Vault Series: John Wightkin, CFA, TradeInformatics

On November 8, 2018, John Wightkin, CFA, a senior trade consultant at TradeInformatics, spoke at the Vault Series of the CFA Society Chicago about how the process of examining trading costs can help preserve portfolio alpha.

According  to John, “trading costs can represent close to half of active returns” and the process of analyzing and examining trading costs can help claw back those costs that preserve alpha. The dispersion of average trading costs can be between 3 and 48 basis points per the presentation. The process John outlined to combat these high costs has three basic steps:

  1.  Alpha profiling, which is the analysis of the firm’s linkage and relationship between the portfolio manager, trader, broker and analyst. The “alpha profile” tries to identify the unique DNA of portfolio ideas and then link the process to return preservation and implementation.
  2. Return preservation, which means looking across different participation rates and liquidity buckets for opportunities which might not be apparent. The participation rate refers to identifying active vs passive relative to market flow and the liquidity buckets are determining what order size is relative to average daily volume.
  3. Implementation is the last step to be considered and ought to be low-cost and transparent. The client firm will learn how to take control of trade execution on a specific platform to prevent information leakage, but also use the platform as a way to receive information about market flow and trade reception.

A case study was provided where TradeInformatics examined a hedge fund with 30 traders but no central trading desk. When the trades were working in the desk’s favor, there was an average of 12 minutes between trades, but when trades were working against the desk, or positions were losing, the average time between trades lengthened to 40 minutes. The conclusion drawn was that actual returns were 5.9% lower than “expected return” based on the actual trading patterns.

Using a healthy lifestyle analogy, TradeInformatics concluded that to reduce trading costs, the trading desks should “lose weight and eat a balanced diet” which translates into slowing their trading down and doing it more consistently over both sides of the market, i.e. whether the trades are winning or losing.

Summary / conclusion: The takeaway from John Wightmkin’s slide presentation was to slow down and be more consistent with a firm’s trading practices. The time differential between winning and losing trades was antithetical to the traditional practice within investing of “cutting your losses and letting your winners run”. Trade Informatics often found that the opposite was the case.

Trade Informatics can provide more discipline around the trading / execution process, for which the goal is to ultimately lower trading costs and preserve portfolio alpha.

Distinguished Speaker Series: Rick Waddell, Chairman of Northern Trust

Who better to teach management during a crisis than a former bank CEO who began his job in the midst of the 2008 recession? Rick Waddell has one of the most extensive resumes you’ll find in banking and dedicated his career to growing Northern Trust from a sleepy custody and wealth management firm into the technology-driven asset management and banking leader it is today. Waddell was CFA Society Chicago’s guest speaker on October 10th for its Distinguished Speaker Series luncheon.

He noted proudly that he saw many former and current Northern Trust employees in the audience. “The CFA Society is really important to us at Northern Trust,” he said. Waddell said that he was told not to make his speech a commercial for his bank, and joked that “this eliminates about 95% of my content” and made him ponder what would be a good topic for him to address, ultimately deciding on “5 Things I Learned From the Global Financial Crisis of 2008”.

In Waddell’s mind, the following five key features made the difference between success and failure during the financial crisis.

Capital matters. For any organization with a balance sheet, both the quantity and quality of its capital during ’08 were incredibly important. He noted that capital ratios had been too low in Europe, but generally were roughly OK in the US. He still sees problems with bank capital transparency in Europe today.

Liquidity matters. Again, both the quality and the amount of liquidity are important. Waddell said that he believed that the fall of Lehman Brothers was not due to lack of capital, but to lack of liquidity. The Fed was much more focused on capital during the global financial crisis than liquidity, but the latter was just as important. One of the earliest warning signs Waddell saw that all was not right in the financial world was when HSBC wrote down $11 billion worth of subprime mortgages in March of 2007. Waddell wanted to know if any part of Northern Trust had exposure to subprime lending and found that, while they didn’t make the loans themselves, they still had subprime-related instruments in some of their investment pools. Another warning sign came in August 2007 when Waddell learned that a securities lending collateral pool was facing losses when a number of banks withdrew from the niche Auction Rate Securities (ARS) market and banks holding the formerly liquid instruments suddenly faced losses.

Leadership and management during a crisis matter. Waddell said that during a tumultuous period, “the good and the not so good in all of us comes out.” With his background focused on commercial banking, he had to learn a lot of things quickly during the crisis as a new CEO leading a diversified financial firm. At the same time, Waddell had consultants and executives coming to him asking who he was going to fire in order to shed costs. Firing people immediately after the bank’s best year on record (2007) didn’t make sense to Waddell. He didn’t want to go down that route, and it turned out that staying the course and not making widespread headcount reductions was the right decision.

Culture matters. “At Northern Trust, our values are service, expertise and integrity,” said Waddell. Having that culture in place before a crisis hit was extraordinarily important. While Waddell admitted that Northern Trust has its share of problems like any firm, and its culture needs to evolve while holding employees more accountable, having a set of values that the team buys into was one of the main reasons the firm navigated the crisis so well. “Culture is more important than strategy,” Waddell said, echoing management consulting pioneer Peter Drucker. Despite the bank’s commitment to its partners and Waddell’s desire to avoid mass layoffs, its ROE fell to 8.2% in 2011, below its cost of capital, so the bank went on a mission to cut costs while still avoiding large layoffs that could have demoralized staff.

