May 2017 Investment Exchange Forum: Investing in Asia

The Investment Exchange Forum was held on May 10th at the CFA Society Chicago office at 33 N LaSalle St. The group had lively discussions on the topic at hand surrounding Investments in Asia and broader stock pitches we were considering making investments in or currently held positions in.

David W. of Morningstar started us off with pitching Albemarle Corporation (NYSE: ALB)–a global developer, manufacturer, and marketer of highly-engineered specialty chemicals including lithium, a key component of David’s thesis. Lithium is used in the batteries of electric cars and David believes the market is underestimating the long term potential for electric vehicle adoption. While the market may view the developers of the electric car market such as Tesla at full value (or some would argue over-valued), the way to play the trend is by betting on the suppliers and miners of the components that make up the electric car battery. As adoption grows and as fuel standards continue to increase, all auto manufacturers will have to adjust and likely move into the either fully electric or hybrid vehicles. These secular changes will ultimately drive an increased need for electricity (positive for utilities), lower demand for gas-focused energy (negative for energy) and higher demand for materials used in battery components such as lithium and cobalt (positive for chemical/mining companies). Risks include the phase out of current federal/state incentive programs, lower oil prices making gasoline cheaper, and the still relatively high costs of implementing a fully electric vehicle versus a gas combustion engine.

Matt C. of US Bank also proposed an investment in Asia and two in the US REIT market, New York REIT (NYSE:NYRT), iStar (NYSE:STAR), and Hunter Douglas (AMS:HDG). We started off looking at New York REIT as a liquidation arbitrage play with the perceived liquidation value well in excess of its share price of $9.69/sh as of 5/10/17. New York REIT is an owner operator of 19 properties, which aggregate 3.3 million rentable square feet in primarily office assets in New York City. On January 3rd, 2017, NYRT shareholders approved a plan to liquidate the company. The investment thesis is supported by a number of factors including private market transactions for New York City Class A office rents in the low 4% cap rat rate range. A 4.5% cap rate on last quarters reported NOI equates to a $12.50/sh share price for NYRT. Winthrop Realty Advisors was appointed as the liquidation manager for the assets in March 2017. An incentive plan is in place where Winthrop would participate in added upside bonuses if the liquidation amount totals over $11/sh. We believe Winthrop’s management team would be hesitant to accept the terms of the agreement if they didn’t believe they could achieve over $11/sh in liquidation value. Winthrop Realty Trust, a diversified REIT run by NYRT’s existing management team, excluding CEO Wendy Silverstein, announced its liquidation in April 2014. The initial liquidation estimate was “at least $13.80/share”; to date, $9.25 of dividends have been paid, and the 2016 10-K suggested the remaining assets are estimated to be valued at $9/share, taking the total liquidation estimate to  $18.25, or 32% in excess of the original estimate. As stated in a proxy filing dated September 26, 2016, the company received an offer from a publicly traded REIT for $11.25/share in December 2015, excluding the Viceroy hotel.  With fundamentals in New York City office stable, we fail to see why a 20% discount to this prior offer should exist in the marketplace today.

After our meeting, NYRT reported first quarter results under the liquidation basis of accounting after the close on 5/10/17. The liquidation basis of accounting requires that management estimate the net sales proceeds on an undiscounted basis as well as the undiscounted estimate of future revenues and expenses of the company the through the end of liquidation. The net assets in liquidation at quarter-end were valued at $9.25/sh—disappointing investors in after-market hours sending the shares down 9% after hours. The earnings call provided further clarity around the management team’s liquidation strategy. No assets can be sold until debt assumption has been reached on World-Wide Plaza ($875mm) which includes mezzanine lenders. The debt should be assumed in the near term and there are currently no other assets on the market other than WWP which is expected to close by the end of 3Q17. Liquidation expected to be completed by the 1Q18, however company is not under distress. The company has 2 years to liquidate the holdings (until 4Q18). NYRT is open to someone acquiring NYRT as portfolio, however will continue to proceeding with liquidation efforts.

Two other companies discussed included iStar (STAR), a US mortgage REIT that turned into a landlord after the recession of 2008. Matt likes investing in REITs, particularly smaller cap mortgage REITs because he believes there is a lot of mispricing in the market. The background is that the company hasn’t paid a dividend since 2010 and they have been soaking up their NOL’s as they sell off properties they have foreclosed on. Matt said the company believes that shares could be worth two to three times current trading levels if the assets are broken up and sold separately in the private market. Finally, Matt presented Hunter Douglas (AMS:HDG) which is an overseas company operating in two business segments—window coverings and architectural products—both which provide the company with remarkable cash flows. The company is based in the Netherlands and is 70% family owned leaving float at only 30%, a key risk for the investment. There is ample cash on balance sheet, however we discussed examples including Nokia and Emerson Radio where you can burn cash by investing in unprofitable ventures in your own business.

