Distinguished Speaker Series: Michael O’Grady, Chairman and CEO, Northern Trust

On June 13th local investment professionals gathered at the Chicago Club to hear a “fireside chat” with Michael O’Grady, chairman and CEO of Northern Trust. Marie Winters CFA, past chair of the CFA Society Chicago served as host and interviewer. To begin, O’Grady outlined Northern Trust’s core values that he said were the prime reasons the firm is about to celebrate 130 years of success, and why it remains independent at a time of rapid consolidation in financial services. These values are: service, expertise, and integrity. Northern Trust has focused on these since its inception, with the interpretation, or application, of them evolving to fit the times.  O’Grady expanded as follows:

  • Service applies not just to clients, but also to employees (or partners as Northern refers to them internally), and the community. A commitment of service to these constituents has always driven Northern‘s strategy. While the firm is known publicly for its key products (such as wealth management and asset servicing) it sees itself as a service organization.
  • Expertise is a point of pride for Northern Trust. It employs over 300 charterholders (the most of any firm based in Chicago) but the expertise the firm embraces extends beyond investment management to include other functional areas such as technology, and banking.
  • Integrity, put simply, means always doing the right thing, no matter how difficult. Again, the firm applies this broadly to relationships with partners and the community as well as clients.

Winters’s first question had to do with strategic changes that O’Grady had made since becoming CEO at the end of 2018 (or that he had planned for the near future). He did not answer specifically, but instead listed three drivers of success that he intends to emphasize: 

  1. Service excellence, a combination of his first two core values, which requires understanding the constant change in the business.
  2. Productivity, an absolutely critical need in a time of low revenue growth. Productivity improvements have been a focus at Northern for several years in a program called “Value for Spend”, which seeks to get more out of each dollar of expense.
  3. Investing for growth–determining where the firm should invest now to generate growth in the future.  Again, this reflects the recent history of slower revenue growth. 

Responding to a question about how Northern Trust is addressing the secular shift from active to passive management, O’Grady noted that Northern provides products that follow both strategies. The focus on efficiency is his key to success within passive products because of the low fee levels. Within active strategies, the focus is on leveraging Northern Trust’s expertise in factor-based analysis. Both of these product lines appear in their lineup of multi-asset class solutions.

When asked about investing for ESG (Environmental, Social, and Governance) factors, O’Grady said Northern Trust sees a clear and growing interest from clients. Designing and building such products requires a vast amount of new information and we are only in the early days of reporting that. Gathering accurate information consistently, and analyzing it thoroughly, will be key to success in ESG investing. This is made challenging by the changing nature of our economy.  The number of publicly-traded companies is shrinking, in favor of private companies. Obviously, public companies are more likely to report relevant data pertaining to ESG factors (and in a more consistent manner) than are private companies. So, even for the private equity investor, following ESG strategies is a challenge.

When asked about the importance of technology and digital innovation, O’Grady turned to data security. At front of mind for him was protecting clients’ private information. Technological innovation changes our world faster and faster (blockchain and cloud computing were two drivers of change he mentioned). With this change, clients demand more information, delivered more quickly, but the more we rely on technology to satisfy that demand, the greater the exposure to cybersecurity threats. Ironically, technology will have to be the principal tool in protecting against this risk. O’Grady then made an observation about technological innovation that illustrated one big way it has changed our world. He turned around the saying that “necessity is the mother of invention” to innovation being the mother of necessity. So, not only does technology allow us to do more with less, it also allows us to do things we never thought possible, never knew we could do, and even never knew we needed to do. This gets to the heart of the fears that technology destroys job opportunities. Rather, it creates more than it destroys.

The final area that Winters asked about was how Northern Trust is addressing diversity and inclusion. O’Grady said he’s proud of what Northern Trust has done so far, while acknowledging that the process continues. He specifically noted success in improving diversity metrics in hiring, especially for entry-level jobs, but sees more improvement needed further along the career path. That improvement requires new information that will inform the company on the causes of this shortcoming, and define the corrective actions. So far, they have learned that male managers tend to change roles more often early in their careers, giving the appearance of broader experience when they are considered for promotions. By measuring this and reporting it to managers Northern Trust can hold them accountable for removing any gender-based biases. Further, he noted the firm needs to be more active in assuring that development programs are open to women and people of color and the firm’s culture, which has served it so well for so long, may also have served as an obstacle to advancement. It must evolve to embrace a new commitment to improving diversity.