Strategy matters. Waddell said that having skin in the game was important during the recession. He found that the trend of banks securitizing assets and immediately getting them off their balance sheet led to a lack of skin in the game with financial institutions, and this made the crisis even worse.

Waddell continued on at length about his experience during the financial crisis. In 2009, large US banks were forced to accept a capital injection as part of TARP. Northern Trust was well-capitalized and didn’t need the money, but regulators hinted that they needed to comply or there could be consequences. Waddell said that the TARP program was in theory a good idea that could act as a stimulus, but the problem was that there weren’t enough borrowers demanding capital for it to have much of an impact. What was originally termed the “healthy bank program” soon became “the bailout” in the public’s eyes, which led to protest movements such as Occupy Wall Street, some of which were held immediately outside Northern Trust’s headquarters at LaSalle and Monroe. This populist take on the government bailing out fat cat bankers hurt the perception of Northern Trust, despite the firm’s insistence that it didn’t need capital and its desire to quickly repay the money. Waddell said that the terms of the loan Northern Trust was forced to take netted taxpayers a 15.5% return, and TARP overall was one of the most successful investments for taxpayers in recent history and very profitable for the government.

Blame for the crisis is difficult to assess, but Waddell said that the Fed was responsible for missing some of the warning signs, banks were also responsible to an extent for lax standards, and consumers were also responsible by borrowing far more money than they were able to repay. Waddell said that eventually there will be a recession in the US but the banking system will be in a much better position to not only withstand it, but even be a positive force for stability. One thing that remains unresolved is the issue of “too big to fail”, but bank capital and credit quality have greatly improved overall. While he noticed some clues that markets were starting to crack back in 2007, Waddell sees few red flags on the horizon today. He said that usually problems will manifest early on in the mortgage market, but that the industry appears to be functioning fairly normally now. There could be some issues with Brexit next year, and Northern Trust continues to monitor that situation closely, as well as the Chinese economy and issues around cybersecurity. In his Q&A, Waddell said that young professionals considering a career in banking will still find opportunities in the future, as the practice of safeguarding assets and allocating capital will be around for a long time. He was slightly less upbeat about the prospects for the asset management industry in light of the disruptions faced by robo advisers, low (and sometimes free, in the case of Fidelity) account fees, and the trend towards passive investing.

True to Northern Trust’s values, Waddell finished his speech by encouraging the audience to get involved in a philanthropic endeavor that aligns with their interest, saying “to much is given, much is expected”. Lastly, he noted the firm’s long history of collaborating with United Way and said that there’s still much work to be done.

Distinguished Speaker Series: James Bullard, President and CEO of the St. Louis Federal Reserve Bank

On September 12th, CFA Society Chicago welcomed James Bullard, president and CEO of the St. Louis Federal Reserve Bank. Members and guests heard Bullard’s remarks over breakfast at The University Club.

The focus of the discussion explored a possible strategy to extend the U.S. economic expansion. Bullard noted that historical signals used by monetary policy makers have broken down, specifically the empirical Phillips curve relationship. As a result Bullard suggested putting more weight on financial market signals, such as the slope of the yield curve and market -based inflation expectations. Handled properly, these signals could help the Federal Open Market Committee (FOMC) better identify the neutral policy rate and possibly extend the U.S. economic expansion.

Following are excerpts from Bullard’s presentation “What Is the Best Strategy for Extending the U.S. Economy’s Expansion?

The Disappearing Phillips Curve

Prior to 1995 inflation expectations were not well anchored. Around 1995, the U.S. inflation rate reached 2 percent, and U.S inflation expectations stabilized near that value. Bullard interpreted this as the U.S. having an implicit inflation target of 2 percent after 1995, calling it the inflation-targeting era. The FOMC named an explicit inflation target of 2 percent in January 2012, but Bullard said he believes that the Committee behaved as if it had a 2 percent target well before that date. The post 1995 period in the U.S. coincided with a global movement among central banks toward inflation targeting beginning in the early 1990s. During this period, the 2 percent inflation target became an international standard.

Once inflation expectations stabilized around this international standard, the empirical relationship between inflation and unemployment– the so called “Phillips curve”–began to disappear. Bullard provided a chart showing the slope of the Phillips curve has been drifting toward zero since the 1990’s and has been close to zero for the past several years.

Current monetary policy strategy

The conventional wisdom in current U.S. monetary policy is based on the Phillips curve and suggests that the policy rate should continue to rise in order to contain any increase in inflationary pressures. However, in the current era of inflation targeting, neither low unemployment nor faster real GDP growth gives a reliable signal of inflationary pressure because those empirical relationships have broken down. Continuing to raise the policy rate in such an environment could cause the FOMC to go too far, raising recession risk unnecessarily.

Given that, Bullard suggested using financial market signals such as the yield curve as an alternative to the Phillips curve. The slope of the yield curve is considered a good predictor of future real economic activity in the U.S. This is true both in empirical academic research and in more casual assessments. Generally speaking, financial market information suggests that current monetary policy is neutral or even somewhat restrictive today. Specifically, the yield curve is quite flat, and market based inflation expectations, adjusted to a personal consumption expenditures basis, remain somewhat below the FOMC’s 2 percent target. Financial market information also suggests the policy rate path in the June 2018 summary of Economic Projections (SEP) is too hawkish for the current macroeconomic environment.

