Author: Robert Mudra, CFA

Distinguished Speaker Series: John V. Miller, CFA


A State of Political Brinkmanship: Illinois at the crossroads, again.

How can a state with a large, diverse economic base have a credit risk premium in junk bond territory? It’s easy, when political brinkmanship and years of fiscal mismanagement create an enduring state of legislative paralysis.

That’s right, according to John V. Miller, CFA, Managing Director and Co-Head of Fixed Income at Nuveen Asset Management, Illinois’ economic base should support a AAA credit rating and yet its general obligation (GO) bonds currently trade below investment grade—at a 140 basis point credit risk premium.

Miller, who recently spoke at CFA Chicago’s Distinguished Speakers Series luncheon, cited decades of budgetary imbalances and the state’s failure to properly fund its pension plans as primary reasons why Illinois has the lowest credit rating in the nation (Baa1 from Moody’s, A- from S&P and BBB+ from Fitch).

Yet, all is not lost. If the political gridlock in Springfield can be broken, the path back to fiscal health is not that complicated. It will just take time and discipline

The Illinois Budget Stalemate: A Public Disservice

Illinois has been operating without a budget since July 1, 2015. Disagreements over needed spending reforms, increased taxes or both have created an epic budget stalemate which may drag into fiscal year 2017. Miller says the stalemate is, “more entrenched than anyone can imagine. The parties are far apart and passionate about it.”

In the meantime, the citizenry suffer. State appropriations for higher education and funding for social services have been cut off. This led Moody’s to downgrade the credit ratings of Northern Illinois University, Northeastern Illinois University and Eastern Illinois University on February 24, 2016. The list of affected organizations, and the people they serve, is long and includes:

Sadly, from Miller’s point of view, the legislators appear more concerned about picking up additional seats in the November 8th general election than resolving the budget stalemate. He feels that eventually there will be enough voter angst for someone to lose political support—and that would be a good thing. After all, it’s supposed to be about public service, right?

Long-term Problems Require Long-term Solutions

One of the most important points Miller made was that it took a long time for Illinois to build up the magnitude of deficits we’re dealing with and we should all realize that it will take a long time to fix them.

The 2017 fiscal year budget gap is estimated to be about $6.6 billion, or about 20% of revenues. While that sounds insurmountable, Miller says that if Illinois were to increase the individual income tax rate back to the 5% rate that was in effect from 2011 to 2014, it would raise $4.1 billion and cover most of the projected deficit.

Even with that increase, Miller says Illinois would have the 16th lowest personal tax rate in the nation and he feels it’s highly likely that a tax increase will need to be part of the solution. And, in my opinion, we need spending reform and term limits as well.

Public Pension Plans

Illinois’ public pension plan deficit is another story. At $111 billion in unfunded liabilities, and a combined funded ratio across all plans of only 41.9%, it’s often described as the worst funded pension system in America.  How did this happen? According to David McKinney, of Crain’s Chicago Business, it didn’t happen by accident.

In McKinney’s October 2015 article, The Illinois Pension Disaster: What went wrong?he shows that Governors and legislators, Republicans and Democrats, repeatedly approved financially toxic changes to the plan. In short, here are the big reasons why Illinois’ plan is so underfunded today:

  1. Deferred Pension Payments– Known as “The Edgar Ramp,” state contributions were set artificially low in the 1990s causing contributions to accelerate dramatically in 2012. This is an example of “kicking the can down the road.” The deferred amounts eventually have to be paid but with compound interest.
  2. No Pension Payments– If deferring pension payments is a bad idea so is skipping them. Illinois declared a “pension holiday” in 2005 and 2006, avoiding $1 billion in payments per year, based on false sense of security created by a 2004 borrowing plan that boosted the funding status to 61%. In total, underpayments from 1985 to 2012 were $41.2 billion.
  3. Increased Benefits– In 1989, a compounding 3% cost-of-living adjustment (COLA) was added to the benefit promise and another round of enhancements in the 1990s. Today a “consideration plan” is being discussed which presents a choice between giving up COLA increases and including pay raises in the calculation of the calculation of retirement benefits. Miller points out that the “consideration” model could save up to $1 billion in annual costs and cut the annual contribution by 15%.
  4. Early Retirement Offers – A 2002 early retirement offer (for those over 50 years old) created a stampede of 11,039 retirements that increased the liability by $2.3 billion.
  5. Poor Investment Results– The collapse of the 2000 dot-com bubble and 2008 stock market meltdown then added $15.9 billion in investment losses to the liability. Some perceive these events as largely outside of the state’s control but, in reality, they are related to the plan’s investment policy statement and risk management program. For more on how to effectively manage a defined benefit pension plan see Pension Finance: Putting the Risks and Costs of Defined Benefit Pension Plans Back under Your Control by M. Barton Waring.

In Miller’s opinion, the Illinois Supreme Court’s decision finding Illinois’ 2013 pension reform law unconstitutional was brutal from an economic point of view. He points out that other states have been able to make adjustments to their plans, the COLAs and/or complete conversions to 401Ks.  However, Illinois law has some of the toughest language in the nation on protecting pension benefits. And last week, the Illinois Supreme Court also rejected plans to cut future retirement benefit plans for Chicago city workers.

The fact remains that both Illinois and the City of Chicago significantly underfunded their pension plans, well below actuarial required payments, for years. In my view, the Supreme Court has it right. Illinois has always needed legislative leaders with the fiscal discipline to carry through on the state’s commitments, while avoiding toxic financial mistakes, and the ability to appropriately modify future retirement programs.

The following quote, by Winston Churchill, aptly describes the conundrum.

“When the situation was manageable it was neglected, and now that it is thoroughly out of hand we apply too late the remedies which then might have effected a cure. There is nothing new in the story. It is as old as the sibylline books. It falls into that long, dismal catalogue of the fruitlessness of experience and the confirmed unteachability of mankind. Want of foresight, unwillingness to act when action would be simple and effective, lack of clear thinking, confusion of counsel until the emergency comes, until self-preservation strikes its jarring gong–these are the features which constitute the endless repetition of history.”

—House of Commons, 2 May 1935, after the Stresa Conference, in which Britain, France and Italy agreed—futilely—to maintain the independence of Austria.

Act and the Bond Markets will Respond 

As simple as it sounds, the bond markets will respond favorably to positive fiscal actions. Miller noted that the credit risk premium on Chicago GO bonds dropped by over 100 basis points after the City of Chicago approved a $543 million property tax increase in October of 2015 (slide below). He explained that that getting rid of variable rate debt and swaps while raising taxes sends the right signal to the market.



However, Chicago’s GO spreads are up again due to contagion from the Chicago Public Schools (CPS) deteriorating fiscal condition. The Chicago Teachers Union has approved a one-day teacher walk out on April 1, 2016 which adds more pressure to the situation. Unfortunately, as we saw earlier in this story, it’s often the most vulnerable that get hurt when we reach this level of political brinkmanship. Let’s hope some positive steps can be taken, and the markets will take notice.

Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back under Your Control

Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back under Your Control

Book Recommendation: Waring, M. Barton. Pension Finance – Putting the Risks and Costs of Defined Benefit Plans Back under Your ControlNew Jersey: John Wiley & Sons, Inc., 2012. Print.

This article provides a detailed, technical overview of one of my favorite books on how to effectively manage defined benefit pension plans. M. Barton Waring does an amazing job of simplifying this highly complex topic while providing incredible insights—that every investor should understand—on risk and return. By the way, if you’re looking for information on how an individual can effectively plan and save for retirement (using 5th grade math), then I’d suggest you click here to readThe Retirement Lifeguard. 

About the Author

M. Barton Waring is a financial economist and lawyer, and an active researcher in pension finance and investing. He retired in 2009 from his role as Chief Investment Officer for investment strategy and policy, emeritus, at Barclays Global Investors. Mr. Waring is well known in the pension industry for his many thoughtful and often prizewinning articles. He serves on the editorial board of theFinancial Analysts Journal and as an Associate Editor of the Journal of Portfolio Management” (cover).


I highly recommend Pension Finance to you with its very timely guidance on the management of defined-benefit pension plans. Mr. Waring presents a complete treatment of the overall pension accounting system on a market-value basis for the purposes of improving plan management. Even if not adopted for financial reporting purposes, implementation of a mark-to-market based pension accounting system with a surplus optimization investment strategy could provide significant benefits to both labor and management. Waring also presents a thorough discussion of risk management and investment strategy. In short, with better economic information and more informed risk management strategies, better pension plan management decisions can be made and defined-benefit plans can be well funded and managed with lower risk.

The Need for Economic Pension Accounting Information

The following quotation aptly describes Waring’s view of the need for economic pension accounting information:

“While it may appear that going to market value accounting causes new problems for the plans, the fact is that it doesn’t – the plan’s status is what it is, regardless of the accounting. But economic accounting brings a benefit, a clear-eyed view of what is really going on in the plan, a means of understanding the plan’s true financial condition, a means of understanding the true cost of benefit changes, and a means of understanding the true level of contributions needed to support the benefit promises. It even provides a path to investment strategies that reduce risk to the deficit and to contributions. So while there may be short-term pain, the path to longevity for pension plans must include economic accounting and actuarial approaches. Traditional accounting and actuarial work held sway as plan solvency declined; the path back is to use better tools (225).”

The total unfunded pension plan debt for all plans (public and private) in the United States is estimated to be at least $4 trillion dollars (2). The size and complexity of this crisis as revealed through current actuarial and accounting methodologies have provided misleading information to both plan sponsors and participants. The fact that the pension funding crisis is as bad as it is should tell us that the current approach is not working. This is big money and it’s intended to be available to solve the most difficult financial problem that most people face during their lives: safely accumulating the means to retire comfortably after their working years are over (4). Clearly, these are significant issues for employers and employees alike and Waring provides an objective analysis that can assist in both labor negotiations (such as recognizing the Full Economic Liability which includes both off-book and on-book liabilities) and pension plan management. In addition, Waring outlines 22 Propositions which are important pension finance principles that may come as a surprise to many.

Weaknesses of Traditional Actuarial Asset/Liability Studies

Several of the traditional pension management tools have simply not delivered the desired results. Actuarial asset/liability studies have led to recommended portfolios of 80% equities and 20% bonds or 60% equities and 40% bonds (187). Yet, the portfolios do not hold enough long bond durations to hedge the liability which means that in declining interest rate environments the liability goes up dramatically while the value of the fixed income assets barley follow (188). On the equity side, these high allocations could increase your deficit by 10% of assets every time the market falls by 10% which adds significant volatility (146). The studies often over-complicate the analysis with Monte Carlo simulations which are misused as an “actuary in a box” (185). Waring explains that asset/liability studies are not needed as “surplus optimization” handles the investment strategy problem perfectly .

The Surplus Optimization Solution = LMAP + RAP

Surplus optimization controls the economic “surplus” (or deficit) of the plan. First, the interest rate and inflation risks of the liability stream (future benefit payments) are hedged through a Liability-Matching Asset Portfolio (LMAP). This is the single biggest risk management decision of the plan and hedging the economic liability can reduce over half of the variance of the plan (179). The accounting always follows the economics, if not sooner than later, and this approach will then significantly reduce the volatility in pension expense and contributions (20). Second, a Risky Asset Portfolio (RAP) can be added in a risk-controlled manner, if desired, but this is completely optional. One approach for the RAP would be to put in place an improved Dutch system: If the sponsor wants to invest in risky assets over and above an LMAP hedging portfolio, it must be fully funded – and then some. This policy can be improved by quantifying it: The cushion should be established relative to the surplus risk generated by holding the RAP in such a way as to manage the probability of becoming underfunded (261).