Nick R. of Oculus Asset Management proposed a number of investments in Asia including Cross-Harbour Holdings Ltd (HKG:0032), Methanex Corporation (NASDAQ:MEOH), and Swire Pacific Ltd (HKG:0019). Cross-Harbour Holdings is a $4.3B Honk Kong investment holding company that owns toll roads for tunnels that go into Hong Kong and owns subsidiaries that operate driver training centers. The company maintains 61% gross margins and has ample cash on the balance sheet creating a natural floor for shares. Share price performance has been astounding—since 2014 the stock has delivered an over 100% return doubling from near $5.50/sh to $12/sh where it trades today. Methanex is a China spread business that sells Methanol made out of coal in China, in which they possess a dominant monopoly. The Company operates production sites in Canada, Chile, Egypt, New Zealand. Finally, Swire Pacific Ltd, is a Hong Kong based company that is the Holdco of five diversified well-run businesses in Hong Kong. The business operates as a diversified conglomerate controlling an aviation manufacturer, a Coke bottler, tugboats and steamboats, and other subsidiaries. The company maintains 25% operating margins, however the largest risk to this investment is its lack of float with the private owners owning the majority of outstanding shares. Because of this, the company trades at a discount for both the lack of control and its conglomerate structure. Risks to these investments include currency risk, unique rules on the exchanges, poor corporate governance, and lack of float outstanding.

The Investment Exchange Forum is held every other month. Please check the CFA Society Chicago website to register for the next event.

Volunteer of the Month: June 2017

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Andrew Bushey, CFA

Andrew Bushey, CFA

The Social Events Advisory Group is tasked with organizing relaxing, entertaining, and networking-oriented events that will appeal to the Society’s diverse membership. Andrew has been actively involved on the advisory group since 2016 and is part of a core group of members thinking outside the box when planning social events.

Today Andrew is being recognized for his efforts with the Society’s kickball team. Since the inception in summer 2014, Andrew has played every year on the team and will be serving as team captain when the summer league starts later this month.

Help us in thanking Andrew for taking his advisory group duties to the next level and making the Society champions on the field!

We appreciate all you do for the Society Andrew!

FINTECH EXCHANGE 2017

Hosted by Barchart, the third annual FinTech Exchange held on April 27th at Venue SIX10 highlighted the latest in technology innovation for financial markets and trading firms. The 2017 event focused on methods in which data is delivered, stored, analyzed and visualized; as well as the new types of data in the alternative space. It featured 10-minute Lightning Round presentations, topic specific round table discussions, plus an all-day exhibit hall for networking that featured a Live DJ and Pro Ping Pong action.

Barchart’s CEO Mark Haraburda, delivered the opening remarks and highlighted the fact that Chicago was ranked among the top five FinTech hubs in the world by Deloitte. In Deloitte’s published report, Connecting Global Fintech: Interim Hub Review 2017, Chicago acts as the epicenter for all FinTech activity in the Midwest, representing well over 20,000 financial institutions.

The keynote speaker was Vaidy Krishnan from Tableau, a software company that helps people see and understand their data. He spoke about choosing an analytics platform that not only offers data visualization, but also can provide visual analytics that help you dive into the “why” of your data. Data visualization tools such as static dashboards are the start of the analytical process and not the end; while visual analytics software go a step further and provide interactive exploration of the data to its most granular detail.

The Lightning Rounds began with Maria Belianina from OneTick speaking about the power of integrating with a single point platform for tick data management and analysis. In addition to being a data warehouse, OneTick is directly integrated with R and MATLAB for quantitative analysis.

Julie Menacho from the CME Group spoke about the exchange’s market technology and data services. CME Datamine offers historical data via the cloud through a partnership with Amazon Web Services and software provider TickSmith. She then went on to discuss the CME’s initiative around Alternative Data, which she described as non-traditional data sources which can be leveraged as part of the investment process. One example was satellite imagery of where world oil tanks were being stored to give an idea of the current supply of oil. These new sources of untapped data can be a predictive indicator of market performance.

Sean Naismith from Enova Decisions talked about harnessing the power of predictive analytics. He spoke about their decision management system Colossus, which is integrated with multiple data providers to help produce optimal decisions in real-time. These predictive analytics are used to help detect fraud, minimize credit risk, and optimize operations in real-time.

