Transitions Techniques

From back-office roles to a decision-making roles

How to make a transition from a back-office, support role to a decision-making role in investment management was the topic of discussion on November 18th for a panel with real experiences in making just such a career move. Moderated by Eric Schweitzer, vice president at Challenger Gray & Christmas, the panel featured three charterholder members of our society:

  • Vincent Baxter, CFA – Associate Equity Portfolio Manager, Northern Trust Asset Management
  • Jackson Finks, CFA – Analyst, Dearborn Partners
  • Oday Tillawi – Associate/Desk Analyst – Investment Grade Credit, Allstate Investments

To begin, Schweitzer asked the panelists to describe both their current roles and the support positions they had transitioned away from. Finks joined Dearborn Partners in 2013 after a year in trust operations at US Bank. His first role at Dearborn was in trade support and operations, but after a year he was able to move up to analyst in support of the firm’s rising dividend strategies.

Tillawi began at Allstate in the Financial Planning and Analysis team responsible for the financial planning and reporting for the business unit. He shifted from there onto the fixed income portfolio management team within the past year where he both assists the senior portfolio managers directly and conducts fundamental research on investment grade credits. He passed the Level III of the CFA exam this year.

Baxter, has been a portfolio manager for tax-aware quantitative equity strategies at Northern Trust Asset Management for the past year. He moved into that position in stages, from back office, and middle-office roles supporting asset management.

Schweitzer then dove into the meat of the discussion by asking the panelists to focus in turn on three steps to the transition process: Preparation, Targeting, and Interviewing. Although they might not have been aware of these steps, of necessity they had to proceed through them to reach their goals.

Preparation

Finks led off by saying he realized very quickly that his introductory position in trust operations would not lead to something he aspired to. The positions of higher responsibility he would be able to advance into from his starting point held no allure for him. So, he immediately enrolled in the CFA exam series and began networking at other firms. One such networking meeting led to a job offer in trade support at Dearborn.  While this was a lateral move in terms of the role and responsibilities, he saw a better chance at advancing into a more desirable role at the smaller firm than he could see at US Bank.

Tillawi also relied on the CFA program to open doors for him. Inside Allstate, the competition for openings in asset management was high, so he realized he would need to be aggressive from the start, and working toward a charter fit the bill. He also sought out a mentor on the team he was targeting and found that not only did that relationship help him get recognized when an investment-related position opened, it also was beneficial in studying for the exams.  He made a habit of writing a summary of each meeting with his mentor to have a record of his suggestions.

Regarding mentoring, Baxter mentioned that while in his middle office role he was seated in close proximity to the portfolio managers he supported. That allowed for opportunities to educate himself by questioning the experts he supported, effectively making them unofficial mentors. Tillawi recommended being assertive and asking respected people to serve as a mentor, especially if working at a firm without a formal mentoring program. In his experience, many people are very willing to mentor a junior colleague who shows initiative. He also suggested preparing a career development plan as an aid to maximizing the benefits of a mentor.

In response to Schweitzer’s question about skills the panelists developed to enhance their chances for advancement, Finks and Baxter agreed that enhanced communication skills were critical keys to success in their new roles where they had to communicate regularly with sales and client service professionals and sometimes clients. Finks strongly endorsed networking skills. All three panelists strongly supported enhancing Excel skills. Even in a world of ever more prevalent modeling and analytical systems, Excel remains a prime tool in asset management and many people do not know how to use its full potential.   Finks said he became the “go to” authority on Excel in his office and provided assistance to colleagues, which only enhanced his chances for advancement.

Targeting

As two of the panelists had transitioned internally, only Finks could provide comments on the second step of Targeting. He cast a large net while networking because he needed to change firms to improve his chances at his hoped-for position. He employed personal and business contacts to land an introduction at Dearborn Partners. He advised people to maintain strong contacts with anyone in their networks who are most likely to be influential in hiring and promoting in the areas one aspires to join. 

In response to Schweitzer’s question about the importance of company culture, Finks thought that he was too early in his career to give that much importance. He was more concerned in the role first. However, Tillawi, also early in his career, pointed out that we typically spend half our waking hours at work so getting the correct cultural fit, at least at some point, will be critical to career success as well as personal happiness.

As for networking, which Schweitzer considered a part of targeting, all three panelists had pointed observations. Baxter noted that it’s easier to do in a large company, simply because of the larger pool of co-workers, but he recommended making a personal connection with new contacts to make yourself more easily remembered.  Finks and Tillawi both recommended attendance at the Society’s events for easy, and well-targeted networking. Tillawi said he had success sending cold e-mails to people he thought would be especially helpful. Social media, especially LinkedIn, can be an invaluable tool. Schweitzer pointed out that it is now the first screening tool used in candidate searches, and also that research at Challenger has shown that new hires are most frequently second-degree connections with the key decision makers in the search.

