Distinguished Speaker Series: Dr. David Kelly, CFA


Dr. David, Kelly, CFA

Dr. David Kelly, CFA, the Chief Global strategist for J.P. Morgan Global Investment Management, provided his thoughts and views on investing in the current low/no rate environment.

Starting with a review of the U.S. economy Kelly noted that real GDP has grown just over 2% on average over the past five years. Under normal circumstances this level of growth is considered anemic, but the current slow and steady expansion is acceptable from Kelly’s point of view. Consumers are benefiting from low mortgages and gas prices, overall demand is growing, and banks are issuing more credit. Kelly considers this economy analogous to a healthy tortoise – it does not move swiftly, but it is steady. It is unrealistic for the U.S. economy to grow at historical levels (+3%) given the low unemployment rate, which from Kelly’s point of view is the biggest impediment to continued growth of the economy. Kelly believes that the sliding unemployment and labor participation rates are due to the aging population. Baby boomers comprise a large segment of the working population, the oldest of which became eligible for retirement in 2011. Boomers will of course will continue to retire, constraining the labor market, and helping the unemployment and participation rates to fall further. To combat the coming labor shortage Kelly suggested comprehensive immigration reform, bringing more people (workers) in to the U.S.  If immigration reform is not successful the unemployment rate could fall into the 3% range, constricting the economy to a growth rate under 2%.

Kelly believes that the Federal Reserve needs to raise rates in September. If this window were missed then the Fed would likely have to wait until December to not affect the November election. Further delays in raising the Fed Funds rate will make raising rates harder to do in the future – the Fed will be provided with more reasons for not raising rates, which will further undermine its credibility.

dsc_3084As of April 2016, 35% of all developed world government bonds had a yield below zero. Low global rates have helped lower U.S. interest rates. Global bond buyers looking for better yields have moved to U.S. denominated securities driving down domestic yields. However, Kelly suggested that rising rates in the U.S. could act a balloon to world bond rates. Given the current and projected fixed income market, Kelly suggested underweighting domestic and global fixed income until real rates reach a normalized range.

Turning to the equity markets Kelly believes the current equity market is still relatively cheap. Do to the expected rising rate environment the financial sector should be overweighed while the utility sector is expected to underperform. However, there is more upside outside of the U.S. equity market in Europe and the emerging market space.  These areas should outperform in the medium term based on stronger relative earnings. The current forward P/E of the S&P 500 is around 17x earnings, over the long-term average of 16x, while the MSCI EAFE forward P/E is at its long-term average.

Kelly took questions at the end of the presentation from several members from the audience. One individual asked “How best should a government sustain a countries economic growth?” Kelly’s answer was a bit surprising in that he focused on income inequality – the more there is, the less sustainable economic growth becomes. Kelly noted that most problems that create income inequality start with single parent families (SPF). In the 1980’s, 18% of households were SPF. As of this past year the SPF households number 42%, which from any number of perspectives is an alarming statistic.

CFA Society Chicago Book Club:

The Only Game in Town by Mohamed El-Erian

the-only-game-in-townExtraordinary central bank interventions during economic crises aren’t new.  In his Pulitzer Prize-winning Lords of Finance, Liaquat Ahamed mentions Emperor Tiberius injecting one million gold pieces into the Roman economy to keep it from collapsing in 33 AD.  Extraordinary central bank policy coordination similarly isn’t new, as Mr. Ahamed notes with the frequent meetings between the heads of British, French, US, and German Central Banks and the resulting coordinated policy actions during the First World War and the Great Depression.  What is new is the extent and duration of those interventions and the absence of any corresponding fiscal or structural reforms. After Tiberius’s intervention, Rome soon returned its focus to commerce, conquest, and imperial assassination.  Roman merchants and farmers didn’t sit idly waiting for the next round of monetary stimulus and then dispose of their wares and crops in panicked fire sales when cheap money didn’t materialize.  Contrast that with our times.  Six years into an economic expansion, interest rates remain at historic lows—even negative in several major economies—with little hope of fiscal or structural reform.  A small uptick in volatility can elicit calls for further quantitative easing (college campuses apparently aren’t the only places where people are clamoring for safe spaces).  Central banks have become The Only Game in Town, the title of Dr. El-Erian’s book and the subject of the CFA Society Chicago’s July 19, 2016, Book Club meeting.

Dr. El-Erian brings uniquely diverse cultural, educational, and professional perspectives to the financial crisis and the ensuing central bank interventions.  His mother is French and his Father is Egyptian, and he spent time growing up in Egypt, in France, where his father was the Egyptian Ambassador to that country, and in New York City, where his father worked at the United Nations.  His enrichment continued in the United Kingdom where he attended boarding school, Cambridge, and finally Oxford, where he earned a doctorate in economics.  His professional resume is equally diverse and impressive.  It includes the International Monetary Fund (IMF), Harvard University’s endowment, and PIMCO, one of the world’s largest bond investors with approximately $2 trillion under management.  It’s there where Dr. El-Erian served as co-CIO along with PIMCO-founder Bill Gross.  That’s in addition to his numerous publications, boards and committees, and his previous book, When Markets Collide, which won the Financial Times and Goldman Sachs Business Book of the Year Award as well as The Economist’s Book of the Year Award in 2008.