Catherine Clay from the CBOE discussed how the CBOE is keeping its innovative mojo, through the two P’s, Process and Partners. She described the CBOE’s weekly development release cycle to push out code related enhancements. She also went over the CBOE’s technology partnerships that allow the exchange to expand their market data and product offerings.

In honor of National Bring your Child to Work Day, Jim Austin of Vertex Analytics decided to put his kids to work! They put on a fun re-enactment of a chaotic open outcry where all you heard was the fill order. Jim used this to highlight the amount of undocumented activity that can occur during trading. He then brought us into today’s world of big market data and electronic trading. Vertex provides a solution to capture, manage, and analyze this financial market data, currently collecting over 4.5 billion market messages per day. Firms can also use Vertex’s platform to supervise their own trading patterns and behavior, which can be used to mitigate compliance violations.

The final two presentations focused on how FinTech is disrupting retail trading. Tim McDermott of Nadex, highlighted the key issues that hold individuals back from trading. These key issues included margin requirements, fear of professional traders, time constraints, and an unclear path on how to begin. Nadex offers small binary option contracts with a floor of $0 and a ceiling of $100, limiting a trader’s overall risk. It’s also easy to open an account and begin trading if you pass all the checks, usually within 15 minutes. Michael Patak from Topstep Trader also believes there’s a lot of opportunity in retail. He believes that by combining education with games, you can attract new traders to the marketplace. TopStep Trader provides a path where you can fine tune your approach using real-time simulated accounts.

I attended one of the roundtable sessions led by Jason Henrichs and Lisa Curran, CFA, from FinTEx, a Chicago based nonprofit, and learned how they’re growing the FinTech ecosystem in the Midwest. Lisa went on to speak about how FinTEx is focused on promoting collaboration among their member firms and modeled their events to resemble those hosted by CFA Society Chicago. Jason discussed their partnership with FinTech Sandbox, a nonprofit group that provides startups free access to financial data and infrastructure. This partnership should provide a boost to Chicago’s already surging FinTech sector.

This was my first time attending the FinTech Exchange but it will not be my last. I wasn’t aware of the vast amount of innovation occurring right here on our doorsteps in Chicago, and I’m excited to see how these new sources of data impact the Financial Services sector.

Vault Series: Doug Ramsey, CFA, CMT, The Leuthold Group, LLC

Playing the Market Melt-Up

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The CFA Society Chicago gathered in the Vault Room at 33 North LaSalle to hear Doug Ramsey, CFA of Leuthold Weeden Capital Management discuss the likely future direction of the equity market. Ramsey is the CIO of The Leuthold Group and co-portfolio manager of the Leuthold Core Investment Fund and Leuthold Global Fund. .

Ramsey is both a CFA charterholder and a Chartered Market Technician (“CMT”). Holders of the CMT have demonstrated expertise in the theory, practice and application of technical analysis. He maintains Leuthold’s proprietary Major Trend Index, a multi-factor model that utilizes mainly technical data. The model contains a long history of market data going back to 1930. The data and subsequent market behavior discussed in the Vault Room included data up to May 12th of this year.

The Major Trend Index is comprised of 130 indicators that roll-up into 5 categories. The categories are comprised of quantitative and qualitative factors that influence the direction of markets. A plus and minus figure is computed for each category and a ratio that includes all the data is computed. The Major Trend Index yielded a ratio of 1.14 as of May 12th,  a ratio over 1.00 is considered bullish.

The age of the current bull equity market has many speculating that the bull market is nearing an end. Ramsey spoke at length as to how his model can be used to forecast a market top. The Major Trend Index concludes that the current bull market has more room to run. He believes that the equity market sell-off in early 2016 has set the stage for another leg-up in the current bull market.

The model used by Ramsey uses seven (7) stock market indices to monitor the health of the equity market.  They are as follows:

  • Dow 65 Composite
  • Dow Transports
  • Dow Utilities
  • Russell 2000
  • S&P 500 Financials
  • S&P 500 Cyclicals
  • NYSE Advance/Decline Line

Negative performance in at least 5 of these 7 categories has foretold a market top. Ramsey characterizes a market top as a “lonely” one. The bull market is propelled at its end by only one or two sectors before a bear market begins.

DSC_3744Ramsey then spoke at some length about the market sell-off that occurred at the beginning of 2016 and its effect on the current bull market. In May of 2015 six (6) of the seven (7) categories were in negative territory which is a strong indication of a market top. The equity market was essentially flat in 2015 and the beginning of 2016 a market correction occurred. A bear market did not occur as the index only fell 14%, by definition a bear market does not begin before a 20% sell-off.