Interviewing

Schweitzer then moved on to the final step, Interviewing. Baxter had perhaps the most insightful comment to make on interviewing. As a candidate seeking to move from the middle office into a front office investment role, he assumed he would not have the best qualifications on paper relative to other candidates already within the investment decision making chain. He made up for that by demonstrating his passion for investment management. That paid off for him in time. Tillawi was surprised at how little he was asked in interviews about technical information. Rather, he described more of the questions as situational or behavioral. Others with the same aspirations should be prepared for them.

In final wrap-up comments, Finks advised patience. Recognize that the transition process will play out slowly and take longer than expected. Baxter said having a definite idea of the target role is critical, while Tillawi added it should be a goal that one can write down to help maintain focus.

Mental Skills: Get Your Head in the Game

How to control and increase one’s mental skills was the topic that drew a capacity crowd for the latest installment of CFA Society Chicago’s Vault Series on August 20. The featured speaker was Jim Gary, a Licensed Clinical Professional Counselor with 52 years’ experience in the mental health field. In 1999, Gary started a program to help high school athletes adapt behavioral techniques to enhance their confidence and performance. One of his students was Tom Kulentes, who found the program so rewarding it led him to a career as a high school psychology teacher and, eventually principal. He also joined Gary as a partner in his counselling business. Gary’s success with student athletes received wide media attention, to the point that the Chicago Blackhawks commissioned him to work with their players and staff. He was the first mental health therapist on the staff of an NHL team, so he developed the completely new role on his own. Gary had the honor of working with the teams that won three Stanley Cup Championships (earning him a ring for each one).

Gray began his presentation with a demonstration of a simple visualization exercise. He had the audience stand up and twist their upper bodies as far to the side as they could without moving below the waist. Then he asked them to close their eyes; draw, hold and release a deep breath; and visualize repeating the exercise while trying to turn further. Then they repeated the movement with closed eyes.  Most in the room were able to turn further than they had the first time. The effectiveness of the example was evident to everyone. Gray called visualization–when the mind directs the action of the body, a simple and effective tool that everyone can use to increase their effectiveness and performance in many ways (but that few do). When we train our minds to send a positive message to the body, we will get a positive result, although Gary also demonstrated that negative messages create a correspondingly opposite effect. Visualization has even been shown to be effective in medicine. With the right coaching and a strong signal, the body can respond in a way that helps a patient recover.

Gary next introduced his partner, Tom Kulentes. Now a high school principal, Kulentes experienced such a positive impact from Gary’s counselling when he was a high school wrestler that he has applied it in his professional and personal life ever since, eventually joining him as a business partner. Kulentes approaches his role as a school administrator by assuming his students begin with an unknown, but unlimited capability–or talent–to learn and improve themselves. Such talent can’t be measured, but it can be increased with improved mental skills. These skills can be taught and enhanced with mental exercises and are one of the best predictors of performance.

Gary and Kulentes used their work with the Chicago Blackhawks hockey team to illustrate the application of mental skills counselling. Like all teams in the National Hockey League, the Blackhawks operate at the highest level of competition in their field. They employ the best athletes, selected from around the world, guided by top coaches, trainers, and counsellors focusing on attaining peak performance of both body and mind through deliberate, intense training and practice. The level of competition creates intense pressure on all participants but especially the players. They need to perform at peak levels consistently while managing the pressure of travel, risk of injury, intense media coverage, contract negotiations, and fan expectations, not to mention family obligations.

Kulentes likened the competitive, pressure-packed environment of the professional hockey player to that of investment managers. The environment creates stress which he defined as the body’s internal response to external pressure. He diagrammed stress graphically under a bell curve. A state of stress occupied the center, tallest part of the curve where the subject should feel energized and focused, where performance peaks because work seems to be easy. By contrast, in the left tail, the subject might feel bored or detached from performance which can improve as he moves to the right on the stress spectrum and up the curve. Past the sweet point in the middle of the curve, stress increases greatly and becomes distress characterized by increasing fatigue, burn-out, poor health, and culminating in a breakdown. Successful performance requires knowing oneself well enough to stay in the mid-range of the spectrum and at the peak level under the curve. Kulentes emphasized this by quoting a proverb: “Mastering others is strength, but mastering ourselves is power.”

