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.

Vault Series: Bob Greer, CoreCommodity Management LLC

The why and how of commodity investing–especially when considered as a core position in a well-balanced portfolio–was the topic of the latest CFA Society Chicago Vault Series event held on November 28th, 2017. The presenter was Bob Greer, Senior Advisor at CoreCommodity Management LLC, and Scholar in Residence at the JP Morgan Center for Commodities at the Denver School of Business of the University of Colorado.

Commodities as a Hedge Against Inflation

Greer began by presenting a ten year chart of the Bloomberg Commodity Spot Index (slide 2) which showed considerable swings from highs to lows, but not an impressive net average annual gain. However, for comparison he pointed to other periods when large cap stocks (measured by the S&P 500 Index) provided similarly bland returns—for example, the decades ending in 1974 and 2008 (slide 3). Rather, it’s when one looks at commodities in a portfolio reaching across asset classes that the benefits show up in diversification and the contribution to risk-adjusted returns. This has been especially true during periods of rising inflation when commodities have provided returns that vastly exceed those of bonds and global equities–and even beat natural resource equities by several hundred basis points (slide 4).  This performance, in turn, stems from the high correlation commodities have to inflation—especially unexpected inflation (slides 5 & 6). Unexpected inflation is the investor’s worst enemy in that it has been a major factor in extremely poor, highly correlated returns for both equities and fixed income. Conversely, periods of high unexpected inflation are precisely when commodities have been at their best. Because inflation has been low for a long time, unexpected inflation may have faded from investors’ memories, but Bob offered a list of reasons why that could change soon:

  • Slow growth in the supply of labor in developed countries, with demographic trends showing no sign of reversal, will eventually lead to wage inflation,
  • The rise of populists governments makes trade restrictions increasingly likely,
  • An infrastructure build-out will increase demand for commodities,
  • Large, and growing, government budget deficits are more likely to lead governments to choose a monetary solution (i.e., inflation).

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Commodities as a Diversifying Element

Besides performing as a good inflation hedge, commodities have also performed well as a diversifying element. Greer presented a chart (slide 8) of three year correlations between commodities, stocks, and bonds that showed, at least until the 2008 financial crisis, that pairing commodities with stocks and bonds, diversified as well as the more common stock/bond pairing. During the crisis, this benefit broke down as the unprecedented need for liquidity among all types of investors, raised correlations for many asset classes far beyond anything measured in the past.

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Successful commodity investing calls for active management in Greer’s view.  He compared the returns of the Bloomberg indices of spot and futures commodity prices from 2001-17 (slide 9).  While both were volatile, the spot prices generated a cumulative return of about 150%, but the futures prices ended with a small negative cumulative return.  Because the price curve of most futures contracts exhibits a positive slope, rolling out of an expiring contract and extending into a new, longer contract, usually creates a loss. This “negative roll yield” causes the persistent return lag in commodity futures portfolios, and is a primary reason Bob advocates for an active strategy in commodity investing. Commodity futures are less subject to the forces of “irrational exuberance” because there is no limitation on the number of contracts that may trade, and futures prices must converge with cash market prices eventually. This makes analysis of commodity futures prices more effective than for other asset classes. Among the tools managers use to beat the index are:

  • Timing of the roll into new contracts
  • Curve positioning
  • Mis-weighting the constituents versus the index
  • Management of collateral away from passive T-Bills
  • Selective use of commodity equities in place of futures.

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One metric managers use in applying these tools is a comparison of commodity prices relative to the underlying cost of production (slides 11-12). Over long periods, prices have averaged 30-35% above the cost of production but with significant variability (and including occasional periods of a discount relationship). This applies not only in the aggregate, but also among the various commodities within the Bloomberg Commodity Index. Recent data for the prices of the index members showed a range from a discount of 29% below the cost of production (for Kansas City Board of Trade Wheat) to a premium of 71% (for London Metals Exchange Zinc).