A forward-looking strategy

More directly emphasizing financial market information naturally constitutes a forward looking monetary policy strategy. One of the great strengths of financial market information is that markets are forward looking and have taken into account all available information when determining prices. Thus, markets have made a judgment on the effects of the fiscal package in the U.S., ongoing trade discussions, developments in emerging markets, and a myriad of other factors in determining current prices.

Financial markets and the Fed

Financial markets price in future Fed policy, which creates some feedback to actual Fed policy if policymakers are taking signals from financial markets. This has to be handled carefully. Ideally, there would be a fixed point between Fed communications and market based expectations of future Fed policy, i.e., the two would be close to each other. Bullard said that generally speaking, markets have currently priced in a more dovish policy than indicated by the FOMC’s SEP – they expect the Committee to be more dovish than announced but still not enough to achieve the inflation target.

Caveats on financial market signals

Financial market information is not infallible, and markets can only do so much in attempting to predict future macroeconomic performance. The empirical evidence on yield curve inversion in the U.S. is relatively strong, and TIPS -based inflation expectations have generally been correct in predicting subdued inflationary pressures in recent years. Therefore, both policymakers and market professionals need to take these financial market signals seriously.

Risks 

Bullard suggested that yield curve inversion would likely increase the vulnerability of the economy to recession. An inflation outbreak is possible but seems unlikely at this point. By closely monitoring market based inflation expectations, the FOMC can keep inflationary pressure under close surveillance. In addition, financial stability risk is generally considered moderate at this juncture. Arguably, these are being addressed through Dodd-Frank and related initiatives, including stress testing.

Opportunities

The current expansion dating from the 2007-2009 recession has been long and subdued on average. The slow pace of growth suggests the expansion could have much further to go. The strong performance of current labor markets could entice marginally attached workers back to work, increasing skills and enhancing resiliency before the next downturn.

Uncertainty

Another long standing issue in macroeconomics is how to think about parameter uncertainty, or more broadly, model uncertainty. Bullard pointed to two studies: Brainard (1967) suggested that when model parameters are in doubt, policy should be more cautious than otherwise and, Hansen and Sargent (2008) suggested that, in some cases, policymakers might want to be more aggressive than otherwise. This is an unresolved issue, but how to handle parameter uncertainty has been a concern for the FOMC for years.

Conclusion

Bullard re-iterated his position stressing that U.S. monetary policymakers should put more weight than usual on financial market signals in the current macroeconomic environment due to the breakdown of the empirical Phillips curve. Handled properly, current financial market information can provide the basis for a better forward-looking monetary policy strategy. The flattening yield curve and subdued market-based inflation expectations suggest that the current monetary policy stance is already neutral or possibly somewhat restrictive.

Vault Series: James D. Shilling, DePaul Department of Real Estate

The Evolution of Modern Real Estate and its Role in a Multi-Asset Portfolio

CFA Society Chicago gathered in the Vault at 33 North LaSalle to hear Professor James Shilling from the DePaul Department of Real Estate discuss the evolution of commercial real estate and its increasing role in a diversified portfolio. Shilling was the James A. Grasskamp Professor of Real Estate and Urban Land Economics at the University of Wisconsin and currently holds the George L. Ruff Endowed Chair in the Real Estate Center at DePaul University.

Professor Shilling began his presentation by showing that the value of diversification has been recognized since the days of King Solomon (circa 970 BC). He then goes on to discuss how Nobel Laureates Harry M. Markowitz (1952) and Robert C. Merton (1973) quantified the concept of diversification for the portfolio.

Harry M. Markowitz is known as the Father of Modern Portfolio Theory. His work set the stage for the Capital Asset Pricing Model (CAPM) and a two-fund theorem. This theorem holds that for diversification purposes investors should hold a combination of the risk-free asset and a market portfolio of risky assets.

Robert C. Merton extended the Markowitz framework by allowing for multiple sources of uncertainty. In this framework commercial real estate can now assume a critical role as investors require another “hedge” against risk. However, real estate was slow to enter portfolios as there were only a few indices that could track performance. Beginning in the late 1970’s and early 1980’s the development of appraisal-based commercial real estate indices ameliorated this problem.

Professor Shilling pointed out that during prolonged periods of low economic growth and low interest rates the inclusion of commercial real estate is of great benefit to any investment portfolio. He argued that the current US economy continues to reflect this “secular stagnation”. The persistence of low interest rates has incented portfolio managers to leave fixed income and increase their investments in real estate. Current pension portfolios average around a 10% exposure to commercial real estate. If recent trends continue, this exposure will only increase.

The present state of the US commercial real estate market reflects the continuance of a slow growth economy. With portfolio managers searching for yield, the vehicle of choice has in many instances been commercial real estate. Professor Shilling argues that this influx of money has continued to compress cap rates, which for some properties approach 3%.

Professor Shilling pointed out that during prolonged periods of low economic growth and low interest rates the inclusion of commercial real estate is of great benefit to any investment portfolio.

Increasing correlation between asset classes due to lower interest rates and the trend towards a flat yield curve has produced a scenario for portfolio managers where there is “nowhere to hide”.   It is increasingly difficult to achieve diversification using only developed market assets. He argues that more effective diversification can be achieved through investments in emerging markets assets.