The fact that a bear market did not occur after the 2015 signal does not necessarily negate the usefulness of the model. The year 2015 coincided with a trough in corporate earnings and the market reflected that. Ramsey believes that the 14% pullback that occurred in early 2016 has given new life to the current bull market which in his opinion does not look to have reached its top.

Following his presentation Ramsey spoke with a group of attendees on a number of topics including:

  • Momentum investing works, investing in sectors or companies that have already experienced price appreciation can still yield profit.
  • Tech valuations are not in bubble territory. Several slides in his presentation illustrated the strong earnings that are now being realized by tech companies.
  • You can make an argument that low volatility (higher dividend)  stocks may have reached bubble territory since investors appear to be drawn to these.

CFA Society Chicago Book Club:

How to Measure Anything: Finding the Value of Intangibles in Business by Douglas W. Hubbard

how-to-measure-anythingPath dependence is the phenomenon often used to explain why people sometimes persist with practices that are no longer optimal or economically rational. Statistics is another area where path dependence has struck. The statistical techniques that students learn in school, the ones that practitioners apply in industry, and the ones researchers use in journal publications often aren’t the best or the most appropriate ones but rather the ones that continue to be used because they’ve always been used.  Douglas Hubbard’s How to Measure Anything (2010) attempts to update some of those techniques for the 21st century.  In addition, he offers some refreshing perspectives on behavioral finance and the biases that adversely affect decision makers, even the so-called professional decision makers at the executive level in industry and government. Finally, he offers a unifying framework for decomposing complex problems into individual variables, assessing the value of reducing the uncertainty for each of those variables, measuring those variables, and finally determining probabilities through Monte Carlo simulations and Bayesian statistics.

Starting with antiquated statistical techniques, every former stats 101 student probably remembers going through some type of hypothesis testing exercise such as testing if a coin is fair, a drug works, voters prefer a candidate, etc. Those tests take a null hypothesis, such as assuming that a coin is fair, flipping it multiple times, and then determining the probability of observing a series of outcomes if the coin were fair. If the probability of observing a series of outcomes on a supposedly fair coin is less than some arbitrary threshold, usually five percent, the experimenter rejects the null hypothesis and concludes that the coin is not fair.  For example, the probability of observing five heads out of five flips on a fair coin is 3.13%, which would cause an experimenter using the five percent threshold to reject the null hypothesis that the coin is fair. The five percent shibboleth comes from the statistician Sir Ronald Fisher’s 1925 paper “Statistical Methods for Research Workers.” He wrote a year later in “The Arrangement of Field Experiments” (1926) that the threshold was arbitrary and that other thresholds may be used; however, the damage had been done and the five percent threshold remains as a venerated relic.

The whole process is a convoluted way to approximate the more useful question: What’s the probability of getting a heads on a given coin? The Bayesian approach to statistics, in contrast to the frequentist approach previously described, seeks to do just that. Mr. Hubbard notes that the term “Bayesian” was first used by Fischer himself as a derogatory reference to adherents of the approach named after Rev. Thomas Bayes. Rev. Bayes is credited with developing the first formulation of how new evidence can be used to update prior beliefs.  In the case of Bayesian statistics, new evidence is used to update prior assumptions about probabilities.

Once the distribution of the relevant variables or drivers is better known, Mr. Hubbard postulates a relationship between the variables and generates a hypothetical distribution of the phenomenon that one is trying to predict using Monte Carlo simulations. First developed to solve intractable problems in nuclear physics, modern computing power has made the technique accessible to anyone with a personal computer and an Excel spreadsheet. Instead of trying to compute the probability of a phenomenon such as rolling a two with a pair of dice (“snake eyes”), Monte Carlo simulations flip the problem by simulating thousand or perhaps millions of rolls and then determining what percentage of the rolls were twos. With an Excel spreadsheet, Mr. Hubbard shows how to calculate distributions and expected values for complex phenomenon after estimating the distribution of the underlying variables and their relationships. Monte Carlo simulations are seldom taught in introductory statistics courses. The topic is usually reserved for advanced classes and special topics classes even though the basics of the technique are no more complicated than regression modeling and several other topics that are covered in introductory classes.