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Commodities as an Asset Class

After laying out his reasoning for including commodities in a well-diversified asset allocation model, Greer explained why the timing is good now for an initial investment into commodity futures. The basic reason? They are cheap relative to the more common asset classes (slide 13). Of the twenty-two constituents in the Bloomberg index, only zinc currently trades above 50% if its long term value. By comparison, stocks, bonds, and REITs are all currently above the 95% mark. Global demographic and economic developments indicate a long term rising trend in the demand for all manner of commodities.  World population continues to grow (slide 19), with a concentration in developing countries. Economic growth in these countries will engender an increasing demand for commodities broadly. This is already reflected in changing dietary habits in developing countries where the consumption of meat in all forms is increasing (while it declines in the U.S.). This has knock-on effects on the prices of grains needed to produce the meat (slides 20 & 21).  Growth in developing economies also increases demand for energy (mainly oil) and metals and industrial goods (to build out infrastructure). Graphs displaying the consumption of corn, wheat, copper, coffee, and oil all show persistent, long term rising trends (slide 22).

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Greer provided greater detail regarding the supply and demand for oil. The two most populous countries in the world, China and India consume significantly less energy per capita in the form of oil than developed, slow growing, Japan and the United States (slides 24-26). So, as their economies develop and grow faster than the developed world, China and India will drive global oil demand. Meanwhile the spare productive capacity of OPEC countries has been declining since 2009 (slide 27) and shale oil production in the U.S. is still a small contributor to global supply–just 5% (slide 28).  Thus the long term trend in global economic growth, driven by the developing world, argues for an allocation to commodities as a contributor to both returns and diversification in a well-balanced portfolio.

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Networking with Leadership

CFA Society Chicago gathered on September 27 for the annual Networking with Leadership reception at the Hard Rock Hotel on Michigan Avenue. With no formal presentation or agenda, the members-only event provided a full two hours for networking, making new acquaintances, and renewing old ones. The venue at the Hard Rock included both indoor and outdoor space. A balcony directly off the reception room provided a view of the Michigan Avenue scene below, and was a welcome feature given the unusual warmth for late September. Judging from the nearly sold out attendance of more than 100, our membership values this opportunity for face to face conversations with board members about society business, financial markets, careers, or any topic that comes to mind. Anyone who missed it should make a point to attend next year.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Distinguished Speaker Series: Mario Gabelli, CFA, GAMCO Investors Inc.

Well known value investor Mario Gabelli, CFA, chairman and chief executive officer of GAMCO Investors Inc. and LICT Corp., addressed a capacity audience of CFA Society Chicago members and their guests at the Standard Club on September 14th. In a wide-ranging presentation, Gabelli drew on his four decades as a money manager to offer his insight and wisdom on the current state of the economy and investment markets. He began by extoling the virtues of a CFA Charter, pointing out that only through the detailed analysis of a charterholder could one understand a business well enough to see how it fits into the economy and how to value it correctly. He encouraged everyone to “keep doing what you are doing” to help our country and make capital markets work even better.

Gabelli touched briefly on two topics he believes need regulatory change. The first was ETFs and the advantage they have over mutual funds because of their tax-efficiency.

He strongly advocated for leveling the playing field with an end to the requirement that mutual funds distribute realized capital gains annually, thereby creating a taxable liability for investors even though they have made no transaction. Every other type of investment requires a sale to generate a capital gain, and mutual fund shares ought to be treated the same.

Second, on tax reform, he said Congress needs to cut the corporate income tax rate to make American firms more competitive with foreign ones.  The protracted debate is only serving to delay new investment that our economy badly needs.

Without going into great detail, Gabelli listed several sectors that he thinks currently offer attractive investment opportunities, including:

  • Infrastructure: Although this is on the top of many favored lists, he pointed out that the American Society of Civil Engineers rates infrastructure in the U. S. as D+, which will require new investment regardless of the political environment.
  • Health and Wellness: Drawing on the trend of an aging population, he recommended investments in vision and hearing care, joint replacement, and obesity treatment.
  • Live entertainment: Gabelli described this as being immune to competition from Amazon (or, more generally, the internet). Noting the high valuations put on sports teams in private transactions, he has calculated that a sum-of-the-parts analysis on Madison Square Garden Entertainment yields a value of zero for the New York Knicks.
  • Equipment rental: A secondary play on infrastructure, but one that he expects to do well even without that tailwind.

Annual Business Meeting and Networking Reception

Members gathered for the annual business meeting of the CFA Society Chicago on June 15th at the Wyndham Grand Riverfront Chicago. Held in the hotel’s 39th floor penthouse lounge, the event offered grand views of the intersection of the Chicago River and Michigan Avenue as well as the buildings—both old and new—in the area.

