Investing in Innovation

 

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From L to R: John Pletz; Bruno Bertocci CFA; Tricia Rothschild, CFA; Matt Litfin, CFA; Daniel Nielsen

If you compare the list of Fortune 1000 companies from ten years ago to today, over 70% of its members have been replaced due to disruptive market forces and mergers and acquisitions. In the next ten years another large batch of less-innovative firms will likely be erased from the index as groundbreaking technology continue to affect long-running corporations, causing a frenzy of movement for companies to stay relevant against an incredibly competitive global landscape. Innovation isn’t just a buzzword for corporations these days, but a means toward survival.

Dr. James Conley teaches a course at Northwestern on intellectual property and made for a perfect moderator to lead a discussion on investing in innovation. To begin, he used the same video he plays for his students as an introduction to the panel discussion. The five minute video introduced concepts around the value and management of intangibles by corporations. There has been a marked shift in the asset composition of corporate assets from tangible (factories, buildings, equipment) to intangible (patents, ideas, processes, code). Now over 80% of companies’ market value stems from intangible resources. The video explained how patents protect IP owners and the difference between utility patents (20 year life) and design patents (14 year life). It also laid out the rules for what can be patented and why the patent system matters. Copyright protection was also discussed, and this can give authors and creators 100+ years of protection. Trade secrets, such as the recipe for Coca Cola, receive the highest level of protection and can last indefinitely. The benefits of intellectual property regimes include providing incentives to inventors to create and advance collective knowledge. They also help consumers avoid confusion from competing products. Intellectual property has been receiving a lot of attention lately from many sources, not just in the startup and corporate world. Conley said that Christine Lagarde of the IMF mentioned the phrase six times during a recent address to Kellogg students.

Terry Howerton focuses on tech investing and has built a technology community in Chicago called TechNexus. He said that he believes that innovation will drive industry performance and most innovation will come from an entrepreneurial community, not from incumbent corporations. His firm became an accidental incubator for startups as he found himself acting as a conduit between major corporations looking to be linked up with startups in order to drive innovation.

Conley said that the shift in corporate assets from things like factories and machines to intellectual property and ideas is as significant as the Industrial Revolution. In his investment process he identified 300 companies with the most valuable patent portfolios. This was based upon his own research that indicated companies with stronger intellectual property outperformed companies with weaker intellectual property. The question he often hears is “How can a single factor model (in this case, IP) outperform the market (often to the tune of 200-300 bps a year)?” He says it is due to most investors’ lack of knowledge on which companies actually own good intellectual property assets, and as a result, those firms go undervalued.

dsc_3136On the financial reporting side, Janine Guillot of the Sustainability Accounting Standards Board (SASB) said her group’s goal is to provide reliable valuation measures to intangible assets, which is often hard to do. She discussed how financial reporting needs to evolve as the percent of a company’s overall market value coming from intangible assets continues to increase. This goal will be accomplished by creating a common accounting language across IP and intangibles that is industry-based. The board has created a set of material, non-financial factors that are grouped into five themes:

  • Human Capital
  • Social Capital
  • Environmental Capital
  • Business Innovation
  • Leadership and Governance

The panel noted that corporate ventures are difficult. Not too many Alphabets (parent of Google), with its strong investing capabilities, exist in the corporate world. Time horizons often pose a challenge, as corporate earnings are measured by the quarter while success in the VC world can take many years. The primary goal of a corporate venture also needs to be due to strategic reasons, not to drive short-term returns.

Howerton told a story about an insurance firm that was bragging about undertaking an IT project that would be the biggest of all time, taking over 36 million man hours. Successfully completing the project, with its immense cost, would be seen by many as incredibly risky. Yet that same corporation would view sending four people off to an idea lab to try to come up with innovative solutions as “too risky”. Companies need to recalibrate to the new realities of risk and failure as the pace of the economic landscape moves increasingly rapidly and longstanding businesses find themselves irrelevant in the new economy.

Best Practices in Risk Management

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What is risk?

Many metrics and measures fall into the overall category of investment risk, including operational risk, market risk and credit risk. Investment risk is generally defined as “loss arising from changes in interest rates, credit spreads, equity prices, foreign exchange or commodity prices.”  Liquidity risk, at the forefront of many investors’ minds these days, could also be added to this list as a standalone item or included as part of price risk.

While a definition of market and credit risk may be fairly understood, the concept of “operational risk” is sometimes more nebulous. Operational risk could be described as “losses due to anything else, aside from market and credit risk”. But there are other ways to lose money that shouldn’t necessarily be categorized as true risks, such as not having the right strategy or the right timing on an investment, which could be considered outside the scope of what a risk management function can do.

Michelle McCarthy, Managing Director at Nuveen Investments, stated that each type of risk has its own type of P&L distribution. Credit, with its main reward being coupon payment and repayment of principle, has much lower upside and a bigger left tail, or possibility of large losses, than market risk, which follows a more normal distribution. Operational risk also displays a larger loss potential. Combining the three main types of risk into a single cohesive measurement becomes difficult given their differences in distribution.

There are also two primary styles of risk, binary risks and risks of degree. Binary risks are purely unwanted and offer no upside potential, and include things like fraud, theft and legal violations. Companies can use controls and processes to manage these risks to as close to nil as possible. Risks of degree offer upside potential, and are the result of an investment decision. These types of risks are market or credit-related, and need to be managed and monitored. As a risk manager, McCarthy looks out for hidden risks that may not show up in a risk report, risks that are disproportionate to the amount of the potential gain, and risks that have a potentially unexpected return distribution.

What types of risk metrics are important to a hedge fund manager? Jennifer Stack said that at Grosvenor they often look at many different measures instead of relying upon a single number, and utilize Value-at-Risk (VaR), contribution to VaR, stress testing and factor models the company has built. While VaR is helpful for a total portfolio view risk that can integrate exposures across asset classes, different asset classes often require different risk measures.  For instance, looking at the Value-at-Risk (particularly historic Value-at-Risk) of real estate is often misleading as returns look smooth and volatility appears artificially low as a result. Regarding how best to protect a portfolio, Jennifer said that as a hedge fund investor, “sometimes the best hedge is to sell.”

 

Organizational Structure

Mike Edleson of University of Chicago kicked off the panel with some background on his institution’s endowment. He described their organization as “very enterprise risk focused” and said that they employ a total of 28 investment professionals, with 3 devoted to risk management.

Noreen Jones of NYSTRS said that her pension sees its primary goal as funding liquidity. Every month, NYSTRS delivers benefit payments to 150,000 retirees, and these payments total $600 million a month. The pension’s risk management group is only two years old and was created in response to a regulatory analysis of a gap on calculating and reporting risk at the total plan level. In response, NYSTRS built their risk group from scratch and currently employs four risk professionals tasked with measuring and monitoring the risk of a $100 billion asset pool. Initially, the risk group found it difficult to get a buy-in on a formal risk management approach across portfolio management groups. While the public market groups were used to routine risk measurement and monitoring, the attitude of the private market teams was often “My portfolio didn’t lose money, so where’s the risk?”

