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:

EXTREME WEALTH INEQUALITY

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 INTERNET

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.

INNOVATION

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.

INDIVIDUALITY

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, Charles Schwab & Co, Inc

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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

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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.

 

Panelists:

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