In developing the LMAP, you match the accrued liability’s total return sensitivity by matching (1) the dollar real interest rate duration and (2) the dollar inflation duration (147). This effectively provides immunity of the surplus or deficit of the plan to market risk and thus protects the funding level. In addition, it addresses a key goal of pension managers which is to stabilize the economic normal cost which is the expense accrued to the sponsor in this period for benefits that will be owed to employees at their future time of retirement and stabilizes future contributions.

Benefit Policy Drives Costs and Contributions (not discount rates)

The actuarial funding method concept is another relic of the past that should be eliminated. This approach assumed that future benefits would be paid out of contributions plus earnings on the investment. In reality, the funding method was a “balancing act” in which contribution levels were experimentally adjusted up or down while the “expected” rate of return assumption was adjusted up and down as well. The temptation was to select higher “expected” rates of return to reduce contributions as well as reduce the “valuation” of the liability (196). In short, the required rate of return should not be used for the management of the pension plan. When holding a LMAP, contributions are really just a function of the benefit policy plus or minus some minor gains or losses from the RAP (if held).

Adding Exotic Assets is Not the Answer

Waring makes a huge point of the fact that plan sponsors and strategists agonize over which new asset classes to add to their portfolios (e.g. hedge funds, venture capital, exotic beta classes, etc.). Yet there is no “magic” asset class that always goes up and that you are able to accurately choose in advance. He reminds us that finance theory is quite clear on this matter and that the Risky Asset Portfolio (RAP) should be a market-capitalization weighted portfolio of all risky assets. Otherwise, we are assuming that our asset manager has some specific, unique market knowledge that suggests he can outperform the market over a finite period of time on a risk-adjusted basis. In reality, the results will be a random outcome and not a good strategic decision (145).

Taking More Risk is Not the Answer

Some sponsors may attempt to “pay for the plan” by adding even more risky assets to the portfolio (146). However, the point cannot be under emphasized that sponsors will not “get” the “required” or “expected” rate of return on their investments over time. In fact, a realized (actual) return is drawn from a wide distribution of returns if you’re investing in risky securities (213). Market returns can be quite volatile and long periods of bad luck (realized returns less than expected returns) are just as likely as long periods of good luck (1980s-1990s) (40). The market declines of 1998, 2002 and 2008-2010 damaged the asset side of most plans as well as significantly increased deficits. This type of volatility typically adds to the deficits because sponsors typically don’t want to make up the loss with contributions. In the end, the deficits are left in place hoping that they will go away in the future. They could potentially or they could also get worse, much worse.

Hoping Time Reduces Risk is Not the Answer

Another common misconception is that risk goes away over the long term but in fact it accumulates with time. The standard deviation of returns increases by the square root of the number of years. For example, if the time horizon is 25 years then the standard deviation of returns (risk) over the period is five times wider (√25 years = 5)  than the one-year standard deviation of returns. The risks to wealth accumulate with time and we must remember that markets will fail to meet the expected return assumption (39).

First Hedge the Liability – It’s the Single Biggest Risk

The key conclusion is that the biggest single risk to hedge in a pension plan is the liability. Sponsors spend a lot of time focused on asset allocation decisions which can only marginally help the plan while ignoring the decision to hedge the liability. In short, sponsors should do three things in this regard (1) hedge the interest rate risk of the liability (2) revisit the risk tolerance decision, it is a real investment decision (3) be very careful about any active or tactical decisions that require special skills in order to yield success (146).

Measure the Big Picture: The Full Economic Liability

The process really begins with gaining a full understanding of the economic cost of the plan. The “Full Economic Liability” FEL is the proper starting point for a plan sponsor to gain a complete picture of the on-book and off-book economic liability (63). The off-book liability will inexorably make its way on book eventually. Waring points out that an economically determined accrued liability and its associated normal cost method will accrue portions of the full economic liability related to current employees onto the books over time. On some agreed basis, which will generate the economic accrued liability whose form can be chosen and interpreted as an acceptable funding target for benefit security purposes.

Since the ABO (Accumulated Benefit Obligation) and PBO (Projected Benefit Obligation) are accrued “subsidiary” measures of the liability by definition they leave something off the table. That something is the portion which is still unaccrued for both current and future employees. Waring suggests that wise management teams do consider the off-book (non-legal) obligation and they consider its value when talking to labor during negotiations.

Discount the Liability at Real Risk-free Interest Rates

In order to determine the proper economic value of the liability in today’s dollars one must use market-based discount rates. Some people continue to believe that the expected rate of return on the asset portfolio is the appropriate economic discount rate to use when valuing the liability (future benefit payments). This is still used quite frequently for state pension plans. Yet, the only rates of return we have the power to “require” are the rates on the risk free spot rate curve for a particular time horizon. And the correct rate to use is the spot rate curve for inflation protected government securities (real risk-free interest rates) which is hedgeable. Therefore, you can finance these benefits with little risk to the plan sponsor. Although the accounting liability increases with a lower discount rate the actual economics of the plan (actual cash flows for the benefit payments) are not changed and also cannot be magically reduced if someone elects to use a higher discount rate. In fact, a higher discount rate establishes the rate you must earn on funds borrowed from employees to pay future benefits. From this perspective, if sponsors guarantee higher returns on risky assets which are not realized then they are eventually faced with the realization that the liability was higher than they originally thought and that planned contributions were too low – a “double whammy” (200).

Select a Normal Cost Method that Improves Benefit Security 

A key component of pension expense is normal cost. Waring uses the term “Full Economic Normal Cost” which represents the expense accrued in this period for benefits owed to employees at their retirement (also called service cost) however, it does not contain the panoply of other items such as investment returns, financing costs, etc. which are in service cost. There are many different normal cost methods: ABO – accumulated benefit obligation, PBO – projected benefit obligation, present value benefits or “initial funding method”, the “cost prorate constant dollar method” or Entry Age Normal (EAN) cost methods which is a level payment approach. Ironically “normal cost” does not affect or control costs over the long term. Rather, costs are a function of the benefit promise.

Although all of the normal cost methods must terminate at the full funding requirement, the speed or pace of the accumulation of the accrued liability must be observed carefully. Therefore, it has an important impact on benefit security. Waring prefers the economic version of the EAN method because it makes sense to those who think of a pension as a constant proportion of the overall pay package which is then useful in both budgeting and benefit negotiations and seems to be the right compromise between labor and management (98).

The practical point is that if the “notional normal cost” entries were in fact real monetary contributions which were calculated similar to a payment amortizing a debt (253) and placed into a liability-matching asset portfolio then the possibility of becoming underfunded through investment results will be substantially eliminated. In this case, the pension assets would grow following the same line as the on-book accrued liability. The funds would ultimately be there to pay the liabilities when they come due.

Utilize Mark-to-Market Management Accounting Information

Waring recommends the use of this economic mark-to-market “management accounting” picture because today’s smoothing and amortization of pension accounting data is not a hedge and does not provide risk control. There are no “smoothed” assets to purchase to hedge against a smoothed liability (248). An economic hedge on the surplus/deficit will naturally smooth out pension expense and contributions and is a superior approach. The fact is that conventional amortization and smoothing of data actually add risk rather than reduce it.

Importantly, even if the formal accounting continues to be done on a conventional basis (until political and regulatory changes are made IASB, FASB, GASB) moving to an economic accounting view for management of the plan is highly recommended. In addition, once the underlying economic risks of the plan are properly measured, the conventional accounting risk measures will also be under control. In short, it provides guidance to discover what’s really going on “under the hood” of the plan.

Be Good Stewards: Act on Behalf of the Beneficiaries 

Plan sponsors must be good stewards of the plan assets that are required to provide for employees in their old age. Across the industry, confusion and fear has led many plan sponsors to switch to defined contribution (DC) plans because they provided more clarity of both cost and accounting for such plans. However, Mr. Waring contends that the best defined-contribution (DC) plan is still not as good as the worst defined-benefit plan. Why? Because, defined contribution plans have not been shown to accumulate the level of resources an employee needs to adequately be prepared for retirement. For example, one detailed study showed the average account value for employees over the age of 60, that has been in a DC plan longer than 30 years, was only about $180,000 which is too low to provide for retirement (224). Waring points out that DC plans don’t seem to be the answer but that DB plans can be saved if one first recognizes the need to measure them on an economic basis and then optimize the surplus of the plan.

Face the Problem Head On

Mr. Waring believes the best way to address the problem is to face it head on. The advantages will be to establish more certain costs now and minimize the probability of further negative surprises later. Managing the accounting is not the route to controlling pension-funding risk or cost. Rather, only good benefit policies and some lucky investment returns will help. And good policies can only come from meaningful economic information.

Pension Finance is an excellent read for anyone in the defined-benefit pension plan administration or management roles. I completely enjoyed Pension Financeand applaud Mr. Waring for his forthright analysis of the subject.

The Retirement Lifeguard

The Retirement Lifeguard

After reading one of my recent posts, a good friend paradoxically asked “What’s a pension anyway?” And his point is well taken – millions of Americans don’t have a traditional defined benefit pension plan or even a defined contribution plan. So how are they going to accumulate enough assets to retire and just how much money will they need to save for retirement?

It seems to me that the average worker is in need of a “Retirement Lifeguard”to help them develop and plan their retirement savings program. Fortunately, Stephen C. Sexauer and Laurence B. Siegel commendably address this issue in their article entitled “A Pension Promise to Oneself” which appeared in theFinancial Analysts Journal, Volume 69 · Number 6 ©2013 CFA Institute: 13-32.

Sexauer and Siegal assuage numerous concerns by saying, Don’t have a pension? Don’t worry. Most people don’t. They will get to retire, and so will you(13). And then the authors go on to provide a clear, simple framework for thinking about retirement planning issues and offer a basic “toolkit” to help you get started.

What is “A Pension Promise to Oneself?”

The basic function of any pension or savings plan is to shift consumption over time. In other words, how do you save enough during 45 working years (e.g. ages 20 to 65) to make it last for another 20 to 40 years of retirement? Simply put, one must first accumulate assets by forgoing consumption during the working years and then decumulate the assets, enabling consumption, in retirement. And you may consume what you saved plus (or minus) investment returns (14). Sexauer and Siegal contend that, “with or without your employer’s assistance, you have the ability to make “A Pension Promise to Oneself” and deliver on that promise by making pension payments to yourself from the moment you retire until the end of your life or your spouses life, whichever comes later” (13).

The Personal Pension Plan

In order to create your own Personal Pension Plan the authors outline three basic steps and include examples for a typical high school teacher and sanitation worker given the assumption of “minimum risk investing” which we will discuss later. Here are the 3 basic steps:

(1) Estimate how much annual income you will need during retirement.

For starters, Sexauer and Siegal indicate that this step can be as easy as using a simple rule of thumb like 70% of your pre-retirement income (16). However, I also like to use a “bottoms up” approach by developing an estimated budget of expected future expenses. In this regard, I’d recommend using the U.S. Department of Labor, Employee Benefits Security Administration (EBSA), booklet entitled “Taking the Mystery out of Retirement Planning” which provides a set of easy-to-complete templates.

Then, the authors subtract expected Social Security payments to determine the yearly amount the investor will need to generate from personal savings in retirement. By the way, you can get an estimate of your Social Security benefits by using the Retirement Estimator on the official Social Security website (

(2) Calculate the “retirement multiple” or total amount of savings to accumulate.

