Distinguished Speaker Series: Mario Gabelli, CFA, GAMCO Investors Inc.

Well known value investor Mario Gabelli, CFA, chairman and chief executive officer of GAMCO Investors Inc. and LICT Corp., addressed a capacity audience of CFA Society Chicago members and their guests at the Standard Club on September 14th. In a wide-ranging presentation, Gabelli drew on his four decades as a money manager to offer his insight and wisdom on the current state of the economy and investment markets. He began by extoling the virtues of a CFA Charter, pointing out that only through the detailed analysis of a charterholder could one understand a business well enough to see how it fits into the economy and how to value it correctly. He encouraged everyone to “keep doing what you are doing” to help our country and make capital markets work even better.

Gabelli touched briefly on two topics he believes need regulatory change. The first was ETFs and the advantage they have over mutual funds because of their tax-efficiency.

He strongly advocated for leveling the playing field with an end to the requirement that mutual funds distribute realized capital gains annually, thereby creating a taxable liability for investors even though they have made no transaction. Every other type of investment requires a sale to generate a capital gain, and mutual fund shares ought to be treated the same.

Second, on tax reform, he said Congress needs to cut the corporate income tax rate to make American firms more competitive with foreign ones.  The protracted debate is only serving to delay new investment that our economy badly needs.

Without going into great detail, Gabelli listed several sectors that he thinks currently offer attractive investment opportunities, including:

  • Infrastructure: Although this is on the top of many favored lists, he pointed out that the American Society of Civil Engineers rates infrastructure in the U. S. as D+, which will require new investment regardless of the political environment.
  • Health and Wellness: Drawing on the trend of an aging population, he recommended investments in vision and hearing care, joint replacement, and obesity treatment.
  • Live entertainment: Gabelli described this as being immune to competition from Amazon (or, more generally, the internet). Noting the high valuations put on sports teams in private transactions, he has calculated that a sum-of-the-parts analysis on Madison Square Garden Entertainment yields a value of zero for the New York Knicks.
  • Equipment rental: A secondary play on infrastructure, but one that he expects to do well even without that tailwind.

Four Tips to Launch a Successful Finance Career

If you’re just beginning your career in finance, you might feel your career path is defined; head down, work hard, and eventually the real career choices will present themselves down the road. This is of course true to an extent – the finance industry certainly demands earning your stripes – but that doesn’t mean you can’t begin opening up doors during those early years.

You may already be studying for the CFA exams, which is an important milestone in the career of most investment professional’s careers. As you navigate the roughly four years that it takes to complete the three levels of the CFA Program, it’s important to do whatever you can to make these as meaningful as possible.

These tips should help you do just that:

Read, and read ravenously.

Read everything in our field that you can get your hands on (including and beyond the CFA curriculum). Try to read broadly across topics and disciplines; for example, if you’re in equities, take time to learn about credit or commodities to make yourself more well-rounded. Ask people you meet what they read and what they enjoyed learning.

An incredible array of opportunities exist in finance, and the more areas and disciplines you know the more opportunities you’ll have. The most successful people spend a good portion of their day devouring information, asking questions and listening.

Avoid networking at your own peril. (And put the phone away).

Not everyone is an extrovert, and that’s okay. Everyone, though, can benefit from the opportunities made through networking, whether for friendship, commerce or career.

You’ve been reading (you have been reading, right?), so you have strong points of view and pointed questions to ask. Put the phone away, be confident and ask smart questions. Most folks love the opportunity to explain what they do, and they will see you as someone willing to take initiative if you initiate a good conversation.

Don’t procrastinate getting an advanced credential.

I think you need at least one advanced credential (if not two) to compete in today’s job market. Both a CFA charter and MBA are highly useful for financial professionals, so avoid a long, protracted process on deciding which one to get. The earlier you begin the process, the higher the lifetime dividend.

In my case, I immediately plunged into the CFA curriculum just a year into my career, and that gave me a big boost. It helped me interview for jobs that I would never have the opportunity to land otherwise. I strongly believe having a CFA charter in your 20s or early 30s will offer more career optionality down the line.

Listen to yourself.

In those first few years, keep a keen eye out for moments where you feel in the flow, or when you are the happiest during your job. Ask yourself what were you doing during those moments and what about that project or job aspect you really liked. How can you structure your future career to include more of those types of situations?