In addition to his qualifications to write on the subject, Mr. El-Erian served as CFA Society Chicago’s keynote speaker at its 2015 Annual Dinner, which further piqued Book Club members’ interest.  In his exposition of the issues facing global markets and central banks’ responses to them, Dr El-Erian didn’t disappoint the assembled Book Club Members.  In the plain-spoken fashion that made When Markets Collide a classic, he explained complex, interdisciplinary phenomenon in simple terms with the assistance of helpful metaphors.

For example, he explained the collapse in confidence and liquidity during the crisis in terms of a drive through: Customers pay at the first window and receive their food at the second.  When customers aren’t confident that they’ll receive their food at the second window, they’ll demand it at the first window.  When restaurants don’t relent, both parties that otherwise wish to transact will walk away – market failure.  As another example, he explained that trying to push certain products and activities out of the banking system was like pushing on a waterbed.  Rather than remove the activity, pushing simply displaces the activity to elsewhere in the bank and non-bank financial sectors.

Dr. El-Erian also noted the increase in the size and power of the end-users of capital, the buy-side, relative to financial intermediaries, the sell-side.  The phenomenon has been noted, among others, by John Rogers, the former CEO and President of the CFA Institute, in A New Era of Fiduciary Capitalism? Let’s Hope So, which appeared in the May/June 2014 edition of the Financial Analysts Journal.  Dr. El-Erian explained the consequence of that transformation, namely that the growing end-users are trying to force more transactions through the shrinking pipes of the financial intermediaries.  The result in the financial world is as calamitous as the result in the plumbing world.

In all, Dr. El-Erian noted nine challenging trends in global economies related to extraordinary extended central bank interventions, the subject of Part Three of his book: inadequate growth models, high unemployment, increased inequality, decreased institutional credibility, political gridlock, increased trade imbalances and tensions between the core and the periphery of the global economy, the rise of shadow banking, decreased liquidity (the pipes mentioned above), and finally the increased complacency among market participants due to a perceived central bank put.  In that exposition Dr. El-Erian touched on several insightful points.  For example, he noted the Bank of International Settlements (BIS) meetings allowing for back-channel discussions and problem solving between the monetary authorities of different economies.  A similar mechanism for averting armed conflicts through international organizations such as the United Nations has been noted in Bruce Russett and John O’Neal’s Triangulating Peace.  Perhaps a longer book would have allowed those points to be developed further.  The Only Game in Town is only 296 pages, including appendix.

That largely concluded the exposition of the problem, where Book Club Members gave Dr. El-Erian high marks.  The remainder of the book was a meandering attempt to solve the problems noted in the first part of the book, which left members disappointed.  The desultory journey covered bi-modal distributions, behavioral finance, several other topics, and even a section on diversity in the workplace.  One member quipped that the last chapter of the book was probably a last-gasp effort to fulfill a contractual minimum page requirement with the publisher.  Dr. El-Erian had a similar chapter on organizational leadership at the end of When Markets Collide.  In that book he also noted the failure of macro-prudential regulators such as the IMF, his former employer, to balance their academic training with technical knowledge gleaned from actual market participants.  Perhaps better institutional leadership and reforms, including more diversity, could foster economic stability and growth, but Dr. El-Erian failed to argue the point persuasively, at least in the judgement of the participating Book Club members.

The Only Game in Town is a worthwhile addition to the discussion about the continued role of central banks in the current economy and the potential pitfalls of continuing down the current path.  Even though Dr. El-Erian ultimately failed to solve the problems he elucidated, he’s hardly alone in that regard.

CFA Society Chicago Chairman’s Letter to Membership

img_1799Dear Fellow Charterholders and CFA Society Chicago Members:

Based on feedback we have received, we are initiating this quarterly Chairman of the Board Message to all our members. The intent is to keep the membership informed of the activities and priorities of the Board of Directors.

This Board for the 2016 – 2017 fiscal year met for the first time on July 27, 2016. We began the session by reviewing the previous year and are happy to report CFA Society Chicago finished the 2015 – 2016 fiscal year on June 30, 2016 with strong with reserves of nearly $1.89 million on revenues of $1.4 million. Membership grew to a record 4,563 members, a 2.7% increase from a year ago. We finished the year with an operating loss of $86,600 versus a projected loss of $185,000. The unrealized loss was $18,400 for a total Net Loss of $105,000. During the year, over 140 events were held ranging from 25 to 1,200 participants.