Now the fun part. Sexauer and Siegel reduce the retirement calculation down to a multiplication problem that even a fifth grader can solve (18)! The retirement multiple (RM) is the number of years of income you need to save in order to retire while investing risklessly (or as close to risklessly as markets allow), where “income” is not your current pay but the cash flow you need to generate, over and above Social Security benefits, in retirement. (17) For example, at current market rates, the authors conclude that the retirement multiple RM is 21.47x. So if you need to generate $50,000 per year in retirement then you need to have 21.47 times that amount in assets or $1,073,000 ($50,000 X 21.47 = $1,073,000). (17) {Technical note: The RM is the reciprocal of the DCDB yield: 1 / 4.657% = 21.47 and you can find the DCDB yield at (18)}

Here’s where the authors’ examples really help to illustrate the methodology.

As shown in Table 1, Sexauer and Siegel (19) project the final (40th year) salary of a Columbus High School Teacher as $79,904 as highlighted in yellow below.


Then, using the 70% retirement income rule-of-thumb discussed earlier, the authors’ determine that the teacher will need $55,933 per year of income in retirement (Line A). Next, deduct expected Social Security Payments of $24,912 per year and we can see that the teacher will need $31,021 (Line C) per year from his/her “Personal Pension Plan.” Finally, by applying the retirement multiple (RM) of 21.47 to this amount we see that the teacher will need to accumulate $666,111 in order to retire (Line E) (19).

(3) Determine the savings rates necessary to accumulate the assets.

The final step is to determine the annual savings rates, and dollar amounts of annual income, that should be saved and invested in minimum-risk investments in order to accumulate $666,419 by the retirement date. In this regard, the authors present a spreadsheet of data for the Columbus High School teacher example that illustrates the assumed growth rates in earnings and annual savings levels necessary to achieve the goal. I’ve illustrated this data in graphical form below. Graph 1, shows that the teacher’s asset accumulation plan successfully achieves $666,419 in accumulated savings after 40 years.

Graph 1: Asset Accumulation Plan


Graph 2, below, provides a closer look at the projected annual income levels and the percentage of income that needs to be saved each year (Annual Savings Rate %) over forty years. Does the percentage of annual income that needs to be saved surprise you? (10% in year 1, 28% in year 20 and 32% in year 40)?

Spoiler Alert: Saving for retirement requires saving a large proportion of your income! “Like dieting, it’s simple to understand but not easy to do (16).”

Graph 2: Annual Income and Annual Savings Rates (%)

In this example, Sexauer and Siegel are conservative in using today’s real risk free rate of return of zero on Treasury Inflation-Protected Securities (TIPS). However, the point is to develop a base case where the investor can guarantee the results and that’s why the “risk minimizing investment” approach is used. In practice, many investors try to reduce the savings burden by taking on “shortfall risk” (the risk of not achieving the asset accumulation goal) by investing in riskier assets like equities with the promise of higher returns. But remember this warning, if the increased risk does not pay off then the investor will ultimately increase the savings burden rather than reduce it (21). And remember, investing in risky assets does not change the retirement multiple or the savings goal one needs to achieve (23).

Sounds simple. Are we done yet?

Not so fast. The truth is that real life is much more complicated than a few simple tables or graphs can depict. As Yogi Berra once said, “It’s tough to make predictions, especially about the future.”

Importantly, Sexauer and Siegel include a thorough discussion about the “adaptive behavior” that’s also required to keep your “Personal Pension Plan” on track. The authors explain that it’s important to make “Personal Fiscal Adjustments” (PFAs) when favorable or unfavorable surprises occur on either side of your balance sheet. These adjustments include increasing or decreasing consumption levels or the production of income. This is really a natural process and people make these types of adaptive changes all the time. For example, parents might move in with their children for a time if necessary. Others might find an opportunity to work full time for a portion of their retirement. The important point is that people can and do make the required adjustments to match needs and resources (15).

Live for Today – Plan for Tomorrow

I really enjoyed Sexauer and Siegel’s pragmatic approach to demystifying the retirement savings problem. They did an outstanding job of simplifying complexity for the average investor and showed that saving for retirement can be done, with limited risk, if you make a simple plan, monitor it and adapt to life’s changing conditions.

I think it’s important to be good stewards of the resources we have and to make sound financial plans for tomorrow. And let’s not forget the bigger picture. Don’t forget to live for today rather than for “retirement.” We aren’t guaranteed tomorrow so live with honesty and integrity, caring for the needs of others and treating others with dignity and respect. It’s much more rewarding to be generous with your time and resources than to build a retirement planning spreadsheet!

Stephen C. Sexauer is the chief investment officer, US multi-asset, at Allianz Global Investors, New York City. Lawrence B. Siegel is the Gary P. Brinson Director of Research at the Research Foundation of CFA Institute, Charlottesville, Virginia.

New Risks for Municipal Bond Investors

New Risks for Municipal Bond Investors

Hey! Mom-and-pop retail investors still own about 75% of the municipal bond market (directly or indirectly). They want a stable asset class with relatively few defaults, high credit ratings and interest income that’s tax free at the federal, state and local levels, if possible. In short, they want their father’s Oldsmobile.

Yet, today we’re seeing more stressed municipal credits than ever. Detroit, Michigan, filed for Chapter 9 bankruptcy protection in 2013 and is now the largest municipal bankruptcy filing in U.S. history at $18 billion. In this environment, there are new risks for municipal bond investors to evaluate. So investors should think again and remember the old advertising slogan: This is notyour father’s Oldsmobile—or his municipal bond either!

Public Finance: Key Issues and Red Flags 

To address this timely topic, the CFA Society of Chicago brought a panel of experts together for a program entitled: Uncovering Value and Risks in Stressed Municipal Credits. The panel was moderated by Arlene Bohner, Senior Director U.S. Public Finance, at Fitch Ratings and provided forward-looking insights on how to navigate these uncharted waters.

Bohner opened with a big picture overview of key state credit issues. She noted that U.S. states have broad economies and tax bases with substantial control over spending and raising revenue and this, in turn, generally supports their higher credit ratings. However, most governments made heavy cuts during the ’08-’09 recession and are still challenged by higher labor costs, pension funding deficits and huge infrastructure needs.

Longer-term, Bohner feels states remain significantly exposed to the possibility of federal funding cuts (e.g. Medicaid), although Bohner says, “Fitch believes states would have time to adjust to any significant federal actions.” Even still, Fitch has Connecticut, Illinois, Mississippi, and New Jersey currently on a negative outlook yet feels most state ratings will remain stable. In addition, she notes that steep cuts to vulnerable discretionary programs and/or federal tax code changes could have significant effects on state budgets and economies over time.

At the municipal level, Bohner looks for a number of red flags including:

  • Declining revenue base
  • Declining population and/or school enrollment
  • Increasing unemployment rate, coupled with a declining labor force
  • Relatively high tax burden
  • High and rising fixed cost burden
  • Declining assessed property valuations
  • Large debt issuances for controversial / non-essential projects
  • High levels of variable rate debt or swap obligations (> 15% of total debt)
  • Unusually contentious relationships among officials and/or with the State (including poor relationships between management, labor and taxpayers)
  • Inability to resolve labor disputes
  • Long-term labor contracts with inflexible terms
  • Low pension funding ratios with payments below actuarial required contributions (ARC)
  • Agressive budgeting and/or economic assumptions
  • Weak disclosure practices

Bohner now expects to see increased debt issuance at the municipal level to address deferred maintenance and capital needs. She notes that “pay-go” capital spending, which uses savings or current cash flow to finance projects, was reduced or eliminated by most governments well into the recovery. She also cautions investors about the increasing use of direct bank loans (private placements) for municipal financing due to their lack of transparency.

Forward-looking Municipal Metrics

Richard Ciccarone, President and CEO, Merritt Research Services LLC, reported that most cities experienced net general fund deficits from 2008 through 2010 and this was a reflection of the economic downturn. During this period, as many as 62% of big cities (over 500,000 population) and 58% of all cities reported deficits. But Ciccarone points out that Meredith Whitney’s prediction of billions being lost in the muni bond market didn’t come true and that general fund deficits returned to the 23% to 41% range between 2011 through 2014 (see graph below).

Percent of Cities with a Net General Fund Deficit                                    

 All Cities vs. Biggest Cities (Over 500,000 Population) FY 2006-2014

Source: Merritt Research Services, LLC

But that’s ex post information and investors need effective ex ante tools to guide future investment decisions. Ciccarone says, “in almost all distressed situations the unrestricted net asset ratio is negative.” Ciccarone started using this ratio around 2000 and says it has key predictive capability. As shown below, the ratio compares unrestricted net assets, which are resources considered usable for any purpose (numerator), to governmental activities expenditures, which are outflows of resources recorded on the government-wide financial statements per GASB Statement No. 34 (denominator).

Source: Merritt Research Services, LLC

Like a coverage ratio, this metric illustrates the availability of funds relative to expenditures—so the higher the ratio the better. As shown below, the largest cities (a with population over 500,000) have fallen into negative territory since 2009. Meanwhile, for all of the 2,000 cities in Ciccarone’s study, unrestricted net assets were between 20% to 23% of governmental activities expenditures from 2011 to 2014.

Importantly, we need to look at the government-wide balance sheet rather than the fund accounting statements that ignore long-term liabilities. Remember that governmental fund accounting focuses on the short run. But the government-wide balance sheet will reveal pension obligations, OPEB, debt and contra assets with deficit financing and no assets or revenue supporting them.

In regards to significantly underfunded pension obligations, Ciccarone’s big concern is that they may restrict a municipality’s ability to provide essential services (police, fire, garbage, etc.). He emphasized that Chicago’s actuarially required pension contribution (ARC) was as high as 55% of its general fund expenditures in 2014. That’s more than three times the level of other big cities (with a population over 500,000) as shown below. However, like many big cities, Chicago actually paid in far less to its pension plans than its actuarially required contribution levels.

Pension Requirements for Chicago and Big Cities:                          

Annual (Actuarial) Pension Cost as a % of General Fund                                                             Single Employer Plans only (2007-2014)

 Source: Merritt Research Services, LLC

Watch the Early to Mid-Career Numbers

Ciccarone’s final piece of forward-looking advice is to watch the early (25-29 years) to mid-career (30-34 years, 35-39 years) population numbers. These numbers tend to fall in distressed areas and Ciccarone says we need to watch them closely for Chicago. The charts below illustrate the decline for fallen angelslike Detroit and Puerto Rico. Fortunately, Chicago appears to be holding its own on these metrics and/or increasing in some areas.

Detroit Early to Mid-Career Population Groups                                      

(25-29 Years, 30-34 Years and 35-39 Years)

Source: Merritt Research Services, LLC & Government Census Data

Puerto Rico Early to Mid-Career Population Groups                            

(25-29 Years, 30-34 Years and 35-39 Years)

Source: Merritt Research Services, Inc. & Government Census Data

Chicago Early to Mid-Career Population Groups                                      

(25-29 Years, 30-34 Years and 35-39 Years)

Source: Merritt Research Services, Inc. & Government Census Data

Bankruptcy – Is the stigma is gone?

 Shawn O’Leary, Senior Vice President, Senior Research Analyst at Nuveen Investments is concerned that the stigma associated with default is gone. O’Leary noted that historically there’s been a significant fear of losing access to credit markets during bankruptcy. Yet he points out that  Detroit, Michigan, Jefferson County, Alabama and Stockton, California all refinanced and gained market access after bankruptcy. These cities are among the top five municipal bankruptcies in US history (below).