I’d also suggest taking time to reflect on what you want out of a career. While having money and a challenging, important job is great, many folks find that they are happier with more of a work-life balance, and understanding how much of each aspect you need to make yourself happy is key.

So, hit those books! And remember to keep these tips in mind – when that door does open for you, you’ll be poised to take full advantage of the opportunity.

Distinguished Speaker Series: Jean-Marie Eveillard, First Eagle Funds

Value investing makes sense; it works over time, so how come there are so few of us?

On August 9th, CFA Society Chicago welcomed Jean-Marie Eveillard, senior investment adviser to First Eagle Funds, at the Chicago Club. The famed investor behind $110 billion First Eagle Investment Management has long believed that value investing can be a lonely place.

The septuagenarian still follows the advice of Warren Buffet and his predecessor Benjamin Graham. “The best book on investing ever written is [Ben Graham’s book] Intelligent Investor,” he said. Despite the sustained popularity of those pioneers today, pure value investing is becoming increasingly rare, Eveillard said.

Value investors must shun the wisdom of the crowds, and more importantly, they must be right. Sometimes value investing is fashionable, oftentimes it is not. Eveillard estimates that only 5% of the investment industry practices value investing. The limited embrace of a value tilt is partially due to the career risk portfolio managers face when choosing out-of-favor stocks. Sometimes investing in these stocks may take years for an investment thesis to play out, and asset owners are frequently less patient. The fear of losing a job causes herding into more socially acceptable stocks, and this dynamic makes it very hard for an investor to commit to value. This often tilts mutual funds towards becoming “closet indexers”, said Eveillard.

Eveillard discussed how he uses both qualitative and quantitative in his process. As a value investor, he marches to the beat of his own drum, eschewing the tactics used by marketing-focused money managers.

Jean-Marie Eveillard, First Eagle Funds

“I never spent a penny on advertising,” said Eveillard, contrasting his near singular approach to investing to more commercially-minded mutual fund companies. In his talk, which connected his years working in the industry with the thinkers that most influenced him, one area mentioned was the Austrian school of economics, particularly its 1974 Nobel Prize winner Von Hayek. Margin of safety was also mentioned, with Eveillard saying that it was the secret of strong investors.

Interestingly, Eveillard reckoned that a great deal of his success as a portfolio manager didn’t come from the stocks he picked; it came from what he didn’t own. Eveillard cited a number of examples such as Japanese stocks in the late 1980s, tech stocks in the late 90s, both of which he avoided. Eveillard was asked if he thought there is currently a bubble reminiscent of the late 1990s in today’s tech stocks, and Eveillard opined that today isn’t as bad as the dotcom bust era defined by the epic failures of Webvan and Pets.com.

Covering his use of qualitative data, Eveillard told a story about Enron, saying that he asked a research analyst on his team to look into the firm for a possible investment. The analyst found Enron’s statement footnotes incomprehensible, to which Eveillard responded that if that was the case, they’d move onto something else and wouldn’t invest.

Eveillard noted that so many of the numbers you see in accounting estimates are estimates. He said that in the late 1990s, he would often spot crafty CFOs who would observe the letter of the regulation, but not necessarily the spirit. In some ways, Eveillard said, accounting is more a reflection of a cultural mindset, with more conservative, risk-averse cultures taking earnings provisions on potentially low risk items. A good international investor needs to be mindful of the cultural differences in preparing accounting statements.

On the Efficient Market Hypothesis, Eveillard said that “it denies human nature.” He’d often debate the EMH with his academic friends and they would say that although they might agree, they needed to find a new theory before abandoning an old theory.

He mentioned the topic of moat, a means of ensuring that a company has a long run sustainable advantage. One reason that Warren Buffet rarely sells stocks is because it is hard to find companies with sustainable advantages, and once one is identified, an investor simply needs to be patient.

Given the strong outperformance of growth vs value stocks in the US over the past decade and the dearth of dedicated value investors, a change in investor mindset might be needed before value investing returns to vogue. But patient investors such as Jean-Marie Eveillard will be willing to wait it out.

Distinguished Speaker Series: Brian Singer, CFA, William Blair

CFA Society Chicago hosted Brain Singer, CFA, on July 19, 2017 at The Standard Club to present on the topic – Riding the Waves: Dynamic Asset Allocation (DAA) and Evolution of Top-Down Investing.