QE Postmortem

A review of the Quantitative Easing (QE) programs conducted by central banks around the world since the financial crisis of 2008-09 was the topic of a panel discussion before a full house at the Hotel Allegro on September 13th. Dr. Dejanir Silva, professor of Business at the Gies School of Business at the University of Illinois served as moderator. Dr. Dejanir focuses his research on unconventional monetary policy, financial regulation, and entrepreneurial risk-taking. His panelists included:

  • Roberto Perli, from Cornerstone Macro in Washington, D.C. where he heads global monetary policy research. Prior to moving to the private sector in 2010, Dr. Perli worked at the Federal Reserve Board, assisting with the formulation of monetary policy.
  • Nomi Prins, journalist and author with experience in international investment banking.
  • Brett Ryan, senior economist at Deutsche Bank responsible for high-frequency data forecasting for North America.

Dr. Dejanir kicked-off the event with preliminary comments starting with a quote from the former President of the Federal Reserve Board, Ben Bernanke:

“The problem with quantitative easing is it works in practice, but it doesn’t work in theory.”

More specifically, Dr. Dejanir explained that although empirical tests have shown positive effects of QE, we don’t have a clear understanding of the channel by which it works: the how and why of QE. This condition makes QE programs difficult to plan, execute, and, most importantly, evaluate after the fact.

The panelists then gave their general observations on QE as conducted by the Federal Reserve (Fed), European Central Bank (ECB), and the Bank of Japan (BOJ). Prins pointed out the huge size of the programs—the equivalent of $22 trillion. Even though the Fed has begun (slowly) to unwind its QE program, the ECB and BOJ are still accumulating securities. Prins called this an “artificial subsidy” which has encouraged investors of all types to take more risk than they otherwise would (or should) have. Perversely, this could end up having a destabilizing impact.

Ryan complimented the central banks for conducting QE claiming it helped avoid a long, global depression, and he added, they had learned a lot about how to use the tool in the future. He admitted surprise that the term premium in financial markets hadn’t returned to pre-crisis levels, and wondered what this might imply for the performance of risk assets in the future.

Perli, pointed out that, because the QE programs at the ECB and BOJ are still underway, conducting a postmortem is premature. Indeed, the ensuing discussion failed to reach many insightful conclusions about QE.

Dr. Dejanir then asked the panelists if central banks should conduct QE at all, in light of the risks it poses for them (by investing in asset classes beyond sovereign debt) and for investors (by reaching out on the risk spectrum further than usual). Ryan thought the risks were lower for the U.S. than for other countries because the dollar is the world’s reserve currency. That effectively removes a limit on QE for the Fed. He added that the increases in required bank capital enacted during the crisis counteracted the QE programs by requiring banks to operate at lower leverage ratios. This has led to the idea of flexible capital regulations allowing for their application counter-cyclically. The Fed is conducting research into this concept.

Perli, said that in a time of extreme crisis, central banks must take actions that go beyond standard policy, and the recent experience fits the bill. However, he questioned the separate nature of the various QE programs, and suggested a coordinated effort could be more effective in the future.

Prins, acknowledged the inherent riskiness of QE. She contended that a lot of the liquidity has found its way into equity markets, either from end investors, or corporate buybacks. She feared that future rounds might require further investments into equity markets by the central banks to be effective. She also noted that the lack of a clear exit strategy added to the uncertainty, if not the outright risk, of QE programs.

The next question put to the panelists was whether or not the central banks should (or would) seek to reduce their balance sheets to pre-crisis levels. All three were skeptical that they would. With specific regard to U.S. MBS, Ryan doubted the Fed could reduce its holdings significantly without a material impact on the market, which it would be reluctant to do. Banks invest heavily in agency MBS because of their low-risk weighting in determining capital requirements. Prins pointed out the Fed would be careful not to upset the MBS market and generate a knock-on negative impact on bank capital. Perli expected all central banks to continue with greatly expanded balance sheets for the foreseeable future. He also expects a slow transition to transactions-based policy rates rather than administered ones. Ryan seconded this opinion and endorsed SOFR (Secured Overnight Financing Rate)–essentially the overnight treasury repo rate–as an alternative to Fed Funds.

The discussion moved on to the topic of the increase in indebtedness since the crisis. Prins presented figures highlighting recent changes. Total household debt has barely budged since 2007, rising just $100 billion to $9.4 trillion. However, this masks a shift of over $1 trillion from mortgage debt to other types of consumer debt. Non-financial corporate debt has nearly doubled to $3 trillion (Ryan noted that ratios of corporate indebtedness have reached levels usually characteristic of recessions). Student loans have risen dramatically, in relative terms, from $500 billion to $1.4 trillion. When sovereigns are included, total global debt has risen from about $97 trillion to $247 trillion, mainly because debt remains very cheap for borrowers almost everywhere in the world. All panelists acknowledged, however, that emerging market countries, having to borrow in developed markets, will struggle to service their debt denominated in foreign currencies.

The debt question eventually led into the final topic of the event: inequality. Ryan noted that inequality has been rising since 1980 but has only become an issue more recently. Dr. Dejanir asked if central banks should take inequality into consideration in conducting QE in the future.  Ryan responded that central banks lacked tools to address the issue. Perli agreed, saying that in times of crisis, central banks had to act to help economies quickly, without consideration of side issues like inequality. In any case, inequality is a macro policy issue, not a monetary policy one. Prins thought inequality should be addressed with regulations all the time, not just during crises.