Grosvenor Capital has $45 billion in AUM and approximately 400 employees, mainly in Chicago. Its primary business is a hedge fund-of-funds, where it invests money on behalf of institutional and individual clients into various external hedge fund portfolios. Jennifer Stack, the firm’s head of risk, said that their primary goal is to “achieve not only great returns, but to achieve great returns on a risk-adjusted basis.” Grosvenor operates under a system of checks and balances between its risk function and investing functions to achieve that goal.

The panel discussed how risk ought to fit in with the broader investment function. According to David Kuenzi of Aurora Investment Management, risk management can’t be merely a policing function focused on divesting “too risky” securities; it needs to be a collaborative exercise with the portfolio management team.

Sometimes being a risk manager can be a very lonely place. During the Dotcom boom of the late 1990s, McCarthy had to have difficult conversations with star portfolio managers making piles of money on internet stocks about their sector concentration risk. To Jennifer Stack, risk “is not so much about policing, but having a second set of eyes.” And often the best portfolio managers will welcome a conversation about risk, added McCarthy.

 

Risk Budgeting

“We’re a little different than other endowments,” Mike Edleson said of his employer, the University of Chicago endowment fund.  Instead of a traditional investment policy statement that would dictate targets for asset class allocations, University of Chicago follows a risk budgeting approach. “There are 12 or 13 things that we’ve found to be our primary risk and return drivers,” Edleson said.

As University of Chicago researched risk budgeting and a potential shift away from a policy statement to guide investment allocation decisions, they determined that equity market performance was the most important factor for overall risk and return. This led them to the formalization of their risk budget, which is comprised of four pillars:

  • An overall portfolio beta of between .75 and .80
  • A liquidity constraint that caps private investments at 35%
  • The ability to maintain a beta of between .75 and .80 even during a financial crisis (betas typically rise during large market drawdowns)
  • An absence of leverage (which takes into account the use of implied leverage often embedded in derivatives)

University of Chicago is not the only investor looking at employing a risk budgeting framework. Jones said NYSTRS is also working on one, and the Employees’ Retirement System of the State of Hawaii is also building an allocation strategy around risk factor groups instead of asset classes. Edleson said that staying right on their risk budget forces a discussion around trade-offs into each allocation discussion, putting risk at the forefront of every decision made.

 

Liquidity Risk

Buying illiquid assets may look good on the way in, as each subsequent purchase by a portfolio manager tends to raise the price, but could pose a problem on the way down if there is a dearth of buying interest.

For Jones at NYSTRS, coming up with the $600 million due to beneficiaries each month is a huge challenge that is at the forefront of the fund’s investment officers’ minds. In addition to the benefit payments they must pay, they also must deal with flows from rebalancing activities and undrawn commitments that need to be paid. They do a cash flow projection to help guide their allocations and measure their liquidity in months of payroll. Given their high liquidity needs, NYSTRS has a large chunk of its portfolio in Treasury securities, one of the world’s most liquid markets.

In a hedge fund context, measuring and managing liquidity can be a bit different. Jennifer Stack of Grosvenor looks at liquidity in two ways: the degree of mismatch between a manager’s long term investment and short-term financing, and the underlying asset liquidity.

While investors usually want as much liquidity as possible, there is a potential for too much liquidity. University of Chicago actually rejected two hedge fund managers’ proposals as they found the redemption terms to be overly generous given the liquidity of the underlying securities. The endowment didn’t want to find itself last to redeem if there was a stampede out the door, which could result in the endowment holding the most illiquid portions of the manager’s positions.

 

Managing Risk in a Crisis

Another risk management puzzle arises because “Humans are stupid, and we love to buy high and sell low,” said Edleson, “Especially those in the investment community”. As with any shrewd investor, the University of Chicago endowment wishes to be countercyclical with their private market allocations, but this is “horrendously hard to do in practice”. So University of Chicago always does the same thing, and keeps their beta consistent across normal and distressed market conditions.

“How does one account for betas changing in a crisis event?” McCarthy posed to the panel. At Aurora, David Kuenzi likes to run his portfolios through a stress test focused on the Lehman Brothers bankruptcy in 2008, which he said was “a gift, in a sense” to risk managers as it provided a recent event to use to see how portfolios might perform in a crisis condition. While many securities of today’s portfolios weren’t around in 1987, one of the most common stress test scenarios risk managers like to use, many of the securities in today’s portfolios were around in 2008.

Another facet of risk that University of Chicago focuses on is the potential for regime change, particularly how correlations between securities tends to change over time. As risk-on, risk-off has been the flavor du jour for the macroeconomic environment for nearly a decade, this isn’t always the case. Edleson said that over time, stock and bond correlation is positive about 50% of the time and negative 50% of the time, making it difficult to discern any general relationship outside the context of each particular regime. In addition to stress testing prices, it’s worthwhile to stress test the correlations between market variables and model the effect of potential regime changes on the portfolio.

As risk evolves from measures like duration to Value-at-Risk to modeling macroeconomic shocks, there are a dizzying amount of metrics investors can look at and use to manage their portfolios. As risk practitioners, “We don’t know the future, but we can know our exposures,” said McCarthy. We can determine how our portfolios might break down in an extreme event, and we can instill a culture of risk awareness in our organization in order to avoid huge losses, with hope of buying during a crisis as opposed to selling.

 

Panelists:

Mike Edleson, CFA – Chief Risk Officer, The University of Chicago Endowment Fund
Noreen Jones, CPA, CFA, CAIA, FRM – Director of Risk Management, New York State Teachers’ Retirement System
David Kuenzi, CFA – Partner and Managing Director, Aurora Investment Management
Jennifer N. Stack, Ph.D. – Head of Risk Management, Managing Director, Grosvenor Capital Management

Moderator: Michelle McCarthy – Managing Director, Nuveen Investments

Distinguished Speaker Series: Tom Ricketts, CFA

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Chairman of the Chicago Cubs and Incapital LLC, Tom Ricketts, CFA, speaks to local financial and investment professionals at the Standard Club on April 12, 2016.

After his family acquired the Cubs in 2009, Tom Ricketts, CFA, found the storied franchise in disarray. Despite not winning a World Series championship in over a hundred years, the team continued to pack fans into historic Wrigley Field. But with the 3rd highest payroll and the 2nd worst record in the National League in 2011, success didn’t seem to be just around the corner. In a presentation to CFA Society Chicago, Ricketts offered his playbook for turning the perennial “Lovable Loser” Cubs into a championship-caliber squad in just five years.