Singer is the head of the Dynamic Allocation Strategies team and a portfolio manager at William Blair where he shares responsibility for strategy setting and portfolio construction across all DAS portfolios. He serves on the endowment investment committee for Exeter College at Oxford University and on Rehabilitation Institute of Chicago Foundation’s board. He is also the chairman of the “Free to Choose Network.”

In 2015, Singer received CFA Institute’s Distinguished Service Award and has formerly served as a board member and chair of the CFA Institute board of governors. He has written extensively on global portfolio, currency, and performance issues. In 2015, he was also inducted into the Performance and Risk Management Hall of Fame by The Spaulding Group.

While the hot debate of traditional active vs. passive consumes most talks in the investment industry, Singer focused on the other leg of liquid investment strategies, Liquid Alternative Investing. He focused his presentation on the following four broad strategies:

  • Risk Parity;
  • Smart Beta;
  • Risk Premia; and
  • Active currency.

Quest for a superior investment strategy has given birth to many new ideas and terms that have changed the investment landscape as it was known two decades ago. After the advent of efficient market hypothesis and rise of CAPM, we now live in the world of smart beta and where CAPM is seen as dead by many. However, Singer believes CAPM is not all that dead. He advised to consider long-term horizons rather than the short-term when evaluating the relevance of CAPM as his initial remarks. He expressed how Modern Portfolio Theory post financial crisis has been seen as wounded where risks are known to be non-static and non-symmetric and that tail size does matter. He recommends focusing on the Macro investing models with dynamic allocation strategies for dealing with systematic risks in line with return expectations.

He re-iterated validity of CAPM while discussing risk parity strategies from a passive (35% Global Equity – 65% Global Fixed Income) and an active (traditional asset allocation) standpoint.

He also presented how the understanding of betas and alpha in the pre and post CAPM world has changed. In the advent of Smart Beta – Systematized Alpha, he cautioned against considering it as a free lunch and discussed smart beta strategies. He noted that such strategies aim at exploiting “Persistent” systematic risks following an auto-pilot strategy. He also cautioned against them as being static in nature relying on back tested rule sets. Further along in the presentation, he explained how such narrow rule sets can bring about volatility and fragility in the investment process and later provided recommendations to overcome such issues.

While discussing the risk premia strategy, Singer stressed on macro diversification based on fundamentals with a long term focus. For the short term, he advised to utilize unique rule set disciplines to navigate a dynamic path and ignore the media ripples which tend to make investment management process more fragile. He explained differing strategies using an example of a village at the foot of a mountain facing the risk of an avalanche taking extreme actions such as complete evacuation of the area vs. building fences to contain the snow to tackle the risk. He discussed different strategies to cope with risks faced in the investment world based on narrow vs. broad rule sets and impact of such rule sets on the overall investment process and asset allocation.

The speaker also spent a fair amount of time to share the active currency investment strategy. Despite not being an asset class, Singer explained that active currency investment is an effective alternative investment strategy as correlation of passive and active currency with assets is very low. He noted that currencies tend to converge to equilibrium prices (using PPP and IRP) faster (average of ~4-5 years) compared to assets (average of ~8-10 years). He presented varying half-life of currencies and asset classes along with correlation of USD index with monthly MSCI returns being as low as 30%.

He shared his Antifragile Investment Process methodology consisting of identifying and assessing opportunities of value to price discrepancies and designing portfolios with integrated risk exposures. He noted that such investment processes are dynamic, imperfect, progressive and make use of evolving tool set stating it to be analogous to growth of a living organism.

Singer also shared the idea of forming an Antifragile Investment Team for which “cognitive diversity” is key as he believes such team resources back multiple ideas using “wisdom-of-crowd framework” for survival. Such teams work continually to Research, Implement, Perform and Review numerous ideas as opposed to fragile teams which resources back few ideas that cannot afford dismissal.

He concluded by making a recommendation to identify market inefficiencies as dynamic investment opportunities stating: “There needs to be a level of market inefficiency to have market efficiency”. He again stressed on following wider rule sets for asset allocation decisions for a less fragile investment process.