The 5 Biggest Municipal Bankruptcies in US History 

  1. Detroit, Michigan (2013)                                          $18 billion
  2. Jefferson County, Alabama (2011)                           $4 billion
  3. Orange County, California (1994)                            $2 billion
  4. Stockton, California (2012)                                        $1 billion
  5. San Bernardino County, California (2012)       $500 million

 Source: Forbes/Capital Economics

Ciccarone agrees with O’Leary and feels that in this environment the potential for more bankruptcies is definitely there—especially if policymakers approve additional bankruptcy statues like the one Governor Rauner proposed in Illinois. Today, approximately 24 states have been granted bankruptcy rights by their State legislatures but U.S. Territories, like Peurto Rico, cannot.

Lessons from Detroit

Bill Grady, CFA, Senior Portfolio Manager, Allstate Investments says that the problems in Detroit were brewing for decades. Grady says, “if you didn’t see them coming—shame on you.” After all, Detroit lost 50% of its population over the last 11 years. And looking even further back, it had been consistently losing population since the 1950s. Today, Grady hears even more municipalities talking about using bankruptcy as a negotiating tool.

O’Leary quickly added that people assume “special revenue bonds” will always pay principal and interest. In the case of Detroit, O’Leary was stunned by a federal judge who wanted to transfer his investors’ collateral (on water and sewer lines) out for ten years in order to redirect payments to unsecured creditors ahead of him. Even some attorneys suggested that he really wasn’t a secured creditor because Detroit had billions in unfunded capital expenditures. Ultimately, he says it took the ratings agencies to help force a tender offer by insisting that paying less than what’s due is recognized as a default.

Puerto Rico – Neither Fish nor Fowl

According to Bloomberg’s Michelle Kaske and Martin Braun, at $72 billion, The Commonwealth of Puerto Rico has more debt than any U.S. state government except California and New York and had been borrowing to pay its debts when they came due, until it defaulted on its payments in August 2015 (see Puerto Rico’s Slide, Bloomberg Quick Take 10/22/15). Notably, Puerto Rico’s bonds are exempt from local, state and federal taxes everywhere in the US—which made it easy for the US territory to double its debt in ten years.

O’Leary explains, “the problem with Puerto Rico is that it’s neither fish nor fowl.” O’Leary says it’s not a true sovereign nation (so they can’t go to the International Monetary Fund) and, unlike municipalities, it doesn’t have collective action clauses which would enable bondholders to implement a debt restructuring plan as long as the majority agrees. Rather, it’s like U.S. states that can’t file for bankruptcy. Hence, Puerto Rico can only ask for a settlement and that encourages creditors to holdout during negotiations. Ultimately, O’Leary feels the federal government needs to step in and make a deal happen.

To that end, on October 21st the Obama Administration announced its support for legislation that would grant Puerto Rico Chapter 9 bankruptcy protection, and a legal framework for U.S. Territories to conduct debt restructuring. Only time will tell if Congress will approve such a measure.

Bill Grady wraps up by saying, “hedge funds are controlling billions of dollars in bonds in Puerto Rico so it’s nearly impossible to take a position there without exceptional research capabilities.” In the end, Ciccarone thinks bondholders will probably recover between 40% to 70% of their investment—at typical sovereign default rates—while noting that the Puerto Rico’s 8% bonds have recently been trading in that range.

A Crisis in Illinois?

Illinois currently has an underfunded pension system of over $100 billion and the lowest credit rating of any state. Notably, Fitch lowered its rating on Illinois’ general obligation bonds to BBB- (just three steps above junk status) on October 19th and Moody’s downgraded the GO bonds to Baa1 on Oct 28th. And we shouldn’t forget that the state of Illinois has been operating without a budget since July 1, 2015. Bill Grady says, “Illinois and Chicago have been penalized but haven’t hit money yet.” So he wouldn’t handicap either as buying opportunities at this point saying, “you would need a cast iron stomach.”

Finally, Ciccarone thinks there will probably be a crisis at the Chicago Public Schools (CPS) first, then there’s the potential for a happy ending. Chicago has a $20 billion unfunded pension liability and has serious structural budget gaps. On the bright side, Ciccarone points out that Chicago’s school, city and county taxes are still only half that of New York on a per capita basis. And on October 28th, the Chicago City Council passed a $543 million property tax increase to be phased in over four years which will help maintain police, fire and other city services. But he still thinks there will be a lot more paper sold and people losing money before it gets better.

In closing, I’d simply add that these risks do not mean that we should avoid the municipal bond market. Rather, we should consider the relevant factors and metrics described above to carefully select the right municipal bond issues for our portfolios. When given a choice, choose well!

Chemical Footprint: Screening Stocks for Chemicals of Concern

Chemicals are in virtually every product we buy from clothing, cosmetics, furniture, shampoo, fragrances, and building products to the food we eat and, of course, the pharmaceuticals used to treat illnesses. In short, life as we know it would not exist without chemicals.

Yet, chemicals also can be harmful and pose risks to human health depending upon their nature and the amount of time we’re exposed to them. So as a consumer, investor or business executive, it’s critical to understand your exposure to “chemicals of concern.”

Chemicals of Concern

Across the world, various regulatory, industry and government agencies have established lists of chemicals of concern. Any chemical that can potentially cause harm can be considered hazardous. However, certain chemicals can persist in the environment (air, water, land, plants and animals), build up in animal tissues and be toxic—causing different types of harm ranging from mild skin irritations to cancer.

Chemicals of high concern (CoHCs), as defined under the California Candidate Chemical List, include:

  • Carcinogens, mutagens or reproductive toxins (CMR)
  • Persistent bioaccumulative and toxic substances (PBT)
  • Other chemicals for which there is scientific evidence of probable serious effects on human health or the environment
  • A chemical whose breakdown products result in a CoHC that meets any of the above criteria

Sounds complicated but extremely important, right? Absolutely, socially responsible investors recognize that the improper use of chemicals can cause materially adverse investment performance and even greater harm to society. Therefore, it’s important that your investment manager conduct a broad screening for chemicals of concern when selecting stocks for your portfolio. Let’s look at a real-world example.

Lumber Liquidators (LL) – Linked to Health and Safety Violations

On March 1, 2015, Anderson Cooper, CBS News correspondent, reported on 60 Minutes that the laminate flooring sold by Lumber Liquidators (LL) may fail to meet health and safety standards because it contained high levels offormaldehyde, a known cancer causing chemical. As shown below, the stock price fell sharply just before and immediately following the report—then down 72% since the start of the year.

Source: Wall Street Journal Online

What went wrong?  Allegedly, it appears that Lumber Liquidators failed to properly control its supply chain by sourcing lower-cost, formaldehyde-tainted laminate flooring manufactured overseas. The flooring was tested by 3 independent labs and failed to meet California formaldehyde emissions standards (CARB-2) with levels, on average, six or seven times higher than allowed and in some cases as high as twenty times higher than allowed.

What were the repercussions? Lumber Liquidator’s CEO, Robert Lynch, resigned on June 16, 2015, and the company announced it would discontinue the sale of the laminate flooring manufactured overseas. Now, the company faces a growing number of product liability and securities lawsuits including allegations that its directors breached their fiduciary duties by failing to properly oversee the laminate flooring manufactured overseas.

This story offers an interesting case study on the importance of Socially Responsible Investing (SRI) and the value of careful environmental, social and governance (ESG) screening. Here are a couple of key takeaways:

I. Watch the Profit Margins  – 60 Minutes reported that Whitney Tilson, a hedge fund manager, correctly identified that Lumber Liquidators had doubled its profit margins in just two years. An unusual gain in a commodity business. These gains should have led more analysts to question the sustainability of the increased profits and the underlying business drivers.

II. Don’t forget the “S” in ESG – Some key social factors that can have a material impact on the value of a stock include (1) customer satisfaction (2) product safety and liability (3) supply chain management and (4) occupational health and safety.

In this case, Lumber Liquidators frequently advertised images of children playing on new hardwood and laminate flooring. Unfortunately, due to their size, children are also the most likely to first show symptoms of exposure to harmful chemicals. So, the risks of providing an unsafe product, used by children and in the home, ultimately destroyed customer satisfaction and caused homeowners to immediately rip the flooring out. Responsible investors should evaluate if the supply chain is sustainable and provides occupational health and safety to its workers.

Sustainable Investing: The ESG Approach

A sustainable approach to investing incorporates the analysis of material, non-financial ESG factors into the investment decision-making process and helps determine the final selection of securities for your portfolio. Analyzing material ESG factors ultimately helps investors rank order stocks before making final investment decisions.

Start with the Chemicals of Concern by Industry

When screening prospective investments, it’s helpful to start by identifying the chemicals of concern used in the industry you’re evaluating. Then determine the level of revenues from products containing those substances and explore the firm’s processes and controls for managing its chemicals. Look for information from industry, regulatory and government sources such as:

Benchmark and Rank Order Your Investments

After you’ve gained a broad perspective on the industry, it’s time to collect the sustainability metrics. In the Household and Personal Products industry, for example, the Sustainable Accounting Standards Board (SASB) suggests the following four metrics regarding chemicals of concern under its Product Environmental, Health and Safety Performance topic:

  1. Revenues from products that contain REACH substances of very high concern (SVHC) (Metric CN0602-05)
  2. Revenue from products that contain substances on the California DTSC Candidate Chemicals List. (Metric CN0602-06)
  3. Discussion of process to identify and manage emerging materials and chemicals of concern. (Metric CN0602-07)
  4. Revenues from products designed with green chemistry principals (Metric CN0602-08)

Ultimately, we’re trying to identify the firm’s “chemical footprint.” To that end, the Chemical Footprint Project (CFP) Assessment Tool (released on June 19, 2015) also provides a good resource for publicly benchmarking chemical use and management. It’s backed by over $1.1 trillion in purchasing and investment power with signatories that include Aviva Investors, BNP Paribas IP, Boston Common Asset Management, Calvert Investments, Miller/Howard InvestmentsTrillium Asset Management, Zevin Asset Management, Dignity Health, Kaiser Permanente, Staples, Target and many others.

In the final analysis, we’re looking for best-in-class performers and screening out firms with significant risks. In the long-term, integrating ESG analysis into the investment decision-making process will help identify companies with business models that are more sustainable, socially responsible and profitable.

Investing in a Changing Climate

Investing in a Changing Climate

Is climate change for real? The short answer is yes. According to Doug Sisterson, co-author with Seth B. Darling of How to Change Minds About Our Changing Climate…about 98% of climate scientists believe that the Earth’s climate systems are changing due to “anthropogenic” (caused or produced by humans) greenhouse gas (GHG) emissions.

Based on peer-reviewed scientific reports, The International Panel on Climate Change (IPCC) concludes that the effects of greenhouse gas emissions, and their anthropogenic drivers, are extremely likely (95% – 100%) to have been the dominate cause of global warming since the mid-20th century in its Climate Change 2014 Synthesis Report Summary for Policymakers (4). The IPCC describes the causes of climate as follows:

SPM 1.2 Causes of Climate Change

“Anthropogenic greenhouse gas emissions have increased since the pre-industrial era, driven largely by economic and population growth, and are now higher than ever. This has led to atmospheric concentrations of carbon dioxide, methane and nitrous oxide that are unprecedented in at least the last 800,000 years. Their effects, together with those of other anthropogenic drivers, have been detected throughout the climate system and are extremely likely to have been the dominant cause of the observed warming since the mid-20th century.  {1.2, 1.3.1}” (4).