Kulentes continued by explaining the concept of a growth mindset versus a fixed mindset, as defined by the psychologist Carol Dweck. Everyone possesses elements of both, with one usually dominant. People with a dominant fixed mindset perceive their talent, or ability, as fixed, or limited to certain areas where they feel more of an innate aptitude. Growth mindset people perceive ability as something that can be developed and increased over time with effort. They see challenges as opportunities to improve while the fixed mindset person sees them as obstacles, or risks to avoid. The growth mindset person focuses on process while the fixed mindset person focuses on outcomes. People perceived as great achievers (even over-achievers) all demonstrate a growth mindset. He presented examples such as Mozart and Einstein, along with a number of greats from the world of sports.

The attribute that most sets growth mind set people apart is “grit” which Kulentes defined as:

  • Applying sustained effort strenuously over time,
  • Enduring temporary setbacks, obstacles, and failures, and
  • Persevering until the desired goal is achieved.

People exhibiting this sort of grit will enjoy greater success than they otherwise would.  Kulentes described success as the visible part of an iceberg, lying above the surface. It’s small compared to what’s below the surface which represents the important features on which success depends such as dedication, hard work, and diligence.

Gary returned to the lectern to complete the presentation by introducing one more concept: that of the Self Talk.  This he described as a brief statement affirming one’s commitment to taking control of how the mind controls the body. As examples he provided:

  • “I will take control of the messages I give myself.”
  • “Today I will recognize negative thoughts and replace them with positive thoughts.”
  • “Don’t let the pressure exceed the pleasure.” (From Cubs manager Joe Maddon.)

Distinguished Speaker Series: Michael O’Grady, 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.

Vault Series: Aegon Asset Management

On Demographics, Growth, and Investing: When the structural collides with the cyclical

Francis Rybinski CFA, treated CFA Society Chicago to his analysis of the current global demographic situation and its implications at the latest Vault Series lecture on March 12.  Rybinski is the chief macro strategist at Aegon Asset Management, responsible for guiding the firm’s global macroeconomic view pertaining to tactical and strategic asset allocation. His presentation included a wealth of statistics that highlighted the weak rates of growth of both population and productivity in developed economies around the world and how that situation limits investment managers.

Rybinski began with some observations on the trend in GDP growth in the U.S.:

  • Actual GDP growth has declined erratically from about 4% in the early post-World War II period, to 3% late in the last century, to just 2% since the last financial crisis. Growth above 2% in very recent quarters has not persisted long enough to define a change in trend.  (Slide 4)
  • Accompanying this change has been a decline in the volatility of the growth rate, both absolutely and relative to potential growth.
  • While growth has been slowing, the business cycle has been lengthening. The economy seems to be stretching out expansions by pacing itself at a slower rate of growth.

The two driving factors behind GDP growth are the rates of growth in the labor force, and in productivity. Both have been anemic with little expectation of a move to the upside. The Congressional Budget Office projects near term potential GDP growth at less than 2%, incorporating 0.5% growth of the labor force and 1.4% productivity growth. Rybinski argued that even if the labor force were to grow at 1.4% (the average since 1950) potential GDP would not reach 3%, and would trend downward after 2020.  Even boosting productivity to 2% gets GDP growth only to 2.5%. While President Trump claims his policies will increase productivity well beyond its recent trend, Rybinski is skeptical. He listed several forces most likely to boost productivity significantly including autonomous vehicles, robotics, 3D printing, genomics, and generally the internet of things. He doubted any of these could be as transformative as the forces that drove productivity higher in the 20th century such as the expansion of the electric power grid, telecommunications, and the development of computers. Maintaining a persistent 3% growth in GDP would take 2% productivity growth—a level last experienced in the 1990’s tech boom–and 1% labor force growth–which would be dependent on increased immigration.

Rybinski applied the term “demographic drag” to the situation he had described. Noting that it exists throughout developed economies, he concluded that “It’s a small(er) world after all”. (Or at least a slower growing world.) This situation, he thought, was at the root of many current global movements such as the new nationalism, anti-immigration stands, and the Brexit vote. The demographic situation also has implications for retirement investing and the social safety net. Lower prospective investment returns will require even higher amounts of savings to fund retirement, and/or an increased burden on government retirement plans.

Rybinski went on to present more demographic data to support his premise.