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“Every single day I wake up and think about winning the World Series” – Tom Ricketts, CFA

As the team’s new owner, Ricketts put forth three goals for the organization:

  1. Win the World Series
  2. Preserve historic Wrigley Field
  3. Act as a contributor to the community

“Every single day I wake up and think about winning the World Series,” said Ricketts. He shared an interaction he often has with older Cubs aficionados: a fan approaches and tells him “Mr. Ricketts, I’m 70 years old and a huge Cubs fan, can you please win the World Series before I die?” To which, Mr. Ricketts typically responds, “Well, how’s your health? Are you exercising and eating healthy?”

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Tom Ricketts, CFA, and Distinguished Speaker Series Advisory Group member, Jim Stirling, CFA, meet with attendees before the presentation.

When Theo Epstein was hired as General Manager, the Cubs had a poorly ranked farm system and a very old, overpaid team. The Tribune organization, which Ricketts reckoned wanted to win as much as any owner, seemed to focus on short term success and viewed each season as a “discrete event”, hardly the way to build a championship team in his opinion. The Cubs executives began their quest for a championship by looking extensively at data. One thing they found was that the correlation between regular season winning percentage and playoff winning percentage is often somewhat low. In fact, many Wild Card teams haveended up winning the World Series in the past decade. Ricketts interpreted this as regular season records not mattering as much as simply reaching the playoffs for a chance to win.

Another insight that came out of their research involved the relationship between payroll and winning. A commonly held view by the media is that if you spend a lot of money on talented players, you will win a lot of games. Sports writers often consider payroll expenditure a good proxy for a franchise’s commitment to winning. After analyzing the data, the Cubs management realized that this simply wasn’t true.

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Tom Ricketts, CFA, with CFA Society Chicago’s Executive Committee. (L to R: Doug Jackman, CFA; Marie Winters, CFA, CAIA; Tom Ricketts, CFA; Kerry Jordan, CFA; Shannon, Curley, CFA

“Correlation between payroll size and winning percentage is much lower than you’d expect. You can’t just go out and buy wins,” Ricketts said, proving his point with a graph of the two variables’ low R-squared (a measure of goodness of fit of a model). The correlation between high payroll and winning percentage has subsequently declined even further in the past few years. Ricketts sought to understand why that might be. He found his answer in Major League Baseball’s contract system, which divides a player’s lifecycle into three phases:

  1. MLB debut
  2. Arbitration
  3. Free Agency

During the MLB debut phase, players often earn far less than their fair value. For instance, last year’s NL Rookie of the Year Kris Bryant will earn just $652,000 in 2016, despite batting more home runs than all but 13 players in the National League in 2015. Meanwhile, 35 year-old Curtis Granderson was less productive than Bryant, finishing with 29 fewer RBIs in 2015, yet is paid over 20 times the amount Bryant receives. This shows the asymmetry between production and cost that Ricketts says can hamper teams’ efforts to win.

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The Distinguished Speaker Series luncheon featuring Tom Ricketts, CFA, was one of the largest with more than 350 attendees.

The arbitration phase was characterized by Ricketts as a presentation by a player’s agent saying effectively that the represented player “was probably the best player on the team, and should receive an appropriately massive salary”, while the team’s presentation would sound more like “This individual shouldn’t even be in baseball and is fortunate to receive anything at all.” Following both presentations to a neutral arbitration panel, teams and agents will often meet somewhere in the middle on salary.

After six years following the debut and arbitration phase, salaries finally become lucrative as Major League Baseball players enter free agency. The problem for a team is that by the time a player reaches this stage, their Wins Above Replacement value (Wins Above Replacement, or WAR, is an overall measure of a player’s production and value) has typically peaked, and teams end up overpaying heavily for aging, declining talent. This was the case with the Cubs team that the Ricketts family inherited from the Tribune Corporation.

A slide charting the average players pay alongside WAR was shown, depicting a huge mismatch between value and pay early and late in a player’s career. The left portion of the chart (early on in a player’s career when their value to their team exceeds their pay) indicated an economic surplus for the organization, while the right portion of the chart (when a player’s pay exceeds value-added) showed an economic surplus for aging players. Puzzlingly, free agents sign the most lucrative contracts of their careers almost exactly when their production begins to slow down.

Another factor exacerbating the effect of low WAR relative to salary in players’ later years (i.e. free agency) is the growing practice of teams giving young, highly talented players longer contract extensions. Buster Posey’s 8 year, $167 million deal at age 26 was used as a good example of this. The net effect of longer contracts for star players is that quality players are entering free agency at an older age, when their WAR has typically peaked and their talents are in decline. Given these developments, it has become harder and harder to “buy a winner” and simply acquire high-priced free agent talent in order to win the World Series.

In light of that information, what were the Cubs to do in order to build a winner?

Their solution: focus on building a core of young, homegrown talent.

A number of other problems plagued the Cubs in 2011. According to Ricketts, the team had perhaps the worst facilities in Major League Baseball and didn’t have a clear philosophy on how to play the game. The Cubs developed the following plan:

  1. Upgrade all facilities
  2. Improve and expand scouting capabilities
  3. Focus on player development – create a “Cubs way” including a how-to manual for players detailing how to play the game
  4. Talent Acquisition
  5. Contract Extensions

The Cubs made a series of trades focused on length of control and getting younger, often moving older, more established players for prospects. The average age of their traded players was 31, compared to an average age of 23 for players received in trades. Ricketts reviewed several recent Cubs moves. According to the Cubs Chairman, the trade for Jake Arrieta was “the best trade in the history of mankind”, which was met with laughter and smiles by the audience.

After shedding older players and their costly contracts, developing prospects was the next key part of the Cubs strategy for sustained success. Ricketts noted that 24 out of 50 players playing in the 2015 World Series between the Mets and Royals were homegrown talent – players who had come up through each team’s farm system. The Cubs aggressive moves to cut older players and focus on improving their pipeline paid off in a big way. By 2015, ESPN reported that the Cubs had the #1 farm system in the MLB. In just five years after beginning a rebuilding effort in 2011, the Cubs entered the 2016 season with the most talented squad in the Major Leagues.

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CFA Society Chicago Vice Chair, Doug Jackman, CFA, welcomes Tom Ricketts, CFA.

On rooftops, Ricketts opined that it’s a difficult business situation when people across the street have access to your product for free. The practice of watching games at Wrigley on Waveland and Sheffield avenue rooftops began organically, with residents bringing up a cooler of beer and occasionally inviting a friend over to watch the game. Then some enterprising individuals began charging fans to go up on their rooftops and take in the Cubs, forever changing the rooftops into a commercial endeavor. The Tribune Corporation viewed rooftops as a threat and moved to block their view of the field. Rooftop owners responded by petitioning the City of Chicago to assign landmark status to three distinct elements: the marquee, the scoreboard, and most critically for them, the “natural slope of the bleachers”. The last item effectively prohibited the Cubs organization from blocking the rooftops’ view. Now, Ricketts said, the Cubs have made peace with the rooftop owners, their presence being one of the most distinct aspects of watching a baseball game at Wrigley Field.