Two primary areas of focus for the 2016 – 2017 period will be to promote Employer Engagement and Society Volunteerism. The Society has developed tools and reports to track the levels of each, and we will utilize the information to target growth areas during the year. The success of our programming depends on our volunteers and their employers support.  We aspire to develop a community of inclusion, diversity and respect, which is one of our five organizational pillars. Please get involved!

We also discussed and continue to evaluate opportunities in the areas of Advocacy and Financial Literacy which will continue to be developed over the coming year by a new Advocacy Task Force and the Membership Engagement group, respectively.

The CFA Institute has begun to elicit feedback from the Societies on the Continuing Education (CE) program. As part of this process, David Larrabee, CFA, Director, Member and Corporate Products with CFA Institute, attended the board meeting and presented an overview of the current CE program. CFA Institute is examining the voluntary status of the program and assessing the effects of making it mandatory. There are no near term plans to make CE mandatory but the Institute is seeking input globally on the matter, as well as the broader topic of how it might strengthen the current CE program.

The Board discussed in detail many of the issues that would need to be addressed before mandatory CE would be considered such as: encompassing current employer training and educational programs, incorporating other professional designation CE programs and events, and developing a robust, accessible and affordable programming.

The Board offered suggestions on incentives to encourage members to take continuing education which included an online assessment when renewing membership, a recognition program for members that take continuing education, and a communication presenting the value proposition on why continuing education is important.

We would like to thank Mr. Larrabee and the Institute for providing us the opportunity to discuss continuing education.  We are anticipating additional information regarding important issue in the future and we will keep you apprised of any developments.

During the next few weeks CFA Society Chicago will be holding events including the Distinguished Speaker Series luncheon programs featuring Jeff Ubben, Chief Executive Officer of Value-Act Capital, on September 21st and Jimmy Levin, Managing Director of Och-Ziff Capital Management, on Oct 4th. The Education Advisory Group will be presenting “Investing in Innovation” on September 28th. Please visit www.cfachicago.org for additional information and registration details.

The end of summer also means CFA Society Chicago’s Annual Dinner is around the corner, with this year’s event being held at Navy Pier on November 2, 2016. Registration for the 30th Annual Dinner is now open and features Cliff Asness, Managing Principal and CIO of AQR Capital, as this year’s keynote speaker. The Hortense-Friedman Award for Excellence will be presented to Richard Ennis, CFA, and posthumously to George Norton. If you are interested in sponsoring this year’s dinner please contact Kim Augustyn, Director of Programming and Sponsorship at kaugustyn@cfachicago.org or (312) 251-1301.

The strength of CFA Society Chicago benefits from the efforts of all our volunteers and the support of our local firms. We hope to continue to be a leading voice and a resource for our members and your firms. Thank you to all the current volunteers and the support of your firms. If you would like to learn more about how you or your firm can participate in our programming opportunities, please reach out to CFA Society Chicago at (312) 251-1301 or info@cfachicago.org.



Douglas Jackman, CFA
Chairman, CFA Society Chicago


Distinguished Speaker Series: Charlie Dreifus, CFA

DSC_2907“The proliferation of non-Gaap (financial measures) has added to the proliferation of growth,” said Charlie Dreifus, CFA.

Dreifus is a managing director and portfolio manager with The Royce Funds which focuses on providing small-cap, value mutual funds.  Dreifus is the portfolio manager for the Royce Special Equity Fund and the Royce Special Equity Multi-Cap Fund, with over 18 and 5 years on the funds, respectively.

Dreifus’ focus, for many years, has been on the value approach to portfolio management.   A key aspect of his approach is the utilization of accounting skepticism.  Dreifus shared his thoughts on the increased usage of non-GAAP measures and the resulting side effects.

He started with a story.  He had a conversation with a particular company to seek GAAP guidance.  Although the company already provided non-GAAP guidance, Dreifus was informed that “GAAP guidance is unavailable without unreasonable effort.”  Dreifus responded, “…but you need GAAP to get non-GAAP.”  And the attendees broke out laughing.

DSC_2918Dreifus reported that the number of S&P companies reporting non-GAAP measures has increased to 88%.  The consequences of the increased focus on non-GAAP include decreased clarity in reporting results and in increase in wiggle room to achieve desired results.  The desired results have, of course, have a direct linkage to executive and incentive compensation.  Executive compensation is being geared more towards non-GAAP and with the ability to front load expenses with non-GAAP measures, financial windfalls can be significant.  Audit committees have been strengthened by Sarbanes-Oxley.  Dreifus would like to see the committees act to disallow the gaming of earnings to beat analysts’ expectations.  They should take more responsibility for the reported economic stats.  Ideally, we would see “full, fair & balanced reportable numbers.”

Dreifus finds the number of times audit committees meet informative.  If the number is low or high, it raises a red flag.  He would like to believe that changes to our non-GAAP reliant system would develop within the audit committee; however, the challenge is sparking any involved person/party to take ownership of the responsibility.