In the end the panel had no concrete conclusions on QE, but agreed on some broader points:

  • Despite uncertainty over the size, timing, and ending of their programs, the central banks in the largest global economies needed to act beyond monetary policy, to help their economies recover from the great recession.
  • Experience has shown that these programs entail risks that could prove to be larger problems in the future.
  • Central banks should learn from their experience with recent QE programs, share that knowledge, and plan now for more coordinated programs when they are needed next.

Distinguished Speaker Series: Morton Schapiro, Northwestern University

How is your earnings trajectory impacted if you attend a top private versus a top public institution? How many students pay the full ticket price of tuition and what is the average tuition payment post-financial aid?  Should we be concerned about the levels of student loan debt in this country?

These questions and more were the topics of discussion at The Chicago Club where approximately 150 investment professionals gathered to hear Morton Schapiro, economist and the current president of Northwestern University, opine on the state of funding for higher education. For background, Morton Schapiro is currently the 16th president of Northwestern University for which his term began in September of 2009. He is a Professor of Economics at Northwestern and also holds appointments in the Kellogg School of Management and the School of Education and Social Policy. He previously served as the president of Williams College. Schapiro is among the nation’s leading experts on the economics of higher education, with particular expertise in the area of college financing and affordability and on trends in educational costs and student aid. He has written more than 100 articles, and he has written or edited nine books, his most recent Cents and Sensibility: What Economics Can Learn from the Humanities (Amazon). His most recent book challenges modern day economics and discusses how economics can be improved through reading great literature, and even taking a step further, how one can improve investment performance through being immersed in great literature.

The industry of higher education is a fascinating one in that it is unlike any other industry in the world. In fact, some economists do not even consider it as an industry at all, however Shapiro argues the industry can be viewed with many similarities to a traditional business sector. Dissecting the industry of higher education, nationwide there are 4,400 colleges and universities that can be bifurcated into public and private, and for-profit and non-for-profit. As for students, or “customers” of the industry, there are 17 million undergraduate students and 3 million graduate or professional students. If you were to combine all the operating budgets of these 4,400 institutions, you would reach $600 billion dollars, or roughly 3% of this country’s GDP. Now this figure may seem large to some, but what one must also take into consideration is the multiplier effect of this 3%—the present value of future cash flows from the individuals that are bestowed with a great education and their respective spending impacts on other sectors of the economy.

Let’s dig in to take a closer look at the composition of these 4,400 institutions. Of these higher level education institutions, only about 350 schools (or 8%) have any admission standards whatsoever. Said another way, 92% of these higher education institutions accept anyone who applies. On the other end of the spectrum, for every twelve students who apply at Northwestern, only one is accepted equating to a less than 8% acceptance rate. Stanford, Harvard and Yale have even lower acceptance rates closer to ~5%. The reality is, the vast majority of students at higher education institutions are enrolled at schools that take everyone who applies. Further, of the 350 schools that do have admission standards, only about the top 150 schools get much publicity with the overwhelming attention going to the top 60 accredited research universities comprised of 26 private institutions including Stanford and Northwestern, and 34 of the public institutions including University of Illinois at Urbana Champaign, Michigan and Wisconsin.

This begs the question, how important is it to go attend to one of the top 60 accredited research universities? As most financial minded people would conjure, it ultimately comes down to a simple rate of return equation. Shapiro points out that we are at record rates of return for higher level education. The New York Fed looked at the direct costs of room and board and tuition plus the opportunity costs of entering the labor force immediately after high school. It took 23 years to cover the direct and indirect costs of a college education 25 years ago. Today, it takes less than 10 years to cover the direct and indirect costs—despite the rising cost of tuition that we’ve seen over the last 10 years. The return on higher education has increased much more rapidly than the rising cost of tuition. Simply put, higher level education is more important today than ever to maximize a student’s future expected earnings potential.

Let’s bring demographics into the analysis. Statistics show if you grew up in a household in the bottom 20% income range and you earned a degree from a higher level education institution, you had a 21% chance of jumping to the top 20% of income earners in the United States. The national average of a child growing up in the bottom 20% income earning household jumping to the top quintile is ~8%, leaving the non-attending high level education student in the low-mid-single digit percent range. This means that a lower-income student has roughly a four-times better chance at making the transition to the top quintile of household earners if he/she attends a higher level education institution versus if he/she does not attend. Further, if you went to one of the accredited public universities, the chances of moving from the bottom bracket to the top actually increased to 42%, roughly eight-times a child who does not attend any college or university. Taking it one step further, if a student attends one of the top private institutions, their chances of success (measured financially) moves to over 50%. Higher education matters.

This then begs the question, “Do the benefits of this higher education outweigh the costs?” Currently there is ~$1.4 trillion dollars of student loan debt outstanding in the United States. However, less than 1% of students have loan balances over $100,000. In fact, only 60% of college graduates have student loan debt (40% graduate debt free) and the average student loan balance for those that have loans is only $30,000. If you look at the rate of return on higher level education, particularly if you are attending a top 60 school, you cover the costs of your education very quickly. One area of concern is attendance at a less accredited “for-profit” school where we find the vast majority of student loan defaults.

