in oupu. Conversely, I V reas any change in IA revenue as price change (inflaion). Only I R isolaes oupu change, defined by flow of funds, from price change. This oupu change is measured in he example as a $1,000 increase in revenue ($26,000 - $25,000) which equals he $400,000 flow of funds * 25 basis poins. There may be oher price deflaors ha could isolae changes in invesmen advice oupu bu he range of deflaors included in example E are consruced only from daa ha are direcly available o he PPI program from muual fund invesmen advisors. An Empirical View The choice of I R as he "bes" deflaor in he previous secion was based on he premise ha, a a minimum, he real difference beween invesmen advice revenues in wo periods should be equal o he change in revenue due o ne flows. However, a more rigorous es of he deflaion properies of I R is possible. The es is based on wo daa sources. The firs is an unpublished price index from a PPI sample of IA fees for Money Marke Funds, Bond Funds, Sock Funds and Hybrid Funds. To simplify, only IA fees for sock funds are considered. 13 The second daa source is from an ICI repor ha racks more han 4,300 porfolio values on a monhly basis ha accoun for more han 90 percen of he asses of U.S. based muual sock funds. The ICI repor separaes he dollar value of ne flows (new sales, redempions and ne exchanges), which can be used o esimae changes in he value of IA oupu as described above. Because he PPI's coverage of muual sock fund advisors is based on a relaively small sample, i will be ineresing o see if he deflaion properies of he PPI yield a measure of real revenue ha approximaes he measure implied by he ICI daa. 14 Noe ha any changes in he PPI s sock fund advice index due o he pricing componen mus be excluded from comparisons 13 Limiing he es o sock fund advisors is in some ways more challenging because heir revenues will end o be more volaile due o he relaive volailiy of sock fund asse values. 14 The PPI sample includes 72 muual sock fund advisors. 7

8 R + ). 15 The comparison period exends over a 12-1 monh period ha begins on Jul-00, which corresponds wih he PPI s base dae for he IA index. wih ICI growh raes (recall ha I = ( 1 GR) Table 2: ICI Growh Rae for Muual Sock Fund Porfolio Asses A Reference Period Muual Sock Fund Asses July-00 (billions) B Comparison Period Muual Sock Fund Asses Jul-01 Including Ne Flows (billions) C Comparison Period Muual Sock Fund Ne Flows Jul-00 o Jul-01 (billions) From Muual Fund Facs and Figures, Monhly Asses, Flows and Sales, Table 2 presens daa from ICI ha measures he growh rae of essenially he enire value of muual sock fund asses from Jul-00 o Jul-01, excluding ne flows. This ne growh rae can be esimaed as follows: (B-C)/A or ( )/4244.1= ICI growh raes indicae ha muual sock fund asses fell abou 19 percen during a paricularly volaile period ha saw general declines in mos equiy markes. The ICI daa does no direcly measure he change in invesmen advice revenue or prices during his period, bu if is unchanged, hen an impued invesmen advice price index for sock funds will be proporionally equivalen o he change in sock fund asse growh repored by ICI. Table 3 presens aggregae PPI daa used o consruc he asse growh rae componen of is sock fund advisors index, excluding flow of funds. Table 3: PPI Growh Rae for Muual Sock Fund Porfolio Asses A Reference Period Muual Sock Fund Asses July-00 (billions) B Comparison Period Muual Sock Fund Asses Jul-01 Excludes Ne Flows (billions) Using he same raio as in able 2, he ne growh rae of sock fund asses sampled by he PPI can be saed as: B/A or 789.1/979.3= The PPI measure indicaes ha sock fund asse values fell abou 20 percen compared o he ICI measure of 19 percen. 16 While boh he ICI and PPI exhibi significan declines, he PPI measure declines more rapidly. Par of he difference beween PPI and ICI growh raes is ha ICI surveys over 90 percen of muual sock funds wih reference period asse values of more han $4 rillion, while he PPI sample included funds wih reference period asses of only $980 billion. However, anoher and perhaps more imporan facor is ha he ICI flow of funds does no conrol for he enry of new funds. In he reference period he ICI survey included 4,134 sock funds, bu in he comparison period he number of funds had grown o 4,644. The 12 percen growh in funds, which represen new enrans (wih relaively small asse values) relaive o he reference period, a leas parly conribues o he slower negaive growh rae of he ICI relaive o he PPI. Summary 15 The PPI requesed each muual fund advisor o repor changes in and calculae he growh rae for a reference period porfolio excluding ne flows. The growh rae calculaion is similar o how muual funds repor performance measures in heir prospecus. 16 The PPI for sock fund advisors acually declined o during his ime period due o a small increase (1.59 percen) in he componen of he pricing formula. The average weighed in he reference period was approximaely 51. 8

9 The PPI sraegy for consrucing price indexes for muual fund advisors explicily recognizes he indusry pracice of pricing services based on a rae imes a porfolio value. One of he benefis of his sraegy is ha nominal flucuaions in equiy markes are no ransmied o he naional accouns as changes in real oupu. 17 While a cerain amoun of ambiguiy remains, which should be expeced when comparisons are made beween differen daa ses, he ICI and PPI daa are so close, i appears ha he PPI has been able o effecively operaionalize he indusry pricing mechanism of I R = ( 1+ GR). In so doing, he PPI has also me he indusry revenue-pricing mechanism finess 1 of use crieria described in he opening secion. However, I R does no direcly address he concepually difficul issue of idenifying and measuring qualiy change in IA oupu. Qualiy change measures for invesmen advice will have o a leas consider he implicaions of he efficien markes heory or even more specifically he concep of qualiy change in he conex of Malkiel's (1999) updaed release of "Random Walk Down Wall Sree". A search for he mos appropriae mehodology ha quanifies invesmen advice qualiy change in a FIOPI framework may be explored in a follow-up paper. 17 Naional income accounans would likely consider he ransmial of he ofen volaile swings in equiy markes o changes in real oupu as inappropriae. A deflaor based on I R removes his volailiy, while sill allowing ne flows o ener he naional accouns as changes in real oupu. 9

10 References Chan, L., e al, "The Level and Persisence of Growh Raes", May 2001, Working paper #8282 Naional Bureau of Economic Research, Cambridge, MA. Collins, S., "Muual Fund Asses and Flows in 2000", February 2001, Invesmen Company Insiue Perspecive, Vol. 7/No. 2. Malkiel, B., "A Random Walk Down Wall Sree", 1999, Pub. W.W. Noron & Company. McCool, T., e al, "Muual Fund Fees: Addiional Disclosure Could Encourage Price Compeiion", July 2000, Repor prepared by he GAO for he Commerce Commiee of he U.S. House of Represenaives. Rea, J., Reid, B., Millar, K., "Operaing Expense Raios, Asses, and Economies of Scale in Equiy Muual Funds", December 1999, Invesmen Company Insiue Perspecive, Vol. 5/No. 5. Rea, J., Reid, B., "Trends in he Ownership Cos of Equiy Muual Funds", November 1998, Invesmen Company Insiue Perspecive, Vol. 4/No