At the end of the presentation he commented on the following questions from the audience:

Big Geo-Political risks to consider

  1. Domestic to US – Impact of proposed regulatory changes to Volcker Rule which may cause tail risk.
  2. International – Follow European Union market especially outcomes of the Italian Election and monitor the risk of national banks going bankrupt.

How to tackle Behavioral Risk?

  1. Incorporate it in Risk Premium.
  2. Since behaviors cannot be predicted, focus on identifying significant behavioral shifts – both frequency and magnitude of signature behavioral shifts.

Near term opportunities in Active Currency

  1. Short on Developed market currencies including USD (currently expensive).
  2. Long on Emerging market currencies.

The Active vs. Passive Debate

 

 

 

 

 

 

 

 

 

 

 

 

On Tuesday, June 13, approximately 400 people gathered at the Standard Club to attend CFA Society Chicago’s forum on trends, insights and case studies about active vs. passive investment strategies. An additional 200 joined the event via webcast. All of the participants agreed that the terms active and passive represent a spectrum. Nat Kellog, CFA, director of research at Marquette Associates, moderated the first debate.

 TRENDS & INSIGHTS

Joel Dickson, Ph.D., global head of investment research and development with Vanguard, began the conversation by stating Vanguard’s objective to generate market performance at the lowest cost. He noted that if one group has a persistent information advantage than another must be disadvantaged because the aggregate investment results represent a zero sum game. The discussion then focused on whether or not empirical data suggests that the winners can be identified in advance.

Brett Hammond, research leader at the Capital Group stated the firm’s strategy of increasing the number of analyst visits with company management to make superior qualitative decisions about business strategy and execution. Hammond estimated that 1,600 domestic mutual funds employ a factor based approach to quantitatively structuring portfolios. He notes that these strategies represent a form of active management. He also believes that they create opportunities for investment management firms with a long term perspective and superior fundamental analysis.

Aye Soe, CFA, managing director, Global Research & Design at S&P Dow Jones Indices, noted that Paul Samuelson’s 1974 article Challenge to Judgement, promoted the idea of a portfolio that tracks the S&P 500.

Since then, indexes and index funds have evolved to tilt toward factors in an attempt to enhance returns. This evolution moves the objective from market returns to alpha, which is the goal of active management. Soe suggested that the nature of the bond market and bench mark indexes provide more opportunity for deviations (i.e. exclude Treasury bonds) from the market to enhance returns.

The conversation addressed the impact of the rise of index funds on the price discovery role of the securities markets. The Bernstein article- Why Passive Investing is Worse than Marxism may overstate the impact. Although index funds now own approximately 25% of US equity capitalization, they only represent about 5% of trading.

KEYNOTE INTERVIEW

Bob Litterman then interviewed Eugene F. Fama, 2013 Nobel laureate in economic sciences and Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business, to learn about the evolution of his thoughts over the past 50 years. Dr. Fama drew a distinction between active and passive approaches to factor tilts in portfolios. An attempt to time factor premiums or add an additional level of analysis produces an active approach.

Fama acknowledged the impact of micro-cap stocks noted in a May 2017 paper titled Replicating Anomalies. This paper concludes that the excess returns identified for most factor based strategies disappears when you adjust for the outsized impact of extremely small companies. Fama emphasized the need to adjust for this impact, a sound basis in financial economics and persistency in the results across markets and time. He noted the robustness of the value factor and the more limited effect of the size factor on portfolio returns. Momentum represents a factor that is evident in the data, but hard to exploit because of the extreme overweight required in illiquid, micro-cap stocks. Fama noted that momentum represents “the biggest embarrassment to the efficient market hypothesis” because it does not fit well into financial theory.

One trend identified over the past 50 years is the growth in the study of financial economics. In the 1960s, MIT and the University of Chicago dominated this area of study. Now, every major university devotes resources to data analysis for market anomalies.

Firms like Dimensional Fund Advisors and Vanguard devote substantial resources to fulfill their corporate governance responsibilities as shareholders. The firms also employ sophisticated trading strategies to obtain best execution. Fama noted that active managers who add value deserve to earn a return on their human capital. As a result, the excess return generally flows to the manager, not the investor in the fund.