What scares people from pursuing higher level education most often is the quoted “sticker price”. Although the sticker price of higher level education is what garners the most attention, the majority of students do not pay the full sticker price. In fact, only 25% of students attending four-year public universities pay the full sticker price. The average sticker price for in-state tuition is $10,000.  In fact, 75% of students receive some form of financial aid lowering the average student cost of attendance to ~$4,000/year for a public university. At the top private institutions, only 15% of students pay the full sticker price. The average tuition at these higher-level educations is $35,000/year and with the help of financial aid, the average student pays only $15,000 per year.   At Northwestern, roughly 40% of students pay the full $72,000/year sticker price and the remaining 60% of students pay on average $28,000/year. With the average student paying $28,000/year, Shapiro points out it is rather deceptive to only focus on the full $72,000 sticker price.

The event wrapped up with a Q&A session, where the focus was on top public schools vs. top private schools, financial aid, online education, and best advice for future students.

  • Top private school vs. top public schools. Penn State did a study that showed if a student could graduate through Penn State in four years and you paid full sticker price at both Penn State and University of Pennsylvania, your earnings potential was not dependent on which school you attended. However, if you attend a public school, graduation rates tend to be closer to 4.5 to 5 years, whereas the private universities are closer to 4 years. Demographically, the study showed that if you are a Caucasian coming from a wealthy family, you are just as better off at a top public school as you are at a top private institution. If you are a female, it tips marginally in favor of going to the top private. If you are a minority, you are much better off at a top private institution. There is a lot of debate on why these results are the way they are.
  • Financial aid and the rise of merit-based aid. Many schools have made a move towards merit-based aid versus needs-based aid; however Northwestern has not made this transition. Shapiro’s position is needs-based aid provides more value—the merit is being accepted into one of these prestigious institutions that changes the trajectory of your future earnings stream in a dramatic way. Shapiro doesn’t believe we should discount school for students who come from well-off households.
  • Online education. Despite a rise in popularity, it is impossible to disrupt the control the top 60 institutions have on the marketplace. Technology has made all higher level education better in terms of greater efficiencies, but Shapiro doesn’t envision the online degrees disrupting the premier institutions. Generally speaking, the higher institutions do not accept credit from online institutions.
  • Best advice for future students: Apply early. Northwestern takes 50% of their students through early admission. The school wants those students who would do anything to be able to attend their university. Find a school where your child will really thrive and not find himself/herself in over his/her head and apply early.

Transition Techniques

Eric Schweitzer, vice president, global outplacement and executive coaching consultancy at Challenger, Gray & Christmas, Inc. lead a panel discussion about employment transition on Tuesday, August 7 for members of the CFA Society Chicago. In addition to leading the conversation, Eric shared his experience transitioning from a bank trust department to an outplacement and coaching position. He emphasized the importance of preparation to identify relevant skills and brand.

Nancy Fehrenbach, CFA, a financial planning analyst with Phase 3 Advisory Services, Ltd. shared her process “re-entering” the investment advisory business after an extended time working as a mother, for non-profits, and as a school board president. Fehrenbach found that networking with friends and acquaintances helped her gain insights into how her experiences and skills could translate into a new role in the financial services industry. She found that investment advisory firms often look for new hires with “a book of business.” Her time away from the industry and skill set focused on analysis and customer service versus new business development. She eventually found the appropriate role for her providing financial planning services to individuals.

Daryl Brown, CFA, a director of market strategy at TransUnion, found self-evaluation tools and books, like What Color is Your Parachute, helpful in “boiling down” his skill set to effectively sell himself. Brown emphasized the importance of networking through LinkedIn. He used LinkedIn to find people that had a connection to employers that he wanted to pursue. He found that people wanted to offer assistance. Daryl encouraged the audience to reach out, even if it feels uncomfortable. Brown subscribed to the LinkedIn premium level and used the skills and endorsement features.

Phil Jandora, CFA, a senior transitions analyst in the Investments group at Willis Towers Watson, supported the critical importance of social media in his job search process. He used LinkedIn to learn about opportunities and to build out second and third level contacts. Jandora’s experience supports the advice presented in various “Jump Start Your Job Search” messages- your resume is a necessity but your network is critical. Jandora also noted that programs like Toast Masters or improvisation training can help build the communication skills necessary for the job search process.

Tim Byhre, CFA, director of business valuation at RSM, emphasized the importance of level two connections in the job search process. Most significant, he noted the importance of maintaining and building relationships before you need them. Byhre also noted his use of Glassdoor to learn about the culture of companies. He read Glassdoor reviews about what it’s like to work at the firm to determine if the firm would be a good fit for him. Tim emphasized the importance of writing down your skill set along with an explanation of how they can be used to further the success of a potential employer.  He found this preparedness very helpful when interviewing.

Eric Schweitzer supported the importance of networking and emphasized that you should know the answers to the following questions before making calls – why am I calling, what am I looking for, and why am I looking? He also noted that you should ask the individual to “do something”- offer a reference, referral, opening to a company, etc.

The panel emphasized the importance of finding a cultural fit. Fehrenbach noted her desire to work with people that she liked and enjoyed being around. Schweitzer noted that the right role at the wrong company can lead to failure. Brown said that potential employers will probably recognize a cultural mismatch, so don’t waste time compromising for a paycheck.