The IPCC presents an interesting graphical view of GHG emissions (in gigatonne of CO2-equivalent per year, Gt CO2-eq/yr) for the period of 1970 to 2010 (shown below). Interestingly, annual CO2 emissions from fossil fuel combustion andindustrial processes accounted for 65% of the 49 Gt total. Other major sources include methane (CH4) at 16%, CO2 from Forestry and Other Land Use (FOLU) at 11% and Nitrous Oxide (NO2) at 6.2%.

What are the risks of climate change?

The risks associated with global warming are expected to create widespread impacts across the planet—and include more severe weather-related events. In Asia, IPCC identifies increased drought-related water and food shortages, more heat-related human mortality and increased flood damage to infrastructure, livelihoods and settlements. Europe faces increased damage from river and costal floods, increased water restrictions and increased damage from extreme heat events and wildfires. North America faces similar problems with increased damage from wildfires, increased heat-related human mortality and increased damage from river and costal urban flooding. The oceans face reduced fisheries catch potential, mass coral bleaching/mortality and increased damage from costal inundation and loss of habitat (14). While this is not an exhaustive list, the point is that the effects are widespread and can impact human health, agriculture, housing, infrastructure and many other industries too—think of massive insurance claims after extreme weather events.

What’s the global plan?

In order to limit the harmful effects of global warming, The United Nations Framework Convention on Climate Change (2010) established a global accord in Copenhagen that attempts to limit the future increase in global temperature to 2 degree Celsius from pre-industrial temperatures. Since scientists estimate an almost linear relationship between cumulative CO2 emissions and projected global temperature change to the year 2100; this effectively means that a “carbon budget” on CO2 emissions has been established between 430 to 530 Gt CO2. The graph below illustrates the relationship between the carbon budget (CO2 emissions permitted below a 2 degree temperature increase) and climate change.

Problem solved?

Not so fast. Under this carbon budget, the International Energy Agency (IEA) reports that no more than one-third of proven fossil fuel reserves can be consumed prior to 2050, unless carbon capture and storage (CCS) is widely deployed in its 2012 World Energy Outlook.

No more than one-third of proven reserves of fossil fuels can be consumed prior to 2050 if the world is to achieve the 2 °C goal, unless carbon capture and storage (CCS) technology is widely deployed” (3).

This dilemma has led some to conclude that fossil fuel reserves may become “stranded assets” that won’t or can’t be used in the future—which could lead to asset write downs (impairment) on balance sheets and imply that current stock prices are overvalued. The Carbon Tracker Initiative notes that assets can be stranded for regulatory, economic or physical reasons.

Stranded assets are fossil fuel energy and generation resources which, at some time prior to the end of their economic life (as assumed at the investment decision point), are no longer able to earn an economic return (i.e. meet the company’s internal rate of return), as a result of changes in the market and regulatory environment associated with the transition to a low-carbon economy.” Carbon Tracker Initiative: Resources: Stranded Assets, Web. June 2015.

However, according to Julie Fox Gorte, Ph.D., senior vice president for Sustainable Investing at Pax World Investments, “Factually, unburnable carbon doesn’t exist.” In short, Dr. Fox Gorte correctly points out that in order for fossil fuel reserves to become stranded (unburnable) assets there would need to be new regulations that don’t exist today in Pax World’s ESG MattersEven still, I believe new environmental regulations, legislation and carbon markets will develop and we must pay very close attention to them.

I know of no nation that has or is considering legislation to make it either illegal or uneconomic to extract remaining coal, oil or natural gas reserves and burn them in the engine of commerce, mostly to produce energy” (1).

What can investors do? 

First, recognize that the problem is real. Second, understand that the timing, magnitude and consequences of climate change are evolving issues. Consequently, one could develop an investment strategy that evolves as new scientific information, technology, environmental markets (for greenhouse gases, carbon, water, weather risk, etc.) and legislative or regulatory policies emerge.

Many colleges, universities, foundations, cities and other civic, charitable and religious institutions have opted to divest from fossil fuels (see Go Fossil Free Divestment Commitments). Others have opted to influence change through corporate engagement. And still others use low carbon indexes to increase exposure, while reducing tracking error, to more carbon-efficient companies (seeMSCI Beyond Divestment: Using Low Carbon Indexes).

Finally, let’s not forget that climate change will create new investment opportunities and environmental markets. Surprisingly, the best trade can be counterintuitive.Richard L. Sandor, Ph.D., Chairman and Chief Executive Officer, Environmental Financial Products, LLC, recently talked about his new book Sustainable Investing and Environmental Markets: Opportunities in a New Asset Class by authors Sandor, Clark, Kanakasabai and Marques in Chicago. Sandor explained that environmental markets often over-estimate the cost of compliance with new regulations so the best trade could be to short the carbon market—even though your gut is telling you that the price will go up.

Networking at Weber Grill Restaurant!

SteakThere’s no better way to start the summer than with good barbecue! In early June 2015, CFA Chicago members gathered at the Weber Grill Restaurant in Lombard, where patrons can watch Master Chefs grill steaks, burgers, chops, chicken and fish – right before their eyes – on real Weber Kettle Grills.  That’s right; The Weber Grill heats about 2,000 lbs of real charcoal per day to 1,500oF for a unique indoor grilling experience.

Shannon Curley, CFA, Executive Director – CFA Society of Chicago, and Kim Augustyn, CMP, Director of Programs and Sponsorships, warmly welcomed CFA Chicago members to the evening’s three-course progressive networking dinner. The atmosphere was relaxed and jovial with table conversations ranging from hedge funds and derivatives to golf and new babies (congratulations Brendan!).

Kim explained that attendees would switch tables to meet different people after each dinner course, according to the information printed on our nametags.  It sounded great until I realized that my nametag read: Table 4, Table 4 and Table 4.  I was beginning to feel like Marlon Brando, the Don of the Corleone crime family in the Godfather movie, conducting business in a restaurant.

Then, suddenly it all made sense. CFA Charterholders would recognize this as a simple case of serial correlation. Statistically, given the smaller size of the gathering, extreme events like this were even more likely to occur than in larger samples.  It all worked out in the end, but in real life, we must remember that patterns tend to repeat themselves more often than we think they should and this, of course, also explains why Apple had to reprogram its “random” iTunes shuffle algorithm so the same song doesn’t play twice in a row.

Don’t worry if you missed this great networking opportunity—there will be many more in the near future. In the meantime, there’s no reason you need to miss out on good BBQ, so here’s my favorite recipe for great 4th of July BBQ ribs!

Day Before: Put pork ribs in crock pot. Pour in one 16-oz bottle of Coke (to break down connective tissue).  Cover and leave on high for 4 hours.  Wrap ribs in plastic wrap and aluminum foil.  Refrigerate overnight.

Next Day:  Make “The Secret Sauce”: ½ c Ketchup, 1 ½ T Worcestershire Sauce, 1 can tomato soup, 1 can water, 1 good-sized onion diced, celery (to suit your taste).  Bring to boil on stove.  Then, simmer for 15 minutes with cover off.

Brown ribs on grill.  Apply some BBQ sauce on the grill and pour the rest over on plate.


ESG: A Material Information Advantage

Does your ESG integration program have an edge? If not, read on. Everyone knows that it’s difficult to produce alpha—an abnormal excess return over the market—due to skill rather than luck. And yet, by looking deeply, and at the right factors, one can find investment opportunities (and market inefficiencies) that are overlooked by others.

Howard Marks, Co-Chairman of Oaktree Capital Management, refers to this process as “second-level thinking” in his incredible book The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor (46). Marks goes on to explain:

 Second-level thinkers know that, to achieve superior results, they have to have an edge in either information or analysis, or both” (78).

Sustainable investing is all about second-level thinking. First, we need to gain an informational advantage by identifying material environmental, social and governance (ESG) factors. Then, we need to understand how that information drives intrinsic value, and cash flow, to design investment strategies that appropriately meet the client’s risk and return objectives over an appropriate time horizon.


Corporate Sustainability: First Evidence on Materiality

The good news is that Harvard researchers have found new evidence linking performance on sustainability issues to financial performance. Importantly, the research differentiates between material and immaterial sustainability factors—addressing a significant gap in prior research.

Authors Mozaffar Khan, George Serafeim and Aaron Yoon from Harvard Business School present their findings in Corporate Sustainability: First Evidence on Materiality (Working Paper 15-0703). A major finding is that firms with high performance on material sustainability issues and concurrently low immateriality  scores have the best future stock performance—generating an annualized alpha of 6.01%.

Using calendar-time portfolio stock return regressions we find that firms with good performance on material sustainability issues significantly outperform firms with poor performance on these issues, suggesting that investments in sustainability issues are shareholder-value enhancing” (1).

In addition, firms with good performance on material sustainability factors also  outperformed those with good performance on immaterial sustainability factors by an annualized alpha of 1.96%. So, again good performance on the right (material) ESG factors adds value. The results are summarized below.

Source: Sustainability Accounting Standards Board (SASB) Industry-based Standards to Guide Disclosure and Action on Material Sustainability Information Slide 22 (2015).

Even good performance on immaterial sustainability factors added .6% annualized alpha. At a minimum, this means that sustainability investments are not shareholder value-destroying (3). However, firms with poor performance on sustainability factors (both material and immaterial) underperformed by an annualized alpha of -2.90%.

What’s the big idea? Access to material sustainability information can give your ESG integration program an edge.


Material ESG Information Access

In the Harvard study cited above, the data collection process was driven based on materiality guidance on sustainability issues from SASB. The SASB website provides a sector-level materiality map that identifies sustainability issues by level of materiality at In short, this map is a great starting point for identifying which issues are likely to be material for more than 50% of the industries in the sector. Then, the Harvard researchers used MSCI KLD as the source of their sustainability data—which is the most widely used dataset by past studies (7).

SASB sustainability issues are organized under the following five categories: Environmental, Social Capital, Human Capital, Business Model and Innovation and Leadership and Governance. For example, the environmental category contains issues like greenhouse gas (GHG) emissions, air quality, energy management, fuel management, water and wastewater management, waste and hazardous materials management and biodiversity impact.

After identifying the material issues, the SASB Standards Navigator can be used to research specific “evidence-based metrics” that are known to impact business value in the areas of revenues, costs, assets, liabilities and cost of capital. Bottom line, it’s all about analyzing the right non-financial ESG metrics that can have a material impact on financial performance.

For illustrative purposes, a few SASB environmental accounting metrics applicable to the Oil and Gas Exploration and Production industry are shown below. As you can see, each metric in the SASB Standards has a unique reference number, description and a clearly defined unit of measurement.

Sector: Non-renewable Resources, Industry: Oil & Gas Exploration and Production

  • Greenhouse Gas Emissions – Accounting Metric NR0101-01 – Gross global Scope 1 emissions, percentage covered under a regulatory program, percentage by hydrocarbon resource. Unit = Metric tons (t) CO2-e, Percentage (%). The registrant shall disclose gross global Scope 1 greenhouse gas (GHG) emissions to the atmosphere of the six greenhouse gases covered under the Kyoto Protocol: carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride
  • Air Quality – Accounting Metric NR0101-04 – Air emissions for the following pollutants: NOx (excluding N2O ), SOx, volatile organic compounds (VOCs), and particulate matter (PM) Unit = Metric Tons (t)
  • Water Management – Accounting Metric NR0101-06 – Volume of produced water and blowback generated; percentage (1) discharged, (2) injected, (3) recycled; hydrocarbon content in discharged water. Unit = Cubic meters (m3), Percentage (%), Metric tons (t)
  • Reserves Valuation & Capital Expenditures – Accounting Metric NR0101-22 – Sensitivity of hydrocarbon reserve levels to future price projection scenarios that account for a price on carbon emissions. Unit = Million barrels (MMbbls), Million standard cubic feet (MMscf).