The conversation concluded with comments about the future direction of the investment advisory industry. The movement from investment managers to financial advisors to wealth management may move the compensation model from a percentage of assets under management to an hourly or fee for service basis. The growth of “robo advisors” may create another tool for wealth managers to serve clients, versus a replacement for the advisor. The role of the advisor may shift toward a focus on the distribution of possible outcomes and the incorporation of uncertainty in financial plans.

CASE STUDIES

Lisa Haag, CFA, director of investment strategy with The Boeing Company, presented the case for active management of defined benefit and defined contribution retirement plan assets. The Boeing Company’s defined benefit plan has 25% of its assets invested in publicly traded equities with only 5% employing passive strategies. The remainder of the plan’s assets is invested in long duration bonds and alternative investments.

Jason Laurie, CFA, of Altair works with near 300 high net worth family groups. Passive strategies represent 10% to 15% of assets. Laurie noted the firm’s size provides them with the opportunity to negotiate low fees for clients. He emphasized the importance of patience with active managers by noting that over 90% of top managers periodically experience one to three years of sub-par performance.

Marc Levinson, chair of the Illinois State Board of Investments, outlined the transition from active management toward passive management of the State’s pension assets since September 2015. The $4 billion of defined contribution assets moved from 75% active to all passive. The $17 billion defined benefit assets moved to 70% passive. The state moved from near 100 managers to less than 20. Levinson lead the Board from the political nature of “who are you going to replace my guy with” to a market approach that did not require hiring a manager with a sponsor.

In conclusion, two of the three entities continue a commitment to selecting managers who can beat the market after fees. In contrast, two of the first three panelists and Fama presented a case that the financial markets efficient from a beat the market after fees perspective. The debate goes on.

Big Ideas: Evolving Trends and Skills on the Minds of Investment Professionals

What is happening to the investment industry? Where are we heading? How can I keep up? And, more often, how can I stay ahead of the curve? I attended more than 100 events for CFA Society Chicago in the last year, and nearly every time I find that small talk between CFA charterholders quickly turns to big ideas such as these.

We’re an analytical group, so it comes as no surprise to me that most of our members already understand that the investment industry is rife with change. Many already feel it in their daily work. And as I move between conversations and events, I know that no professional is more prepared for the future than a charterholder.

Take technology, for example. Blockchain, robo-advisors, high-speed trading, you name it; it’s impossible to deny their growing presence in our industry. These forces, along with the emergence of passive investments and ETFs, have put downward pressure on fees. This is great for investors as they will be able to gain more from their investments. However, these forces also put downward pressure on investment companies’ revenues. This leads to an arms race to collect assets, increase use of collective investments (as individual stock analysis is expensive), and ramp up technological investments.

Technical competence is essential to help investors navigate this rapidly changing environment. Starting in 2019, the CFA program curriculum will contain questions on data mining in order to keep this technical edge sharp. For future years, CFA Institute is even considering artificial intelligence questions. At CFA Society Chicago, we have and continue to explore these topics for professional development sessions that keep our members up to speed.

However, technical competence is not enough. As the needs of investors and the nature of investment practice change, ‘soft skills’ are becoming just as essential. Skillful client communication and presentation, brand building, networking, leadership, and improvisation are often needed to provide maximum value to clients. CFA Society Chicago members have already begun taking advantage of the new soft skill workshop developed by our Professional Development Advisory Group.

Ethics, though, will be the skill that will keep us on the right track. Confidence in our profession can only be built through a commitment to a high standard of ethics and embracing rules that protect the rights of investors. Charterholders already lead this charge. Charterholders are already rigorously trained in ethics and embrace the Statement of Investor Rights as drafted by CFA Institute. Furthermore, CFA Institute is a staunch advocate of a universal fiduciary standard.

Whether technical, “soft,” or ethical, every challenge our members see presents an opportunity to demonstrate their skills to meet them – some new, and some old. It’s just another chance for charterholders to prove their value.

Annual Business Meeting and Networking Reception

Members gathered for the annual business meeting of the CFA Society Chicago on June 15th at the Wyndham Grand Riverfront Chicago. Held in the hotel’s 39th floor penthouse lounge, the event offered grand views of the intersection of the Chicago River and Michigan Avenue as well as the buildings—both old and new—in the area.

