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.

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.

Slide 9

 

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.