Importantly, SASB standards are drawing wide interest across the globe and have been downloaded over 27,392 times by more than 4,640 users in over 65 countries in top capital markets including the U.S. ($25.9B), E.U. ($10.4B), Japan ($4.6B), China (3.9B) and Hong Kong ($3.1 B) (Slide 24).

SASB standards can be downloaded, at no charge, for a variety of sectors and industries at: Additionally, MSCI ESG Research sells a comprehensive suite of ESG data, ratings and research products.  See


A Vision of the Future

As noted at the outset, after gaining an informational advantage one must then be able to efficiently analyze the data in order to design investment strategies that appropriately meet the client’s risk and return objectives. Given the wealth of new ESG information that will be coming down the pike through the SASB Standards, there will be exciting opportunities to develop new investment strategies and analysis.

For example, financial analysts will enjoy creating new multi-factor regression models that incorporate material ESG factors in an attempt to forecast sources of performance and risk. And there will be even more ways to conduct peer comparisons with a complete data set—using consistent ESG units—while benchmarking against the industry average.

SASB provides a vision of this future in the illustration below. It shows a hypothetical peer comparison using sustainability fundamentals in the pharmaceutical industry.

Source: SASB: Industry-based Standards to Guide Disclosure and Action on Material Sustainability Information Slide 19 (2015).

It’s my hope that more access to high-quality, material ESG information will improve the investment decision making-process, increase business competition and lead us to a more sustainable future.

CFA Chicago: Investing in Latin America

CFA Chicago: Investing in Latin America

¡Que fantástico! ¡Que increíble!  The CFA Society of Chicago recently celebrated its 90th anniversary by welcoming investment professionals from across Latin America to the Midwest for its 2015 Annual Conference: Emerging Opportunities in Latin America!

Christopher Vincent, CFA, Chairman CFA Chicago and Partner at William Blair, cast the vision for the conference that enabled participants to gain deep market insights on Latin America and foster new relationships across Latin American CFA Societies. On the Society’s 90th anniversary, Chris pointed out that CFA Chicago is the oldest investment analysts society in the world. It was founded in 1925—with a membership of 4—and today is the 6th largest society in the world with more than 4,300 members.

Chris gave a special thanks to Marie Winters, CFA, SVP Northern Trust, Larry Cook, CFA, Executive Director UBS Global Asset Management and Garrett Glawe, CFA, Vice President MSCI, who did a fantastic job as co-chairs for the 2015 Annual Meeting. Garrett Glawe served as an outstanding Master of Ceremonies (and is now available to MC other events…The Academy Awards, Music Awards, Emmys, etc.). Chris gave special thanks to Northern Trust, Aberdeen Asset Management, BNY Mellon and FitchRatings for their support and generous corporate sponsorships which made the event possible.

On a brief housekeeping note, the information flow at the conference was designed like a funnel. We started at the macro / geo-political level and gradually worked our way down through broad Latin American business issues and investment industry trends to more specific regional and industry investment risks and opportunities. Please keep this in mind as you look for information relevant to your needs in the report below.

It should also be noted that the panelists did not provide specific recommendations to buy or sell particular securities or provide investment advice.

The Politics of Economic Reform

Christopher Garman, Head of Country Analysis at eurasia group, opened the conference with a broad overview of how the  Latin American political environment may impact your investment portfolio. Although each country has different political issues, Garman emphasized, “For the first time in a long time, emerging markets are at a political turning point which investors need to appreciate.” In short, today there really is a unifying theme in emerging markets that are at a political inflection point.

For the first time in a long time, emerging markets are at a political turning point which investors need to appreciate.” Chris Garmen, eurasia group

Specifically, Garmen observes that Latin America is at the end of a “political super-cycle.” Back in 2002, commodity prices were low and political incumbents only held office for 3 years on average. Then, commodity prices increased, there was a period of rapid economic growth and incumbents remained in office for 7.2 years on average. In short, it was a very good time to be a politician but not many economic reforms took place.

Source: eurasia group, May 2015 Latin America Outlook (Slide 2)

Today, Garman indicates that Latin America is facing slower economic growth and a “messy” end to its super-cycle. Incumbents barely win re-election and weak second-termers hold office while facing high fiscal demands from a rapidly growing middle class. Garman explains that the problem is particularly acute in Latin America where economies are highly dependent on commodity exports and the growing middle class makes up a larger share of the population than in other emerging markets.

Source: eurasia group, May 2015 Latin America Outlook (Slide 3)

As shown above, there has been extraordinary growth in the emerging middle class across Latin America which now represents 30% to 80% of the population in some countries. These new middle class families demand more security, education, health care and other public services from overwhelmed governments that are rapidly losing public support as shown below.

Source: eurasia group, May 2015 Latin America Outlook (Slide 3)

Garmen then presented a detailed analysis and outlook for a number of Latin American countries. The highlights are summarized below.

Brazil: Short-term Trajectory: Neutral, Long-term Trajectory: Neutral

Garman is cautiously optimistic on Brazil. In the wake of the state-controlled oil company scandal at Petrobras, Garman feels President Dilma Rousseff’s administration is seeing a meaningful course correction. He feels Brazil is moving towards a more market-friendly equilibrium and a constructive response to the political pressure. The government can increase taxes without congressional approval and has already done so to avoid losing investment grade status on its debt. In the oil and gas E&P sector, Garman expects an open pre-salt costal shelf framework will allow others to get involved in production. In addition, watch for aggressive selling of assets to improve Brazil’s financial position and new rules to attract investors to infrastructure projects like airports, highways and railroad projects.

Garmen estimates a 60% probability that Brazil “muddles through” and a very large fat tail risk of 40% that the course correction could be undermined if the corruption probe (Operation Carwash) spreads to other sectors of the economy with knock-on effects. There is significant risk the investigation grows because the federal prosecutors office, federal police and judiciary all have a high degree of independence (normally a very good thing) in Brazil. The bad news is that if it grows to the scale of the Italy’s Mani Pulte (“clean hands”) operation—which reached 5,000 executives and politicians—then Garman points out we could see a 3% to 4% contraction in GDP.

Mexico: Short-term Trajectory: Positive, Long-term Trajectory: Positive

Garmen notes that Mexico is the inverse of Brazil. Although President Pena Nieto has lost popularity amidst scandals it shouldn’t influence his ability to execute reforms. Importantly, President Nieto made significant constitutional reforms in energy, education and other areas all within his first year in office and the June 2015 mid-term elections shouldn’t change this dynamic. Garman expects that quick implementation of energy and telecom reforms are still likely. Longer-term, the big risk is that slower growth and discontent produce a leftist candidate in 2018.

Colombia: Short-term Trajectory: Neutral, Long-term Trajectory: Neutral

Colombia is facing strong external headwinds due to lower oil prices. Garman believes that President Santos’ second-term success will be tied to his ability to deal with the Revolutionary Armed Forces of Colombia (FARC) but expects that a deal remains likely within a year and will be a boon for the oil sector. Lower oil production will add pressure to the fiscal accounts increasing risks for higher taxes and short-term pain but Garman has a constructive muddle-through view.

Argentina: Short-term Trajectory: Negative, Long-term Trajectory: Positive

Garmen expects the October elections to be very competitive between Daniel Scioli (FPV), Sergio Massa (FR) and Mauricio Macri (PRO) but notes that there are no major differences between the candidates. In short, he feels that there will be constructive policy adjustments after the election regardless of whoever wins. However, successful implementation of the adjustments will be very challenging for any administration due to significant macroeconomic events. Watch for a lifting of foreign exchange (FX) controls, increased debt issuance and a possible settlement with holdouts.

Venezuela: Short-term Trajectory: Negative, Long-term Trajectory: Negative

In Venezuela, Garman estimates the probability of a credit event in 2016 at 60%. He reports that it’s likely the government will make the necessary adjustments to service its debt in 2015 but will enter 2016 with very little in the bank. The government is willing to dramatically cut imports and liquidate assets. Garman feels President Maduro will maintain power through the election. However, if Maduro is unable to finish his term, with 70% disapproval ratings, then Garman suggests a social/political crisis could develop where the military steps in to put a damper on it. Complicating matters further, there are no strong alternative candidates within the chavismo.

Chile: Short-term Trajectory: Negative, Long-term Trajectory: Negative

In Chile, Garman reports that the risk to investors will be high as costly reforms advance and economic growth remains subdued. Tax and electoral reforms have been approved and education and labor reforms are advancing. Chile had enjoyed more than two decades of successful economic policies and political stability but today there are high demands for additional spending and regulation.

Peru: Short-term Trajectory: Neutral, Long-term Trajectory: Neutral

In Peru, Garman feels that the political risk is high but it remains one of Latin America’s best performing economies. He believes that its economic and investment polices are unlikely to change before the end of President Humala’s term in 2016. However, it’s likely that a populist candidate could emerge and reverse policy in 2016.

Click here for a link to Chris Garman’s full presentation.

Navigating Business Challenges in Latin America

The first panel discussion of the day was moderated by Ignacio Campos, Director of Strategy & Business Development, Fortune Brands Home and Security, and revealed key insights on navigating business challenges in Latin America. This panel of corporate executives provided interesting perspectives across the pharmaceuticals, lighting and food service industries.

Anil G. D’Souza, Corporate Vice President – Japan and Emerging Markets, Hospira, Inc., sees the best opportunities for Hospira’s infusion and pharamcutical services in Brazil and Mexico due to the size of the markets and low per capita spending on healthcare. D’Souza explains, “Healthcare is not a want but a need—and that’s a huge advantage.” He believes it’s essential to develop your strategy and then stick with—only changing tactics—until a fundamental change occurs.

Hospira’s strategy works with governments and industry associations to stay ahead of the game and influence results. D’Souze capitalizes on acquisitions and joint ventures as a means to gain access to public tender participation bids. His biggest challenges involve import restrictions. In Brazil, public-private partnerships are utilized to transfer technology over a five to ten year period which D’Souze reports works well if the technology will be obsolete after 5 years.

Dave Riesmeyer, Executive Vice President of Panasonic Lighting Americas, Inc.believes it takes two things to win in Latin America. First, a well-postioned entry strategy with a strong brand and technology that’s recognized. Second, a strong local partner. He observes that the customer is no less demanding in Latin America and you need the proper logistics, import and legal support to get the product delivered on time. Like D’Souza, Riesmeyer looks for joint venture opportunities to reduce investment costs and provide an off ramp if things go wrong.

Reismeyer stresses that security issues are the biggest risk of doing business in Latin America. He believes security is worse in Mexico today than it was ten years ago—especially near the US border. Reismeyer said, “It’s statistically more dangerous to travel in Latin America than it is in Africa.” In addition, he points out that all of the Latin American countries have old infrastructure (roads, bridges, etc.) which significantly impact traffic and logistics.

