Preserving Alpha through Successful Execution

Alpha is the ability to generate superior risk-adjusted returns compared to the return of an appropriate index. The purpose of most equity trades for managed portfolios is to hopefully create alpha for that portfolio. The hidden costs of not obtaining the best execution can destroy that alpha.

How does the trader know his trade is being treated fairly with respect to other trades being placed at the same time? Is the trade being shown to the right people? The SEC website lists 20 exchanges approved for securities trading. What drives the decision by a trader to use one exchange over another?

CFA Society Chicago’s Education Advisory Group hosted a panel discussion on insights on market structure in the equity market and how this structure affects equity trading today. The moderator was Michael Thompson, CFA. The panelists were Haim Bodek, Nanette Buziak and Larry Harris, CFA. Their backgrounds are as follows:

Michael Thompson, CFA – Mr. Thompson is a Partner and Head of Domestic Equity and Derivatives Trading for William Blair Investment Management. Mr. Thompson began his career in the late 1980s as a securities trader associate with Principal Financial.

dsc_3238Haim Bodek – Mr. Bodek is a Managing Principal of Decimus Capital Markets, LLC a tactical co nsulting and strategic advisory firm focused on high frequency trading (“HFT”) and U.S. equities market structure. Mr. Bodek is the author of two books on market structure and is known as a whistleblower that brought attention to the questionable practices of HFT.

Nanette Buziak – Ms. Buziak is Head of Equity Trading at Voya Investment Management. Ms. Buziak manages a team of equity traders and is responsible for all facets of equity trading and related operations at Voya.

Larry Harris, Ph.D., CFA – Dr. Harris holds the Fred V. Keenan Chair in Finance at the USC Marshall School of Business.  Dr. Harris addresses regulatory and practitioner issues in trading and investment management in his research and consulting.

Mr. Thompson began the panel discussion by briefly speaking about his background and introducing each panelist. Mr. Thompson provided a brief history of the changes in equity trading since the late 1980s. When Mr. Thompson began his career, there were only two exchanges and orders were brought to brokers who announced the bid or offer on the floor of the exchange. There were only two recognized equity markets, the NASDAQ and the New York Stock Exchange. By his estimate there are now 13 well known exchanges and 40 dark pools that can trade, with all trades done electronically. Each panelist made a brief presentation which is summarized below:

Dr. Larry Harris

  • The need for speed critical, you need to be the first in line for execution or the first to cancel if you don’t want to get hit.
  • A buyer grants a “put” option to the market and the market will move away from a buyer over time.
  • Brokers can hide orders or search for hidden orders. Dark pools will not show orders.
  • Limit trades often come with price discretion. Someone with a limit order of 23 might accept a price of 21; however this fact is not shared with everyone.
  • “Maker-taker” fee structures have become more common. The broker will typically extract a fee from the taker and rebate part of that fee in the form a liquidity rebate to the maker.

Haim Bodek

  • There are basically two worlds in equity trading, HFT and non-HFT. Firms that specialize in HFT exploit the structure of the market to take advantage.
  • HFT is not really a quant strategy.
  • The two biggest HFT firms paid substantial fines to the SEC in 2012 due to the work of Mr. Bodek in exposing the unfair advantage of firms using HFT when competing with traders not using HFT.
  • HFT comprises around 40% of equity volume and is still legal to use as long as those firms use proper disclosure.

Nanette Buziak.

  • Her team is composed of traders, analysts and portfolio managers who are all cognizant of trading costs. The team strives to limit the implicit costs of trading.
  • The average print size of an equity trade is around 217 shares; her typical trades at Voya are in the millions of shares.
  • Need to assess what venue is appropriate for what trade. Does the name trade in dark pools?
  • HFT is not an issue as long as she feels her positions are not compromised. Some venues can be more toxic than others.
  • Liquidity appears to be coming out of the market at this time since the dwindling amount of IPO’s are not able to replace firms lost to M&A.

There was a brief Q&A session following the panel’s presentations that touched on the following topics:

  • There was some frustration expressed on how slowly the SEC responds to complaints. Since the SEC must follow due process, it is up to institutions to do their own due diligences on these venues and brokers.
  • Firms that do large equity buybacks in many cases use minority brokers.
  • In assessing what algorithm to use when trading it’s important not to use those that are repeatable and can be used against you.
  • Voya’s portfolio managers know what names are not liquid and they will not build a large position in a thinly traded stock.