All agreed that a disciplined process with a focus on the future that reaches out to second level contacts can produce a successful employment transition. Throughout the process, focus on the audience’s perspective with an emphasis on “how” or “why” versus “what”. A final thought from Schweitzer – employers want to know how you are going to help them fix their problems without bringing any of your own along.

Volunteer of the Month: August 2018

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       Kevin Ross, CFA

Kevin Ross, CFA, has been a CFA Society Chicago member since 2009 and served on several advisory groups including Education, Distinguished Speaker Series and Professional Development.

This month Kevin is being recognized for his efforts with the Professional Development Advisory Group.  Kevin has served as a mentor for the Society’s Mentorship Program since the inception of the revamped program. This summer Kevin has taken a lead role with the Mentorship Program and elevated it by researching and securing a speaker to present a 90-minute session on what it takes to establish a strong mentoring experience. This session will be available to the broader membership in late October accessible via the Society’s website.

Kevin, thank you on a job well done!

Distinguished Speaker Series: Ari Paul, CFA, BlockTower Capital

It was an inauspicious day for a cryptocurrency discussion. With many cryptocurrencies down by over 10% on August 8th, Ari Paul, CFA, CIO of BlockTower Capital, gave CFA charterholders a crash course in blockchain technology and the various cryptocurrencies available for investors.

Paul said that surprisingly, many risk management professionals such as himself were among the biggest proponents of cryptocurrencies. Risk skills are definitely helpful for evaluating and investing in digital assets such as Bitcoin, and Paul believes that the space sits at the intersection of game theory, cryptography, computer science, economics, venture capital and public markets. He said that very few individuals have all of these skills, and that there is a big opportunity for people with just a small amount of cryptocurrency knowledge to generate large returns because most people don’t know much about the space yet. He compared investing in cryptocurrencies today to investing in stocks pre-Benjamin Graham. Although the idea of the blockchain is not exactly new (Paul pointed to patents received by IBM back in the 1970s for distributed databases), the current digital coin offerings such as Bitcoin, Litecoin and Ethereum are all under a decade old.

The big question when considering how to approach cryptocurrencies is “What are these helping and why do we need this?”

Paul said that a big part of the need stems from banking and capital markets technology being incredibly obsolete. He cited the examples of ACH bank transfers taking 4 days to process and $35 fees for international Western Union transfers being an opportunity for cryptocurrency disruption. While the internet has greatly increased the speed of messaging and email, payment transfers have not seen the same amount of development.

There are 3 main enhancements to the original ideas of distributed databases that have greatly increased the interest in digital currencies and blockchain lately:

  • Proof of work mining, which ensure skin in the game
  • Public key cryptography
  • Permissionless blockchain

A simple definition of blockchain could be a type of database that has its transaction entries linked with cryptography, the art of solving codes. Cryptocurrencies are the intrinsic, tradeable tokens of blockchain and the most commonly known version is Bitcoin, which had over $100 billion in market cap on the day of this presentation. Intrinsic tokens can be spent on monetary transmissions (Bitcoin) or on decentralized computing power (Ethereum). There are also asset backed tokens that can be created by a third party.

There are over a thousand digital coins tracked by coinmarketcap.com, but Paul said that the use cases and value propositions of most of them can be described in terms of three distinct categories:

  • A censorship-resistant store of value – “digital gold” or a “Swiss bank on a phone”
  • Utility tokens – amusement park tickets or paid API codes
  • Tokenized securities – crypto versions of traditional asset ownership interest

Paul said that the Initial Coin Offering market, or ICOs, has exploded in the past year, becoming larger than the overall seed stage VC market. “Many people, including myself, are skeptical of the ICO business model,” Paul said, saying that ICOs are like “hot potatoes” that speculators will often try to offload on unsuspecting get-rich-quick hopeful investors, saying that they can be seen as analogs to Chuck E. Cheese tokens.

In terms of how investors are accessing cryptocurrencies, Paul said that “we’re transitioning from crypto being un-investible [by most] to far easier,” mentioning Coinbase and other exchanges that have greatly risen in stature over the past couple years. While individuals have an easier time of buying digital coins such as Bitcoin, it is still difficult for institutional investors to access them because there aren’t many good custody options. Paul thinks that major custody bank State Street may be as far as three years away from launching a viable cryptocurrency custody product. There is also a high degree of risk of theft with the coins, and even a sophisticated investor such as Paul believes that his firm will ultimately lose money from a collapsed exchange, such as the hack of Mt Gox in 2014. Other factors limiting institutional participation in crypto include operational risk in handling the assets, the lack of credible managers with 2+ year track records and the absence of well-constructed, low fee passive indexes.

Despite the 2018 meltdown in cryptocurrency prices, Paul appeared sanguine about their long term prospects, noting that every 2 years or so there has been a large boom-bust cycle in the space, and that the potential for growth is still enormous. While Bitcoin is “already obsolete from a technology perspective” according to Paul, it still commands a widely-known brand name in the space and there’s still a huge amount of investment by institutions such as CBOE and Square. It’s difficult to know which cryptocurrency will win out in the future, but Paul believes that an allocation could make sense for some investors that can be patient riding the frequent ups and downs of the digital coin landscape.

