Distinguished Speaker Series: Rick Waddell, Chairman of Northern Trust

Who better to teach management during a crisis than a former bank CEO who began his job in the midst of the 2008 recession? Rick Waddell has one of the most extensive resumes you’ll find in banking and dedicated his career to growing Northern Trust from a sleepy custody and wealth management firm into the technology-driven asset management and banking leader it is today. Waddell was CFA Society Chicago’s guest speaker on October 10th for its Distinguished Speaker Series luncheon.

He noted proudly that he saw many former and current Northern Trust employees in the audience. “The CFA Society is really important to us at Northern Trust,” he said. Waddell said that he was told not to make his speech a commercial for his bank, and joked that “this eliminates about 95% of my content” and made him ponder what would be a good topic for him to address, ultimately deciding on “5 Things I Learned From the Global Financial Crisis of 2008”.

In Waddell’s mind, the following five key features made the difference between success and failure during the financial crisis.

Capital matters. For any organization with a balance sheet, both the quantity and quality of its capital during ’08 were incredibly important. He noted that capital ratios had been too low in Europe, but generally were roughly OK in the US. He still sees problems with bank capital transparency in Europe today.

Liquidity matters. Again, both the quality and the amount of liquidity are important. Waddell said that he believed that the fall of Lehman Brothers was not due to lack of capital, but to lack of liquidity. The Fed was much more focused on capital during the global financial crisis than liquidity, but the latter was just as important. One of the earliest warning signs Waddell saw that all was not right in the financial world was when HSBC wrote down $11 billion worth of subprime mortgages in March of 2007. Waddell wanted to know if any part of Northern Trust had exposure to subprime lending and found that, while they didn’t make the loans themselves, they still had subprime-related instruments in some of their investment pools. Another warning sign came in August 2007 when Waddell learned that a securities lending collateral pool was facing losses when a number of banks withdrew from the niche Auction Rate Securities (ARS) market and banks holding the formerly liquid instruments suddenly faced losses.

Leadership and management during a crisis matter. Waddell said that during a tumultuous period, “the good and the not so good in all of us comes out.” With his background focused on commercial banking, he had to learn a lot of things quickly during the crisis as a new CEO leading a diversified financial firm. At the same time, Waddell had consultants and executives coming to him asking who he was going to fire in order to shed costs. Firing people immediately after the bank’s best year on record (2007) didn’t make sense to Waddell. He didn’t want to go down that route, and it turned out that staying the course and not making widespread headcount reductions was the right decision.

Culture matters. “At Northern Trust, our values are service, expertise and integrity,” said Waddell. Having that culture in place before a crisis hit was extraordinarily important. While Waddell admitted that Northern Trust has its share of problems like any firm, and its culture needs to evolve while holding employees more accountable, having a set of values that the team buys into was one of the main reasons the firm navigated the crisis so well. “Culture is more important than strategy,” Waddell said, echoing management consulting pioneer Peter Drucker. Despite the bank’s commitment to its partners and Waddell’s desire to avoid mass layoffs, its ROE fell to 8.2% in 2011, below its cost of capital, so the bank went on a mission to cut costs while still avoiding large layoffs that could have demoralized staff.

Strategy matters. Waddell said that having skin in the game was important during the recession. He found that the trend of banks securitizing assets and immediately getting them off their balance sheet led to a lack of skin in the game with financial institutions, and this made the crisis even worse.

Waddell continued on at length about his experience during the financial crisis. In 2009, large US banks were forced to accept a capital injection as part of TARP. Northern Trust was well-capitalized and didn’t need the money, but regulators hinted that they needed to comply or there could be consequences. Waddell said that the TARP program was in theory a good idea that could act as a stimulus, but the problem was that there weren’t enough borrowers demanding capital for it to have much of an impact. What was originally termed the “healthy bank program” soon became “the bailout” in the public’s eyes, which led to protest movements such as Occupy Wall Street, some of which were held immediately outside Northern Trust’s headquarters at LaSalle and Monroe. This populist take on the government bailing out fat cat bankers hurt the perception of Northern Trust, despite the firm’s insistence that it didn’t need capital and its desire to quickly repay the money. Waddell said that the terms of the loan Northern Trust was forced to take netted taxpayers a 15.5% return, and TARP overall was one of the most successful investments for taxpayers in recent history and very profitable for the government.