Shannon Curley, CFA, CEO of the Society, kicked off the business part of the event by recognizing the society’s staff and board, as well as Advisory Group co-chairs for their contributions during the past year.  He noted that their efforts make our chapter the vibrant society that it is. He turned the mic over to Doug Jackman, CFA, out-going chairman, who summarized the highlights of the past year. Membership has increased to over 4,600 making the Chicago society the sixth largest in the world, and–as the oldest in the world–we rank as a leader within CFA Institute.

156CFA Society Chicago sponsored 150 events in the fiscal year with one of the most successful ones being the just completed Active vs. Passive Debate featuring Nobel Laureate, Eugene Fama. Jackman emphasized that the focus of programming has been (and will continue to be) education and advocacy of financial literacy. A few of the prominent names who presented at chapter events in the past year include Charles Evans (President, Federal Reserve Bank of Chicago), David Kelly, CFA (JP Morgan), T. Bondurant French, CFA (Adams Street Partners), Liz Ann Sonders (Charles Schwab), and Dan Clifton (Strategas). The new Vault Series brought in industry experts to address special topics. The first speakers included Melissa Brown (Axioma), David Ranson (HCWE & Co.), and Doug Ramsey (Leuthold). Jackman also recognized the work of the Professional Development Advisory Group in producing numerous events to help our membership enhance “soft-skills”.

123Secretary/Treasurer Tom Digenan, CFA (now vice chair of the Society) presented the financial update highlighted by a $100,000 operating surplus (thanks to strong attendance at the Distinguished Speaker Series lunches and the Annual Dinner) and a $200,000 capital gain in reserves leaving them at 16 months of coverage (vs. a target of 13 months).

Jackman next presented the slate of officers for fiscal 2018 including Marie Winters, CFA, as chairman, Tom Digenan, CFA, as vice chair, and Tanya Williams, CFA, as secretary/treasurer. In addition three new Class C Directors were nominated for three year terms and four new Class E Directors were nominated for one year terms. All candidates were approved by a “show-of-hands” vote.

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Jackman then recognized out-going board members Kerry Jordan, CFA, Chris Mier, CFA, Maura Murrihy, CFA, Mark Schmid, and Lyndon Taylor as well as nine departing co-chairs of advisory groups. Curley similarly recognized Doug Jackman, CFA, for his service as board chairman including reinvigorating the relationship between our society and the University of Chicago and for obtaining funding from the CFA Institute that allowed us to bring in notable speakers like Eugene Fama and Tom Ricketts, CFA.

Finally, incoming chairman Marie Winters, CFA, looked to the future, describing her hopes to build on our past successes in the areas of employer engagement, volunteerism, and the challenges presented by technology and new regulations. Winters also pointed to improving gender diversity as a focus of attention, noting that it is surprisingly poor (just 13% of our members are women) for an industry built on a foundation of diversification.

With the business part of the meeting completed, attendees moved to the outdoor patio to enjoy the views and libations.

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Building Investor Trust Through GIPS

On May 9th, CFA Society Chicago members gathered to hear a panel of experts address the merits of adopting the Global Investment Performance Standards (GIPS) in the Vault Room at 33 N. LaSalle. The eminent panel comprised a service provider, a regulator, and an asset manager user and included:

  • Daniel Brinks, compliance examiner with the Securities and Exchange Commission (SEC) with a focus on investment advisors,
  • Richard Kemmling, CPA, CIPM, CGMA, President of Ashland Partners & Company LLC, a specialty CPA firm that was a pioneer in the GIPS verification business, and serves over 700 client firms in that area.
  • Matthew Lyberg, CFA, CIPM, Senior Vice President and Director of Performance Attribution with Acadian Asset Management.

DSC_3715Anju Grover, CIPM, senior GIPS analyst with the Investment Performance Standards Policy Group of the CFA Institute (CFAI) served as moderator. In her opening remarks she pointed out that 2017 marks the 30th anniversary of GIPS which she described as one of the CFA Institute’s most successful products. Despite the fact that adopting GIPS is completely voluntary, they are widely recognized as a best practice for reporting investment performance by asset managers, asset owners, and consultants all around the world.