  • In the 1970’s, a demographic tailwind driven by the maturing of the baby-boom generation and the flood of women entering the work force, provided a big boost to GDP growth in the U.S. This has now become a tailwind as the baby-boomers reach retirement age and the increase in women in the work force has leveled off. This leaves only productivity to boost GDP growth.
  • The fertility rate in the U.S. declined by about 50% from 1960-75 and has been under the replacement rate of 2.1 births per woman for a decade. Similar trends appear around the world in countries across the income spectrum.
  • The share of the U.S. population over age 55 is about 27% and continues to rise.  The share in the prime working years has been trending down for over twenty years and is now under 50%.  The share ages 16-24 is not growing, but is stagnant at about 15%.
  • The old age dependency ratio (ratio of people ages 20-64 vs. those older) has received a lot of attention because of its dramatic down trend. Rybinski showed that, when adjusted for the increase in the labor force participation rate since 1948, the decline is not as significant, but the trend is still negative. This is a common feature across developed economies.
  • Currently, immigration accounts for just over 40% of U.S. population growth and it is rising. Native births account for the other 60%, but the share is declining. Within ten years, these factors will be about equal and by 2045, immigration could provide more than 70% of population growth.
  • Average life expectancy continues to increase and has reached 72 years globally (80 years in high income countries).
  • Increasing life expectancies and earlier retirements mean more time is spent in retirement. In 2010 it reached 13 years in the U.S. and 18 years in Germany.  Even China has advanced to eight years from just two in 1990. This adds stress to retirement plans—an inauspicious factor in the U.S. where over 95% of public pension plans were underfunded to a cumulative total of $1.1 trillion by 2017.

Rybinski had one positive observation regarding inflation, based on the correlation between inflation and the dependency ratio. His data shows that countries with a worsening ratio (primarily the U.S., the E.U. and Japan) have experienced low rates of inflation (under 2%) for the past five years. Countries with higher inflation (such as India, Brazil, Turkey, and South Africa) have improving dependency ratios. Not only has inflation been low in developed economies, but it has also been less volatile. These two trends have put downward pressure on the term premia of sovereign debt. In fact, the term premium on the 10-year U.S. Treasury note is negative, and Aegon expects it to remain so, with the extremely low yields on German Bunds an important reason. 

With the Federal Reserve taking a less aggressive position on raising interest rates and inflation expectations anchored, Aegon expects rates on treasury debt to remain at their historically low levels. 

From his analysis Rybinski provided two implications for asset allocation:

  1. As inflation has declined secularly in the past forty years, the correlation of returns on treasuries vs. equities has fallen from strongly positive, to slightly negative. Thus, treasury debt has been a good hedge against equity markets. With Aegon’s forecast for low inflation to hold treasury yields lower for longer, he expects this hedge relationship to continue.
  2. Low growth of global GDP, and the worsening demographic situation, will place a premium on growth investments. Searching these out will be the primary challenge for investment managers in the foreseeable future. This would typically suggest emerging or frontier markets, but they present increased risks. Many are not easy places to conduct business. Managers will need to be highly selective on choosing which countries to invest in, and will also need to search for pockets of growth hidden in selected industries or companies within developed markets.

Supplement: Post-Event Q&A by Brian Gilmartin, CFA

The overall theme of the presentation was that as the US population has aged, from the 1960’s “baby boom” being in full swing to the Generation X, Y and Z’s, of today, US GDP trend growth has slowed, and the aging of the US population is presenting challenges for everything from retired workers outliving their savings to putting pressure on public and private pension fund plans.

In other words, the “demographic tailwind” has become a “demographic headwind” (per two slides within the presentation) for the USA, much like it has become in Japan.

“Trend” growth for the US economy was 6% in the 1960’s, slowing to 4% in the 1980’s and 1990’s and is now just 2.5% today. (My thought on this was that, the US economy – in terms of real GDP was also much lower in the 1960’s, just under $1 trillion in each of the 4 quarters in 1966 per the FRED database, to over $20 trillion by Q4 ’18. The logic being growth looks faster with a smaller denominator.)

Frank Rybinski noted the decline in global fertility as well as the increasing life expectancy and slowing population growth rates has resulted in a “global silver” economy as the number of countries with more 65+ adults than kids under the age of 15 has expanded from 30 in 2015 to a projection of over 60 by 2035.

From an investing perspective, the presentation noted that the older a society becomes, the slower the change in the CPI, and in the Q&A following the presentation, Frank was asked if this changes the role of the Fed as America ages. Frank Rybinski noted that finding the “optimal policy” for the Fed today is more challenging given demographics, since the “old rules” (and Frank Rybinski” specifically cited the Taylor Rule) may have diminished influence in the future.

From an asset allocation perspective, looking strictly at demographics, the Frontier and Emerging Markets are better longer-term equity investments given that GDP growth and productivity improvements are still to be seen by many of these economies while Japan and old world Europe and other mature countries (and even the US to some degree) are at the opposite end of the spectrum and bond market investments and US Treasuries should be held in portfolios, with Aegon calling Treasuries a “viable portfolio hedge” as structurally slower growth and low inflation keep inflation contained.