Blame for the crisis is difficult to assess, but Waddell said that the Fed was responsible for missing some of the warning signs, banks were also responsible to an extent for lax standards, and consumers were also responsible by borrowing far more money than they were able to repay. Waddell said that eventually there will be a recession in the US but the banking system will be in a much better position to not only withstand it, but even be a positive force for stability. One thing that remains unresolved is the issue of “too big to fail”, but bank capital and credit quality have greatly improved overall. While he noticed some clues that markets were starting to crack back in 2007, Waddell sees few red flags on the horizon today. He said that usually problems will manifest early on in the mortgage market, but that the industry appears to be functioning fairly normally now. There could be some issues with Brexit next year, and Northern Trust continues to monitor that situation closely, as well as the Chinese economy and issues around cybersecurity. In his Q&A, Waddell said that young professionals considering a career in banking will still find opportunities in the future, as the practice of safeguarding assets and allocating capital will be around for a long time. He was slightly less upbeat about the prospects for the asset management industry in light of the disruptions faced by robo advisers, low (and sometimes free, in the case of Fidelity) account fees, and the trend towards passive investing.

True to Northern Trust’s values, Waddell finished his speech by encouraging the audience to get involved in a philanthropic endeavor that aligns with their interest, saying “to much is given, much is expected”. Lastly, he noted the firm’s long history of collaborating with United Way and said that there’s still much work to be done.

Distinguished Speaker Series: Ari Paul, CFA, BlockTower Capital

It was an inauspicious day for a cryptocurrency discussion. With many cryptocurrencies down by over 10% on August 8th, Ari Paul, CFA, CIO of BlockTower Capital, gave CFA charterholders a crash course in blockchain technology and the various cryptocurrencies available for investors.

Paul said that surprisingly, many risk management professionals such as himself were among the biggest proponents of cryptocurrencies. Risk skills are definitely helpful for evaluating and investing in digital assets such as Bitcoin, and Paul believes that the space sits at the intersection of game theory, cryptography, computer science, economics, venture capital and public markets. He said that very few individuals have all of these skills, and that there is a big opportunity for people with just a small amount of cryptocurrency knowledge to generate large returns because most people don’t know much about the space yet. He compared investing in cryptocurrencies today to investing in stocks pre-Benjamin Graham. Although the idea of the blockchain is not exactly new (Paul pointed to patents received by IBM back in the 1970s for distributed databases), the current digital coin offerings such as Bitcoin, Litecoin and Ethereum are all under a decade old.

The big question when considering how to approach cryptocurrencies is “What are these helping and why do we need this?”

Paul said that a big part of the need stems from banking and capital markets technology being incredibly obsolete. He cited the examples of ACH bank transfers taking 4 days to process and $35 fees for international Western Union transfers being an opportunity for cryptocurrency disruption. While the internet has greatly increased the speed of messaging and email, payment transfers have not seen the same amount of development.

There are 3 main enhancements to the original ideas of distributed databases that have greatly increased the interest in digital currencies and blockchain lately:

  • Proof of work mining, which ensure skin in the game
  • Public key cryptography
  • Permissionless blockchain

A simple definition of blockchain could be a type of database that has its transaction entries linked with cryptography, the art of solving codes. Cryptocurrencies are the intrinsic, tradeable tokens of blockchain and the most commonly known version is Bitcoin, which had over $100 billion in market cap on the day of this presentation. Intrinsic tokens can be spent on monetary transmissions (Bitcoin) or on decentralized computing power (Ethereum). There are also asset backed tokens that can be created by a third party.