On the other hand, Dreifus does grant that GAAP is not perfect either.  Nevertheless, his goal is to raise the level of consciousness within the industry and its participants.  Especially in the context of recent record-setting equity market levels, the talk has motivated deeper reflections on valuations.

CFA Society Chicago’s 2016 Annual Business Meeting

DSC_2952Beginning with a cocktail and appetizer hour, CFA Society Chicago’s annual business meeting was held at the Virgin Hotel on June 20th. Chief Executive Officer, Shannon Curley, CFA, led off with a summary of this past year which he labeled under the major theme of “Building the Base”.

The four major activities of focus were:

  1. Redesigning the website
  2. Working with CFA Institute to rebuild the CRM database
  3. Improving outreach to local universities and employers
  4. Preparing the office move to 33 N. LaSalle Street, Suite 910, Chicago, IL 60602

Following Curley’s remarks, Chicago Chairman Kerry Jordan, CFA, highlighted some of the accomplishments of this special 90th anniversary year:

  • The Society hosted over 130 events (with 9 sellouts!)
  • Record attendance at the 2015 Annual Dinner
  • Membership is up to 4,524 total members

Jordan complimented the invaluable contributions of the Advisory Group Co-chairs, and made special mention of the increased program offering of the Professional Development Advisory Group.

Examples of new or expanded initiatives include:

  • Creation of a new task force to determine how the CFA Society Chicago can be more helpful toward advocacy:
  • Launching of the CFA Women’s Network
  • The financial literacy program
  • Education of pension trustees
  • Branding campaign
  • Community service

Jordan then spoke about a few global initiatives involving the CFA Institute. Paul Smith, CEO of CFA Institute, has scheduled visits at over 140 local societies across the globe and was in Chicago to attend the regional and global finals of the CFA Institute Research Challenge.  Over the past year the CFA Institute has redesigned how local societies can receive funding for building brand awareness.

Jordan participated in the global brand campaign as part of a committee including six other charterholders to discuss the charter, what it means and how it can be made more prominent in the future.

Jordan then concluded by thanking the CFA Society Chicago staff and Shannon Curley, CFA, for his effort to grow the Chicago Society.

Marie Winters, CFA, Treasurer of CFA Society Chicago, was introduced next. Her remarks were brief, but included the society’s current financial standing including reserves sufficient enough to cover 14 months of operating expense. Recently we have used reserves strategically to upgrade technology and quality of programming.

After the 2015-2016 executive committee was thanked, Doug Jackman, CFA, was introduced as the incoming Chairman.

In the business portion of the meeting, the by-laws were approved, as well as the new slate of directors and officers for CFA Society Chicago.

Awards for amazing service were given to Justin Shepard, CFA, and Chris Vincent, CFA, and a special thanks was given to Larry Cook, CFA, who is departing as the Education Advisory Group co-chair.

Finally, Jackman was introduced as the next Chairman of the Board of Directors. Jackman spoke about not having a personal agenda, just his privilege to oversee the overarching agenda to build a strong Society which thrives on its volunteer system. Toward this goal CFA society Chicago plans to invest in upgrading systems and generating more active participation by members and member firms.

CFA Society Chicago is open to any ideas on how the Chicago society can further strengthen its brand and reputation.

The evening concluded with a reception that was a great opportunity to reconnect as well as meet new and interesting members.

CFA Society Chicago Book Club:

Age of Ambition: Chasing Fortune, Truth, and Faith in the New China by Evan Osnos

age of ambitionMost of us have a well-formed macro perspective on China. It’s the world’s second largest economy and a key U.S. trading partner with growing influence in Asia and globally. In Age of Ambition Evan Osnos takes us beyond the statistics, building a complex portrait of China through its people. The author introduces us to citizens from all walks of life with widely different views on politics, the economy, social issues and the Country’s future. He reveals the monumental changes, challenges and contradictions China faces by telling their stories, tracing their lives over the years and exploring their goals, aspirations and attitudes. It’s an up close and personal look that’s highly engaging.

We follow several progressive reformers like Ai Weiwei, a famous artist who publicly mocks inequities; Han Han, a snarky and wildly popular blogger who takes aim at rampant hypocrisy; Liu Xiaobo, a leading voice for human rights who won a Nobel Peace Prize while imprisoned for advocating political reforms; and Chen Guangcheng, the “blind peasant lawyer” who helps his poor rural neighbors fight injustice by local officials.

We also meet conservative nationalists like Lin Yifu who defected from Taiwan to China in 1979 with the dream of helping China reclaim its greatness. He became a chief economist at World Bank and evangelized China’s central planning methods. Tang Jie is a graduate student whose viral patriotic video inspired Chinese people to stand against protests of China’s repression in Tibet. He and other nationalists view foreign criticism as part of an ongoing plot to encircle and weaken China. Interviews with these and other personalities span years and it’s fascinating to observe how their views develop as the country rapidly evolves.