Sub-Saharan Africa, Frontier Markets and Emerging Markets should be held as equity investments given the longer-term GDP growth potential, while Treasuries and fixed-income should be held for clients in mature countries.

2019 Annual Celebration

CFA Society Chicago held its annual celebration for new members and volunteers on Thursday, January 17, 2019. The venue was a new one the Society, hosting the event at River Roast on LaSalle Street just north of the river. Attendees enjoyed a spacious, private setting away from the public area of the restaurant. The setting provided an excellent opportunity for new members to build their professional networks, and for everyone to reconnect with friends and colleagues.

CEO of the Society, Shannon Curley, CFA, led off the official portion of the event by welcoming everyone, and introducing members of CFA Society Chicago’s Board of Directors and co-chairs of advisory groups who were present. He added a special welcome to new members, encouraging them to take advantage of the event to speak with members of the various advisory groups represented, and consider volunteering their time by joining one. Finally, Shannon gave a well-deserved thank you to society staff for planning this (and every) event. 

Shannon then announced the list of volunteers recognized for their outstanding contributions during 2018 to each advisory group:

Annual Dinner – Cara Esser, CFA

Professional Development – Kevin Ross, CFA

Communications – Lisa Davenport, CFA

Education Seminars – Matthew Morris, CFA

Distinguished Speakers Series – Arthur Olunwa, CFA

Membership Engagement – Deb Koch, CFA

Social Events – Jenny McNicholas

CFA Women’s Network – Bhavna Khurana, CFA

Our Outstanding Volunteers!

Shannon continued by thanking the co-chairs of the advisory groups for the extensive time and energy they put into making the events the society offers so valuable to our membership. All recognized volunteers received a gift from the Society in appreciation of their service. The final piece of official business was the drawing of raffle prizes (to some the highlight of the event). This year, everyone could choose to enter their choice of two drawings for overnight stays for two at the Standard Cub or Hyatt Regency. Congratulations to Ben Huddleston, CFA, and Pranay Subedi, CFA, winners of the raffle! With the official business completed, the socializing continued for the remainder of the event.

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: Kunal Kapoor, CFA, Morningstar

Kunal Kapoor, CFA, chief executive officer of Morningstar, addressed a full house at the University Club on May 16. His address reviewing the current business lines at Morningstar can be summed up in his title–Serving Investors of the Future: Ratings, ESG, and Research Innovations. Most would know Morningstar as a leader in research on mutual funds, the firm’s original product, but Kapoor defined the firm more broadly as a data gatherer and analytics firm. It seeks to deliver innovative data and research to benefit investors by leveraging technology which Kapoor described as an “enabler”.  He provided the following key metrics for the firm:

  • 24 million participants in retirement plans that use Morningstar products or services
  • 12 million individual clients
  • 80% of financial advisors touch Morningstar in some way

Kapoor went on to describe in summary Morningstar’s newer services that many people would not associate with the name. The first was research in individual equities. This began following the tech bubble when institutional investors began to question the objectivity of research from broker-dealers. The environment presented an opportunity for independent research analysis that Morningstar capitalized on. It now employs over 300 equity analysts making it one of the largest independent research providers. Philosophically, the firm takes a very long-term approach a la Warren Buffet. They have even adopted his moat concept to identify companies with defensive characteristics, and as a determinant in Morningstar’s fair value calculation. To judge macro-market conditions, they have developed their proprietary Global Market Barometer (which currently reads as very slightly overvalued).

More recently the firm has expanded into credit research. This was also a response to market upheaval when, after the crisis in housing-related securities, investors viewed research from dealers, as well as the major ratings firms, with skepticism. Kapoor expects credit research to be a growth driver in the future.

Morningstar uses its data and analytics in equity research to provide indices as well. The Wide Moat Focus Index selects for firms with the widest moats in their universe and weights them according to the scale of undervaluation relative to fair value.

Morningstar recently purchased the remaining equity in Pitchbook, a data analytics firm focused on the private equity and venture capital markets, in which it previously had a minority interest. This is a response to the shrinking public equity market that is encouraging more investors to look to the private markets for new investment ideas. Data gathering and analysis is more difficult in this arena, but Morningstar intends to make it an area of focus.

ESG (Environmental, Social, and Governance) investing is yet another new product area for Morningstar. Kapoor noted that this is more than the SRI (socially responsible investing) of the past which sought to eliminate certain out-of–favor companies or sectors (e.g., gamboling, tobacco, or alcohol). Rather, Morningstar scores companies on various ESG-related metrics to identify those more likely to succeed because of their adherence to responsible policies regarding their impact on the environment and their communities. The market for ESG investing is estimated at $23 trillion and covering 26% of retail investments. Additionally, we are at the beginning of a huge wealth transfer from older to younger investors with more women making investment decisions. Both groups demonstrate a preference for investment products with an ESG focus. To address this opportunity, Morningstar has partnered with Sustainalytics, a leader in ESG research and ratings, to score mutual funds and ETFs.