There are over a thousand digital coins tracked by coinmarketcap.com, but Paul said that the use cases and value propositions of most of them can be described in terms of three distinct categories:

  • A censorship-resistant store of value – “digital gold” or a “Swiss bank on a phone”
  • Utility tokens – amusement park tickets or paid API codes
  • Tokenized securities – crypto versions of traditional asset ownership interest

Paul said that the Initial Coin Offering market, or ICOs, has exploded in the past year, becoming larger than the overall seed stage VC market. “Many people, including myself, are skeptical of the ICO business model,” Paul said, saying that ICOs are like “hot potatoes” that speculators will often try to offload on unsuspecting get-rich-quick hopeful investors, saying that they can be seen as analogs to Chuck E. Cheese tokens.

In terms of how investors are accessing cryptocurrencies, Paul said that “we’re transitioning from crypto being un-investible [by most] to far easier,” mentioning Coinbase and other exchanges that have greatly risen in stature over the past couple years. While individuals have an easier time of buying digital coins such as Bitcoin, it is still difficult for institutional investors to access them because there aren’t many good custody options. Paul thinks that major custody bank State Street may be as far as three years away from launching a viable cryptocurrency custody product. There is also a high degree of risk of theft with the coins, and even a sophisticated investor such as Paul believes that his firm will ultimately lose money from a collapsed exchange, such as the hack of Mt Gox in 2014. Other factors limiting institutional participation in crypto include operational risk in handling the assets, the lack of credible managers with 2+ year track records and the absence of well-constructed, low fee passive indexes.

Despite the 2018 meltdown in cryptocurrency prices, Paul appeared sanguine about their long term prospects, noting that every 2 years or so there has been a large boom-bust cycle in the space, and that the potential for growth is still enormous. While Bitcoin is “already obsolete from a technology perspective” according to Paul, it still commands a widely-known brand name in the space and there’s still a huge amount of investment by institutions such as CBOE and Square. It’s difficult to know which cryptocurrency will win out in the future, but Paul believes that an allocation could make sense for some investors that can be patient riding the frequent ups and downs of the digital coin landscape.

Distinguished Speaker Series: Jane Buchan, PAAMCO

Jane Buchan

The hedge fund industry has been assailed by the media as a costly, underperforming asset class, yet according to PAAMCO CEO Jane Buchan, that rhetoric simply isn’t true. On April 18th, the founder of the Irvine, CA-based hedge fund-of-funds presented to CFA Society Chicago to share her views on the hedge fund landscape.

Buchan is tired of hedge funds getting beat up in the press, and her talk both defended the industry and talked about new opportunities currently being developed. She said that the environment lately has been difficult for active equity managers and interest rates and volatility continue to remain stubbornly low. Some results of this backdrop include:

  1. Investors are focused on beta
  2. Perceived differentiation is low, causing allocators to emphasize fees
  3. Simplicity is key

The market climate has affected the hedge fund industry by giving rise to Alternative Risk Premia (ARP) strategies, which focus on fees and simplicity, and deals and co-investments, which can offer investors lower fees. PAAMCO has been active in developing risk premia solutions, which can be described as a means to access a hedge fund-like return at a lower cost with enhanced liquidity than typical hedge funds. Buchan cited Albourne’s research on ARP that shows $216 billion is invested in these types of strategies today. Somewhat surprisingly, 80% is managed by sell side broker / dealers and only 20% is managed by asset managers.

Despite the media’s negative coverage of the hedge fund industry, there is still a lot of capital in hedge funds at around $3.2 trillion, which has been growing at a fast pace. “It seems like hedge funds are the dog you want to kick,” said Buchan of the media’s view on them, saying she “suppose[s] somebody has to be the villain.” Buchan mentioned news such as the wager between Buffet and Tarrant on hedge funds outperforming the S&P 500. Given the lower market exposure of hedge funds, it is a tough bet for them to win, she said.

Considering the market environment we’re in, what’s an investor to do? “The only free lunch is diversification,” opined Buchan. One example of that is volatility strategies. Buchan said that they often look horrible on a standalone risk-adjusted basis, but on the portfolio level, adding volatility can offer significant benefits. “It’s hard when [investors] add hedge funds for downside protection and there’s no downside,” she said.

