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:

  • Annual Dinner Advisory GroupDSC_3308
  • 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.

Vault Series: Melissa Brown, CFA, Axioma

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Managing risk, specifically equity market risk, was the topic of CFA Society Chicago’s new Vault Series on January 11. The series brings noted investment experts to Chicago on a bi-monthly basis to share their thoughts and insights on the investment scene. The name comes from the common-area conference room in the Society’s new home at 33 North LaSalle Street, a space that was, indeed, once the safe deposit vault for a bank. The latest flat screen video monitors hang over the bare steel safe deposit boxes still line the walls. The day’s speaker was Melissa Brown, CFA, Senior Director of Applied Research at Axioma, a provider of risk management and portfolio analysis models and tools serving asset managers and institutional investors. Brown provides perspective and insight on market risks as measured and quantified by Axioma’s data and analytics.

Brown began by noting there are many types and measures of risks (e.g., Value at Risk, standard deviation, credit risk, liquidity risk, etc.) but Axioma defines it as the expected volatility of a market (they focus on equity markets) over a defined investment horizon. It is a function of volatility and correlations, both of which they see as being persistent over time, and therefore possible to forecast from the past. Currently, Axioma sees benchmark risks as low, but volatility is unlikely to decline further. In 2016, volatility declined in most equity markets around the world, despite a jump in mid-year following the “Brexit” vote. This was more pronounced in U. S. markets than other countries, and also in developed markets more than emerging markets. The level of volatility at the end of the year was not materially different from levels in 2000.

Axioma decomposes risk by looking at five components:

  • Portfolio holdings (generally are they more or less risky?)
  • Characteristics of the holdings (sector, industry, cap size, etc.)
  • Security-specific risks (which rose in 2016)
  • Factor volatility (an important component in Q4)
  • Correlations

The last one, correlations, is very low now and is the reason market volatility is low despite the relatively high volatility of individual securities.  Sector also plays an important role here. In the U. S. in 2016 there was a wide dispersion of risks and returns by sector. Consumer discretionary, Technology, Energy, and Materials all did well with declining risk. Finance, real estate, telecom, and utilities had very mixed results, but also with generally lower risk (except for finance). The dispersion of sector returns peaked in November at levels near records for Axioma’s database. Brown pointed out that the low correlations could provide an opportunity for active management to outperform passive.

Taking an international view, Brown noted that as of the end of the year, risk in developed markets is highly concentrated (see Italy, Greece, and Iceland) while in emerging markets, risk is more widely (and evenly) scattered. This situation developed during the fourth quarter and reflects the strength of the dollar, which is more of a challenge for emerging markets than for developed. Switzerland just nudged out the U. S. for the lowest risk by country at year end. Mexico holds the distinction as the riskiest country, again reflecting the weakness of the peso since the U. S. election.

Distinguished Speaker Series: Dan Clifton, Strategas Research Partners

“Angry is the New Hope” was the title and theme of the presentation on December 6 from Dan Clifton, Partner and Head of Policy Research for Strategas Research Partners. Hope was the watch word of the Obama administration, but the surprise election of Donald Trump reflects anger in the electorate. This anger stems from the persistent, subpar economic growth since the end of the financial crisis. In the eight years since, growth in GDP has averaged just 2%, versus the long term trend of 3%. That 1% annual shortfall, has created a cumulative GDP gap of $2.6 trillion dollars. The support that Bernie Sanders received late into the campaign indicates the voter anger extends across the political spectrum, not just within the Republican Party.DSC_3255

While Donald Trump’s election may have surprised many people, beneath the surface there were several indications that he would prevail:

  • Audiences for the Republican debates were three times what the Democrats attracted in 2008, the last time there was an outgoing administration. Ratings for these debates were even greater than popular reality television shows suggesting a great interest in making changes in Washington.
  • Weakness in the U.S. equity markets in the three months leading up to the election has a reliable history as an indicator for a loss by the party in power.
  • The finance and energy sectors outperformed the broad market in the last three months, also predicting a Republican win.
  • Support for populist, “non-traditional” parties, is gaining momentum around the world as confirmed by the Brexit vote in the United Kingdom. The push for change is global, not limited to the U. S.

This global shift toward populism is creating an urgency for governments to get their economies moving faster again. Hence, the victory for Donald Trump. Clifton listed several areas of emphasis for the new Trump Administration:

  1. DSC_3257Greater geo-political risk—as we have already seen from the phone call to the President of Taiwan, Trump has little concern for protocol and his use of Twitter increases the chance of off-the-cuff communications.
  2. Trade Policy—Trump made bold changes to trade policy a key part of his campaign and as president he will have the power to enact many of them unilaterally. Will he do so without seeking the guidance of his advisors or the congress?
  3. Fiscal Policy—the financial markets have quickly priced in everything Trump promised to do during the campaign (witness the sharp increase in interest rates and stock markets). In reality congress is unlikely to give him everything he wants and, even that, more slowly than the market expects. In particular, congress is likely to be more concerned about increasing the budget deficit than will be the president.
  4. Tax Reform—done correctly, tax reform (unlike a tax cut) will be neutral to the deficit in the early years, but achieving it is difficult and slow. True tax reform has only been done once before (1986).  A key question is whether it’s done via budget reconciliation, which is very partisan and leads to compromises that reduce the effectiveness, or dynamic scoring which accounts for the stimulating effect of the reduction in tax rates. Clifton called repatriation of foreign earnings the crown jewel of tax reform with a forecast of a potential $1 trillion coming into U. S. over fifteen months. This will add to the stimulus impact from tax reform and fiscal spending.
  5. Stimulus spending—also difficult to get done quickly–see Obama’s disappointing efforts in 2009. Clifton thought infrastructure stocks had run up too far, too fast since the election and that energy-related projects will get the emphasis from president Trump. He is likely to give a green light to several dozen projects currently being held up by the Obama administration over global warming concerns.