In response to where they see the market in 5 years, most participants felt there would be little change in that time. With the new administration, Dodd-Frank might be in jeopardy

The Art of Negotiating Compensation: Getting Paid What You Are Worth

Laurel Bellows is the Managing Partner of her namesake, boutique firm, The Bellows Law Group, P.C. whose practice areas include Executive Compensation, Business Consultation, Business Litigation, Employment Law & Human Resources, and Personal Legal Services.

Bellows focused on tips and topics for negotiating compensation packages, yet frequently widened the scope by noting these strategies are applicable in any type of negotiation.

dsc_3183A key takeaway was preparation is power. Bellows suggested writing out your own, ideal or dream deal to have as goal which you can test to ensure your expectations are realistic. Likewise, one must also take into account whether or not the company’s goal to determine your performance/bonus is also an achievable goal. To assist in this process, Bellows had a novel approach. In addition to using resources such as trade associations, public data (if one is lucky), and informational dsc_3159interviews, she suggested a brainstorming session. Inviting friends over for a candid discussion and feedback over drinks could enhance your preparations.

The key to negotiation is determining what you are worth, regardless of previous earnings. Determine your level of responsibility, skills, and efforts beyond simply whether you are generating a cost or revenue. Ideally monetizing your value will create leverage. More importantly, it will establish a connection to the employer’s perspective with your understanding of the position and potential role in the greater organization. Nevertheless, employers’ key challenges remain; identifying, motivating and retaining talent.

dsc_3162During the initial negotiations, if the employer asks for your compensation target, then assure them that they can come to an agreement. Emphasize you are really interested in joining the team and would prefer an offer before discussing specifics. With an offer in hand, force the employer to specify the numbers of the compensation package first. With a significant pause and a flinch or “hmm…,” counter with a nearly “blush-level” offer. From this dsc_3167point on, your research and preparation becomes your support to confidently negotiate with informed certainty. You have anticipated their counter argument and able to support your case. You may concede a lower initial package if you can have a six-month performance review to have the opportunity to earn a package closer to your initial offer.

Finally, always have a best alternative at any moment. If you are fortunate, it may be taking an offer from different employer or realizing the negotiation will not end in an agreement and walking away.

Check out Laurel’s 10 pointers below:

Bullets by Bellow: 10 Pointers for Successful Negotiations

  • Prepare, prepare, prepare
  • Determine the extent of your counterpart’s authority
  • Set a precise goal. Be able to justify your goal and quantify your demands
  • Put your dream agreement in writing
  • Keep your best alternative in mind
  • Identify other party’s principal goal and best alternative
  • Role Play: Practice your questions. Anticipate answers to questions you will be asked
  • Strategize Timing
  • Your name and your reputation are inseparable
  • Remember: Not every negotiation ends in agreement

Investing in Innovation

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Distinguished Speaker Series: Jeffrey W. Ubben, ValueAct Capital

Come so far…now the slog

dsc_3125CFA Society Chicago’s Distinguished Speaker Series hosted Jeffrey W. Ubben at the University Club. Mr. Ubben is Founder, Chief Executive Officer and Chief Investment Officer at ValueAct Capital. Prior to founding ValueAct, Mr. Ubben was a portfolio manager at Fidelity and a managing partner at Blum Capital. ValueAct is a hedge fund that invests in companies in fundamentally “good” businesses that are available at depressed valuations. The company typically manages 10-18 investments with total assets over $11 billion.

Although Mr. Ubben’ s hedge fund is located in San Francisco, he spent part of his life in the Chicago area and is a graduate of the Kellogg School MBA program at Northwestern University. His appearance at the University Club was in part a homecoming; his parents were in attendance.

Mr. Ubben began his presentation with three charts that chronicled the history of the debt and equity markets beginning in the late 1970’s to its current state. They were as follows:

  • “Corporate Equities to GDP”
  • “Governance Timeline”
  • “US Total Credit Market Debt as % of GDP”

The corporate equities and credit market charts illustrated the rapid growth of the equity and debt markets in comparison to GDP. Mr. Ubben blames “fed-induced financial engineering” for the outsize growth of debt.  Historically low interest rates have fanned these flames as companies have gotten a free pass to increase leverage. He lamented the thinking that stocks are the new bonds and feels that stocks are currently priced nearly to perfection. The “Governance Timeline” showed a history of shareholder activism beginning with hostile LBO’s in the late 1970’s to current attempts by shareholders to change the composition of target companies Board of Directors.