“Now let’s have some fun with data,” said the former Dartmouth professor. Buchan showed the audience a number of return histograms and asked them to figure out which asset class they were. One surprise was how concentrated the hedge fund returns were compared to high yield, which had larger tails. Private equity, also a top performing asset class, also had a much fatter tailed distribution of returns than hedge funds. One of the benefits of lower volatility is higher compound returns over time, Buchan said. This is something that current hedge fund investors are well aware of, she said, pointing to the previously referenced $3.2 trillion invested in the industry.

Another positive trend for the hedge fund industry can be found in corporate 10k filings. Buchan said that PAAMCO has been tracking them and has found that corporate defined benefit pensions are moving cash from private equity into more liquid, alpha strategies such as hedge funds. Like all asset classes, there will be periods where hedge funds underperform and outperform, but there is still a lot to like given their high return to risk ratios compared to other asset classes.

Lastly, Buchan encouraged attendees to support women in finance with the organizations Women Who Invest and 100 Women in Finance. Despite a number of studies showing that women can often make superior investors than men, Buchan said that some research indicates that a female hedge fund manager must outperform a male counterpart by 150-200 bps in order to achieve the same level of AUM.

Distinguished Speaker Series: Jeremy Grantham, GMO

Few encapsulate the time-honored principles of value investing as Jeremy Grantham, co-founder and chief investment strategist of Grantham, Mayo, & van Otterloo (GMO). On January 23, close to 400 attendees gathered at the Standard Club for CFA Society Chicago’s January Distinguished Speaker Series luncheon where Grantham gave CFA charterholders and guests alike the tools needed to spot bubbles before they burst, as well as some food for thought on the environment and renewable energy. Several hundred others watched the presentation via webcast.

“I put this talk together on Halloween which is very suitable for this topic,” Grantham said before going through some ways to determine if the market has reached a stage of irrational exuberance. He thinks that the market is racing towards a near term melt up. But first, Grantham wanted to talk about cryptocurrencies.

In a talk in 2017, he said that he expected Bitcoin to crash before the real crash of equities prices. Since then, Bitcoin has retreated from a high of nearly $20,000 down to just over $10,000, giving the first part of Grantham’s prediction some credibility. “I know nothing about Bitcoin, I just look at it as a historian would look at it,” admitted Grantham.

The question “Are we near a melt up?” kicked off Grantham’s presentation. The expression “melt up” is becoming a frequently searched term on Google, which is another sign Grantham identified as a possible sign of a bubble. The term refers to a sudden flow of cash that drives stock prices higher, often related more closely to momentum and sentiment than underlying market fundamentals. Melt ups tend to lead to their dreaded cousin, the meltdown, and are a key concern for allocators such as Grantham’s firm GMO.

Some other classic bubbles from history include the South Sea Stock bubble, the 1929 S&P 500 bubble and the Dotcom bubble of the late 90s. The 2007 housing bubble was “the best looking bubble I’ve seen,” said Grantham, admiring the chart’s perfect conical shape.

Comparing today’s price chart with prior bubbles gives Grantham some relief. Right now, the S&P 500 doesn’t resemble a classic bubble. Prices would need to accelerate by 60% in the final bull phase over 21 months for it to rank in the same league as some of history’s more noteworthy bubbles.

While markets appear to be frothy yet not quite a true bubble, it’s important to watch out for clues that can help identify a bubbly market. First we can look at the advance/decline ratio. As the ratio declines, that can be seen as anearly warning sign for the broader market, with fewer stocks carrying the market higher.

Valuation is another clue investors often look at to determine if we’re in a bubble. Grantham agrees that markets are very expensive. Looking at a modified Shiller CAPE ratio, there was only one time in history where equities were this pricey. That year was 1929, and it led to a precipitous fall and the largest stock market decline in history. While expensive, looking at price-to-earnings ratios tells you very little about the likelihood and timing of a bubble bursting, opined Grantham. He gave the example of exploding PE ratios in 1990s Japan as one example where a very high ratio led to an even higher ratio.

So if looking at valuation doesn’t work for spotting bubbles, what does? Grantham said that using indicators of market participants’ euphoria is a much better route. Margin buying of equities and outperformance of quality stocks vs high beta stocks are a couple items to explore. The US housing market also is showing some signs of bubbliness. Nobody is talking about housing looking like a bubble right now but there are definitely some signs, according to Grantham.