Shannon Curley, CFA, CEO of the Society, kicked off the business part of the event by recognizing the society’s staff and board, as well as Advisory Group co-chairs for their contributions during the past year.  He noted that their efforts make our chapter the vibrant society that it is. He turned the mic over to Doug Jackman, CFA, out-going chairman, who summarized the highlights of the past year. Membership has increased to over 4,600 making the Chicago society the sixth largest in the world, and–as the oldest in the world–we rank as a leader within CFA Institute.

156CFA Society Chicago sponsored 150 events in the fiscal year with one of the most successful ones being the just completed Active vs. Passive Debate featuring Nobel Laureate, Eugene Fama. Jackman emphasized that the focus of programming has been (and will continue to be) education and advocacy of financial literacy. A few of the prominent names who presented at chapter events in the past year include Charles Evans (President, Federal Reserve Bank of Chicago), David Kelly, CFA (JP Morgan), T. Bondurant French, CFA (Adams Street Partners), Liz Ann Sonders (Charles Schwab), and Dan Clifton (Strategas). The new Vault Series brought in industry experts to address special topics. The first speakers included Melissa Brown (Axioma), David Ranson (HCWE & Co.), and Doug Ramsey (Leuthold). Jackman also recognized the work of the Professional Development Advisory Group in producing numerous events to help our membership enhance “soft-skills”.

123Secretary/Treasurer Tom Digenan, CFA (now vice chair of the Society) presented the financial update highlighted by a $100,000 operating surplus (thanks to strong attendance at the Distinguished Speaker Series lunches and the Annual Dinner) and a $200,000 capital gain in reserves leaving them at 16 months of coverage (vs. a target of 13 months).

Jackman next presented the slate of officers for fiscal 2018 including Marie Winters, CFA, as chairman, Tom Digenan, CFA, as vice chair, and Tanya Williams, CFA, as secretary/treasurer. In addition three new Class C Directors were nominated for three year terms and four new Class E Directors were nominated for one year terms. All candidates were approved by a “show-of-hands” vote.

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Jackman then recognized out-going board members Kerry Jordan, CFA, Chris Mier, CFA, Maura Murrihy, CFA, Mark Schmid, and Lyndon Taylor as well as nine departing co-chairs of advisory groups. Curley similarly recognized Doug Jackman, CFA, for his service as board chairman including reinvigorating the relationship between our society and the University of Chicago and for obtaining funding from the CFA Institute that allowed us to bring in notable speakers like Eugene Fama and Tom Ricketts, CFA.

Finally, incoming chairman Marie Winters, CFA, looked to the future, describing her hopes to build on our past successes in the areas of employer engagement, volunteerism, and the challenges presented by technology and new regulations. Winters also pointed to improving gender diversity as a focus of attention, noting that it is surprisingly poor (just 13% of our members are women) for an industry built on a foundation of diversification.

With the business part of the meeting completed, attendees moved to the outdoor patio to enjoy the views and libations.

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Distinguished Speaker Series: Gary P. Brinson, CFA, The Brinson Foundation

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On May 24th, a packed hall gathered for lunch at The Standard Club in Downtown Chicago to listen to renowned value investor Gary P. Brinson, CFA, while he shared his latest thoughts on the markets. Brinson founded Brinson Partners, a Chicago-based asset management firm that was acquired in 1994 by Swiss Bank, the predecessor of UBS, for $750 million. After the sale to Swiss bank, Brinson ran the asset management division of Swiss Bank to what later became known UBS Global Asset Management. Many consider Brinson to be one of the investment industries greatest thought leaders, although likely by design, he left the audience lots to ponder in his Investment Market Conundrums presentation.

 

 

 

 

 

 

 

 

 

 

Using mean reversion with a 90-year historical lens. Brinson started off his presentation with a simple question: “What perplexes you?” and undoubtedly we moved on to what perplexes the investing legend himself. Despite volatility being at stubbornly low levels, the securities market today presents some very unique challenges and opportunities with macroeconomic datapoints that currently have meaningful deltas to their long-run mean. To start, real interest rates on long duration assets have turned negative in some countries across the world. Notably Germany (-0.9%), the United Kingdom (-2.0%), and Sweden (-1.2%) all have 10-year real interest rates that are in negatively territory and Switzerland, even further down the curve, with a negative -0.2% nominal 10-year interest rate. Theoretically it is an investment conundrum to hold capital to invest and to consider where you loan money to a government that inherently isn’t a risk free investment for a return that would leave you with less capital than when you started—and that is without a default!  Theoretically, it is very hard to compute the existence of long term negative nominal rates.