Finally, Kapoor spoke to Morningstar’s processes by describing their Robotic Process Automation (RPA) effort which seeks to automate rote tasks as much as possible to improve the timeliness and reliability of products and services.  He believes there’s no activity that can’t be automated to some degree which offers the benefits of lower cost, increased scale, and improved compliance, all of which contribute to better outcomes for investors who use Morningstar’s products.

Charterholder Jobs of the Future

Where can CFA charterholders look for career opportunities outside of traditional roles like research analyst or portfolio manager? That was the focus of the Jobs of the Future event sponsored by CFA Society Chicago’s Professional Development Advisory Group on April 12th. Held in the spacious conference center at 1 North Wacker Drive, the event was comprised of two panel discussions preceded by a keynote speech on employment trends in the asset management industry. The topic was popular with society members with nearly 100 in attendance.

Tyler Cloherty, CFA, global head of research at the Casey Quirk Knowledge Center kicked off the event with a research report entitled State of the Industry: Strategic Change in Asset Management and its Impact on Practitioners. He outlined changes currently underway in the investment management field and the consequent effects they will have on the types of roles asset managers will be looking to fill and the skills they will need. To begin, Cloherty noted that employment in asset management is at an all-time high having grown 8.6% between 2014 and 2016.  However, there are meaningful changes in the makeup of the total:

  • Investment professionals (portfolio managers and analysts) have shown the largest growth from 24.9% to 26.6% of industry staff, driven by increases in illiquid capabilities and allocation teams. However compensation for this group has declined slightly.
  • Conversely, distribution has seen the largest decline (from 28.7% to 26.1%) which masks a shift from institutional channels to retail, and an increase in product development roles. Despite this decline, compensation in this area has risen about 5%.
  • Operations has increase share from 45.2% to 46.2% reflecting the build-out of risk management and compliance functions. Here also, compensation has risen by 5%.
  • Firm management has held steady at just over 1% of industry staffing, but compensation has declined by a significant 16%.

Cloherty then went on to describe three factors defining the changing landscape for talent in the industry:

  1. Evolving Client Expectations—Reflecting a general push for cost control, which is manifested in the shift from active to passive strategies, and also the demand for more consistent performance in active products. Clients are seeking value for the fees they pay. In addition, they want more digital engagement to increase their own efficiency.
  2. Industry Catalysts—Including a host of trends: fee compression, commoditization of products, slow growth (especially in developed markets) and rising fixed costs (for more compliance, technology, data collection, and regulations).
  3. External Catalysts—Increasing importance of technology, data, automation, and even artificial intelligence, are the primary external catalysts.

 

Tyler Cloherty, CFA

Cloherty’s research has defined four strategic paths managers may choose to address this changing landscape.  Each has unique consequences for career opportunities for industry participants. The first strategy is to differentiate on product which requires that products perform well relative to expectations. This in turn means clients must see consistent value for the fees charged. Success here will depend on the effective application of data analysis, risk management, portfolio customization, and/or trading enhancements. In addition, cost containment through process automation and systems rationalization will be important. This strategy is likely to offer increased job opportunities involving the collection, analysis, and interpretation of increased volumes of data; fewer roles for traditional investment analysts; a shift of research and portfolio management resources to satisfy the rising demand for illiquid capabilities and allocation strategies; and greater separation of compensation between top talent and the median performers.

The second strategy is to differentiate on client experience by offering a premium service level built around client outcomes. This will require firms to build effective distribution teams to establish and maintain client engagement over a long sales cycle. This begins with identifying prospects using insightful market segmentation and data analysis, and continues through multi-channel outreach, digital marketing, automated sales and client relations tools, thought leadership materials, cross selling, high touch client reporting with mobile capabilities/apps, and in-person client interaction to close the sale and retain business. This strategy will demand more talent in data management, digital marketing, channel expertise, client service, and advice delivery.

Firms can also decide to compete on cost which requires automation, outsourcing, and realignment of incentives. Automation and outsourcing can both be applied to data management, accounting and settlement processes, distribution (via sub-advisory), back and middle office functions, and clerical duties. Investment management and distribution staff are typically the most expensive and their incentives will need to change to make them more efficient. Shifting incentive compensation to long-term payouts and focusing on client retention rather than gross sales are key here. This strategy will boost employment opportunities at third party/outsource providers and internally toward project managers to drive the transformation.

