LETTERS TO THE EDITOR

"The Diversification Puzzie": A Comment

I think the article by Meir Statman in the July/ August 2004 issue is one of the best articles of that sort I've ever read. I've spent the past 21 years advising individual investors, and many of the wealthiest are real estate entrepreneurs. Sometimes, they are not well-educated people, but they have excellent "heads for business." With that sort of investor, I almost always find myself holding them back from making "irrational" investments of too much money in one stock, which they often view as similar to one building or one shopping center. (I assume that method is how they have invested in real estate. So, if you were to include attitudes framed by commercial real estate in your study of investor attitudes, the lack of diversification might be even more pronounced than you fotmd.) The article was extremely helpful in indicating a way to help such investors make intelligent decisions about risk and return. An Interested Reader
"Stock Options and the Lying Liars Who Don't Want to Expense Them": A Comment

In response to the article by Clifford Asness in the July/August 2004 issue, I agree with Mr. Asness that stock options should be expensed. But I disagree with his rationale, which appears to echo that of the Financial Accounting Standards Board. The FASB reasoning contains two flaws. The first is the assumption that employee options are a form of equity. The second derives from the first. The FASB wants to expense the cost of employee options as though the company were giving away free equity. Employee options are not truly equity as understood in the market, so the hypothetical example that Mr. Asness uses is misleading. He infers that if Company A were to buy at-the-money options in the market and give them to employees, the cash result would be equivalent to issuing the options directly to employees. Any company manager foolish enough to follow Company A's example, however, should be promptly fired. Traded options are not equal in value to employee options because the employees are restricted from spending them and if the employees change jobs before their options vest, they must forfeit the options. If Company A were to offer the employees a choice between 100 restricted employee options or cash equal to the cost of buying 100 traded options in Company A's stock, most astute employees
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would choose cash. They could pocket the cash or buy their options in the market and receive the same capital gains as those employees who chose to accept employee options. In addition, they could cash out whenever they wanted. If employees chose to pocket the cash now, of what value was the transaction to the company? The company paid and got nothing in return. The purpose of restricted employee options is not to pay an employee an extra bonus for doing nothing; it is to keep valuable employees from wandering off to work for competitors and to provide an incentive for employees to work harder to increase the company's share value. Therefore, employee options are not market equity instruments; they are employee incentive contracts. How, then, should employee options be expensed? Consider this example: Company A has one incentive plan that issues employee options priced at the market when granted and vested at the end of four years, at which time, they must be exercised or they expire. When the options are exercised, the company buys the equivalent number of shares in the market. The cash cost of the options is the difference between the option grant price and the market price at the time shares are issued to the employee and equivalent shares are purchased in the market. A second incentive plan ties a cash bonus to the gain in Company A's share price over the next four years. The plans result in identical cash costs to the company and have no impact on the number of shares outstanding. Under current accounting rules, the expense for the bonus plan is charged in the year the bonus is paid but because the FASB treats employee options as equity instruments, the cost of the stock option plan is expensed when the plan is initiated^based on a probability estimate of the future value of the options and with no future income adjustment if the charge doesn't match the actual expense. Either the actual cost should be charged when incurred, as in the case of the cash bonus, or the estimated cost should be treated as a contingent liability. As a contingent liability, the estimated cost could be charged at the time the incentive plan is initiated and then marked to market as the exercise date approached. HoUister B. Sykes
Formerly Adjunct Professor of Management New York University Cranford, New Jersey
2004, CFA Institute

Financial Analysts Journal

"Stock Options and the Lying Liars Who Don't Want to Expense Them": Author's Response

In my article, I intentionally tried to stay clear of the precise issues regarding how to account for the expensing of stock options. Rather, I decided to fight the most important battlethat they are an expense. This battle still has not been won, and in it, Hollister Sykes and I are allies. I did not endorse any particular approach to expensing, including that of the Financial Accounting Standards Board (and the idea that options are equity is certainly not my "rationale" for expensing them; rather, my rationale is that they have value). In addition, in my notesNote 4 and especially Note 7I raised the issues that concern Mr. Sykes by explicitly saying that the idea that options should not be expensed entirely in the year issued is "very reasonable" without further caveat. Thus, Mr. Sykes raises interesting points, but we do not disagree on much. I do think that, together, we have created yet another excellent example of why important informationin this case, my view on multiyear expensingshould not be relegated to a footnote. I wish the technology lobby agreed. Clifford S. Asness AQR Capital Management, LLC New York City
"Stock Options and the Lying Liars Who Don't Want to Expense Them": A Comment

not truly brand all who disagree with me on this issue liars! The title is meant to be somewhat whimsical . . . ." The title is a play on the title of Al Franken's book Lies and the Lying Liars Who Tell Them. Suffice it to say, the Editor of the FA] and CFA Institute are on record as mirroring Mr. Asness's perspective that stock options are an expense. No offense was intended in our decision to publish this articleexcept perhaps to those who seek personal gain through a refusal to expense stock options! Robert D. Arnott
"Stock Options and the Lying Liars Who Don't Want to Expense Them": A Comment