The author takes us beyond the headlines of scandals and disasters like China’s real estate boom, organized crime and explosive growth in Macau, riots in the Uighur region, earthquake in Sichuan, conflict with Japan over the Diaoyu Islands and the “Harmony Express” bullet train crash. State controlled media tries to shape these stories but is often undermined when details emerge. The collapse of schools in the Sichuan earthquake and the “Harmony Express” crash were eventually linked to corruption that allowed shoddy building practices. Fraud was so widespread in the railroad ministry that its chief Liu Zhijun was convicted of taking kickbacks and bribery to win a Party Central Committee post. However, the truth-seeking public also can pay a price. After the Sichuan earthquake, parents who demanded information about missing children were detained.

Several book club attendees thought the author could have quantified the material better. And we also noted he doesn’t take a position or recommend action to resolve the country’s challenges. It’s true, Age of Ambition isn’t China-by-the-numbers, but it does offer rich insight into the Chinese worldview and their perspective on the country’s challenges. Our discussion was made especially interesting having Yunjin Wang and Yang Xu, CFA, add clarity and context about their home country. Both felt the book was accurate, but also noted significant changes have occurred in the short time since it was published in 2014, including the crack down on fraud and tightening of the “Great Firewall” by incoming President Xi Jinping, as well as the profound effects of ongoing economic shifts.

Key takeaways from Age of Ambition were the existential threats facing the Communist Party and their hold on power:


Market-based policies have created dramatic growth, but the benefits have gone mostly to politically connected businessmen and officials. China’s true Gini coefficient of wealth distribution is estimated at 0.61, among the world’s worst. This inequality stands in stark contrast to the Party’s ideal of a classless society. There’s growing frustration with the lack of social mobility. Wages for college grads have been flat since 2003 and there are six million new college grads per year. Meanwhile economic growth is slowing. “Parental connections” were found to be the most decisive factor in a child’s earning potential instead of “parental education,” the typical factor in other countries.


The Party is wary of fast-moving ideas, even those that support the government. Control of information is absolutely crucial to them and the book gives a fascinating look at their methods: the “Great Firewall,” text message monitoring, “Fifty Centers” paid to disrupt sensitive online conversations, orders issued to news outlets and publishers on forbidden words and topics, etc. But despite this censorship we see how artists, bloggers and activists use the internet to expose corruption and express their views, often with tragic consequences. Internet and mobile phone penetration are growing fast, so this challenge will continue.


To transition its economy toward domestic consumption and grow its service industries, China needs to foster innovation, but official propaganda aiming to have citizens “sing as one voice” and a deeply-rooted requirement for conformity work directly against building a culture of creativity and innovation.


The Party controls the legal system, education, industry, media, communications and faith groups, but as Chinese people become educated, urbanized and wealthier they’re craving more autonomy in their work, family and spiritual lives. This works against Party efforts to “harmonize” society.

Overall, Age of Ambition is a well-written and highly insightful book that’s sure to enrich your understanding of China’s people, challenges and future.

Distinguished Speaker Series: Liz Ann Sonders


The Distinguished Speaker Series recently welcomed Liz Ann Sonders at the Metropolitan Club in the Willis Tower.  Ms. Sonders is currently Chair of the Investment Committee at Windhaven Management Inc., and is Senior Vice President and Chief Investment Strategist of Charles Schwab & Co, Inc.  Her responsibilities at Schwab include market analysis and interpreting economic trends for Schwab clients as they pertain to the equity market.

It is Ms. Sonders view that the following factors mostly favor this “unique” bull market:

  • Central bank policies have diverged with Japan and ECB leading the way in providing any perceived need for liquidity. The US central bank is not going down this path, but rather is looking for opportunities to tighten liquidity.
  • Due to the continued outperformance of the US economy, global economic indicators remain slightly positive. The level of pessimism remains high.
  • A generational shift toward higher savings as driven by the “great recession of 2007-2008” has muted the recovery.
  • The 5-year normalized P/E ratio reveals that the equity market’s value is only slightly above average. This metric is her preferred method of determining the richness of the equity market.
  • Corporate earnings hit a trough in the first quarter, but will recover for the remainder of the year.
  • Leading economic indicators do not lead to the conclusion that a recession looms in the near future.

Ms. Sonders claims the twitter hashtag #NoRecession as her idea; however it is far from “trending” and she does not expect that it will.  The level of pessimism concerning the future of the equity market can be compared to sentiment following the crash of 1987.  This is reflected in equity fund flows that remain negative for equities, making the market mostly reliant on corporate buybacks.