Smart Beta: Smoke and Mirrors or the Next Generation of Investing?

DSC_2604Smart Beta – is it a bad fad or here to stay?

On February 23, two panels set out to discuss that question at the University Club.

Moderator Ben Johnson, CFA, Director of Morningstar’s global ETF research kicked off the discussion with a brief introduction into Smart Beta.

Ben said that the strategies of smart beta don’t necessarily feel smart over the full cycle. Right now there are 539 Exchange Traded Products (ETPs) doing smart beta, with $424 billion in assets and ETPs represent just one wrapper of the strategy. 21% of all ETPs are in the US, and 20% of all total new asset flows are going into smart beta products. The size of smart beta means that it’s too big of a market to ignore. Similarly, in the increasingly crowded ETP space, over a quarter of new launches involves smart beta funds. “This has been an organic growth story,” Ben said. Ben introduced the first panel and asked them to level set the conversation by defining what smart beta means to them.

DSC_2601Craig Lazzara of S&P Dow Jones said he prefers the term “Factor Indices” over smart beta. He quoted Voltaire and said that the saying “The Holy Roman Empire is neither Holy, nor Roman, nor an Empire” applies to smart beta. He encouraged the audience to read William Sharpe’s The Arithmetic of Active Management, which concluded that the average active manager’s return will be less than the average passively managed dollar, a conclusion that helps support the smart beta premise. Craig’s definition of smart beta is simple: Indices that try to deliver returns (or a pattern of returns such as low beta, high volatility, etc) of a factor, not of a benchmark.

Craig went on to say that smart beta factor indices allow a user to “indicize” returns of an active management strategy. “Twenty or thirty years ago, you’d have to pay an active manager to get these kinds of returns,” Craig said. And now with smart beta products, you don’t.

Eugene Podkaminer of Callan Associates began his remarks by saying that he was skeptical about smart beta and thinks that the name smart beta is “stupid”. He said that there is a lot of confusion around smart beta, how strategies are packaged and sold and what is under the hood. Smart beta has been driven largely by retail investors, who are susceptible to return-chasing behavior and clever marketing, while institutional investors with longer time horizons haven’t been as involved. “When you open the hood of a smart beta investment, it’s a different story,” said Eugene, who said he is interested in smart beta from a risk factor allocation perspective.

One important question that needs to be asked of smart beta, according to Eugene is “are you confident that the returns from these factors will continue?”

Trey Heiskell of Blackrock said that smart beta is both old and new. Like Eugene, he also hates the term smart beta and prefers ‘factor-based investing’, which he believes to be a more accurate name. “There is a shift from alpha to smart beta happening right now,” Trey said. And much of its growth is due to the context of the market we are in, with retail investors dissatisfied with the recent underperformance of active managers and growing adoption of ETFs. These are some of the main factors driving the growth in smart beta.

Craig agreed with Trey about smart beta being both old and new, saying that “these strategies have been around for years, packaged differently”.

Once, Craig was asked “What is it that ETFs allow large institutional investors to do that they can’t already do?”

DSC_2612“Absolutely nothing,” he answered. But as a retail investor, now you can get the benefits of factor exposure you want cheaply and easily without dealing with an active manager.

Eugene gave an update on how Callan’s process has evolved and said that now they are very risk and diversification-focused, and when evaluating a potential investment, more interested in its covariance with other investments than its forecasted returns. You need to have a robust set of tools to determine what your factor exposures are, such as a risk model. Some advantages of smart beta ETFs are that they are liquid, transparent and cheap. He said that the question “Why am I paying so much for hedge funds,” will continue as risk factor-based investing grows in popularity. “Indexing and smart beta have chipped away at what we call alpha,” Eugene said.

Craig said that investors need to think about their investments not as a portfolio of stocks, but as a portfolio of attributes. He thinks investors need to consider how they might use smart beta to avoid or minimize paying active management fees.

Eugene stated that smart beta does have some problems. Just because the portfolio appears to perform well in the past, the returns won’t necessarily continue. “Backtests by definition look good,” Eugene said. Smart beta needs to be forward looking, it has to be ex-ante, he said. Investors are trying to build portfolios that work well in the future, and you need to forward-looking economic rationale for any investment you make, which also must apply to smart beta products. Smart beta puts the onus of complex portfolio management tasks on the individual, who now must answer “Why did I make that tilt” instead of asking that same question to a manager.

Trey responded that while an economic rationale is important, it is dangerous to be hyper-focused on short term performance of smart beta.

Craig noted that it is important to watch out for spurious correlation, giving an example of extensive data mining leading to a researcher to conclude that butter production in Bangladesh is a strong leading indicator of the S&P 500.

Trey said that just because it is smart beta, it doesn’t mean you’re excluded from doing your own due diligence.

Eugene posed a philosophical question and asked “Can all market participants do the same thing at the same time? And can everyone be in smart beta at the same time?” This isn’t possible. There has to be someone on the other end. We can’t all be in low volatility products. Why ought to these risk factors continue to deliver these kinds of returns? And how many factors truly exist? At Callan, they don’t believe that there are hundreds of investible factors, they look at about 10.

DSC_2605Trey said that better product definitions on smart beta from index providers are coming up. “Smart beta is the gateway drug to explicit risk factor investing,” said Trey.

Eugene said that smart beta is interesting like a bicycle is interesting, while risk factor investing is more like a race car. “Everyone hates fixed income benchmarks,” Eugene said, saying that that may lend itself well to a smart beta product.

Michael Hunstad said that Northern Trust has been doing factor based investing for 20 years and smart beta is definitely not new. “The hard part with smart beta is making a lot of decisions that were formerly made by your portfolio manager”, Michael said. Some of these decisions are “what factors do I choose?” There are many smart beta providers also, and there are some big considerations involved that clients need help and guidance with.

“Where does smart beta go in my portfolio,” is a very good question. It’s not exactly active, yet not totally passive either. The old way of deciding a manager allocation was by making a list, and allocating to the manager who performed best. This doesn’t work with smart beta, and the selection of products is tough. According to Michael, smart beta is two things:

1) A source of excess return
2) A risk paradigm

If smart beta risk factors are independent sources of return, then they are also independent sources of risk.

Mehmet Beyraktar counted himself among the many in the panel who dislikes the term smart beta, and said investors need to question how the products complement their existing portfolios, and the challenge of smart beta is how to integrate. He said that a big part of the investment process is obtaining the right tools to get transparency into smart beta investments and a means of calculating exposure to risk factors, such as a factor-based risk model. Not that much research is available into how risk factors and smart beta will perform is available just yet, he said.