Finally, firm management can choose to engage in M&A to achieve scale and efficiencies. This route has been increasingly popular in recent years. M&A within the asset management industry reached an all-time high in 2017 with over 200 deals worth nearly $3 trillion. Because cost synergies play a major role in the success of this strategy, it is unlikely to drive growth in employment. All aspects of the organization will feel the impact, but operations usually bears the brunt because it offers the quickest and largest cost reductions.

Two panel discussions followed the keynote address. The first featured three Society members whose career paths led to roles that would have been uncommon for portfolio managers in the past, although they are integral to asset management today:

  • Joan Rockey, CFA, principal and CFO for CastleArk Management LLC, a single family office managing $4 billion. She has special expertise in corporate events and transaction strategy within the private equity, finance, energy, and technology industries. While the investments she oversees could generally be labeled alternatives, or illiquid, Rockey’s role is much more expansive covering firm management, client service, staffing, pricing, product development, and analysis of the competitive landscape.
  • Jeff Kernagis, CFA, vice president and senior portfolio manager for Invesco PowerShares Capital Management responsible for a variety of income-based strategies housed in a new generation of exchange-traded fund products.
  • Warren Arnold, CFA, is a team leader in Northern Trust’s National Wealth Advisor Group. As such he is responsible for both the development of custom wealth management plans and their implementation, which requires an extensive amount of client engagement.

L to R: Joan Rockey, CFA; Jeff Kernagis, CFA; Warren Arnold, CFA

Moderator Andy Feltovich asked the panelists to offer advice to younger charterholders seeking to improve their chances at finding new positions leading to rewarding careers. Arnold, an electrical engineer by education, strongly endorsed broadening one’s skill set and continuously striving to learn more. Adding value often comes from outside one’s primary area of responsibility (in his case, tax or estate planning). Kernagis had two recommendations—looking for ways to marry technology to your job, and networking continuously. Rockey noted that no two people will follow the same career path, even if they end up in similar roles. However as a holder of numerous professional credentials (CFP, CPA, and CAIA among them) she advised attendees to grow their skills with additional professional training.

The second panel comprised three experts employed in corners of asset management that are new for charterholders:

  • Lisa Ezra Curran, CFA, co-founder of FinTEx Chicago, a non-profit organization bringing together FinTech and financial services firms seeking to expand Chicago’s role as a center of financial technology innovation.
  • Marcia Irwin, CFA, managing director of Portfolio Specialists at Manulife Asset Management. In that role she serves as the interface between portfolio managers and client-facing partners to ensure effective communication and positioning of investment strategies as well as top notch client service.
  • David Kiefer, CFA, managing director at J. P. Morgan in the Global Consultant Strategy Team where he services investment consultants who recommend J. P. Morgan products to institutional investors.

L to R: Andy Feltovich, CFA; Marcia Irwin, CFA; David Kiefer, CFA; Lisa Ezra Curran, CFA

Each panelist provided useful insight into their roles. Curran noted how FinTech can be viewed as the application of common technologies across multiple financial services, or the marriage of financial expertise applied with technology to create new roles or enhance old ones. As examples, she pointed out that FinTech has opened up alternative investments to new investors, as well as led to the digitization of mortgage records. This facilitates the flow of information and improves the process of mortgage securitization. It also better informs investors on the intricate details defining mortgage-backed securities. Irwin noted because she is positioned between the sales team (and their clients) on the one side and portfolio managers on the other, communication skills are very important. However, the CFA charter sets her apart and proclaims her investment expertise. Kiefer echoed that point by noting the charter stands out in the sales process. Because he deals with consultants–investment professionals in their own right–he can’t speak from a script about his products. He needs to project deep product knowledge and the charter helps with that.

In providing advice on career guidance, Curran said that was difficult to do because FinTech is so new; the roles within it are still evolving. Kiefer suggested that the RFP team provided an excellent entry point into the investment business. It requires strong communication skills and teaches broad knowledge about a firm’s product set. Irwin’s advice was to approach one’s job from the client’s point of view to understand their needs better and determine how to satisfy them.

Vault Series: Philip Bartow, RiverNorth Capital Management

 

The new asset class of marketplace lending (MPL) was the topic of discussion at CFA Society Chicago’s Vault Series presentation on January 11, 2018. Presenting was Philip Bartow, lead portfolio manager for MPL at RiverNorth Capital Management. What was once a peer-to-peer market for consumer and small business loans has blossomed into a new institutional asset class totaling $27 billion as of 2016.  RiverNorth is a Chicago-based investment manager founded in 2000 with $3.8 billion under management. The firm specializes in opportunistic strategies with a focus on niche markets that offer opportunities to exploit valuation inefficiencies. Marketplace lending is the firm’s newest strategy.