One absolute requirement for a bursting bubble is a Republican Presidency, Grantham said, pointing to Hoover, Nixon and G.W. Bush as some Republicans who’ve presided over bursting bubbles. Grantham said that he believes that there is a greater than 50% chance of a melt up that would bring the S&P 500 to 3200 – 3800. If so, then he thinks that there will be a 90% probability of a meltdown from there.

Climate change and renewable energy was Grantham’s second topic. “The good news is that technology is accelerating along with the damage [being done to the environment],” said Grantham. Wind and solar power are quickly becoming cheaper than coal and nuclear power. Those developments are forcing investors to consider how they are positioning their portfolios in light of climate change. Alternative energy represents “the biggest transformation since the introduction of oil”.

Oil consumption is set to peak in 2020. With many shale companies remaining unprofitable, Grantham thinks that capital will flow towards renewable energy. His firm GMO has a climate change fund that offers opportunities in this space as do a number of other investment managers. “We live in a world where chemical poisons are deeply penetrating everything, “Grantham said, highlighting reduced sperm count among men, deep declines in flying insect populations and reduced grain production as some of the many troubling signs he sees with the environment today.

Right now GMO favors Emerging Markets and EAFE stocks over US stocks and has positioned its portfolio for foreign outperformance over the next few years. Capitalism has produced its benefits, but fails to account for the tragedy of the commons, with pollution, rampant use of fossil fuels and marketing of opioids still taking place despite the harm caused to human life.

Grantham’s talk was indeed as spooky as advertised, and gave attendees plenty to mull over while considering how to position their portfolios against the backdrop of high asset prices and troubling environmental issues.

 

Distinguished Speaker Series Webcast – Jeremy Grantham, GMO

Recorded January 23, 2018

 

Four Tips to Launch a Successful Finance Career

If you’re just beginning your career in finance, you might feel your career path is defined; head down, work hard, and eventually the real career choices will present themselves down the road. This is of course true to an extent – the finance industry certainly demands earning your stripes – but that doesn’t mean you can’t begin opening up doors during those early years.

You may already be studying for the CFA exams, which is an important milestone in the career of most investment professional’s careers. As you navigate the roughly four years that it takes to complete the three levels of the CFA Program, it’s important to do whatever you can to make these as meaningful as possible.

These tips should help you do just that:

Read, and read ravenously.

Read everything in our field that you can get your hands on (including and beyond the CFA curriculum). Try to read broadly across topics and disciplines; for example, if you’re in equities, take time to learn about credit or commodities to make yourself more well-rounded. Ask people you meet what they read and what they enjoyed learning.

An incredible array of opportunities exist in finance, and the more areas and disciplines you know the more opportunities you’ll have. The most successful people spend a good portion of their day devouring information, asking questions and listening.

Avoid networking at your own peril. (And put the phone away).

Not everyone is an extrovert, and that’s okay. Everyone, though, can benefit from the opportunities made through networking, whether for friendship, commerce or career.

You’ve been reading (you have been reading, right?), so you have strong points of view and pointed questions to ask. Put the phone away, be confident and ask smart questions. Most folks love the opportunity to explain what they do, and they will see you as someone willing to take initiative if you initiate a good conversation.

Don’t procrastinate getting an advanced credential.

I think you need at least one advanced credential (if not two) to compete in today’s job market. Both a CFA charter and MBA are highly useful for financial professionals, so avoid a long, protracted process on deciding which one to get. The earlier you begin the process, the higher the lifetime dividend.

In my case, I immediately plunged into the CFA curriculum just a year into my career, and that gave me a big boost. It helped me interview for jobs that I would never have the opportunity to land otherwise. I strongly believe having a CFA charter in your 20s or early 30s will offer more career optionality down the line.

Listen to yourself.

In those first few years, keep a keen eye out for moments where you feel in the flow, or when you are the happiest during your job. Ask yourself what were you doing during those moments and what about that project or job aspect you really liked. How can you structure your future career to include more of those types of situations?