20170524_123647Europe has all sorts of problems; what about the U.S.? The U.S. has a 30 year nominal rate of 2.9% and after backing out a 2.0% inflation target a 0.9% real rate of return. Historically, from 1926-2016, the real return on a 30-year bond in the U.S. was 2.6% vs. 0.9% where it stands today. Mean reversion would call for this 0.9% real rate of return to increase 70bps closer to 1.6%. Turning to inflation, historically, inflation as averaged 2.9% from 1926-2016 and today stands at 2.0% as the difference between TIPS (Treasury Inflation Protected Securities) and the nominal yield. Semi-mean reversion says the likely inflation rate should be somewhere around 2.4%.  Inflation is largely governed by the velocity of money which beginning since the start of the financial crisis has plunged. This may or may not be permanent. If permanent, that estimate of inflation at 2.4% is woefully too low.  No economist seems to know why the velocity of money has slowed so meaningfully. Combining the mean reversion estimations, we should be observing a 30 year treasury rate closer to 4.0% real rate of return (1.6% nominal return + 2.4% inflation).  If the 30 year today (at 2.69% at the time of this publication) were to re-price to 4.0%, the value of that bond trading at a par value of $100 would fall to $81 market value.

Market expectations assuming mean reversion.  Now taking these mean reversion theme and looking at the equity market—one can estimate a nominal return for the S&P 500 at 10.0% with 5.8% in capital appreciation including inflation and 4.0% in income including dividends and share buybacks from operating cash flow (Note: ((1 + 5.8%) * (1 + 4.0%) – 1) = 10.0%). One can expect bonds to offer a 5.5% return, and net of a 2.7% inflation assumption a 2.6% real return compared to a 6.9% real return for US stocks. Comparing where we are today to 1926, P/E ratios are much higher, and dividend yields are much lower. There are a number of factors for this, but if one were to only consider mean reversion, one would expect a 2.2% real growth in earnings, leading to a lower market P/E ratio and a higher market dividend yield. If we consider the path were are on as a new investment equilibrium level and ignore the trends of the early 1900s, one could consider stocks to be fairly valued in this environment. Elevated P/E ratios shouldn’t be of concern and real growth rates of 4.8% (6.8% nominal) with real interest rate debt at 0.9%. However, if we believe real interest rates will increase to the long-term average of 1.6% and inflation to 2.6%, we should model returns on stocks to equal 8.0% (3.2% income and 4.6% capital appreciation) and the return on long term government bonds to be 4.0%. What is rather frightening is the market reaction we would see for the 30-year to trade at 4.0%– long term bonds would fall 19% in principal value and stocks would fall 25% in creating these forward desired return objectives.

20170524_130958Volatility expectations assuming mean reversion.  Standard deviation of large cap stocks was 19.9% from 1926 to 2016.  Over the past year, the markets have average 13.3%. Again if we assume semi-mean reversion, volatility should increase to 16.8%. The risk premiums have also been subdued across all asset classes and in a similar manner these should also increase. The conundrum is what we are now finding is both volatility and correlations are remarkably unstable. These lead financial analysts and portfolio managers with a very tough question – what should we use as the input for volatility? The correlations of returns between the S&P and the 10-year has declined meaningfully and recently went negative.

Share buybacks – A return “on” or “of” investment? Share buybacks should be viewed just as a dividend – a return on investment for shareholders. Today the companies that make up the S&P 500 offer a 2.1% dividend yield, and if we add share buybacks as an additional return on capital this figure increases 40bps to 2.5%. However, how much of these share buy-backs are being financed with debt? Brinson pointed out that using debt to subsidize share buy-backs is a return “of investment, not a return “on investment.

Active vs. Passive Management. To conclude, Brinson switched gears and discussed the hotly debated topic of active versus passive management that left many wondering if he and his firm was either an “expert” or “lucky” coin flipper. He gave the example of 10,000 people in a room where each person was tasked to call their coin flip correctly ten times in a row. Out of the 10,000 people in the room, only nine would be able to accomplish the feat of calling heads or tails correctly ten times in a row. Now these nine coin flippers were clearly one of the 10,000 that got lucky – randomness makes one think you’re looking at something meaningful when you’re really only lucky. Randomness is pervasive in the securities marketplace, and if you make the wrong assumptions thinking data has statistical significance is can lead investors to make very poor decisions.