1 was greatly surprised by the tone of the recent piece by Clifford Asness Quly/August 2004) in such a highly esteemed publication as the Financial Analysts Journal. Disagreement on positions of importance to the public and financial/investment community is common, and indeed, intellectual debate on such issues is desirable. But to imply that those who disagree with one are liars is insulting and inappropriate in fostering debate. Robert A. Olstein Olstein & Associates, L.P. Purchase, New York
"Stock Options and the Lying Liars Who Don't Want to Expense Them": Editor's Response

Clifford Asness's article on management stock options certainly triggered a response. As the letters in this issue suggest, this topic is as polarizing in this narrow context as the recent election. I'd like to point out to Robert Olstein, and anyone else who was offended by the piece's tone, that Mr. Asness's Note 2 did offer a caution that he was being deliberately provocativeespecially in his chosen title! The note reads, "Before anyone gets too worked up, I would
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Cliff Asness's article 0uly/August 2004) was a simply spectacular piece of analysis. He gave the arguments put forth by options' apologists exactly the respect they deserveand then demolished them with dispatch and humor. It made me sorry, for the first time ever, that I hadn't taken the FA} with me to the beach. Now, if only members of the U.S. Congress would read i t . . . I have one tiny quibble. Mr. Asness was too diffident in leading off his piece by asking, "Why this essay when the arguments in favor of expensing options are so clear-cut and obvious?" As the decision on 13 October by the Financial Accounting Standards Board to delay implementation of its options expensing rules until June makes all too clear, the lying liars who have been fighting tooth and nail for more than a decade for their "right" to hide a big slug of labor costs in the footnotes to their financial statements have no intention of taking "no" for an answer. The spineless caving to political pressure against options expensing back in 1994 by the accounting standard setters played no small role in facilitating the culture of corporate greed that spawned the debacles at Enron Corporation, WorldCom, and others. Now we are asked to believe that in delaying implementation of their new standard to the third quarter from the first, they are merely acquiescing to the U.S. SEC request to give companies and accountants time to adjust to truth telling about the cost of options compensation. But make no mistake about it, the SEC's knees got weak because it was flooded with letters from senators suddenly worried that their corporate patrons are too stressed out right now from complying with the demands of the Sarbanes-Oxley Act of 2002 (to "tell the truth") to also fess up to shareholders about their real compensation costs. Give me a break. The forces of obfuscation use exceedingly clever, not to mention well-heeled, lobbyists. In July 2004, the U.S. House of Representatives passed a bill (by a lopsided margin) that
2004, CFA Institute

Letters to the Editor

would override the FASB on options expensing. Only the U.S. Senate's refusalled by Peter Fitzgerald (R, IL) and bolstered by Banking Committee Chairman Richard C. Shelby (R, AL)to allow the bill to the floor thwarted their aims. The FASB's delay buys time for the forces of untruth to revive the issue in the next Congresswhen Senator Fitzgerald will have retired and the Banking Committee may be chaired by another. The issue in this case really is as stark as Mr. Asness put it at the end of his wonderful diatribe: "If expensing options is ultimately not required, we will have knowingly chosen a falsehood over truth and done so in the most callously public fashion after much debate, hand-wringing, and lobbying. That would be bad. Options are the canary in our coalmine. If the canary dies, watch out." The canary is now on the critical list. Political ill winds are again blowing, and Congress could easily veer into declaring that 2 - 2 = 22. If shareholders, bondholders, financial analysts, and other users of financial statements don't find a way to lend some spine to the accounting profession well, they'll deserve what they get: financial fiction.
Kathryn M. Welling Welling@Weeden Greenwich, Connecticut "Are Professional Traders Too Slow to Realize Their Losses?": A Comment

of internal accounting systems on the results of their analysis. Most financial institutions today account for their period-to-period profits by using the mark-to-market convention. If the boss has booked a trade's profits for any perioda day, a month, a yearhe or she is unlikely to want to record a loss in the next period, even if this loss represents simply an unrealized decline from the previous peak. This practice may discourage following a "let your profits ride" trading strategy, which gamblers maintain optimizes profits by holding on to winners. The distribution curve of a gambler's trades will be asymmetrical, with a long right-hand tail. The trading firms' reluctance to carry trades over the end of reporting periods cuts off the profitable side of the tail. Marking to market probably does not affect the other side of this trading dictum, which is "cut your losses early." The result of this "what have you done for me lately" syndrome, however, may be to cut long-held winners out of the set of observations available to Professors Garvey and Murphy. Depending on how they manipulated the data, the proportion of losing trades, therefore, may have been increased relative to what they expected. From the point of view of the financial institutions that mark to market, winners and losers may be getting more equal airtime than optimal trading strategies would suggest.
Robert F. Richards, CFA President Heathbridge Capital Management Ltd. Toronto, Ontario

With respect to the article by Ryan Garvey and Anthony Murphy (July/August 2004), I suggest that the authors might want to explore the influence

The vieios expressed in Letters to the Editor are those of the letter authors, not of CFA Institute or the Financial Analysts Journal.

ERRATA
In "Value at Risk and Expected Stock Returns" by Turan G. Bali and Nusret Cakici in the March/April 2004 issue of the FAJ, the definition of the preranking beta (following the equation at the top of p. 58) is incorrect. It should be "... P;^ ; + P2 ; is the preranking beta for stock;'...." We apologize to the authors for this error and regret the inconvenience to readers. A corrected version of the article may be found online at cfapubs.org/faj/past.html.

November/December 2004

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