The first question Ms. Grove put to the panel was why GIPS would be important to retail investors. Brinks responded that retail investors are just as demanding of a performance standard as are institutional investors, and GIPS fills the bill. Lyberg noted that the line separating retail and institutional investors is blurring. The decline in the popularity of pension plans in favor of defined contribution plans is a primary example. Retail investors are the end users of DC plans and are responsible for investment choices, but the plans are designed, managed, and overseen by investment professionals. So they serve both retail and institutional masters. GIPS also adds a layer of due diligence to a plan, a theme the panelists repeated throughout the event. Kemmling pointed out that GIPS compliance is a common requirement for listing products on the investment platforms that advisors (he specifically mentioned Morgan Stanley and Merrill Lynch) use for their retail clients.

As to challenges firms encounter in adopting GIPS, the panelists listed:

  • Lack of adequate data, or records; difficulty in handling unique accounts,
  • Changes in operating systems that occur during implementation,
  • Incomplete buy-in from all parts of a firm (marketing, accounting, compliance, etc.), and
  • Full support from senior management. The latter point is particularly critical to assure firms commit adequate resources to attain compliance.

Why should firms bear the cost of GIPS compliance? Kemmling answered that they provide a “best practices” process for client reporting and that the verification process provides insight into industry practices. Brinks stated that while GIPS compliance is not required by law or regulation, he considers it in the category of “nice to see” when he examines an asset manager. The verification process is a second pair of eyes –outside eyes–on results reporting. He added that he observes fewer serious problems in general when he examines firms that follow GIPS. The CFA Institute has been training SEC examiners on GIPS so they can understand what the standards mean to adopting firms and apply that knowledge during examinations.

In response to questions from the audience regarding difficulties in complying with GIPS, the panel noted challenges in applying them to more complicated strategies such as currency overlays and alternatives. They suggested that this be a focus of the next revision to the standards which is already underway and targeted for 2020. This revision should also make the standards easier to apply to fund vehicles and for internal reporting to management. The current standards are most easily applied to reporting composite returns to clients, which was their original intent.

Regarding the breadth of acceptance of GIPS, Grover said the CFAI is still gathering data but counts 1,600 firms around the world that claim compliance for at least a portion of their assets. This includes 85 of the 100 largest asset managers who account for 60% of total industry assets under management. Lyberg noted that investment consultants are expanding the adoption of GIPS by using compliance as a screen for including firms in management searches.

When asked how a firm should begin to adopt GIPS, Lyberg suggested starting out modestly by writing high level policies and procedures and making them more detailed over time with experience. He recommended attending the CFAI’s annual GIPS conference to build knowledge and to make contact with other firms that have already adopted the standards. Challenges a firm may encounter include clients who demand using a different performance benchmark than what the firms uses for a strategy, tension between various stakeholders at a firm (e.g., between marketing and compliance), and resistance from legal counsel which often advises against bold statements of compliance that might seem to be guarantees.

As to the benefits to the public from using GIPS, Brinks stated that increased comparability leads to better informed investment decisions and more efficient markets. He noted the decline in fraud tied to inflated claims about performance since the introduction of GIPS thirty years ago. Kemmling noted that measuring the positive impact of GIPS is difficult but they were created for the benefit of investors and are an indication of asset managers’ commitment of resources in support of investors. Grover stated that adopting GIPS for greater transparency and comparability was simply “the right thing to do”.

For final takeaways the panelists offered the following:

  • Lyberg said GIPS levels the playing field among managers, adding that compliant managers couldn’t compete with fraudulent firms such as Bernie Madoff’s.
  • Kemmling, acknowledged that while compliance is not easy, it isn’t expensive and is certainly achievable. Most of the 700 firms his company verifies have less than $1 billion in AUM, indicating the success of small firms at complying with GIPS.
  • Brinks recommended that adopting firms think very carefully about how to apply the standards, looking to the future when writing their policies and procedures to avoid any potential conflicts between them and their capabilities.

Distinguished Speaker Series: T. Bondurant “Bon” French, CFA, Adams Street Partners

DSC_3661T. Bondurant “Bon” French, CFA, executive chairman of Adams Street Partners addressed a large gathering of CFA Society Chicago members on the topic of private market investments on April 5th at the University Club. Adams Street Partners is a Chicago-based manager of private market investments with over 40 years of history and $29 billion in current assets under management.