The Environment for Marketplace Lending

Bartow began with a review of market and economic conditions that support the case for investing in MPL, starting with the interest rate environment. Although the Federal Reserve’s Open Market Committee forecasts three increases in short term rates in 2018, projections from the Fed Funds futures market are less aggressive. The market is saying “lower for longer” still rules the day. In addition, past increases in the Fed Funds rate have caused the yield curve to flatten, making shorter duration instruments relatively more attractive compared to longer investments.

Consumer financial health has improved greatly since the crisis of 2008-09. After a lengthy down trend, the unemployment rate has reached a level consistent with full employment, consumer sentiment gauges are at high levels and are moving in an upward trend. Growth rates of GDP and average hourly wages are finally showing some acceleration. Loan losses on consumer lending (residential mortgages and credit card loans) have fallen from crisis highs to, or below, long term averages.  In addition, corporate credit metrics are strong. Default rates on high yield bonds and leveraged loans have been running below long term averages for several years, and corporate earnings (based on the S&P 500 Index) are strong and expected to rise higher. The household debt service ratio, at just under 10%, sits at a 30 year low, and household debt/GDP at 80%, is at a level not seen since long before the last crisis. In short, the picture of economic fundamentals for both consumers and corporations is a rosy one. A slight rise in consumer delinquencies in 2016 is attributable to borrowers with low FICO scores, under 660 at origination.

The persistence of low interest rates, and the “risk-on” sentiment in financial markets, has pushed valuations to extreme levels. Credit spreads on high yield bonds sit more than a full standard deviation below average levels, and the VIX index of equity market volatility remains very low.

The Case for Marketplace Lending

At its essence, MPL loans involve the use of online platforms to provide secured lending to consumers and small businesses funded by institutional investors. Between borrower and lender sits an innovative loan originator that relies on technology to gather the data to support extending the original loan, servicing it, and monitoring the credit quality. There are 125-150 originators of loans but Lending Club, dating back to 2007, is the largest and most experienced in the market. Established “brick and mortar” banks are only just beginning to get involved.

Bartow began his case for investing in MPL by pointing out the huge spread between the average credit card loan (almost 21%) and the long term average yield in the bond market (measured by the Barclays Aggregate Bond Index) of 4.52%. MPL offer a potential benefit to both borrowers and investors inside this wide difference. The long term average coupon rate on MPL loans is just over 13%, while investors have earned an average of 8.13%.

Several characteristics of MPL loans are instrumental in providing better risk-adjusted returns going forward than direct consumer lending in the past.

  • In particular, originators focus on the higher end of the credit spectrum, lending only to borrowers with FICO scores of 640 to 850 (with an average of 705). This puts them in the higher end of the “near prime” category or better. Borrowers considered subprime and even prime are excluded.
  • In addition, MPL loans are always amortizing installment loans, in contrast to the typical credit card or consumer loan that comes in the form of a revolving credit line. MPL loans thus exhibit a constant rate of repayment, a predictable cash flow, and a lower duration, all of which reduce credit risk. In contrast, revolving credit loans don’t decline. In fact, they often increase ahead of a default as the borrowers tend to draw on their lines more as their financial health slips (slide 16).

An efficient frontier plot of the Orchard U.S. Consumer MPL Index covering January 2014 through September 2017 shows a superior risk-adjusted return versus a variety of relevant Barclays fixed income indices including the 1-3 Year Treasury Index, ABS Credit Card index, Aggregate Index, and High Yield Index, as well as the S&P 500 Index.

Bartow provided further information on the market for investing in MPL loans in general as well as some standards that RiverNorth follows. Although often compared to credit cards loans, MPL loans come in various types and are made to differing borrowers. The most common are consumer loans which are usually used to pay off or consolidate credit card debt. Originators may use a lower loan rate to induce borrowers to allow the originator to pay the credit card directly with the loan proceeds. Doing so has proved to lead to a better record of payment. Student loans and franchisee loans are other common types.

The secondary market for MPL loans is not a liquid one. Trades occur literally “by appointment” when originators announce dates in advance when they will bring supply to market. RiverNorth’s registered mutual fund that invests in MPL loans is an “interval fund”, meaning that it accepts new investments daily, but distributes withdrawals only quarterly, with a limit on the amount. Although many loans go into securitized products, RiverNorth prefers to invest in whole loans directly to improve gross returns. They also buy the entire balance of loans which gives them more control in the case of deteriorating credits or defaults. Loan originators, however, usually retain servicing rights on loans they sell.