Ben offered an exchange he heard between a Middle East-based client and an advisor, where the advisor asked how long the client’s time horizon was, and he responded “We measure in generations.” The client then asked “How often do you look at performance?” and the client said “quarterly”, a huge mismatch between the evaluation period and the investment horizon.

Michael told a story about an investor who thought he could use PMI to make a tactical call on the market. There certainly are leading indicators, but the hard part is determining when they will play out. He said that he doesn’t have much confidence in anyone’s ability to time cycles and market behavior. But multifactor products are the wave of the future in dealing with cyclicality. With smart beta, there is a concentration risk on one end of the allocation spectrum and a dilution risk on the other end. If you simply allocate equally among all the risk factors, you probably will end up with an investment that looks very similar to a cap-weighted benchmark.DSC_2610

 

 

Creating a Stronger Career by Building Your Personal Brand

DSC_2568Managing a brand comes down to two main points:

  • How do others talk about you?
  • And even more importantly: How do you talk about yourself?

Executive coach and Make the Leap! Coaching founder, Curt Wang, brought powerful insight into how financial professionals can learn to brand themselves by finding their strengths and unlocking what they really want out of a career. As he made his way to the stage, Samantha Grant, CFA joked that “Curt is an overachiever and should fit in well with this crowd.”

Curt says “A lot of people hear the word ‘branding’ and say ‘Isn’t that something that corporations do?’” Corporations are certainly at the forefront of branding and messaging, but it’s essential for individuals to find their own brand identity too. Branding helps employers, clients and colleagues visualize who you are and what you do well.

“When you hear the word Volvo, what comes to mind?” Curt asked. “Safety,” everyone shouted out. What about your name? What do people think when they hear your name? There was a pause as the audience contemplated the question. Curt continued. “There are five tests of a great brand,” he said.

  • Value
  • Fit
  • Credible
  • Unique
  • Sustainable

DSC_2575If others don’t know what makes you unique as a person and as an employee, they may pass you by. Sears was one of the top retail outlets in the country for years. Now they aren’t. What changed? They tried to be all things to all people. Whereas most shoppers know that Home Depot is the best place for building supplies and Best Buy has all the latest and greatest electronics, Sears tried to do it all. This left a fuzzy impression in shoppers’ minds about Sears and what it represents. Sears represents an example of a bad brand strategy, the opposite of the clarity found in Volvo’s clear “safety first” messaging.

For those in transition, Curt advised them to not “use all of your best contacts right away, when you’re the least clear about yourself and what you want to do.” Instead, first you ought to figure out what your brand is and exactly what kinds of jobs you are targeting, thus avoiding the fuzziness that comes without having a clear brand identity. Every time you are networking, they really are interviewing you even if they say that they aren’t. If you do a good job and wow them in the conversation, then they may pass your name on to a hiring manager.

Curt showed a series of stock images of doctors and asked us which one we would choose. The audience was about an even split between the choices, with some selecting one because “he looked smart” and others choosing an older doctor because he “looked experienced”. The lesson was that if you don’t manage your brand, people will make assumptions about you. Your position or title alone is not your brand. It’s certainly part of it, but not all of it. Focus on your unique strengths and sell that to employers.

DSC_2572There is a sea of change currently taking place within the corporate world and how young people approach work. Specifically, within Big 4 accounting firms Curt noted that in the past you would see four out of five young hires looking to work their way up the ladder to make partner, working long days and nights in order to make that goal a reality. Nowadays, Curt says, four out of five young Big 4 hires do not want to make partner, with many desiring a different career path entirely. Some employees focused on work / life balance may only wish to work 40 to 50 hour weeks compared to the 80+ hour workweeks other associates might labor through in order to make partner. The shift in thinking has happened because there used to be one well-defined path to the top, and now there are many paths to success. Not all of these paths involve working long hours for many years at a single employer.

In building your brand, your number one goal should be articulating what you are great at. Companies actually want employees to take control of their career because it creates higher engagement and reasons to stay at the firm, not employee turnover as you might initially suspect. In order to articulate what you want from your career, it might be helpful to recall some of your favorite things that you have worked on and why. What do those favorite projects say about you and your ideal career? What strengths did you exhibit during these projects? When did you feel like you were ‘in the zone’ while working? What would it take to become a world-class version of yourself? What would others say you are the go-to person on and why?

After discussing these questions in small groups amongst ourselves, Curt left us with some homework. We were to determine what our top five strengths are, figure out what are our transferable skills for future opportunities would be, and answer the following:

What are the three main components of my personal brand positioning?

  • I am an expert in _____
  • The value of my expertise to people / organizations is _____
  • I am uniquely qualified because _____

For professionals of all career levels, developing branding skills is a great way to sharpen our focus for job opportunities, determine our passions, and further engage with our work. Curt gave us the tools to do just that.

For more information, please visit http://www.maketheleapcoaching.com/.

Distinguished Speakers Series: Kyle Bass

China has been in the news lately, and for all the wrong reasons.

“A hard landing [in China] is practically unavoidable,” legendary hedge fund investor George Soros told Bloomberg while attending the annual World Economic Forum meeting in Davos. “I’m not expecting it, I’m observing it,” he said.

The Chinese government, facing malaise from many angles, issued a swift rebuttal to the investor responsible for “breaking” the Bank of England in 1992, saying that “Soros’ challenge against the renminbi and Hong Kong dollar is unlikely to succeed, there is no doubt about that.” The People’s Daily, China’s Communist Party’s official newsletter, went a step further with the anti-speculative rhetoric and ran an article titled “Declaring war on China’s currency? Ha ha.”

You can add hedge fund manager Kyle Bass to the growing anti-renminbi chorus. Linking the current trouble in China’s stock market to origins in its banking system, Bass gave a sweeping overview of China’s banking system, its growing book of non-performing loans and the potential impact of a Chinese currency devaluation on the global economic system.

Kyle Bass, founder of Hayman Capital, came to the financial world’s attention in 2007 as one of the first financiers to make a fortune on shorting low quality pools of mortgages. The short subprime bet earned him a massive 212% return that year. Further public recognition came from Michael Lewis’ 2011 book Boomerang which examined how cheap financing around the world led to the global financial crisis. It featured Bass prominently as an investor who confidently understood what was going on, and was able to capitalize on it. One anecdote in the book described how Bass bought a million dollars’ worth of nickels from the Federal Reserve, with the belief that the meltdown value of the metal was actually worth $1.36 million. How did he explain the strange, enormous purchase of nickels to the Fed?

“I just like nickels,” he allegedly told them.

Before his speech, Bass quizzed luncheon attendees at the VIP table with the seemingly innocuous question: “Who knows how big the Chinese banking system is?” As we sat there stumped, he laughed and said “Come on, you’re CFAs, you should know this!”

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Kyle Bass, Hayman Capital, speaks to local financial professionals at The Standard Club on January 26, 2016.