French began with a review of historical returns for private equity markets using industry data. Both categories he focused on, venture capital and buyouts, showed superior long term performance (ten years or longer) compared to public equity markets, but weaker relative performance for periods shorter than five years. He doesn’t consider the shorter term underperformance to be significant as success in private market investing requires a very long investment horizon, a feature deriving from the reduced liquidity relative to public markets.

French went on to provide a summary of recent market conditions and performance for both buyout and venture capital pools. His statistics showed that fundraising for buyouts rose sharply from 2005-2008 and then fell just as sharply during the financial crisis. Although there has been a rebounded since 2010, the $368 billion gathered in 2016 still hasn’t topped the pre-crisis amounts. The volume of buyout transactions has recovered much less so since 2009 leaving managers with considerable “dry powder” seeking attractive new investments. This is also reflected in data for buyout fund cash flows. From 2000 through 2009 calls for funding from borrowers regularly exceeded distributions out to investors. However, since 2010, distributions have far exceeded calls. Investors (and their managers) have been especially wary toward new investments since the crisis, a condition exacerbated by the high level of multiples on buyout transactions (similar to the situation in public markets). At more than 10 times enterprise value/EBITDA, these have passed the pre-crisis highs to levels not seen since before 2000.  This situation has driven Adams Street to focus on deals in the middle market which is less efficient, and consequently priced at lower multiples.

DSC_3654Also reflecting caution (and the effects of Dodd-Frank regulations), buyout deal leverage remains below pre-crisis levels (5.5 times in 2016 vs 6.1 times in 2007). However, terms of credit have eased as reflected in the market for covenant-lite debt. This has far exceeded the levels common in 2007 both in terms of absolute amount and share of the new issue market. DSC_3659This has helped the borrowing firms survive economic challenges and also allowed them an opportunity to remain independent for longer.

In the venture capital market (much older but smaller than the buyout market) new fund raising peaked in 2000 during the “tech bubble” and fell sharply when the bubble burst. The subsequent recovery was fairly muted, so the financial crisis had less of an impact on fundraising activity than in the buyout market. The $83 billion raised in 2016, while the highest since 2000, is consistent with the longer trend.  Cash flow in the venture market hasn’t been as persistently strong as in the buyout market because companies are choosing to stay private longer than in the past. Liquidity events, measured by number of deals and total value, peaked in 2014 for both initial public offerings (IPOs) and mergers and acquisitions (M&A). M&A, the larger of the two by far, has shown a smaller decline from the peak than has IPOs, and has held at levels consistent with longer term trend.

French concluded with a brief look at the secondary market for private investments (trades between private market investors as opposed to investors being taken out by IPOs or M&A). This market dates to 1986, but is showing healthy signs of maturing recently. Although the market hit a recent peak in volume in 2014 the decline in the following two years was slight—holding well above the prior trend.  Pricing, as a percent of net asset value, has also been rising. Transactions in 2016 were evenly distributed by the type of investor (pension funds, endowments, financial institutions, etc.) supporting liquidity. In 2016, transactions were more concentrated in newer funds because older funds (created before 2008) are shrinking from their natural positive cash flows, and have less need to trade.

Vault Series: David Ranson, HCWE & Co.

David Ranson provided an enlightening presentation during the second part of CFA Society Chicago’s new Vault Series held on March 15 in the Vault Room of 33 N. LaSalle. Ranson is President and Director of Research at HCWE & Co., an independent investment research firm that was formerly a division of H.C. Wainright & Co. Ranson presented a simple, but effective model–based on his extensive research into capital market returns and correlations–that his firm uses to advise clients on tactical asset allocation. Their process uses historical market price movements to uncover predictive relationships between leading indicators and, highly-correlated, consistent outcomes.

The model’s simplicity derives from viewing the investment universe as comprising just four primary asset classes (exhibit 1):

  • Domestic bonds
  • Gold
  • Domestic equities
  • Foreign assets and physical assets (commodities, real estate, etc.)

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(It’s important to note that the model considers gold as uniquely different from all other commodities.)