Factor-Based Investing

The CFA Women’s Network hosted a lively and vibrant event featuring Patricia Halper, CFA, partner and co-chief investment officer at Chicago Equity Partners. Halper spoke to a room full of engaged members on the topic of factor-based investing which coincides with the popular topic “Smart Beta” investing. The subject is more relevant than ever as investors question the worth of fundamental active stock-pickers in search of both better performance and lower expenses. As a brief introduction, Halper has been working at Chicago Equity Partners for over twenty years as both a member of the quantitative research team and a portfolio manager.  Prior to CEP, she worked at Paine Webber on the institutional futures sales desk. Halper holds a bachelor’s degree in mathematics from Loyola University Chicago, a master’s degree in financial mathematics from the University of Chicago, and is also a CFA charterholder. Currently at Chicago Equity Partners, Halper utilizes factor-based investing strategies to support the firm’s equity decision making processes.

Simply stated, a “factor” is a characteristic of a security that explains its investment return. Factor investing in its most simplistic form can be described by the traditional CAPM equation: E(r) = rf * B(Rp-rf) where beta represents the single factor. In examining how a factor can be used towards making investment decisions, the question an investor must then ask is twofold: “Is this factor a good predictor of future price movements?” and then secondly “Which side of the factor (high beta or low beta in this case) will outperform the index?” Expanding upon a tradition single-factor model, Fama and French introduced the three-factor model in the 1990s which included beta, size and value.  In the late 1990s, quality factors came into light such as balance sheet quality, earnings quality, and quality of the management team. Today, there are hundreds of factors that investment professionals analyze to explain investment returns. Bottom line: factor investing is a known proven strategy that has been around for many years.  If you get the direction of correlated factors correct, you will likely outperform your benchmark.

Some of the most common factors used today include:

  • Value:  Low price/earnings, low price/sales, low price/book value
  • Quality: Strong management team, high earnings quality with lack of one-time items, low balance sheet leverage
  • Momentum: Both price momentum and earnings momentum generally provide outsized returns.
  • Size:  Smaller companies have outperformed larger companies over a long period of time
  • Volatility: Less volatile stocks provide higher expected return over the long term.

There is a key asterisks to the factors noted above. High value, high quality, positive momentum, small market cap, and low volatility have all shown to be positive factors of price performance…  over a 20 YEAR period. Often times, clients don’t have the investment horizon (or patience) to stick with a strategy that doesn’t work over several years, or even more commonly over several quarters.  In fact, the opposite of what is true in the long term (20 years) can be true in the short term (several quarters to even years). The key to understanding which factor is the most relevant to excess return is to understand what cycle of the market we are in. Halper described three market cycles:

  • Expansion: Most often markets are in expansion mode as markets generally trend higher. Momentum factor outperforms the most in expansionary periods (5%+ excess returns) and tends to work because investors tend to chase winners.
  • Downturn: At the end of the expansion period, you see a shift to Low Volatility and High Quality names with strong balance sheets that provide the best excess returns. This period can be considered recessionary with negative GDP growth.
  • Rebound: Finally, the rebound period doesn’t last long between when the downturn ends and when the expansion cycle begins—typically 2-3 quarters.  During this short time period, Value outperforms best.

Taking our single-factor observations above one step further, there is empirical evidence that If you know how to combine multiple factors into a model, a multi-factor portfolio will outperform a single-factor portfolio with less risk. There is a cyclicality in any one factor  and the cyclicality of factors increased during the global financial crisis.  It is best as an investment manager to pick at least two factors to structure your portfolio. That being said, you have to use two factors that are moderately correlated, otherwise one factor will tell you to buy and another to sell and you will naturally be holding the indexed market.. or cash!  How you combine factors, how you weight them, and how you allocate each factor is the name of the game for outsized returns. It is also critical to highlight that another key to successful factor based investing is having high quality data. High quality data has both a wide breadth and a long time horizon and without high quality data, your model will give false signals into which assets to buy and sell.

The analysis of factor based investing begs the question how is it related to the popular term in the industry right now “Smart Beta” investing.  Smart Beta strategies have shown tremendous AUM growth largely due to a general dissatisfaction with traditional equity asset managers. Asset allocators ask of Smart Beta products, “Can you perform better than a traditional passive index at a rate that is cheaper than active equity managers?” To put figures around the growth, in 2008, there was $100mm invested in Smart Beta strategies. Today, there is over $1 Trillion, a ten-fold increase in the last 10 years.  The largest smart beta funds, largely run by Vanguard and Blackrock, trade based on growth and/or value, what is otherwise a very traditional style-based factor investing that has been around for 20 years. When you take a closer look under the hood, even though these products are called “Smart Beta”, it is really the same principles just repackaged with a sexier word for the times. It’s not quant analysis, and if the product is only focused on a single factor, it’s not multi-factor investing either. If the Smart Beta product is only using a single-factor approach, it is simply “Quant 101” that has been around for over 20 years. Multi-factor Smart Beta products are a very small portion of the market which undoubtedly will grow over time. Investors should note that if they plan on buying a smart beta product, be aware of the sector exposures, as some have very high sector exposures which can overwhelm your factor exposure if you are overinvested in an industry that has sector specific issues.

What does the next 10 years look like? What factors will outperform in this current market environment? The Fed is now raising interest rates and ending its 10-year quantitative easing program.  How will turmoil in foreign markets and currencies impact our domestic equity and bond markets here at home? Only time will tell, but what is clear is that factor-based investing should be in every investment manager’s tool chest as they evaluate market trends and the price movements of its underlying securities.