After a brief lament about the lunacy of visiting Chicago in January, Bass quickly cut to the chase with his thesis: China will go through a non-performing loan cycle, and the People’s Bank of China will be forced to devalue their currency. Hardly anyone knows how big the Chinese banking system is, Bass said, and understanding its size and the volume of non-performing assets relative to GDP is key to understanding the direction of the Chinese currency.

Just how big is the Chinese banking system? According to Bass, there are $30 trillion in bank assets on the books, and another $5 trillion in assets off the books, for a total bank asset to GDP ratio of 350%. This is roughly double the level of US banking assets to GDP before the financial crisis. If non-performing loans reach 10% at Chinese banks (that level was as high as 30% in 2001), that would represent a loss of $3 trillion, which is roughly the total level of China’s foreign exchange reserves held at the People’s Bank as of January 2016. China’s currency reserves continue to shrink as capital flows out of the country, and its central bank recorded the largest ever drop in reserves ($107.9 billion) in December 2015. If only 4% of Chinese citizens were to withdrawal the maximum $50,000 allowed, that would vaporize the entire pile of China’s $3.3 trillion in FX reserves. Many elite Chinese are already taking capital out of the country as quickly as possible and are looking to buy real assets with cash flows such as movie theaters, hotels and properties in Vancouver.

The capital flight out of China takes place at a time when China is experiencing its lowest year-over-year growth since 1999, and may actually be as low as 3.6% (Hayman Capital’s estimate). Bass sees six distinct crises currently taking place within China:

  1. A stock market crash
  2. State-owned enterprise transformation
  3. An export-led industrial economy facing a shaky transition to a service-based economy
  4. Declining excess reserves
  5. Property problems
  6. Lack of confidence in the government’s ability to solve the above problems

If non-performing assets rise, that will require a recapitalization of China’s banks, which will stymie new loan creation and push the central bank closer to a large Chinese Yuan devaluation. The devaluation may exceed 15%, and Bass believes that it will likely take place overnight, as a last resort by the bank once its back is up against the wall.

What does that mean for the American investor? A hard landing in China could sap as much as 100-150 basis points from GDP from the US, according to Bass. Although US stocks may decline, Bass doesn’t forecast a huge crash, but there certainly will be deflationary pressure coming from China as a result of the devaluation. The best way to play a potential currency devaluation is by shorting Chinese renminbi, but this is a difficult exposure for an American retail investor to achieve. The best available proxy to individuals may be Hong Kong assets, which are more liquid and tradeable.

Regarding commodities, Bass believes that we are close to a bottom. He drew a line in the sand for oil and said that “a drill bit doesn’t hit the ground at $25”. Bass thinks that the CRB Index may bottom within a few months, but it would not be a good idea to go long oil ahead of any Chinese currency devaluation. The aftermath of that event could represent an attractive opportunity to add to commodity longs. The supply side will resolve an imbalance on its own as lower price levels make it unprofitable to mine and drill, but the demand picture is harder to assess. Bass is unsure how commodity demand in China, a top consumer, would be affected by a large currency devaluation. He thinks bonds still look relatively attractive despite their low yields.

Bass finished his speech with a story about a meeting between former Chinese president Hu Jintao and George W. Bush. It was difficult for the two leaders to get time completely alone. In the moment they had together, Hu Jintao privately confided to Bush that his biggest fear was “creating 20 million jobs a year”. This may prove problematic for China’s current administration as it faces its biggest test yet.

29TH ANNUAL DINNER

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Financial speakers don’t come with a higher profile than billionaire Mohamed El-Erian, whose resume lists a staggering body of achievement: Chair of President Obama’s Global Development Council, Chief Economic Advisor at Allianz, former Co-CIO and CEO at PIMCO and Bloomberg columnist and author.

As attendees milled around the large meeting hall of the Streeterville Sheraton, our annual Society dinner began with soft jazz in the background and steak and salmon slowly finding their way to tables. Experienced investment executives and new Charterholders alike shook hands and networked while dining, excited about the prospect of hearing from one of the preeminent minds in the investment world.

Kerry Jordan, CFA, current Chairman of the CFA Society Chicago, opened the proceedings with a video message from Paul Smith, President and CEO of the CFA Institute, who explained the genesis of the CFA Society Chicago to commemorate our 90th anniversary as an organization. This was no ordinary annual dinner; it was a milestone for our organization and an occasion to celebrate our past and look towards our future.DSC_2216

Each attendee also received a book published by the CFA Society Chicago titled “Celebrating 90 Years” to take home with them. The book, which the Society’s Communications Committee spent over a year preparing, shares biographies of our pioneers, financial news articles from years past and photographs of important places and people who helped shape our organization’s history. As Co-Chairman of the CFA Society Chicago Communications Committee, I’d like to extend my gratitude to everyone who worked on the history project and helped make it happen: many thanks to all of you who spent long weekends in various libraries researching and crafting this excellent book.

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New Charterholders being recognized at the 29th Annual Dinner

 

Kerry Jordan, CFA thanked Paul Smith for his remarks and switched gears to honor the four individuals marking their 50th year as Charterholders. The new class of 177 recently-minted Charterholders was also toasted, with Jordan reminding the audience just how difficult it is to pass all three exams and the massive amount of time and effort expended to earn a CFA Charter. Jordan reiterated the benefits and reach of the CFA Charter, stating that there are now local societies in 71 countries, with over 300 universities globally incorporating the CFA curriculum into their programs.

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Priscilla Perry – Hortense Friedman, CFA, Award for Excellence

The Hortense Friedman, CFA, Award for Excellence was presented to longtime Harris Bank analyst Priscilla Perry. Perry’s biography mentioned that she needed to pass all 3 exams, not just 2, as some Charterholders were given the CFA designation with only two passing exams earlier in the program.

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Priscilla Perry & CFA Chicago Past Chairmen

Jordan then discussed her own personal journey towards becoming Chairman of the CFA Society Chicago. She quipped, in reference to former Chair Heather Brilliant, who had been recently promoted to CEO of Australasia at Morningstar, that she liked the trend of recent CFA Chicago Chairs receiving a ‘Chief’ in front of their job title.

“We’re getting to you Mohamed, just a couple more things,” Jordan said to laughs in the audience as she listed off the event sponsors and graciously thanked them for their kind support.

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Left to Right: Chris Vincent, CFA, Kerry Jordan, CFA, Mohamed El-Erian

Immediate past Chairman Christopher Vincent, CFA was asked to introduce Mohamed El-Erian. In his introduction, Vincent mentioned the parlor game that he likes to play with other company leaders of “who has the most CFA Charterholders” but that he usually prefers a per capita measurement, which favors William Blair.