It’s statistically more dangerous to travel in Latin America than it is in Africa.” Dave Riesmeyer, Panasonic Lighting Americas, Inc.

John Naoum, Sr. Marketing Manager, Global Business Development, Brinker International (owner of Chili’s Bar & Grille and Maggiano’s Little Italy) covered the food service industry. About 30% of Brinker’s fleet of restaurants are in Mexico and the  Andean States where there is a mature market and steady growth. He sees huge potential for growth in Peru and Colombia where Brinker still needs to build infrastructure.

In regards to strategy, Naoum agrees that finding a strong local partner is the most important factor for success. If the market accepts American brands and views the United States in an aspirational manner then it’s a positive sign. However, significant tax and import challenges exist. Naoum explained that it can take six months to launch a new menu item in Latin America as compared to only 3 to 4 weeks in Asia and the Middle East. Furthermore, some import taxes are as high as 45% and make some products, such as ribs in Ecuador, cost prohibitive. Overall, it’s easy to trade and import goods in Mexico, due to NAFTA, but taxes can be high.

Luncheon Keynote Speaker: Ambassador Luis Miguel Castilla

Luis Miguel Castilla, Ambassador of Peru in the US, presented the luncheon keynote address. Ambassador Castilla believes  we are at the end of a structural super cycle in commodities across Latin America. Approximately 81% of Peru’s exports are currently in commodities like copper (which has declined in price for the past 15 quarters), oil and gold. So Peru wants to diversify its export basket and transition to a knowledge-based economy. To that end, Ambassador Castilla stressed the importance of the US-Peru Free Trade Agreement (FTA), the Trans Pacific Partnership (TPP) and Pacific Alliance to Peru’s future.

Ambassador Castilla explained that its FTA with the US is comprehensive and goes well beyond basic goods to include labor, services, investment, intellectual property, government procurement, legal and institutional issues, human rights and democratic principals. In addition, the TPP represents a potential market of over 800 million people and 40% of the world’s GDP. Since interregional trade in Latin America is still less than 10%, due to physical and sanitary barriers, it’s critical for Peru to get to the other side of the Pacific. Peru currently operates the busiest shipping port in South America and ultimately wants to become a hub in the global supply chains through the TPP.

In addition, Peru formed an alliance with Mexico, Chile and Colombia to pursue deep financial integration (e.g. by viewing investments in pension funds in Colombia as domestic investments), liberalization of trade, infrastructure improvements and sharing public finance resources such as disaster risk management. This block of countries represents over 200 million people and a combined GDP of $2.1 trillion USD.

Source: Estimates WEO-FMI (2013), Peru – Development Challenges in a Global Setting, Luis Miguel Castilla (May 2015).

In closing, Ambassador Castilla was asked what advice he would give US Presidents and he replied, “A lack of active US presence in the region is being filled by other big countries.” He went on to point out that the US is the fifth largest investor in Peru after a number of European and Asian countries so he asked, “Why is the US so far down the list?”

A lack of active US presence in the region is being filled by other big countries.” Ambassador of Peru in the US, Luis Castilla

Click here for a link to Ambassador Castilla’s full presentation.

Asset Managers: Opportunities & Challenges in Latin America

Raman Aylur Subramanian, CFA, Managing Director & Head of Index Applied Research for the Americas, MSCI, moderated the next panel discussion on the asset management industry in Latin America. According to Boston Consulting Group, Latin America accounted for only 2.5 % of global assets under management (AuM) in 2013. And this represents a very low proportion relative to GDP. Therefore, Subramanian points out that the nascent industry has significant opportunities for growth. Further supporting this hypothesis, the PwC analysis shown below estimates that AuM in Latin America will grow at a 12.5% CAGR between 2012 and 2020.

Ned Burmeister, SVP & COO, Principal International (US $519 bn AuM, $97.2 bn AuM in Mexico, Brazil and Chile) started off with Principal’s Latin American business strategy. Specifically, Principal seeks to leverage its high-quality pension and mutual fund expertise, within developed pension markets of sufficient size, then springboard into the voluntary mutual fund space.

Burmeister sees great opportunity in the Latin American pension and retirement space because he feels the mandatory contribution programs, in and of themselves, will never provide the kind of replacement income that’s necessary for retirement. As shown on the left, pension assets as a percentage of GDP in Latin America significantly lag those in the US and Europe.

In Brazil, Burmeister says, “The first and only person investors call is the bank.” Banks have had an aggressive and closed architecture directing  clients to their own investments. Hence, Principal sources mostly through Banco do Brasil. Finally, Burmeister believes emerging markets are going to leapfrog from plain vanilla equity or fixed income funds to lifestyle and solutions funds.

Lucas Ramirez, CFA, Head of Research, Sura Asset Management (US $114 bn AuM) also observed that the mutual fund industry in Latin America is dominated by the banks. Ramirez says, “You don’t see Vanguard, Fidelity or Blackrock—but local banks that protect their distribution channels by closing them to others, like Sura.”  Yet, Ramirez points to the expected growth in Latin American AuM, in the BCG forecast provided above, and is optimistic that Sura has the right strategy.

Sura is the largest pension fund manager in Latin America with over 17 million clients and a 23.3% market share in AuM across six countries (Mexico, Colombia, El Salvador, Peru, Chile and Uruguay.) Ramirez explained that Sura’s strategy is to  build a regional sales force of financial advisors offering different solutions (real estate, infrastructure funds, etc.) to increasingly more sophisticated clients in Latin America. Sura then relies on third-party investment teams to pick the stocks.

Manuel E. Mejía-Aoun, Founder, Managing Partner, and Chief Investment Officer of Alpha4x Asset Management, says he launched a hedge fund rather than compete with Principal and Sura. Alpha4x manages two global macro hedge funds: Cayman and Brazil. Their strategy is to focus on interest rates, currencies, sovereign credit and equity indices rather than picking stocks. Overall, Alpha4x tries to create low to slightly negative correlations to major indices, produce consistent risk-adjusted returns and maintain disciplined risk management processes.

Mejia-Aoun explains that a global middle class is developing in Latin American that has more more in common with a lawyer in New York City. When asked about his views on Brazil, Mejia-Aoun joked, “The optimist says Brazil is the country of the future. The pessimist says it will always be.”

The optimist says Brazil is the country of the future. The pessimist says it will always be.” Manuel E. Mejia-Aoun

Click here for a link to Session 3: Asset Managers in Latin America

Investment Opportunities & Risks in Latin America

Dan Kastholm, CFA, Managing Director, Latin America Corporate Finance, FitchRatings, moderated the last panel discussion of the day and successfully brought us from 30,000 feet down to ground level. I had the pleasure of working with Dan to organize this last panel of experts and can tell you that we were fortunate to have Kastholm’s more than twenty years of experience in Latin American markets at our disposal. Kastholm noted that FitchRatings has more than 200 people in Chicago with 60 analysts covering Latin America and following 550 credits. FitchRatings also rates 97% of all cross-boarder issues placed globally. Dan led an interesting discussion with the panel across a variety of asset classes and sectors including equity, fixed income, real estate, energy and infrastructure.

Michael Reynal, Senior Portfolio Manager, Head of Emerging Markets; RS Investments; specializes in Latin American equity investments and markets. Reynal bluntly described the current situation in Latin America as dire with earnings growth crushed the last couple of years and I/B/E/S consensus estimates at -2% in 2015. However, he is a professional stock picker and says, “We are often too negative and don’t capture the turn in the markets.” Reynal tries to look past the political drama and be positioned to avoid the risk of underperformance.

Reynal likes finding promising second and third-tier corporates in Latin America and says, “You have to get on a plane and check them out.” Without providing  specific investment advice, Reynal noted Volaris as an example of a growing low-cost Mexican airline carrier and Ferreyros, a successful Caterpillar distributor, headquartered in Lima, Peru. He also noted M.Dias Branco, a Brazilian cracker and pasta company, which has a large market share in the unbranded cracker market and Gruma—the largest manufacturer of corn flour and tortillas in the world—headquartered in San Pedro Garza García and Nuevo León Mexico. Reynal is optimistic on the energy and transportation sectors in Mexico but is more speculative about prospects in Brazil.

Elizabeth Bell, Investment Manager, Aberdeen Asset Management, is responsible for real estate investment activities throughout the Americas on behalf of both separate accounts and fund-of-funds managed by Aberdeen. Bell sees positive opportunities for local, residential real estate developers in Mexico. She reports that the drop in oil prices has been good for the US consumer and is driving manufacturing in Mexico—which in turn drives demand for industrial warehouse space and housing. She also points to a slowdown of residential demand in Brazil. And she worries that if lending dries up Brazilian developers won’t be able to refinance their working capital and become distressed.

Despite the fact that three large Mexican public home builders filed for bankruptcy in 2014 (Urbi, Homex and Corporación Geo SAB), Bell points to pent up demand for residential housing and says, “There are housing deficits of 10 million units across the residential segment in Mexico.” Furthermore, she explains that one-third of the deficit is in the middle-income segment which is doing well. Bell says, “The problem is that banks are not lending to the sector and equity investors have been too timid to put their capital at risk.”

The problem is that banks are not lending to the sector and equity investors have been too timid to put their capital at risk.” Elizabeth Bell, Aberdeen Asset Management

Bell sees Mexican housing as a bright spot for those who want to step in and fill the liquidity gap by lending to small developers who need capital. Bell has seen 18% to 20% returns on senior debt and 20% to 25% on mezzanine debt. She explains that you have to get past the headline risk and fear of bankruptcy because  many local developers are still earning profits and are willing to take on expensive debt in order to achieve their returns. Also, there is good support for low to middle income buyers who can get loans. Finally, Bell cautions that real estate is high risk and you need to find best-in-class partners to do business in Latin America.

Juan Bosch, Senior Investment Strategist (Argentina) and Independent Director of Compass Group; highlighted the favorable total debt-to-GDP ratios in Latin America provided by aMcKinsey & Company study (below). After the 2008 financial crisis, debt-to-GDP ratios in developed countries increased significantly more than in Argentina, Peru, Mexico, Colombia, Brazil and Chile which are still below 150%. Bosch points out that interest rates in Argentina are near 9% to 10% while other areas of Latin America are at 5%.

Source: McKinsey & Company

Bosch is focusing on more liquid asset classes right now and feels that corporate bond yields are good and is long in the financial sector. He emphasizes the need to  take advantage of growth in the Latin American middle class which is just below Eastern Europe and Central Asia (shown below.) Bosch feels that pursuing alternative investments like real estate and infrastructure is an effective way to tap this demand.

Source: BCA Research 2014

Uwe Schillhorn, CFA, Head of Emerging Market Debt, UBS, views Latin America as many different markets rather than just one. Yet, Shillhorn finds the common denominator to be their heavy reliance on extractive industries and commodities.  In fact, he notes that oil and other commodities have been correlated and this has been a big disappointment for countries like Peru. He’s seen currencies weaken (but says they were fundamentally expensive before) and large nominal devaluations but expects currencies will appreciate once commodity prices stabilize. Schillhorn sees Mexico as a glimmer of hope that’s now in need of a second generation of reforms.

In the bond market, Schillhorn warns that it could be very bad for Latin America when US interest rates start to go up. Schillhorn says, “If rates go up in an orderly fashion then the risk premium won’t go up. But if the market moves quickly then risk premia will widen. And if it’s a violent change then credit spreads will blow out.”

