Distinguished Speaker Series: Rick Rieder, Managing Director, BlackRock

The Distinguished Speaker Series hosted Rick Rieder whose other duties include Chief Investment Officer of Fundamental Fixed Income for BlackRock and Chairman of the BlackRock Investment Council. BlackRock is the largest asset management firm, now managing over $4.3 trillion for clients worldwide.  In 2013 Mr. Rieder was inducted into the Fixed Income Analyst Society Hall of Fame.  He was introduced by James Franke, Co-Chair of CFA Chicago Distinguished Speaker Series Advisory Group.

Rieder’s presentation was entitled “The New Economic and Investment Regime”.  His thesis is that economic forecasting and investing is now dependent on the following four critical factors; 1. Demographics, 2. Leverage, 3 Technology, and 4 Monetary Policy. He went on to demonstrate how each of these factors works to influence the economy and therefore interest rates. His thesis is that growth will be slow and the yield curve will continue to flatten.

Rather than simply alluding to an aging population, Rieder pointed out the employment problem and the financial burden of high student debt on the younger population. The demographics lead him to conclude that current consumption and spending trends will remain low. The implications of leverage in developed and emerging markets point to the continued availability of cheap financing. Rates in the US and UK could grind higher in the context of a flat yield curve. Rieder concluded that technology has created the biggest headwind against inflation and will continue to suppress levels of employment.   With respect to monetary policy, Rieder points out that an important by-product has been that long-dated Treasuries have become scarce due to less supply needing to be issued, continued strong foreign buying and demand for long-dated assets from pension funds and insurance companies.

Rieder concluded by suggesting which asset classes have the best potential for appreciation.  He strongly recommended long-dated municipal bonds as there is very little issuance.  Short dated ABS and CLO’s are also attractive in this environment. Rieder is bullish on the equity market given the cheap financing presently available to corporations, he predicts this will persist.

There was a brief question and answer period following the presentation. On the question of what affect exiting QE might have on the capital markets, Rieder stated that although history says differently, he did not think a big equity sell-off would occur. In response to another question, he thought that high-yield was fundamentally sound and although there would be a pause, it would not suffer big outflows.

Distinguished Speakers Series: Rob Arnott, Chairman & CEO, Research Affiliates

A provocative presentation entitled Conventional Wisdom and Pseudo-Science: Are we Blinded by Theory? took place in front of a sold out audience of 176 on June 19 at the Metropolitan Club. Rob Arnott, Chairman & CEO, Research Affiliates was the speaker who generously shared his unconventional thoughts in debunking several core theories of finance.

His objective was to take us on a whirlwind tour of areas where conventional wisdom can often lead one astray. The premise of Arnott’s talk is that much in the world of finance masquerades as science, but is not. When theory and data conflict the standard reflex is to dismiss the data.

In assuming that theory is correct, one must tacitly assume that all assumptions are correct. Unfortunately, assumptions are oftentimes incorrect, and is the cause of the fissures between theory and reality.

Almost every popular theory of finance can be debunked in some way based on a flaw in the assumptions required to make the theory work.

Efficient Markets, Miller-Modigliani, Modern Portfolio Theory, CAPM, Black Scholes, Cox-Ingersoll-Ross, Behavioral Finance, etc.  –- they all can be taken down in an imperfect world where reality does not cooperate with the assumptions.

An easy example to refute the efficient market theory in the equity markets considers empirical data involving the Top Dog in a sector.

The Top Dog is ranked #1 by market capitalization in a sector, a market, a country, or the world.

To get to Top Dog status requires outperformance. Over the preceding 5 year period, the Top Dog in the US outperforms the broad market by 20%. A global Top Dog outperforms the average stock in the world market by an even more impressive 40% in the 5 years leading up to becoming the Top Dog.

Going forward one might expect equal performance by the Top Dog according to the Efficient Market theory. However, reality suggests underperformance. And not just a modest level of underperformance, data suggests the Top Dog underperforms the market vastly in the ensuing 5 year period. In fact, the entire gain that got them to Top Dog status is often given up as the Top Dogs generally deliver less than bonds and cash. Is this a peculiarity? Or simply evidence that markets are not as efficient as theory suggests?.

Arnott suggested that history could taken a different course. What if, instead of advancing efficient markets in 60’s, there was a promotion of deranged markets. The market is always missing and trying to mean revert?  It would explain anomalies.   What if a DAPM (disorderly asset pricing model) involving mean reversion was advanced? The Nobel Prize might have never been granted to William Sharpe for CAPM and his extension of Markowitz’s portfolio theory.

Refuting CAPM was an easy target as the theory assumes everyone on the planet can borrow or lend at the risk free rate while ignoring taxes and a host of other real factors.  If all of the CAPM assumptions rang true, the theory proves you cannot beat a cap weighted market. Because the assumptions are not true, the conclusion of CAPM theory must be taken as only an approximation of fact.

Working backwards, the assumptions allow for the mathematics to work out. Do not make the mistake of believing the theory proves that is how the world ought to work. Rather, the theory is totally expected given the assumptions. When empirical gaps exist between data and theory, do not automatically assume the data is wrong or bend it in order to justify the theory. Just as important as knowing the theory is to perform a judicious search for gaps in the assumptions.

In summary, Arnott left the audience with a prudent message. Theories are wonderful, and it is not necessary to disregard theory. However, please do not confuse theory with fact. It is not.