Ranson began by describing the role of capital migration in investment performance (exhibit 2). Capital migrates away from countries or markets characterized by economic stagnation, lower asset returns, declining new investment, and rising unemployment, and will flow to areas where the opposite conditions apply. Causes of the poor performance can be excessive government spending, taxation, and regulation, and “regime uncertainty” stemming from secretive or unpredictable policies.  These are difficult to quantify, but are usually accompanied by two more easily measured indicators: currency weakness, and rising economic anxiety (i.e., market stress).  These two indicators are the primary market signals the model relies on.  The price of gold serves to measure a currency’s value, and credit spreads measure economic anxiety.Ranson 1_Page_03

Ranson described four economic scenarios arrayed in quadrants defined by the change in the rates of economic growth and inflation (exhibit 3). Accelerating growth occupies the two lower quadrants and declining growth the top two, while accelerating inflation resides in the two right-hand quadrants and decelerating inflation on the left side. The scenarios (quadrants) determine the best performing assets.  Haven assets (bonds and gold) do best in the two upper scenarios when economic growth declines.  Risk assets (equities and commodities) stand out in the lower half of the array when economies accelerate.  When viewed laterally, financial assets (Ranson called them “soft” assets) that struggle against inflation reside on the left side of the array and those that do better against rising inflation (“hard” assets) reside on the right side.  Hard assets include gold, other commodities, real estate, and foreign equities.  (All foreign equities fit into this category because the model assumes they would perform comparatively well when an investor’s home currency is weak.) Putting the model together, shows gold as the preferred asset in the upper right quadrant (decelerating growth with rising inflation) and bonds preferred in the upper left quadrant (both growth and inflation decelerating). Domestic equities shine in the lower left quadrant (rising growth and decelerating inflation) while commodities and real estate are best in the lower right quadrant when both growth and inflation rise.Ranson 1_Page_04

Ranson presented statistics to support his model (exhibit 4). Separating the past 45 years of available data for the United States, he showed that when the rate of GDP growth accelerated from the prior year, the returns on equities and commodities always improved, while returns on treasury bonds and gold worsened.  When the rate of GDP growth slowed from the prior year, the reverse relationships held: returns on equities and commodities fell, and those for bonds and gold improved.Ranson 1_Page_05

Looking at inflation rates revealed similarly intuitive results (exhibit 6). When the CPI accelerated in a year, financial assets (both stocks and bonds) exhibited weaker returns, and gold and commodities did better than in the prior year.  When the CPI decelerated, financial assets enjoyed improved returns, while gold and commodities worsened.

Putting it all together (exhibit 11), Ranson presented an Asset-Allocation Compass with north pointing to heightened business risk, increasing investment anxiety, weakening economic growth and widening credit spreads. South points to the exact opposite conditions. East points to a weakening, or unstable, currency (measured by the price of gold) and west to a strengthening currency. He then filled in the best asset classes for eight points around the compass. His four primary asset classes occupied the diagonal compass points, corresponding to their positioning in the quadrant array:

  • Gold in the northeast
  • High quality bonds in the northwest
  • Domestic equities in the southwest
  • Hard assets in the southeast

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Ranson assigned the primary points of the compass to sub-groups of the primary classes. The most intuitive one was Treasury Inflation Protected Securities (TIPS) pointing west (declining inflation, strengthening currency). Pointing south toward strengthening growth were risk assets: B-rated junk bonds, MLPs, and developed market foreign equities. Pointing east (rising inflation and a falling currency) were commercial real estate and C-rated junk bonds, assets exhibiting little influence from changing spreads and more from the price of gold. The distinction between B and C-rated junk bonds may be surprising but Ranson’s research has shown that while they are correlated to each other, C’s are much better correlated to the gold price while B’s correlate more to credit spreads.

The compass had nothing listed for north (weakening growth and heightened risk perceptions). Ranson noted that he was not aware of an asset class that would fit well in this slot but, like a gap in the periodic table of the elements, he could describe the attributes he expected it to exhibit. It would have to respond positively to widening credit spreads, and be little effected by the price of gold (or value of the dollar).

In response to a question following his presentation, Ranson pointed out that the correlations his model depends on often take several years to manifest themselves, so the model works best for patient investors with very long investment horizons.

Annual Celebration 2016: New Member and Volunteer Recognition

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CFA Society Chicago Advisory Group Co-Chairs

CFA Society Chicago held its annual celebration for new members and volunteers on Thursday, January 26, 2017. The site was a unique one–the dress circle lounge at the Chicago Opera House, which was filled to near capacity. The event provided a wonderful opportunity for new members to build their professional networks, and a time for everyone to reconnect with friends and colleagues.