Inflation is something that might derail the bull, and per Ms. Sonders it should be on investors’ radar.  Commodity and wage pressure have not forced the Fed’s hand, however they are keen on attempting to normalize rates.  The velocity of money is most important and that has been slow to increase.  Ms. Sonders postulates that the Fed is driven more by the currency markets and the strength of the dollar may be more of an influence of the direction of the Fed.

Ms. Sonders also touched on the high amount of government debt now held by the US and how she thinks that is affecting the economy.  She stressed that high debt levels have led to low US growth and made the economy prone to mid-cycle slowdowns.  However, it has also served to dampen economic cycles on both the upside and the downside.

In her opening remarks Ms. Sonders referred to Martin Zweig and Sir John Templeton who helped shape her thoughts as an investor.  Sir John Templeton stated that bull markets mature on optimism and die on euphoria.  It appears that we have yet to reach the “optimism” stage.  Bull markets have never been killed by longevity.

In the Q&A session following the presentation Ms. Sonders commented on the following:

  • Gold is less an inflation hedge and is now being used more as an alternate currency. Some sovereign debt now has negative carry similar to gold.
  • Active strategies now have an advantage over passive investment strategies; there will be no reversion to a “nifty 50” as seen in the 1970’s.
  • Increased wages have implications for inflation; a September rate hike is not unrealistic.

CFA Society Chicago Book Club:

The Green and the Black: The Complete Story of the Shale Revolution, the Fight Over Fracking, and the Future of Energy by Gary Senovitz

GreenBlackOne of the benefits of being a part of the book club is learning about industries, markets, or products that are outside one’s normal course of life.  I know little of the oil and gas industry, having spent most of my life researching and working in the financial service industry.  I would encourage everyone to keep an eye on the Book Club upcoming lists, and choose one or two that would increase your breadth of knowledge and join us for the discussion.

What happens when a self-described New York liberal (the Green) meets an oilman (the Black)?  Or in an interesting twist of fate they are the same person?  Senovitz is a Managing Director of a Private Equity firm (Lime Rock) in New York that specializes in the oil and gas industry, and is also a devout liberal worried about environmental issues and the future effects of climate change.   The end result is a very entertaining and even handed account of hydraulic fracking and a great story of its history and development.

The book begins with the history of hydraulic fracking and with riveting accounts of its biggest pioneers such as Audrey McClendon of Chesapeake Energy, George Mitchell of Mitchell Energy, Mark Papa of EOG Resources  and Harold Hamm of Continental Resources.  The four are described as the Mount Rushmore of the Shale Revolution.  Their stories are a big part of the boom that led to the success of fracking: risk takers always seemingly on the edge of bankruptcy.  They persevered by staying true to their beliefs and their refusal to give up while others scoffed and laughed at them.  Many accomplished their success, simply because they did not know what else to do but continue to try.

The narrative continues to wind through many of the issues surrounding fracking.  The author breaks down the Documentary Gasland as more staged propaganda than facts and leading to an unneeded public hysteria, but also highlights real concerns such as surface contamination and noise which are very damaging and must be properly managed.  Senovitz remains tortured that fracking will lead to more carbon use, but he runs through large amount of statistics to make his case that it is really a natural gas boom that has led to the United States greatly reducing its dependence on coal and lowering its carbon emissions.  Other benefits include creating jobs, reducing American dependency on foreign energy and improving lives globally by spreading cheaper energy worldwide.

The author also describes the ongoing battle between the Yes in My Backyard (YIMBY) vs. the Not in My Backyard (NIMBY) factions.  States like New York and California (NIMBYs) have no problem utilizing massive amounts of the energy from states like North Dakota and Pennsylvania (YIMBYs), but refuse to let fracking on their home turf.  This visible hypocrisy is well discussed, and the author leaves no doubt that the NIMBY’s arguments are more political than sensible economic or scientific positions.

We found the book to be quick paced, and enjoyable.  The narrative provides a wealth of information that is important for all to consider on this controversial activity.  The Green and the Black is one of those special books which keep many of us returning to the book club.  Please join us in the future; we believe you will not regret the time.

Best Practices in Risk Management














What is risk?

Many metrics and measures fall into the overall category of investment risk, including operational risk, market risk and credit risk. Investment risk is generally defined as “loss arising from changes in interest rates, credit spreads, equity prices, foreign exchange or commodity prices.”  Liquidity risk, at the forefront of many investors’ minds these days, could also be added to this list as a standalone item or included as part of price risk.

While a definition of market and credit risk may be fairly understood, the concept of “operational risk” is sometimes more nebulous. Operational risk could be described as “losses due to anything else, aside from market and credit risk”. But there are other ways to lose money that shouldn’t necessarily be categorized as true risks, such as not having the right strategy or the right timing on an investment, which could be considered outside the scope of what a risk management function can do.