Tying it all together – A Book Recommendation. Brinson concluded with a book recommendation – The Drunkard’s Walk: How Randomness Rules Our Lives by Leonard Mlodinow written in 2008. The book dissects statistical concepts such as regression toward the mean and the law of large numbers, while using examples from wine ratings and school grades to political polls.

Distinguished Speaker Series: Joseph Scoby, Magnetar

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CFA Society of Chicago hosted Joseph Scoby on Thursday, June 8th at the University Club to discuss how markets may be in the early days of a third disruption. Scoby is the Head of Magnetar’s Quantitative Investments Group which includes Alternative Risk Premia and Tactical Trading and brings 30 years of market experience in investments and risk management.

The three stages of disruption can be thought of as 1) active vs. passive in long-only portfolios 2) the advent of smart beta and 3) improving transparency for asset allocation. Scoby then gave three larger themed disruptions in society today, the Human Genome, Horizontal Fracking, and Big Data then expanded to a number of companies which have also disrupted their respective industries, Uber, Amazon, and Netflix. Similar to these aforementioned examples, technology in the market place has allowed managers to see what is going into returns and may be causing a secular change in how we invest.

DSC_3784Scoby gave us three levers of a portfolio 1) asset allocation 2) the manager and 3) cost. When viewing what our portfolio actually mimics, the speaker argued that we could be paying too much for each respective exposure which could lead to increased transparency over time. For example, the systematic return stream of hedge fund managers produced a 0.45 beta, which in the old days or ‘hood closed’ cost investors 2 and 20. Today, the ‘open era’ (transparent era), investor may begin to pay for each part; Alpha, Alternative Risk Premium, Smart Beta, and Beta with varying fees. One may pay 100 basis points for Alpha, but only 0-15 basis points for beta as the Vanguards of the world can replicate comparable results for rock-bottom costs.

The speaker went on to say how alpha is harder to find today given crowding of knowledge and process, as well as capacity issues, which makes cost and execution that much more important (differentiation is harder to find). Going forward, more transparent portfolios may also begin to use alternative risk exposure (return stream derived from exposure to a specific alternative asset class) as a way to differentiate one’s portfolio, and as a result, may earn their higher fees. An example given of alterative risk premium was merger arbitrage; 7% of deals break but most are priced as if 13% break – enabling 5.02% annualized returns with 6.88% volatility for his defined period.

Purchasing alternative risk premium isn’t straight forward, Scoby said, a few firms like Magnetar, AQR, and DFA offer it as well as a few ETF’s.

Oak Brook Progressive Networking Dinner

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On May 23rd, CFA Society Chicago held a progressive networking dinner at Maggiano’s Little Italy in Oak Brook.

A progressive networking dinner allows participants to meet people in a casual environment over good food and drinks. Dinner is split into three rounds; salad/appetizer, main course, and desert. Each participant is assigned a specific table for each round / course. Then over that course, each person has the opportunity to provide an introduction and background to their table mates. After each course the participants reassemble at different tables and sit with a new group. The setup allowed me to meet 15 people during the event.

Conversation at the various tables went quickly from introductions to a wide variety of topics. I shared my first course with a quant from a prop trading firm, a member of an independent financial advisory firm, and a credit underwriter. Conversation ranged from the potential effects of the Department of Labor’s Fiduciary Rule, while another table mate explained how and where to attract funds for a hedge fund that he was starting.

My second and third courses allowed me to meet a new set of individuals including an ETF portfolio manager, wealth manager, institutional asset allocation manager, and financial consultant. These conversations also went in a variety of directions; the nature and constraints that must be followed to build and run a completion fund, the rationale behind currency hedging global trading in the current market, and the Bears trade for the second pick in the recent draft. Consensus on the trade was that it was rich.

My straw poll as to the effectiveness of the event was overwhelmingly positive. The participants I spoke with appreciated the setting, which allowed for more in depth conversation, as well as discussions that involved all of their tablemates.

This event was one of several CFA Society Chicago events that are held in the suburbs each year. The central Oak Brook location allowed 25 people to attend from a variety of suburban locations.