Mr. Ubben stated that value investors like him are attracted to what he termed “pain” experienced by many corporations. This “pain” eventually incents corporations to make decisions that will benefit shareholders. His examples of “no pain” were corporate deal making and lavish pay to CEO’s like Google’s Eric Schmidt.

Mr. Ubben briefly discussed three investments recently made by ValueAct in companies currently experiencing “pain”. These were positions in Rolls Royce, Morgan Stanley and Baker Hughes. In each case Mr. Ubben state briefly what attracted ValueAct and what changes were being made to secure a brighter future for each company. Perhaps this was the “slog” he alluded to in the title of his presentation.

The role ValueAct had in the removal of Steve Ballmer from Microsoft was also discussed. Mr. Ubben stated that he merely encouraged management to listen to its major shareholders opinion of Ballmer’s performance. In contrast, Mr. Ubben made mention of Jeffrey Immelt’s action in selling GE Capital’s multibillion dollar portfolio of real estate assets. GE’s share price has since improved markedly.

There was a lively question and answer session following the presentation. Mr. Ubben was questioned further about ValueAct’s investments. These included questions concerning Morgan Stanley, Valeant Pharmaceutical, Trinity Industries and Alliance Data.

ValueAct’s investment in Valeant Pharmaceuticals was one of which Mr. Ubben spoke at some length. He was quick to admit that this was an investment where ValueAct had taken its eye off the ball. They were instrumental in the CEO change that occurred in 2008 which brought in Michael Pearson. However, Pearson became very aggressive and this led to bad decision making.

Mr. Ubben reiterated his advice to go where there is dis-investment as this is a place where there are lower costs and lower volatility. It is important to measure the quality of any business versus its valuation. Despite many stocks and industries being priced to perfection, there are still parts of the market where opportunities can be found.

 

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Distinguished Speaker Series: Dr. David Kelly, CFA, J.P. Morgan Global Investment Management

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Dr. David, Kelly, CFA

Dr. David Kelly, CFA, the Chief Global strategist for J.P. Morgan Global Investment Management, provided his thoughts and views on investing in the current low/no rate environment.

Starting with a review of the U.S. economy Kelly noted that real GDP has grown just over 2% on average over the past five years. Under normal circumstances this level of growth is considered anemic, but the current slow and steady expansion is acceptable from Kelly’s point of view. Consumers are benefiting from low mortgages and gas prices, overall demand is growing, and banks are issuing more credit. Kelly considers this economy analogous to a healthy tortoise – it does not move swiftly, but it is steady. It is unrealistic for the U.S. economy to grow at historical levels (+3%) given the low unemployment rate, which from Kelly’s point of view is the biggest impediment to continued growth of the economy. Kelly believes that the sliding unemployment and labor participation rates are due to the aging population. Baby boomers comprise a large segment of the working population, the oldest of which became eligible for retirement in 2011. Boomers will of course will continue to retire, constraining the labor market, and helping the unemployment and participation rates to fall further. To combat the coming labor shortage Kelly suggested comprehensive immigration reform, bringing more people (workers) in to the U.S.  If immigration reform is not successful the unemployment rate could fall into the 3% range, constricting the economy to a growth rate under 2%.

Kelly believes that the Federal Reserve needs to raise rates in September. If this window were missed then the Fed would likely have to wait until December to not affect the November election. Further delays in raising the Fed Funds rate will make raising rates harder to do in the future – the Fed will be provided with more reasons for not raising rates, which will further undermine its credibility.

dsc_3084As of April 2016, 35% of all developed world government bonds had a yield below zero. Low global rates have helped lower U.S. interest rates. Global bond buyers looking for better yields have moved to U.S. denominated securities driving down domestic yields. However, Kelly suggested that rising rates in the U.S. could act a balloon to world bond rates. Given the current and projected fixed income market, Kelly suggested underweighting domestic and global fixed income until real rates reach a normalized range.

Turning to the equity markets Kelly believes the current equity market is still relatively cheap. Do to the expected rising rate environment the financial sector should be overweighed while the utility sector is expected to underperform. However, there is more upside outside of the U.S. equity market in Europe and the emerging market space.  These areas should outperform in the medium term based on stronger relative earnings. The current forward P/E of the S&P 500 is around 17x earnings, over the long-term average of 16x, while the MSCI EAFE forward P/E is at its long-term average.