“If rates go up in an orderly fashion then the risk premium won’t go up. But if the market moves quickly then risk premia will widen. And if it’s a violent change then credit spreads will blow out.” Uwe Schillhorn, UBS

Closing Keynote Address

Ernesto Zedillo, President of Mexico (1994-2000), Director of theYale Center for the Study of Globalization, was introduced by Chris Vincent, CFA, to provide the closing keynote address at the 2015 CFA Chicago Annual Conference. Vincent noted that Mr. Zedillo’s life story is truly amazing. Rising from humble working-class beginnings, with a public school education, Zedillo’s drive for self-improvement and public service earned him a masters degree and PhD in economics at Yale University and brought him to the presidency of Mexico.

Zedillo argued that CFA Chicago’s discussion about investing in Latin America was vitally important for two reasons. First, investors simply cannot ignore such an important middle-class region of the world with per capital income at $16,000 USD, over 600 million people and a combined GDP of over $6 trillion USD. Second, Zedillo says Latin America is going through a “special moment.” He explains that about four to five years ago there was widespread optimism and it was easy to invest in Latin America. Today, Zedillo asserts that you must exercise greater caution and use more sophisticated analysis to find the opportunities.

Zedillo argues that we must first understand the history of the region. He believes that most Latin American countries overestimated the resilience of their domestic policies and falsely attributed the results to skillful policy rather. Correspondingly, they underestimated the significant role external events would have on their economies—for good or bad. In retrospect, he points out that there was a systematic underestimation of the impact of the super cycle—which can now be declared as over—and other significant structural challenges (e.g. demographic changes, etc.) now lie ahead. Zedillo warns, “The day of reckoning for becoming complacent is not tomorrow—it’s today”

The day of reckoning for becoming complacent is not tomorrow—it’s today.” Ernesto Zedillo

Zedillo emphasized that Latin America is at a “fork in the road” and the urgency for change in each country is even more critical. He says the “homework” ahead of the region is very complex and cannot be oversimplified. Yet, Zedillo says that with gains in productivity the region can make gains in alleviating poverty, inequality and low per capita income.

Zedillo closed with a few observations on regional challenges. He calls Venezuela’s situation “catastrophic” since its GDP fell 4% last year and is estimated to fall another 7% this year and in 2016. He feels that Argentina, though in recession, is “fixable.” In regards to Brazil, the Latin American giant in terms of size and complexity, Zedillo feels the economy will contract by 1% this year and  be in recession. On a positive note, Zedillo says Mexico is lucky to be more “interdependent” with the US (e.g. NAFTA) than other Latin American countries. Therefore, he believes Mexico will consistently do better after a crisis given its strong connection to the US economy.

Five Hobbit Lessons for Sustainable Investing

In Devin Brown’s Hobbit Lessons: A Map for Life’s Unexpected Journeys, we learn five key lessons drawn from J.R.R. Tolkien’s timeless story The Hobbit. These lessons are well worth remembering and, in fact, may even help add meaning and value to your investment portfolio. And when it comes to sustainable investing, the lessons are particularly fitting because sustainability, by definition, causes us to think even more deeply about the long-term—how we earn our wealth, what we do with it and the implications our investments have on the environment and society.

Hobbit Lesson #1 – When adventure comes knocking, let it in—even if it makes you late for dinner, even if part of you says not to, despite what the neighbors might say. Saying yes to adventure will be good for you, and profitable too—though not in the way you might think” (32).

Developing a sustainable investment program is like embarking on a new adventure. The global sustainable investment market is growing rapidly and there are numerous strategies to help you achieve your goals. Although it may take a little longer to identify and analyze these material non-financial factors (and even make you late for dinner)—I believe that incorporating sustainable environmental, social and governance (ESG) analysis can reduce portfolio risk and generate long-term returns.

Global Growth in SRI Assets

According to the Global Sustainable Investment Review 2014, the world market for sustainable investing (SRI) has grown from (USD) $13.3 trillion in 2012 to $21.4 trillion in assets by 2014 (3). That’s a 26.9% compound annual growth rate (CAGR) in just the past two years. And, sustainable investment assets in Asia have grown at a 15.1% CAGR—from $40 billion to $53 billion over the same timeframe (4).

In my view, this remarkable growth in assets illustrates both the value of a more robust investment decision-making process and the dawn of a new era in sustainable investing.

Sustainable Investment Strategies

Hobbit Lesson #2 – Have your friends’ backs – someone has yours” (58).

As with any great adventure, there are a number of paths to choose from. The paths (or strategies) can demonstrate both your commitment to protect others from harm (e.g. having your friends’ backs) and lead you to opportunities where others can protect you from risk. GSIA reports that seven key sustainable investment strategies have emerged across the globe:

  1. “Negative/exclusionary screening: the exclusion from a fund or portfolio of certain sectors, companies or practices based on specific ESG criteria;
  2. Positive/best-in-class screening: investment in sectors, companies or projects selected for positive ESG performance relative to industry peers;
  3. Norms-based screening: screening of investments against minimum standards of business practice based on international norms;
  4. Integration of ESG factors: the systematic and explicit inclusion by investment managers of environmental, social and governance factors into traditional financial analysis;
  5. Sustainability themed investing: investment in themes or assets specifically related to sustainability (for example clean energy, green technology or sustainable agriculture);
  6. Impact/community investing: targeted investments, typically made in private markets, aimed at solving social or environmental problems, and including community investing, where capital is specifically directed to traditionally underserved individuals or communities, as well as financing that is provided to businesses with a clear social or environmental purpose; and
  7. Corporate engagement and shareholder action: the use of shareholder power to influence corporate behavior, including through direct corporate engagement (i.e., communicating with senior management and/or boards of companies), filing or co-filing shareholder proposals, and proxy voting that is guided by comprehensive ESG guidelines” (6).

Across these investment strategies, GSIA reports that the largest strategy globally is negative screening/exclusions ($14.4 trillion), followed by ESG integration ($12.9 trillion) and corporate engagement/shareholder action ($7.0 trillion). Negative screening is the largest strategy in Europe and ESG integration dominates in the United States, Australia/New Zealand and Asia.

The Association for Sustainable & Responsible Investment in Asia (ASrIA) reports that the top three investment strategies in Asia (ex-Japan) are ESG integration ($23.4 million), negative/exclusionary screening ($16.5 million) and sustainably themed investing ($2.0 million) in their 2014 Asia Sustainable Investment Review(10).

Importantly, Asian investors cite fiduciary duty, financial opportunity and risk management as their primary motivations for sustainable investing (20). Which brings us to Brown’s third lesson:

Hobbit Lesson #3 – Be fond of waistcoats, pocket handkerchiefs and even Arkenstones (just don’t let them become too precious)” (82).

In short, it’s okay to seek financial opportunity and enjoy “fancy” or valuable things. However, Brown draws out Tolkien’s theme and warns us that, “…if we let our possessions become too important, if we let them become too precious, they will eventually come to possess us and bring about our downfall” (81).

Emerging Themes in Asia

Interestingly, the data show that sustainability-themed investment strategies have had the highest asset growth rates—both globally and in Asia. ASrIA reports that game-changing issues like climate change mitigation are driving many countries in Asia to implement more supportive regulatory landscapes for environmentally focused investments like clean tech and renewable energy (14). The four key themes emerging in Asia include new opportunities for clean energy, green bonds, conservation finance and impact investing.

Clean Energy

Bloomberg New Energy Finance expects that over US $250 billion per year will be invested in Asia’s clean energy infrastructure through 2030. Although renewable power is expected to produce a third of the region’s electrical power by 2030, even more coal and oil-fired electric generation can be expected to be used to meet the region’s growing energy needs—and that will lead to a significant rise in emissions as well (21).

China is already the world’s largest energy consumer and it’s expected to increase its energy use by 60% by 2030. Therefore, investment opportunities should abound across Asia as the region attempts to transition to a more sustainable, and environmentally friendly, low-carbon future. In the Philippines, the National Renewable Energy Program (2011-2013) plans to triple renewable capacity to 15.3 GW by 2030. In India, multiple policies have been deployed to increase renewable power such as Renewable Purchase Obligations, Renewable Energy Certificates (“RECs”) and favorable State Electricity Regulatory Commission (SERC) tariffs for mainly private-investment driven renewable generation—though coal will still be a major fuel over the next five years. In Thailand, renewable energy makes up 12.2% of capacity and the Alternative Energy Development Plan (ADEP) (2012 – 2021) has set an ambitious 25% target (22).

Green Bonds

KEXIM Bank in South Korea issued the first green bonds in Asia in 2013. Although the market is still in its infancy, first movers like the Asian Development Bank (ADB), the Development Bank of Japan and Taiwan’s Advanced Semiconductor Engineering have also issued green bonds. And the Chinese government has decided that green bonds will be an important part China’s financial market reform (23).

Hopefully, proceeds from green bonds will help the region finance large-scale energy and environmental projects that will support its transition to a low-carbon growth model. However, investors will need to be cautious and seek full disclosure, transparency and an independent evaluation of these new financing vehicles to ensure that investor expectations can be met (23).

Conservation Finance

The scale of Asia’s economic growth is creating incredible financial wealth but inevitably depletes natural resources and increases the risk of pollution. Globally, we’ve lost 50% of the world’s mammals, birds, amphibians and reptiles over the past 40 years due to human activities that destroy habitat or over-exploit fishing and hunting. Examples in Asia include degradation of natural forest in Indonesia and Cambodia and threats to coral reefs in Southeast Asia by overfishing (24). So, it’s imperative that we protect these truly irreplaceable and invaluable treasures.

 Hobbit Lesson #4 – Remember not all that is gold glitters (in fact, life’s real treasures are quite ordinary looking)” (100).

Conservation finance is a form of impact investing in which part of the investment remains in the ecosystem to enable its conservation (the ‘impact’) and part of it is returned to investors. While more government and regulatory intervention is expected, there remains a US $200 bn – $300 bn funding gap to satisfy global conservation needs. Therefore, asset managers and banks have the opportunity to develop new products and advisory services for private, philanthropic and institutional investors with an appetite for conservation finance (24).

Impact Investing

Impact investing takes an ownership stake in equities, bonds or other instruments to generate social, health and environmental benefits with the expectation of subsequently exiting the investment. ASrIA surveyed Asian investors and found that they recognize financial opportunity, contribution to community and fiduciary duty as primary motivations of impact investing (26). I’d also note that Michael E. Porter and Mark R. Kramer argue that creating societal value is a powerful way to create economic value while meeting the vast unmet needs in the world in their article, “Creating Shared Value,” in the January 2011 issue of Harvard Business Review.

J.P. Morgan estimates that the global impact investment market could absorb between US $400 billion and US $1 trillion over the next decade. And the Rockefeller Foundation forecasts that Southeast Asia will be the next hub for impact investing. However, currently a shortage of viable investment products and limited access to qualified professional advice is reportedly holding impact investing back in Asia (25).

Putting it in Perspective

Part of the adventure of sustainable investing is the opportunity to generate both financial and social returns while addressing the world’s most significant challenges. At times, it might seem hard to believe that your investments can make a global difference but remember this final Hobbit lesson:

 Hobbit Lesson #5 – Recognize you are only a little fellow in a wide world (but still an important part of a larger story)” (122).

ASrIA reports that Malaysia, Hong Kong, South Korea and Singapore are the largest Asian markets for sustainable investments. In addition, Indonesia, Singapore and Hong Kong were the fastest growing markets since 2011 (11). As global and Asian SRI markets continue to grow there will undoubtedly be new risks but there will also be exciting new opportunities for investors!