Diversity improvement was the subject of the first question from the audience about the differences in the various countries where Northern Trust has a significant number of employees. O’Grady acknowledged that policies and actions need to be tailored to the customs, regulations, and existing circumstances in each country. Gender equity is easier to address with consistent policies and programs around the world. However, ethnic diversity requires more customized solutions.

When asked how Northern Trust “walked the talk” on integrity. O’Grady listed three steps: 1) he repeated his rule of always doing the right thing; 2) being transparent, both internally and externally, so your stakeholders understand what you’re saying and doing, and can judge you correctly; and 3) leading by example because telling people how to behave is ineffective. They need to embrace the rules or customs.

When asked what companies O’Grady considers to be his most formidable competitors, he mentioned a few well-known financial services providers but his general comment was more insightful: they need to be mindful of the firms that are excelling at the things Northern Trust also needs to do well. The final audience question asked about Northern Trust’s strategy for growth. O’Grady summarized the firm’s revenue stream as about two-thirds from fees directly connected to the value of the assets they manage or service. They have no control over the value of those assets. The other one-third of revenue comes from earnings on the balance sheet, which are highly correlated to interest rates. Again, they have no control over the level or direction of change in interest rates.  So, they focus on the growth of new business because it’s the factor affecting profit growth that they have the most control over. Secondary factors include productivity improvements (that they see as an offset to inflation), and prudent investments in new businesses or technology.

Impact Investing: A New Investing Paradigm

A large group of CFA charterholders and other interested investment professionals gathered at the Palmer House Hotel to hear the latest thoughts and techniques in Impact Investing from a distinguished panel on June 5. The moderator, Priya Parrish, is a leading proponent of impact investing in the Chicago community of investment managers and managing partner at Impact Engine, a venture capital and private equity manager with a focus on investments that generate positive outcomes in education, health, economic empowerment, and environmental sustainability. Prior to the event Parrish joined us for a quick podcast which can be found on the CFA Society Chicago website and SoundCloud. Her panelists at the event included:

  • Susan Chung CFA, Managing Director of Investment Management at Wespath Institutional Investments, the investment arm serving the United Methodist Church, and other faith-based investors.
  • Andrew Lee, Managing Director and Head of Sustainable and Impact Investing for UBS Global Wealth Management
  • Charles Coustain, Portfolio Manager of Impact Investments at the MacArthur Foundation

Parrish kicked-off the program with an introduction describing the development of impact investing across nearly fifty years of history. The first generation was Socially-Responsible Investing (SRI) dating as far back as the 1970s. Its primary objective was aligning investments with the owner organization’s mission or values. Popular originally with religious organizations, this version relied primarily on negative or positive screening to either exclude companies involved in businesses that were objectionable to the investor (e.g., alcohol, tobacco, or gambling) or to include firms pursuing something the investor sought to encourage. Investment returns often took a back seat to mission alignment. SRI evolved to incorporate consideration of environmental, sustainability, and governance (ESG) factors in an attempt to improve risk-adjusted performance. The reasoning being that companies that excelled on ESG factors were more likely to out-perform lower scoring peers. Impact investing is the latest generation of the model.  It seeks investments that not only generate strong financial returns, but also contribute to positive changes on social matters. Parrish provided a list of seventeen such social matters with education, health care, economic empowerment, and the environment, being the most important ones to Impact Engine.

Parrish noted that, while many people are aware of the social ills often blamed on corporations, the profit motive also gives corporations the power to change society for the better. They only need to recognize this and make it their intention to improve society while pursuing their profit-generating goal.  The element of intentionality is what defines impact investing. The challenge for the impact investor is to identify, select, and manage those firms that intend to make a positive social impact in their businesses, and do so successfully. The audience heard the panelists refer to this element of intentionality repeatedly throughout the event.

Before bringing the panel on stage, Parrish presented a graphic depiction of the spectrum of impact investments. Its vertical axis showed modest return expectations with market return at the top and declining down through return of capital to complete loss. Across the horizontal access ran the approach to impact, beginning with None, and including stages such as Passive, Intentional, and Evidence-based.  The body of the matrix listed the investment products and strategies used to apply the approach toward achieving the return goal.