Trump made repealing Obama Care a signature feature of his campaign but the Republicans in congress are unlikely to repeal it without a viable replacement (which they don’t yet have). More likely they will start by cancelling the surtaxes included in the plan. This will provide a little more stimulus.  The Dodd-Frank law is likely to remain in place, but will also face revisions.

Finally, Clifton predicted that lobbyists will enjoy increased influence in the new administration. Trump will be much more susceptible to their approaches because he is not the ideologue that Obama is.

In response to questions, Clifton predicted that James “Mad Dog Mattis will get the waiver of the seven year rule to allow him to take the Secretary of Defense post and he will be a tough negotiator in that role. As a consequence, David Petraeus (another former general) will not become Secretary of State.

There are several big hurdles in the road to tax reform. One is whether to enact “border-adjustable taxes” (also called the out-sourcing tax) that would prohibit companies from deducting the cost of imported goods from taxable income. This would hurt import heavy industries (like retailers) and help exporters.  Momentum seems to be in favor of it, but it would likely draw a challenge from the World Trade Organization.

The second hurdle is a restriction on using repatriated foreign earnings for share buy-backs.  While it would enjoy political support, it would be very difficult to enact, as money is fungible. It would also be counterproductive by reducing the amount repatriated, and limiting the capital gains take from buybacks.

To the last question about raising the debt ceiling, Clifton called this an under-appreciated, but very important point. It will have to be addressed by this summer and could interfere with the tax reform efforts.

Distinguished Speaker Series: Jimmy Levin, Och-Ziff Capital Management

dsc_3148With interest rates at historic low levels and equity markets at concerning valuations, the subtitle of Distinguished Speaker Jimmy Levin’s presentation on October 4th, Finding Value in the Current Investment Environment, was alluring to say the least. Levin is Executive Managing Director and Head of Global Credit at Och-Ziff Capital Management, a manager of alternative asset strategies for institutional investors. The firm focuses on equity, real estate, credit, and—in particular–multi-asset strategies.  As of the presentation date Och-Ziff was managing approximately $36 billion in assets with nearly half that falling within the firm’s broad definition of the Credit sector. They separate Credit into two categories: Institutional (primarily Collateralized Loan Obligations—CLOs) and Opportunistic. They further separate Opportunistic Credit into Corporate (meaning any single-payer form of debt including sovereign and municipal debt) and Structured Credit which includes all manner of securitized, or asset-backed pools.  Distressed situations are common to both products, and often involve litigation and liquidations. A defining feature of the situations Och-Ziff finds attractive is the opportunity for the firm to exert influence over the resolution of these distressed situations. They prefer to exert this influence in a cooperative manner, but circumstances may require them to play an adversarial role.

Levin asserted that finding value in the current environment requires searching in pockets of the market that are less efficient because institutions, mainly investment banks, are less involved than was the case prior to the financial crisis of 2008-09. Situations involving corporate restructurings were once very big for Och-Ziff but this niche has become very competitive in recent years with more players crowding into the space. Instead Och-Ziff has found success by concentrating their efforts in three areas:

Structured Finance, or working out broken-down, asset-backed products: The securitized market is many times larger than the U.S. High Yield market and the products are more complicated, making for a much less efficient market. The structures were designed to be “bankruptcy- remote” and, therefore, the governing documents do not provide any rules or guidelines for restructuring. That allows a manager able to do its homework and understand the situation to exert a great deal of influence on the resolution.

Market Cycle Trades (essentially market timing): It’s impossible to call turning points perfectly, but a careful manager can make informed judgements on when a market is especially cheap or rich and adjust risk exposures accordingly.  Success here requires that the manager take a contrarian approach, maintain enough liquidity to support opportunistic trading, and be ready to take the opposite side of trades when others are either overly fearful or greedy. Equally important is maintaining moderate risk when the market is not at an extreme valuation.

Bank Disintermediation Trades: Opportunities presented by changes in the regulatory environment since 2009 have reduced the number of market makers as well as their level of activity.  During a period when the size of the credit markets has approximately doubled, sell side activity by any metric has declined by perhaps as much as 80%. The obvious result has been sharply diminished liquidity in all sectors of the market, especially during times of stress such as the first quarter of 2016. These present attractive risk/reward opportunities for managers who are ready, willing, and able to step in and provide liquidity when others can’t. Success here requires patience and flexibility, characteristics that are now lacking in banks because of tighter capital requirements.

The keys to success in all three of these strategies include smart, incisive analysis; astute trading; thorough understanding of complicated structures; and the discipline to be selective about when to enter or exit positions.