Chairman of the Society, Doug Jackman, CFA, led off the official portion of the event by welcoming everyone, and thanking the many volunteers for their hours of effort that make the CFA Society Chicago a success. The Society currently has more than 225 volunteers who make the 100 plus events over the year possible. Jackman gave a special welcome for the new members and encouraged them to seek out the members of the various advisory groups represented at the meeting and to consider joining one to assure the continued success of the society’s programming:

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  • Communications Advisory Group
  • Distinguished Speaker Series Advisory Group
  • Education Advisory Group
  • Membership Engagement Advisory Group
  • Professional Development Advisory Group
  • Social Events Advisory Group
  • CFA Women’s Network

Executive Director Shannon Curley, CFA, then stepped to the mic and announced the list of volunteers recognized for their outstanding contributions during 2016 to each advisory group:

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CFA Society Chicago Volunteers – Outstanding Contribution 2016

Annual Dinner – Melissa Binder, CFA

Professional Development – Shai (Shy) Dobrusin, CFA and Samantha Grant, CFA

Communications – Brad Adams, CFA

Education Seminars – Jeanne Murphy, CFA and Cindy Tsai, CFA

Distinguished Speakers Series – Alan Papier, CFA

Membership Engagement – Gerald Norby, CFA

Social Events – Taylor Champion, CFA

Curley 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 three drawings, each offering a combination of dining, entertainment and hotel vouchers. With the official business completed, the socializing continued for the remainder of the event.

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Diversity Improves Your Bottom Line and How You Can Achieve More of It: Andie Kramer and Al Harris

Recognizing the benefits of a diverse workforce, and overcoming the challenges to it (which are often subtle and hidden below the surface) was the theme of the presentation Andie Kramer and Al Harris made to the CFA Society Chicago on January 18. Andie and Al are practicing attorneys, and also business partners working to build awareness of the benefits of expanded diversity–especially gender diversity–in the workplace. Their starting premise is that teams of diverse members will be more productive because the differences among the members requires that they be more careful in their deliberations, more thoughtful about what they say, more collaborative with each other, and in the end, more productive and innovative. So, increased diversity is not just morally and ethically right, it can also lead to improved results and profits.

If greater diversity is so good, why is it difficult to achieve? Mainly because it takes us out of our comfort zones. We naturally prefer to associate and work with people who are like us in many ways. Reaching consensus with people of differing perspectives can be difficult, so we tend to avoid diverse groups to reduce tension and conflicts. Improving diversity requires addressing several areas, first among them is the challenge of bias which Kramer and Harris define as an unconscious belief, preference, or inclination that inhibits impartiality. Bias in turn is shaped by stereotypes which ascribe behavioral characteristics to someone based on an easily observed characteristic (such as gender, age, race, etc.). These stereotypes form our perceptions and expectations about people even before we know them. Our challenge is to invalidate these misperceptions with real evidence.

Kramer and Harris pointed out two types of personality characteristics that stereotypes assign by gender. Stereotyping considers communal characteristics such as compassion, affection, modesty, sympathy, and warmth to be feminine. Conversely, agentic, or action-oriented characteristics such as aggressiveness, confidence, risk acceptance, and independence are masculine. We naturally consider successful leaders to be agentic, and if we consider those characteristics to be masculine, we create a bias toward men as leaders. Gender bias is often manifested through “micro-aggressions” such as subtle putdowns (verbal and nonverbal), sarcasm, and dismissive gestures.  In Kramer and Harris’s view these provide the scaffolding for workplace discrimination.

What can men and women do to improve this situation? Men must first learn to recognize gender bias, using the indicators of micro-aggressions, and object to it firmly. They should “think slow”, using their rational brains more than the emotional. They should advocate for women as mentors (whether formal or not), and embrace differences. Women need to perform a balancing act: recognize the importance of agentic characteristics, but temper them with the communal.

Organizations can improve diversity by recognizing that gender bias exists and that by holding back women, it leads to sub-optimal results. They should strive to make hiring and promoting practices fair and equitable. An important step toward this is removing subjectivity from the evaluation process as much as possible (for example, eliminating open-ended questions in interviews). Finally, managers should seek feedback on their efforts from employees or external experts.