With new statistical tools in tow, Mr. Hubbard then sets forth on finding what to measure.  Here Mr. Hubbard again notes a pernicious tendency among decision makers to either measure what’s easy to measure or what they’re already familiar with. The solution, Mr. Hubbard argues, is to triage variable before trying to reduce uncertainty about them by introducing metrics to quantify the costs and benefits of acquiring additional information about each variable. He starts with the Expected Value of Perfect Information (EVPI): What would it be worth to know a presently unknown quantity with complete certainty? He then works backwards to determine the incremental Expected Cost of Information (ECI) and the incremental Expected Value of Information (EVI). Finally, he adds a time component, noting that for some decisions the value of information is perishable. Mr. Hubbard notes that adding the time component can prevent what pioneering decision theorist Howard Raiffa called, “Solving the right problem too late.”

In addition to the tendency to measure the wrong things and measure in the wrong amounts, Mr. Hubbard notes several other behavioral and cognitive biases, such as expectancy bias and overconfidence. Instead of just rehashing problems that already have been noted extensively in the behavioral finance literature, Mr. Hubbard goes further and offers solutions, especially to the problem of overconfidence and quantifying uncertainty. When asked to calculate a 90% confidence interval for an unknown quantity, such as the wingspan of a Boeing 747 aircraft, most people choose too narrow a range. Mr. Hubbard shows that with training the average person can estimate ranges for unknown quantities such that on average the true value falls within their estimated range 90% of the time. The training, called “calibration training,” is simple to conduct and has a tremendous success rate.  Organizations should probably spend more time training their executives to become better decision makers given how much time and money as they spend sending them to conferences, hiring executive coaches, and giving them physical and psychological assessments.

When the CFA Society Chicago’s Book Club met to discuss Mr. Hubbard’s book in April 2017, most of the participants welcomed his fresh approach to quantitative and empirical problem solving. If there were any misgivings about the book, they were that it didn’t fully live up to its title: “Finding the Value of Intangibles in Business.” The participants would have welcomed more examples of how the techniques described could be used to value business units or firms that make intensive use of intangibles such as brand identity, intellectual property, or perhaps others.

Hopefully, this won’t be the last time that Mr. Hubbard crosses paths with the Society and we’ll get to fulfill that promise.

 

Building Investor Trust Through GIPS

On May 9th, CFA Society Chicago members gathered to hear a panel of experts address the merits of adopting the Global Investment Performance Standards (GIPS) in the Vault Room at 33 N. LaSalle. The eminent panel comprised a service provider, a regulator, and an asset manager user and included:

  • Daniel Brinks, compliance examiner with the Securities and Exchange Commission (SEC) with a focus on investment advisors,
  • Richard Kemmling, CPA, CIPM, CGMA, President of Ashland Partners & Company LLC, a specialty CPA firm that was a pioneer in the GIPS verification business, and serves over 700 client firms in that area.
  • Matthew Lyberg, CFA, CIPM, Senior Vice President and Director of Performance Attribution with Acadian Asset Management.

DSC_3715Anju Grover, CIPM, senior GIPS analyst with the Investment Performance Standards Policy Group of the CFA Institute (CFAI) served as moderator. In her opening remarks she pointed out that 2017 marks the 30th anniversary of GIPS which she described as one of the CFA Institute’s most successful products. Despite the fact that adopting GIPS is completely voluntary, they are widely recognized as a best practice for reporting investment performance by asset managers, asset owners, and consultants all around the world.

The first question Ms. Grove put to the panel was why GIPS would be important to retail investors. Brinks responded that retail investors are just as demanding of a performance standard as are institutional investors, and GIPS fills the bill. Lyberg noted that the line separating retail and institutional investors is blurring. The decline in the popularity of pension plans in favor of defined contribution plans is a primary example. Retail investors are the end users of DC plans and are responsible for investment choices, but the plans are designed, managed, and overseen by investment professionals. So they serve both retail and institutional masters. GIPS also adds a layer of due diligence to a plan, a theme the panelists repeated throughout the event. Kemmling pointed out that GIPS compliance is a common requirement for listing products on the investment platforms that advisors (he specifically mentioned Morgan Stanley and Merrill Lynch) use for their retail clients.

As to challenges firms encounter in adopting GIPS, the panelists listed:

  • Lack of adequate data, or records; difficulty in handling unique accounts,
  • Changes in operating systems that occur during implementation,
  • Incomplete buy-in from all parts of a firm (marketing, accounting, compliance, etc.), and
  • Full support from senior management. The latter point is particularly critical to assure firms commit adequate resources to attain compliance.

Why should firms bear the cost of GIPS compliance? Kemmling answered that they provide a “best practices” process for client reporting and that the verification process provides insight into industry practices. Brinks stated that while GIPS compliance is not required by law or regulation, he considers it in the category of “nice to see” when he examines an asset manager. The verification process is a second pair of eyes –outside eyes–on results reporting. He added that he observes fewer serious problems in general when he examines firms that follow GIPS. The CFA Institute has been training SEC examiners on GIPS so they can understand what the standards mean to adopting firms and apply that knowledge during examinations.