Parrish then invited the panelists up on stage and asked each to make a brief statement about the involvement of their firms with impact investing. Susan Chung pointed out that Wespath is part of a religious organization and invests for both the church as well as for pension plans for church employees.  The former is primarily done in an SRI style (meaning exclusionary) because they are less concerned with the returns than avoiding investments that conflict with the organization’s values. The qualified funds are more return-seeking so they have adopted impact investing. Engagement with corporate management is their primary tool for effecting change. They sometimes partner with other investors with a like mind to increase their leverage.

Andrew Lee of UBS Wealth Management said the firm sees impact investing as a major trend with a lasting impact so they have embraced it very broadly.  This is driven both internally, by the Wealth Management CIO who is committed to the style, and externally by clients.

The MacArthur Foundation, being a philanthropic organization, takes a different approach. Its primary purpose is effecting positive social change to begin with, and it pursues that objective with direct grants to institutions working in its areas of choice. These aren’t intended to generate a financial return, however as far back as 1983, the foundation began investing in public banks that address special social needs (such as affordable housing) that were underserved by the market. Their involvement was trailblazing in that it encouraged regular, for-profit, banks to invest in the same manner to the point that they now provide more funding than philanthropic organizations. MacArthur’s impact investing has grown to encompass a separate carve out of the foundation’s endowment that seeks return-generating impact investments that further the goals of its grant program.

As to how to select managers who best align with the investor’s goals, both Chung and Lee stressed the need for vigorous research to understand a manager’s process and determine how committed they are to impact investing. Wespath uses a detailed assessment survey to help with this.

Chung outlined how Wespath found a way to incorporate impact investing into passive strategies. By partnering with Blackrock, they were able to access data to score companies on ESG factors. Searching for indicators of either positive or negative correlation to performance, they identified factors used to make slight adjustments to the index components and thereby, drive alpha. As an example, Chung said they discovered that the rate of decline in carbon emissions was a better performance indicator than the gross amount of emissions. So, firms demonstrating the greatest decline, even if from a high base amount, out-performed firms showing lesser declines (or increases) even if from a very low base. The resulting strategy is very neutral on sector and industry metrics, while benefiting from relatively small mis-weights in the individual stock positions. Indexing purists would consider this to be enhanced indexing (if not a quantitative active strategy) rather than true indexing.

All three panelists stressed the importance of collaboration with other firms interested in impact investing to stretch their resources and increase their leverage with managements. This is especially important in the governance area where engagement with company management has proven to be an especially effective way to effect change. Wespath joins with other investors (or asset managers) when they engage with firms to discuss corporate governance. 

Lee added that UBS has determined that engagement with management is the best way to bring about change—far more so than simply voting proxies against management recommendations. This is especially true in the public equity markets. The firm sets an engagement goal at the outset when making a new investment.  

MacArthur collaborated with the Chicago Community Trust (CCT) and Calvert Research and Management to increase the scale and focus of its impact investing. The CCT brought a local focus to the investing to assure that funds were invested where the investors intended them to be.  MacArthur brought its institutional funds and Calvert added funds raised from their individual investors interested in the strategy. 

The Q&A session that followed the discussion lasted for half an hour, indicating the high level of interest from the audience. The first question asked the panelists to identify some impact investments that had not worked out as expected. Chung listed emerging market infrastructure, solar power following the removal of government subsidies, and wind farms in the North Sea. Coustan added for-profit education as an example. Lee noted that sometimes an underperforming investment needs to be reassessed to see if the investor can help the organization improve. The panel was in agreement that impact investing was more difficult to apply to fixed income. Chung advised that fixed income managers should borrow the scoring methodologies used on the equity side.  Lee added that UBS has substituted bonds from supranational financial companies such as the World Bank and UN-sponsored development banks in place of sovereign debt in the high-quality portion of fixed income portfolios. Coustan said MacArthur primarily utilizes private debt vehicles for impact investing because of the flexibility in structure and use of the funds. In these cases, however, their return objective is only to preserve capital.

Big Data, Machine Learning & AI

Cathy O’Neil: Founder of ORCAA and
Author of Weapons of Math Destruction: How Big Data Increases Inequality and Threatens Democracy

Big Data, artificial intelligence (AI) and machine learning are becoming some of the hottest topics in finance. A packed room of CFA charterholders gathered to hear a presentation by Weapons of Math Destruction author Cathy O’Neil and a panel discussion on that topic in early May.