Dressed in a dark suit and a blue tie, El-Erian made his way to the stage amidst thunderous applause, pausing to take a few pictures with Christopher Vincent, CFA and Kerry Jordan, CFA.  The format for the presentation was a one-on-one chat, a la a Charlie Rose interview. Questions from CFA Society Chicago members were solicited ahead of time, with Jordan to act as the interviewer while she and El-Erian sat in armchairs on the Sheraton ballroom stage. Jordan mentioned a few of the questions that had been tossed out, including “How crazy is Bill Gross…really?”, to which El-Erian stared straight ahead with the slightest smirk on his face, wisely declining to offer any thoughts around his old boss at PIMCO.

Given El-Erian’s vast array of job, media and government responsibilities, how does he spend a typical day, a CFA charterholder wanted to know?

While at PIMCO, he would rise at 2:45 AM to compensate for the 3 hour time difference between California and New York, but now El-Erian sleeps in…until 3:30. The audience audibly gasped upon hearing this, realizing that building a net worth of $2.3 billion doesn’t always come with a lot of sleep.

After an early wakeup, El-Erian does some of the same things we all do. He looks to find out what is going on in the world, takes his dog out and makes his daughter breakfast. Sometimes when he lies down at 9 pm to sleep (he aims for about 6.5 hours of sleep a night), he starts tossing and turning and obsessing about how many hours of sleep he’ll get if he can’t fall asleep promptly at 9 pm. Then, El-Erian said, he might begin calculating his 3 day sleep moving average and his 5 day sleep moving average, to chuckles in the financially-oriented audience.

El-Erian has been a fan of the Mets since 1968 and said he was a bit worried about presenting in front of a room full of Cubs fans shortly after his team knocked the North Siders off in the NLCS. “Well, about 20% of you are on my side,” he said, referencing the much smaller Chicago White Sox fan base.

The nature of the conversation shifted as Jordan moved the conversation to the Fed’s decision on whether to raise rates in December. “What are the odds?” Jordan asked.

“High,” El-Erian responded. “But why are we obsessing with 25 basis points?”

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Keynote Mohamed El-Erian

El-Erian had three observations on the current Fed watch:

  • We’ve been living in a non-normal world and we are addicted to the Fed’s help. The Fed has had some missteps in communicating with the market about its plans, and this will likely be the most gradual tightening in Fed history.
  • The Federal Reserve probably won’t raise rates during every meeting and will stop raising rates well below the historical average seen in previous tightening cycles.
  • The world has become a very asymmetrical place, with the ECB moving in a different direction than the Fed and many central banks are out of alignment with respect to their monetary policy. This will likely lead to more foreign exchange and equity market volatility and higher interest rate differentials going forward.

“The Fed is dying to get off of 0%,” said El-Erian, “and the longer they are unconventional with monetary policy, the lower the benefits and the higher the costs.”

Over the past 10 years, society has bet on a growth model with finance, seeing it as an engine of prosperity for the economy. Countries like Iceland greatly expanded the size of banking within their economies with the belief that you can grow a lot with an expanding financial center. “Finance,” said El-Erian, “just got too big.”

Another observation El-Erian made was that the global political system was not stepping up to its economic governance responsibilities. In his mind we need a political system that steps up and a financial system that serves society as a whole to counter the effects of volatile markets and uncertainty around interest rate increases.

He talked about a recent investment he made in a firm that provides credit for very low income individuals, stating that “credit card debt can ruin you.” Technology is changing everything we do, and behavioral finance is now being used to help improve access to credit. The new generation of millennials expects “interaction anytime, anywhere” and companies need to build their strategy around this fact. In 10 to 15 years, Millennials will comprise the main customer base for most firms. El-Erian mentioned peer-to-peer lending, seen on platforms such as Lending Club, as part of the disruptive force currently taking place within finance, enabling individuals to interact in ways that would previously require an intermediary such as a bank. Technology has given rise to a broader trend of individual empowerment, and firms that ignore this change will find themselves rapidly disrupted. El-Erian used the example of the Hilton hotel chain taking a century to build 700,000 rooms while Airbnb accomplished this in a few years. “Starwood is being disrupted by people who never built a hotel in their life,” he said.

Jordan then turned the conversation towards the topic of student loan debt. Over $1.4 trillion is owed by students and this amount has tripled in just a few years, making many consider the student loan market to be the next subprime-like domino waiting to fall. As El-Erian explained, the return on higher education has gone down as the costs have increased, with an increasing household concentration of educational debt. Some options to fix this situation include broader use of community college, an earlier start for financial literacy programs and increasing the transparency around the student loan market, which El-Erian described as very low. “When you have a debt overhang, it impacts everyone,” El-Erian stated, saying that the options of bailing out delinquent borrowers or having an entire segment of society of being crushed by student loan debt are both highly unpalatable.

In El-Erian’s mind, one of the best ways new charterholders can prepare for a successful career would be by learning the languages of emerging economies, particularly Mandarin and Cantonese. The emergence of a much larger global middle class also points to an increased need for financial advice. Another less positive trend El-Erian highlighted was the “hollowing out” of the middle class in the West, resulting in a barbell-style society of poor and rich with few in the middle.

In terms of the investment landscape, El-Erian said it is no longer about products, it’s about solutions. You can’t expect to lob an array of diverse products at consumers and hope for them to construct a solution, the investment industry needs to build solutions for them.

One attendee wanted to know El-Erian’s views on the topic of active versus passive investment. In El-Erian’s mind, there shouldn’t be a debate because there is room for both approaches. Passive investment can be problematic in some asset classes, which El-Erian detailed in an example from earlier in his career while working as an emerging markets bond portfolio manager. At the time, Argentina represented 20% of an emerging markets index, but PIMCO made the decision that the country wasn’t a good credit risk and decided not to allocate any of its capital to Argentine bonds. Some commentators characterized this decision as irresponsible because it was such a large holding in the index and its exclusion would inject a huge tracking error into the PIMCO emerging market fund. Over time, PIMCO’s decision not to invest in Argentina turned out to be a huge success as the country defaulted in 2001-2002, and the exclusion of its bonds in PIMCO’s fund led to strong benchmark outperformance. For this reason, when default and liquidity risk is high, active management is very important. But in some asset classes, active management doesn’t really add much value, El-Erian opined.

Liquidity drives many investment decisions in fixed income and this risk factor has grown in importance as the buy side has increased market participation as sell side participation has declined, resulting in what El-Erian termed “the delusion of liquidity” currently going on in markets.

El-Erian listed three items he would expect economists to name as top initiatives needed to drive economic growth, including structural reform, the fundamental imbalance between the will to spend and the size of the wallet (“Germany has the wallet but not the will, Greece has the will but not the wallet”), and reducing what he sees as excessive levels of debt in the financial system. Publicly-traded markets are especially prone to manipulation by Fed policy, and El-Erian continues to move assets from public markets to cash and private markets as new index highs are reached.