In response to questions from the audience regarding difficulties in complying with GIPS, the panel noted challenges in applying them to more complicated strategies such as currency overlays and alternatives. They suggested that this be a focus of the next revision to the standards which is already underway and targeted for 2020. This revision should also make the standards easier to apply to fund vehicles and for internal reporting to management. The current standards are most easily applied to reporting composite returns to clients, which was their original intent.

Regarding the breadth of acceptance of GIPS, Grover said the CFAI is still gathering data but counts 1,600 firms around the world that claim compliance for at least a portion of their assets. This includes 85 of the 100 largest asset managers who account for 60% of total industry assets under management. Lyberg noted that investment consultants are expanding the adoption of GIPS by using compliance as a screen for including firms in management searches.

When asked how a firm should begin to adopt GIPS, Lyberg suggested starting out modestly by writing high level policies and procedures and making them more detailed over time with experience. He recommended attending the CFAI’s annual GIPS conference to build knowledge and to make contact with other firms that have already adopted the standards. Challenges a firm may encounter include clients who demand using a different performance benchmark than what the firms uses for a strategy, tension between various stakeholders at a firm (e.g., between marketing and compliance), and resistance from legal counsel which often advises against bold statements of compliance that might seem to be guarantees.

As to the benefits to the public from using GIPS, Brinks stated that increased comparability leads to better informed investment decisions and more efficient markets. He noted the decline in fraud tied to inflated claims about performance since the introduction of GIPS thirty years ago. Kemmling noted that measuring the positive impact of GIPS is difficult but they were created for the benefit of investors and are an indication of asset managers’ commitment of resources in support of investors. Grover stated that adopting GIPS for greater transparency and comparability was simply “the right thing to do”.

For final takeaways the panelists offered the following:

  • Lyberg said GIPS levels the playing field among managers, adding that compliant managers couldn’t compete with fraudulent firms such as Bernie Madoff’s.
  • Kemmling, acknowledged that while compliance is not easy, it isn’t expensive and is certainly achievable. Most of the 700 firms his company verifies have less than $1 billion in AUM, indicating the success of small firms at complying with GIPS.
  • Brinks recommended that adopting firms think very carefully about how to apply the standards, looking to the future when writing their policies and procedures to avoid any potential conflicts between them and their capabilities.

Volunteer of the Month: May 2017

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Brad Adams, CFA

Longtime member (22 years to be exact!), Brad Adams, CFA, has served on five advisory groups since 2012. In 2014 he also chaired what was previously the Finance Advisory Group. Currently, he is a member of both the Communications and Professional Development Advisory Groups.

Today Brad is being recognized for his efforts on the Communications Advisory Group. Regularly attending meetings and volunteering to be a reporter at the Society’s events, Brad has made a strong contribution to the Communications Committee.

Brad has published seven CFA Society Chicago Blog articles since the launch of the online publication and is scheduled for more. Help us in thanking Brad for attending Society events and keeping members informed!

Job well done! We appreciate all you do for the Society.

CFA Society Chicago Book Club:

Blockchain Revolution: How the Technology Behind Bitcoin is Changing Money, Business, and the World by Don Tapscott and Alex Tapscott

BlockchainRevolution-674x1024Blockchains are simultaneously feared as a disruptive threat and lauded as a technological panacea, often with little understanding of how they actually work and often with little practical consideration of how they might be implemented. Don Tapscott and Alex Tapscott (father and son, respectively) assist the layperson in understanding how blockchains work and how they could be used in Blockchain Revolution (2016). The authors also, unfortunately, further delude the technological utopians by proposing seemly endless possible uses of blockchain technology while failing to address some of the practical considerations of implementation.

Starting with the positive, Blockchain Revolution is one of the first resources to both explain blockchain technology and to fully explore its potential uses beyond the now somewhat familiar bitcoin. Bitcoin is the digital currency created by “Satoshi Nakamoto” in 2009. Satoshi Nakamoto was the name that was used in internet chat rooms and the like by a person or group of persons who claimed credit for creating the cryptocurrency. Soon after creating bitcoin, Satoshi Nakamoto disappeared and the identity or identities behind the name never have been revealed. Replete with a dubious creation story, bitcoin maintains a religious, cult-like following despite scant uptake and usage. The history of bitcoin has been told elsewhere, including in Paul Vigna’s and Michael J. Casey’s The Age of Cryptocurrency (2016), which was the book of the month for the CFA Society of Chicago’s Book Club in February 2016.