I’d also suggest taking time to reflect on what you want out of a career. While having money and a challenging, important job is great, many folks find that they are happier with more of a work-life balance, and understanding how much of each aspect you need to make yourself happy is key.

So, hit those books! And remember to keep these tips in mind – when that door does open for you, you’ll be poised to take full advantage of the opportunity.

Distinguished Speaker Series: Jean-Marie Eveillard, First Eagle Funds

Value investing makes sense; it works over time, so how come there are so few of us?

On August 9th, CFA Society Chicago welcomed Jean-Marie Eveillard, senior investment adviser to First Eagle Funds, at the Chicago Club. The famed investor behind $110 billion First Eagle Investment Management has long believed that value investing can be a lonely place.

The septuagenarian still follows the advice of Warren Buffet and his predecessor Benjamin Graham. “The best book on investing ever written is [Ben Graham’s book] Intelligent Investor,” he said. Despite the sustained popularity of those pioneers today, pure value investing is becoming increasingly rare, Eveillard said.

Value investors must shun the wisdom of the crowds, and more importantly, they must be right. Sometimes value investing is fashionable, oftentimes it is not. Eveillard estimates that only 5% of the investment industry practices value investing. The limited embrace of a value tilt is partially due to the career risk portfolio managers face when choosing out-of-favor stocks. Sometimes investing in these stocks may take years for an investment thesis to play out, and asset owners are frequently less patient. The fear of losing a job causes herding into more socially acceptable stocks, and this dynamic makes it very hard for an investor to commit to value. This often tilts mutual funds towards becoming “closet indexers”, said Eveillard.

Eveillard discussed how he uses both qualitative and quantitative in his process. As a value investor, he marches to the beat of his own drum, eschewing the tactics used by marketing-focused money managers.

Jean-Marie Eveillard, First Eagle Funds

“I never spent a penny on advertising,” said Eveillard, contrasting his near singular approach to investing to more commercially-minded mutual fund companies. In his talk, which connected his years working in the industry with the thinkers that most influenced him, one area mentioned was the Austrian school of economics, particularly its 1974 Nobel Prize winner Von Hayek. Margin of safety was also mentioned, with Eveillard saying that it was the secret of strong investors.

Interestingly, Eveillard reckoned that a great deal of his success as a portfolio manager didn’t come from the stocks he picked; it came from what he didn’t own. Eveillard cited a number of examples such as Japanese stocks in the late 1980s, tech stocks in the late 90s, both of which he avoided. Eveillard was asked if he thought there is currently a bubble reminiscent of the late 1990s in today’s tech stocks, and Eveillard opined that today isn’t as bad as the dotcom bust era defined by the epic failures of Webvan and Pets.com.

Covering his use of qualitative data, Eveillard told a story about Enron, saying that he asked a research analyst on his team to look into the firm for a possible investment. The analyst found Enron’s statement footnotes incomprehensible, to which Eveillard responded that if that was the case, they’d move onto something else and wouldn’t invest.

Eveillard noted that so many of the numbers you see in accounting estimates are estimates. He said that in the late 1990s, he would often spot crafty CFOs who would observe the letter of the regulation, but not necessarily the spirit. In some ways, Eveillard said, accounting is more a reflection of a cultural mindset, with more conservative, risk-averse cultures taking earnings provisions on potentially low risk items. A good international investor needs to be mindful of the cultural differences in preparing accounting statements.

On the Efficient Market Hypothesis, Eveillard said that “it denies human nature.” He’d often debate the EMH with his academic friends and they would say that although they might agree, they needed to find a new theory before abandoning an old theory.

He mentioned the topic of moat, a means of ensuring that a company has a long run sustainable advantage. One reason that Warren Buffet rarely sells stocks is because it is hard to find companies with sustainable advantages, and once one is identified, an investor simply needs to be patient.

Given the strong outperformance of growth vs value stocks in the US over the past decade and the dearth of dedicated value investors, a change in investor mindset might be needed before value investing returns to vogue. But patient investors such as Jean-Marie Eveillard will be willing to wait it out.

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