Michelle McCarthy, Managing Director at Nuveen Investments, stated that each type of risk has its own type of P&L distribution. Credit, with its main reward being coupon payment and repayment of principle, has much lower upside and a bigger left tail, or possibility of large losses, than market risk, which follows a more normal distribution. Operational risk also displays a larger loss potential. Combining the three main types of risk into a single cohesive measurement becomes difficult given their differences in distribution.

There are also two primary styles of risk, binary risks and risks of degree. Binary risks are purely unwanted and offer no upside potential, and include things like fraud, theft and legal violations. Companies can use controls and processes to manage these risks to as close to nil as possible. Risks of degree offer upside potential, and are the result of an investment decision. These types of risks are market or credit-related, and need to be managed and monitored. As a risk manager, McCarthy looks out for hidden risks that may not show up in a risk report, risks that are disproportionate to the amount of the potential gain, and risks that have a potentially unexpected return distribution.

What types of risk metrics are important to a hedge fund manager? Jennifer Stack said that at Grosvenor they often look at many different measures instead of relying upon a single number, and utilize Value-at-Risk (VaR), contribution to VaR, stress testing and factor models the company has built. While VaR is helpful for a total portfolio view risk that can integrate exposures across asset classes, different asset classes often require different risk measures.  For instance, looking at the Value-at-Risk (particularly historic Value-at-Risk) of real estate is often misleading as returns look smooth and volatility appears artificially low as a result. Regarding how best to protect a portfolio, Jennifer said that as a hedge fund investor, “sometimes the best hedge is to sell.”


Organizational Structure

Mike Edleson of University of Chicago kicked off the panel with some background on his institution’s endowment. He described their organization as “very enterprise risk focused” and said that they employ a total of 28 investment professionals, with 3 devoted to risk management.

Noreen Jones of NYSTRS said that her pension sees its primary goal as funding liquidity. Every month, NYSTRS delivers benefit payments to 150,000 retirees, and these payments total $600 million a month. The pension’s risk management group is only two years old and was created in response to a regulatory analysis of a gap on calculating and reporting risk at the total plan level. In response, NYSTRS built their risk group from scratch and currently employs four risk professionals tasked with measuring and monitoring the risk of a $100 billion asset pool. Initially, the risk group found it difficult to get a buy-in on a formal risk management approach across portfolio management groups. While the public market groups were used to routine risk measurement and monitoring, the attitude of the private market teams was often “My portfolio didn’t lose money, so where’s the risk?”

Grosvenor Capital has $45 billion in AUM and approximately 400 employees, mainly in Chicago. Its primary business is a hedge fund-of-funds, where it invests money on behalf of institutional and individual clients into various external hedge fund portfolios. Jennifer Stack, the firm’s head of risk, said that their primary goal is to “achieve not only great returns, but to achieve great returns on a risk-adjusted basis.” Grosvenor operates under a system of checks and balances between its risk function and investing functions to achieve that goal.

The panel discussed how risk ought to fit in with the broader investment function. According to David Kuenzi of Aurora Investment Management, risk management can’t be merely a policing function focused on divesting “too risky” securities; it needs to be a collaborative exercise with the portfolio management team.

Sometimes being a risk manager can be a very lonely place. During the Dotcom boom of the late 1990s, McCarthy had to have difficult conversations with star portfolio managers making piles of money on internet stocks about their sector concentration risk. To Jennifer Stack, risk “is not so much about policing, but having a second set of eyes.” And often the best portfolio managers will welcome a conversation about risk, added McCarthy.


Risk Budgeting

“We’re a little different than other endowments,” Mike Edleson said of his employer, the University of Chicago endowment fund.  Instead of a traditional investment policy statement that would dictate targets for asset class allocations, University of Chicago follows a risk budgeting approach. “There are 12 or 13 things that we’ve found to be our primary risk and return drivers,” Edleson said.

As University of Chicago researched risk budgeting and a potential shift away from a policy statement to guide investment allocation decisions, they determined that equity market performance was the most important factor for overall risk and return. This led them to the formalization of their risk budget, which is comprised of four pillars:

  • An overall portfolio beta of between .75 and .80
  • A liquidity constraint that caps private investments at 35%
  • The ability to maintain a beta of between .75 and .80 even during a financial crisis (betas typically rise during large market drawdowns)
  • An absence of leverage (which takes into account the use of implied leverage often embedded in derivatives)

University of Chicago is not the only investor looking at employing a risk budgeting framework. Jones said NYSTRS is also working on one, and the Employees’ Retirement System of the State of Hawaii is also building an allocation strategy around risk factor groups instead of asset classes. Edleson said that staying right on their risk budget forces a discussion around trade-offs into each allocation discussion, putting risk at the forefront of every decision made.


Liquidity Risk

Buying illiquid assets may look good on the way in, as each subsequent purchase by a portfolio manager tends to raise the price, but could pose a problem on the way down if there is a dearth of buying interest.