What hasn’t been told widely until now are the other possible applications of the technology underlying bitcoin, the blockchain. A blockchain is nothing more than a ledger for recording transactions. The double-entry bookkeeping system that forms the foundation of modern accounting is widely attributed to Luca Pacioli, a Franciscan Monk and mathematician who lived in the 14th and 15th centuries. There are earlier claims to the discovery, which probably have some merit. There are probably undiscovered cave scribbles that merchant cavepeople used to record exchanges of spears and mastodon parts. As long as there’s been commerce, there’s been the need to record exchanges, and ledgers in some hasty form have probably served the part from time immemorial. The difference between blockchains and most previous ledgers is that previous ledgers resided with a trusted central party to the transaction, whereas blockchain ledgers are distributed, meaning that every member of a network retains a copy of the ledger. When there is a new transaction in the blockchain, members of the network that maintain the ledger verify the authenticity of the new transaction, append it to the chain of all previous transactions, and transmit the updated chain to the network.

That distributed feature is what poses the disruptive threat to numerous businesses that are based on intermediating markets. For example, the Uber business model is based on a central party that sits between drivers and passengers, links the two, and takes a slice of the profits in transaction fees. Similarly, Airbnb disrupted the hotel industry by intermediating the market for lodging by linking people who have spare capacity in their homes with travelers looking for a place to stay. Blockchains could further disrupt the disruptors by allowing those parties to transact directly and take out the middleman.  The Tapscotts mention several other less obvious areas where blockchains could be used to intermediate markets or keep records, such a land and property deeds, personal medical and financial information, stock and bond offerings, contracts, and wills. The authors even argue that intellectual property such as music and other artwork could benefit from blockchains by allowing artists to control access to their works and charge a royalty fee directly to end users when they access them.

The oldest and largest business based on intermediation is, of course, banks. The primary function of banks always has been to intermediate the market of lenders and borrowers. Without banks, potential borrowers could find themselves having to go door-to-door, pleading for loans and negotiating the amount and the terms of the loans with each potential borrower. Banks have always done that legwork primarily by taking deposits and issuing those deposited funds as loans. Add credit and debit cards, foreign exchange, settlement, custody, and clearing to the mix and banks make considerable profits just by sitting between market participants, recording transactions, and taking fees. The Tapscotts and other blockchain utopians contend that all such businesses based on market intermediation will become unnecessary and disappear due to blockchain technology.

The CFA Society Chicago Book Club members who met to discuss Blockchain Revolution during their March 2017 meeting agreed that the range of possible blockchain uses was enlightening but found the tone of the book overly optimistic and found the treatment of implementation challenges lax. Take contracts, for example. The Authors seem to presume that blockchains will obviate the need for traditional contracts and courts to enforce them. A hypothetical blockchain contract might look as follows: A stadium owner engages a vendor to fix the plumbing in his stadium. When a credible party who has access to verify that the work has been completed confirms successful completion of the work in the blockchain, payment is automatically distributed. But what if the stadium owner contests the quality of the work? Was the vendor merely to fix the plumbing so that it didn’t leak or was the vendor supposed to restore the plumbing to like-new status? What if the stadium owner was relying on the repairs being completed by a certain time so that he could host a concert? If the vendor doesn’t complete the repairs, is it liable for the foregone revenue due to the stadium owner’s inability to host the concert? These are not far-flung hypotheticals. Contract law deals with those issues constantly. It’s not clear how blockchain-based contracts will be any better than paper-and-pencil contracts in terms of interpretation and adjudication.

Safety and security of blockchains is given similarly little treatment. Assuming for the sake of argument that the double key encryption technology that blockchains use makes them impenetrable to hackers, they could always just access blockchains using stolen passwords. And unlike when someone fraudulently uses a credit card, there is no legal department at bitcoin to contest the fraudulent transaction or IT department to reset the password.

Blockchain usage will undoubtedly increase. Even without blockchains, market intermediation for a variety of products and services has become increasingly automated and that trend will continue whether by blockchains or by other means. The consequence of that for banks and financial institutions is that they won’t be able to rely as much on the simple act of intermdiation for revenue and will instead have to increasingly compete on knowledge and customer service. Even now customers no longer need banks to purchase a variety of financial products and services, but retail and commercial customers still come to banks and financial institutions for sound advice and financial planning—and to reset their passwords.

Despite its shortcomings, Blockchain Revolution is an important contribution to understanding rapidly evolving blockchain technology, and hopefully others will step up to fill in the missing parts of the puzzle concerning how blockchains will be implemented and administered.