O’Neil began her discussion with Google’s autocomplete predictive search that can occasionally feature unreliable or conspiracy-laden results. She said that Google shouldn’t be able to have it both ways, making money off users’ trust yet saying that bogus search results aren’t their fault.

According to O’Neil, AI is not a model for truth. Artificial intelligence technology could be characterized as a series of opinions fed into an algorithm. The authors behind the algorithm will tell you to “trust the math”, but should we be that trusting when companies are incentivized not by truth but by profit?

AI amounts to making a prediction. There are two parts to an artificial intelligence prediction: the historical data, which contains a possible pattern, and the algorithm’s definition of success (such as a quant generating profit at a certain volatility level). Even mundane things such as determining what to cook for dinner could be characterized as an algorithm.

Our lives are increasingly touched by algorithms, in areas such as banking and credit, policing, jobs and even matchmaking. Sometimes the algorithms are incredibly helpful, but sometimes they can cause a great deal of harm. When a company runs an algorithm on you, you should trust that it will optimize the result to the company’s definition of success, not necessarily what is best for you. O’Neil said that many of today’s algorithms can be characterized as WMDs (Widespread, Mysterious and Destructive). And algorithms do make mistakes, but those mistakes aren’t typically publicized because the algorithms are usually secret intellectual property.

O’Neil told a story about a teacher who was fired because her students received poor test scores. This happened even though the administration didn’t have access to the actual score which was generated in a black box that no one outside of the firm had access to. Finally, access to the scores was provided. Upon reviewing them, the teacher scores looked essentially like completely random numbers with little predictive power from year to year. Some teachers have sued for wrongful termination and have won their cases.

Another example O’Neil gave of an algorithm causing harm was the case of Kyle Beam, who didn’t get a Kroger job because of a personality test result. The test resulted in a “red light” outcome where Kyle was not offered an interview. He complained to his father about the process, who is an attorney, and his father determined that the test violated the Americans With Disabilities act, as it is unlawful for a company to require a health exam as part of a job screening.

One of the main problems with algorithms today is that they tend to look for an initial condition that led to success in the past. Amazon developed a hiring algorithm (that wasn’t ultimately used) that aimed to determine which characteristics of certain hires led to success in the job. The algorithm proxied job success with metrics such as salary raises, promotions and workers who stayed more than four years. Upon scanning the data, the algorithm found that initial conditions such as being named “Jared” and using the word “execute” more frequently on resumes tended to lead to success. Unfortunately, it was also determined that male candidates tended to use the word “execute” more frequently than women, so some of the characteristics the algorithm was searching for were proxies for gender.

Couldn’t there be a market-based solution to all the defects inherent in algorithmic decision-making? According to O’Neil, expecting companies to self-police their own algorithms might be somewhat unlikely. This is because algorithms that maximize profits without any constraint on fairness are more profitable than algorithms with fairness constraints. This dilemma can be seen with Facebook. Facebook has a higher level of engagement and a more lucrative advertising business when its users are arguing about fake news and conspiracies.  Most companies facing demanding shareholders would be reluctant to agree to lower profitability in order to ensure fair algorithms. Because of this issue and others outlined above, O’Neil believes that regulation is needed.

Currently the legality and ethics around employers sourcing alternative data such as health information in order to make hiring decisions is murky. “What’s stopping Walmart from buying data to see who is sick or healthy [in order to make decisions on employment],” O’Neil asked.

O’Neil laid out three principles for responsible algorithm usage:

1) First do no harm

2) Give users the ability to understand scores and decisions

3) Create an FDA-like organization that is tasked with assessing and approving algorithms with a high level of importance

L to R:
Metin Akyol, Ph.D., CFA (Zacks Investment Management) Kevin Franklin (BlackRock),
Sam Shapiro (Goldman Sachs Asset Management), Cathy O’Neil (ORCAA)

During the panel discussion, speakers talked about how machine learning and AI are used in their portfolio management process, particularly parsing through large data sets. They talked about how it is more challenging to hold risk models to the same standard as trading models because risk cannot be directly measured, and the success of a trading model can easily be evaluated by the P&L generated. Are machine learning and Big Data a flash in the pan, or are they here to stay? The CFA Institute believes that it’s the latter, and have added the topics to the 2019 CFA curriculum.