For Jones at NYSTRS, coming up with the $600 million due to beneficiaries each month is a huge challenge that is at the forefront of the fund’s investment officers’ minds. In addition to the benefit payments they must pay, they also must deal with flows from rebalancing activities and undrawn commitments that need to be paid. They do a cash flow projection to help guide their allocations and measure their liquidity in months of payroll. Given their high liquidity needs, NYSTRS has a large chunk of its portfolio in Treasury securities, one of the world’s most liquid markets.

In a hedge fund context, measuring and managing liquidity can be a bit different. Jennifer Stack of Grosvenor looks at liquidity in two ways: the degree of mismatch between a manager’s long term investment and short-term financing, and the underlying asset liquidity.

While investors usually want as much liquidity as possible, there is a potential for too much liquidity. University of Chicago actually rejected two hedge fund managers’ proposals as they found the redemption terms to be overly generous given the liquidity of the underlying securities. The endowment didn’t want to find itself last to redeem if there was a stampede out the door, which could result in the endowment holding the most illiquid portions of the manager’s positions.


Managing Risk in a Crisis

Another risk management puzzle arises because “Humans are stupid, and we love to buy high and sell low,” said Edleson, “Especially those in the investment community”. As with any shrewd investor, the University of Chicago endowment wishes to be countercyclical with their private market allocations, but this is “horrendously hard to do in practice”. So University of Chicago always does the same thing, and keeps their beta consistent across normal and distressed market conditions.

“How does one account for betas changing in a crisis event?” McCarthy posed to the panel. At Aurora, David Kuenzi likes to run his portfolios through a stress test focused on the Lehman Brothers bankruptcy in 2008, which he said was “a gift, in a sense” to risk managers as it provided a recent event to use to see how portfolios might perform in a crisis condition. While many securities of today’s portfolios weren’t around in 1987, one of the most common stress test scenarios risk managers like to use, many of the securities in today’s portfolios were around in 2008.

Another facet of risk that University of Chicago focuses on is the potential for regime change, particularly how correlations between securities tends to change over time. As risk-on, risk-off has been the flavor du jour for the macroeconomic environment for nearly a decade, this isn’t always the case. Edleson said that over time, stock and bond correlation is positive about 50% of the time and negative 50% of the time, making it difficult to discern any general relationship outside the context of each particular regime. In addition to stress testing prices, it’s worthwhile to stress test the correlations between market variables and model the effect of potential regime changes on the portfolio.

As risk evolves from measures like duration to Value-at-Risk to modeling macroeconomic shocks, there are a dizzying amount of metrics investors can look at and use to manage their portfolios. As risk practitioners, “We don’t know the future, but we can know our exposures,” said McCarthy. We can determine how our portfolios might break down in an extreme event, and we can instill a culture of risk awareness in our organization in order to avoid huge losses, with hope of buying during a crisis as opposed to selling.



Mike Edleson, CFA – Chief Risk Officer, The University of Chicago Endowment Fund
Noreen Jones, CPA, CFA, CAIA, FRM – Director of Risk Management, New York State Teachers’ Retirement System
David Kuenzi, CFA – Partner and Managing Director, Aurora Investment Management
Jennifer N. Stack, Ph.D. – Head of Risk Management, Managing Director, Grosvenor Capital Management

Moderator: Michelle McCarthy – Managing Director, Nuveen Investments

Putting Investors First

DSC_2831Each May, CFA Institute and local societies join together to create awareness around placing investors interest first. This event reminds us of why we work in this industry – to best serve our clients.  Moderator Darin Goodwiler guided panelists Jonathan Boersma, CFA, David Hershey, CFA, and Brian Thompson through a discussion on the current regulatory and ethical environment investment professionals are navigating. The panelists provided insights from CFA Institute, the SEC and consulting and investment management disciplines.

Most of the discussion covered the Department of Labor (DOL) rule and its impacts. Given the goal of DOL is to provide objective advise to investors, 93% of 1400 surveyed want the law and 51% think the law is already set up to meet this objective. Broker dealers will be impacted the greatest and it is likely that security sales will be a differentiated title from what we have known as advisors. As the DOL regulation progresses, we can expect to hear a unified message from the SEC and FINRA via social media and other communication channels.  All who give advice to clients are be held to the same standards and it was noted that CFA charterholders, candidates and members have long been held to a very high standard of loyalty, prudence and care. Due to this, no change is expected for this group.

One thing DOL won’t help with is people behaving badly. Culture and management play a role. Ethics training and regulation can help but regulation backward looking is implemented because we learn from our mistakes and play “catch-up” from innovation. Thompson commented that ethical decision making plays into awareness like yoga does into moods and breathing. Panelists felt that best practices are using GIPS and having a strong and visible Chief Compliance Officer.

This event was part of CFA Institute’s annual ethics initiative. For those wanting to practice ethics by role play in an interactive environment, please see http://cfa.is/1WTtG0G to access on-line programs offered by the CFA Institute.