Lastly, Jordan asked El-Erian about what he thinks of the future of finance. El-Erian laughed and said “They always say be afraid of the last question”, stating that he had recently created a Twitter account and was amazed by that platform, and that the future is generally very hard to predict.

To view 29th Annual Dinner pictures online please visit: http://edwardfox.pixieset.com/guestlogin/cfachicago/

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Next-Level LinkedIn Strategies

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Is the resume becoming extinct?  JD Gershbein thinks it’s possible.  Every professional knows that it’s a good idea to have a LinkedIn profile, but how best to build it and find new opportunities?  Gershbein encourages professionals to continuously improve their LinkedIn profiles, which have emerged as the most versatile business document around.  In his talk, Gershbein focused his presentation around what he would do on LinkedIn if he needed a job.  “You’re competing on LinkedIn for three things: time, visibility and attention,” he told us. Gershbein stated that it is important to convert action on LinkedIn to a strategy.  Working with LinkedIn for job leads or new business is a lot like panning for gold in that there is a lot of junk, but worth it if you are methodical and consistent in your approach.  In terms of developing LinkedIn profiles, Gershbein said that there are three sub-movements within the social media revolution currently taking place that we should consider:

Brand Storytelling – where you embrace uniqueness in contributory form or aspirational form

Content Marketing – how you sell yourself

Community Management – living the story you tell in front of the real world

One way that a LinkedIn profile can be better than a resume is that it allows you to show potential employers what you accomplished, along with what you learned as a result of what you accomplished.  Gershbein says that the latter explanation is a very important way to show employers your self-awareness and personal development.  Using LinkedIn publishing, a platform for blog posts and original content from LinkedIn users, is also a good way to achieve your content marketing goals. Writing is a valuable skill in almost every business field and any piece of communication you produce should be considered as part of your strategy.  It’s also important to be accessible.  You can develop an e-signature for your personal email, and you should always include your email address and telephone number in your LinkedIn profile.  When making contact on LinkedIn, Gershbein says it is good to quickly move the conversation offline and schedule what he calls a “brief discovery call”.  Most people are much more likely to agree to a call if it’s described as brief, Gershbein has found.  Another important tip is don’t make the LinkedIn profile a redundant document that provides the same information as your resume.

The most important area on your LinkedIn profile is the summary section.  According to Gershbein, this is the “make or break section” and should be written in third person narrative format.  The summary needs to answer three questions:

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Why should I hire you?

What contributions will you make?

What were the results from what you did?

 

Everything on the LinkedIn profile should help answer these three questions.  Contributions should center on two main areas: contributions to company culture and contributions with clients.  It’s important to answer the question of “Why would you recommend yourself to others?” also.  Keywords are an important consideration because this is how recruiters will find you and connect with you.  Anything shown in bold on your LinkedIn profile appears higher in search results.  The main keywords you want to focus on include your industry, market, job title and specific skills.  It’s a good idea to sprinkle in relevant keywords throughout your profile to rank higher in recruiters’ search results which tend to favor profiles with many connections and profiles with more sections completed.

LinkedIn is an extremely popular website with nearly 350 million users yet remains underutilized by many.  With a more strategic approach and a carefully crafted profile, LinkedIn can provide job seekers with a strong platform for branding, networking and finding new employment opportunities.

 

JD Gershbein is the CEO of Owlish Communications and a specialist in LinkedIn strategy. For more information, visit http://www.owlishcommunications.com

CFA Society Chicago Blog Launches

Dear Colleagues,

Today we are excited to announce the launch a new chapter in the history of CFA Society Chicago the – CFA Society Chicago Blog.

The Communications Advisory Group developed this new communication tool, populating it with event news, speaker recaps, society news and more.  As the blog continues to grow, I invite you to submit articles that address current trends and research in the investment industry.  This blog will also be an exciting part of the society’s 90th anniversary celebration, starting in 2015.

Browse the blog and read about our great events. And CFA Chicago members – consider joining the Communications Advisory Group.

Sincerely,

Communications Advisory Group

CFA Society Chicago

Distinguished Speaker Series: Jeremy Siegel

Distinguished Speaker Series: Jeremy Siegel

Distinguished Speaker Series: Jeremy Siegel

Are stocks overvalued?  Not according to Chicago native Jeremy Siegel.  The Wharton professor and author often described as a “perma-bull” took a sanguine view towards the equity markets in his CFA Chicago presentation, saying that while stocks are the most volatile asset in the short run, they have proven to be most stable asset in the long run, producing an average real return of 6.7% since 1802.

When Dr. Siegel delivered his keynote address to the CFA Chicago Society’s annual dinner in 2011, he described stocks as “undervalued”.  Since then, the S&P 500 has returned nearly 63%.  Slightly less prescient was his prognostication regarding bonds, which he believed to be overvalued at the time.  In his booming, enthusiastic style, Siegel spoke highly of stocks, saying that “In every country in the world, stocks have slaughtered fixed income over the long run”.

One of the most interesting anecdotes Siegel told was around his tenuous media relationship with fallen bond titan Bill Gross.  In Gross’s August 2012 Investment Outlook piece, the former PIMCO portfolio manager wrote that “the cult of equity is dying” and identified Dr. Siegel as the leader of that cult.  “I’ve had my differences with Bill Gross over the years,” Siegel lamented to chuckles in the audience, noting that Gross’s ill-timed call preceded a massive run-up in equity prices.

Turning his attention towards the subject of valuation, Dr. Siegel used the price to earnings multiple over a long time horizon to show that the current market valuation isn’t very far from the norm.  Taking the analysis a step further, Siegel stated that removing high interest rate periods from the PE calculation would indicate an even higher average multiple, suggesting that the market could potentially be undervalued even after nearly doubling from the March 2009 low.  Dr. Siegel then issued a rebuttal to his friend Robert Shiller’s popular Cyclically Adjusted Price to Earnings (CAPE) ratio, stating that in 392 months out of 396 months from 1981 to 2013, the actual 10 year real market returns have exceeded CAPE forecasts.  The CAPE ratio even characterized the S&P 500 as overvalued in May of 2009 when the Dow was at roughly half of its current value.  FASB accounting rulings also affect firm earnings (and thus PE ratios) by requiring firms to write down, but never “write up” investments.  This phenomenon was observed in 2002 due to the acquisition of AOL by Time Warner where the subsequent $99 billion write down produced the largest loss in corporate history, further distorting reported S&P 500 earnings.

Lastly, Dr. Siegel addressed the way the Standard and Poor’s aggregates S&P 500 earnings, saying that the earnings number they report can be wildly distorted due to the firm not cap-weighting each company’s share of profits and losses.  Instead, Dr. Siegel offered National Income and Product Accounts (NIPA) as an alternative earnings measure.  When NIPA earnings are used in the Shiller CAPE ratio, the market shows no overvaluation at all.  Attendees were left with plenty of food for thought around markets and valuation, and Dr. Siegel again delivered an excellent talk.