Distinguished Speaker Series: T. Bondurant “Bon” French, CFA, Adams Street Partners

DSC_3661T. Bondurant “Bon” French, CFA, executive chairman of Adams Street Partners addressed a large gathering of CFA Society Chicago members on the topic of private market investments on April 5th at the University Club. Adams Street Partners is a Chicago-based manager of private market investments with over 40 years of history and $29 billion in current assets under management.

French began with a review of historical returns for private equity markets using industry data. Both categories he focused on, venture capital and buyouts, showed superior long term performance (ten years or longer) compared to public equity markets, but weaker relative performance for periods shorter than five years. He doesn’t consider the shorter term underperformance to be significant as success in private market investing requires a very long investment horizon, a feature deriving from the reduced liquidity relative to public markets.

French went on to provide a summary of recent market conditions and performance for both buyout and venture capital pools. His statistics showed that fundraising for buyouts rose sharply from 2005-2008 and then fell just as sharply during the financial crisis. Although there has been a rebounded since 2010, the $368 billion gathered in 2016 still hasn’t topped the pre-crisis amounts. The volume of buyout transactions has recovered much less so since 2009 leaving managers with considerable “dry powder” seeking attractive new investments. This is also reflected in data for buyout fund cash flows. From 2000 through 2009 calls for funding from borrowers regularly exceeded distributions out to investors. However, since 2010, distributions have far exceeded calls. Investors (and their managers) have been especially wary toward new investments since the crisis, a condition exacerbated by the high level of multiples on buyout transactions (similar to the situation in public markets). At more than 10 times enterprise value/EBITDA, these have passed the pre-crisis highs to levels not seen since before 2000.  This situation has driven Adams Street to focus on deals in the middle market which is less efficient, and consequently priced at lower multiples.

DSC_3654Also reflecting caution (and the effects of Dodd-Frank regulations), buyout deal leverage remains below pre-crisis levels (5.5 times in 2016 vs 6.1 times in 2007). However, terms of credit have eased as reflected in the market for covenant-lite debt. This has far exceeded the levels common in 2007 both in terms of absolute amount and share of the new issue market. DSC_3659This has helped the borrowing firms survive economic challenges and also allowed them an opportunity to remain independent for longer.

In the venture capital market (much older but smaller than the buyout market) new fund raising peaked in 2000 during the “tech bubble” and fell sharply when the bubble burst. The subsequent recovery was fairly muted, so the financial crisis had less of an impact on fundraising activity than in the buyout market. The $83 billion raised in 2016, while the highest since 2000, is consistent with the longer trend.  Cash flow in the venture market hasn’t been as persistently strong as in the buyout market because companies are choosing to stay private longer than in the past. Liquidity events, measured by number of deals and total value, peaked in 2014 for both initial public offerings (IPOs) and mergers and acquisitions (M&A). M&A, the larger of the two by far, has shown a smaller decline from the peak than has IPOs, and has held at levels consistent with longer term trend.

French concluded with a brief look at the secondary market for private investments (trades between private market investors as opposed to investors being taken out by IPOs or M&A). This market dates to 1986, but is showing healthy signs of maturing recently. Although the market hit a recent peak in volume in 2014 the decline in the following two years was slight—holding well above the prior trend.  Pricing, as a percent of net asset value, has also been rising. Transactions in 2016 were evenly distributed by the type of investor (pension funds, endowments, financial institutions, etc.) supporting liquidity. In 2016, transactions were more concentrated in newer funds because older funds (created before 2008) are shrinking from their natural positive cash flows, and have less need to trade.

CFA Society Chicago Candidate Mix & Mingle

stress-391659_1920With every passing day the CFA exam gets near and candidate stress levels rise. What could help? A free event with an open bar, appetizers and pizza! CFA Society Chicago organized an event on March 29th at Hotel Allegro where candidates poured in to relax and network with their peers. They discussed what was and what was not working for them (in hopes to hear similar stories for affirmation that they are not alone!).

Kaplan Schweser, co-host of the event, sponsored a raffle prize of their Review Workshop to a candidate which was awarded to Kevin Anderson. Bijesh Toila, Lecturer at Kaplan Schweser, was sharing his wisdom helping out candidates with any concerns they had and getting feedback on study materials. He views his organization’s partnership with CFA Society Chicago to be a success and looks forward to strengthening it. The Society’s organizing committee members and executives joined the event for moral support of candidates.

We wish all the candidates best of luck on their upcoming exam and wish them success on the path to obtaining their charter!