Kelly took questions at the end of the presentation from several members from the audience. One individual asked “How best should a government sustain a countries economic growth?” Kelly’s answer was a bit surprising in that he focused on income inequality – the more there is, the less sustainable economic growth becomes. Kelly noted that most problems that create income inequality start with single parent families (SPF). In the 1980’s, 18% of households were SPF. As of this past year the SPF households number 42%, which from any number of perspectives is an alarming statistic.

CFA Society Chicago Book Club:

The Only Game in Town by Mohamed El-Erian

the-only-game-in-townExtraordinary central bank interventions during economic crises aren’t new.  In his Pulitzer Prize-winning Lords of Finance, Liaquat Ahamed mentions Emperor Tiberius injecting one million gold pieces into the Roman economy to keep it from collapsing in 33 AD.  Extraordinary central bank policy coordination similarly isn’t new, as Mr. Ahamed notes with the frequent meetings between the heads of British, French, US, and German Central Banks and the resulting coordinated policy actions during the First World War and the Great Depression.  What is new is the extent and duration of those interventions and the absence of any corresponding fiscal or structural reforms. After Tiberius’s intervention, Rome soon returned its focus to commerce, conquest, and imperial assassination.  Roman merchants and farmers didn’t sit idly waiting for the next round of monetary stimulus and then dispose of their wares and crops in panicked fire sales when cheap money didn’t materialize.  Contrast that with our times.  Six years into an economic expansion, interest rates remain at historic lows—even negative in several major economies—with little hope of fiscal or structural reform.  A small uptick in volatility can elicit calls for further quantitative easing (college campuses apparently aren’t the only places where people are clamoring for safe spaces).  Central banks have become The Only Game in Town, the title of Dr. El-Erian’s book and the subject of the CFA Society Chicago’s July 19, 2016, Book Club meeting.

Dr. El-Erian brings uniquely diverse cultural, educational, and professional perspectives to the financial crisis and the ensuing central bank interventions.  His mother is French and his Father is Egyptian, and he spent time growing up in Egypt, in France, where his father was the Egyptian Ambassador to that country, and in New York City, where his father worked at the United Nations.  His enrichment continued in the United Kingdom where he attended boarding school, Cambridge, and finally Oxford, where he earned a doctorate in economics.  His professional resume is equally diverse and impressive.  It includes the International Monetary Fund (IMF), Harvard University’s endowment, and PIMCO, one of the world’s largest bond investors with approximately $2 trillion under management.  It’s there where Dr. El-Erian served as co-CIO along with PIMCO-founder Bill Gross.  That’s in addition to his numerous publications, boards and committees, and his previous book, When Markets Collide, which won the Financial Times and Goldman Sachs Business Book of the Year Award as well as The Economist’s Book of the Year Award in 2008.

In addition to his qualifications to write on the subject, Mr. El-Erian served as CFA Society Chicago’s keynote speaker at its 2015 Annual Dinner, which further piqued Book Club members’ interest.  In his exposition of the issues facing global markets and central banks’ responses to them, Dr El-Erian didn’t disappoint the assembled Book Club Members.  In the plain-spoken fashion that made When Markets Collide a classic, he explained complex, interdisciplinary phenomenon in simple terms with the assistance of helpful metaphors.

For example, he explained the collapse in confidence and liquidity during the crisis in terms of a drive through: Customers pay at the first window and receive their food at the second.  When customers aren’t confident that they’ll receive their food at the second window, they’ll demand it at the first window.  When restaurants don’t relent, both parties that otherwise wish to transact will walk away – market failure.  As another example, he explained that trying to push certain products and activities out of the banking system was like pushing on a waterbed.  Rather than remove the activity, pushing simply displaces the activity to elsewhere in the bank and non-bank financial sectors.

Dr. El-Erian also noted the increase in the size and power of the end-users of capital, the buy-side, relative to financial intermediaries, the sell-side.  The phenomenon has been noted, among others, by John Rogers, the former CEO and President of the CFA Institute, in A New Era of Fiduciary Capitalism? Let’s Hope So, which appeared in the May/June 2014 edition of the Financial Analysts Journal.  Dr. El-Erian explained the consequence of that transformation, namely that the growing end-users are trying to force more transactions through the shrinking pipes of the financial intermediaries.  The result in the financial world is as calamitous as the result in the plumbing world.

In all, Dr. El-Erian noted nine challenging trends in global economies related to extraordinary extended central bank interventions, the subject of Part Three of his book: inadequate growth models, high unemployment, increased inequality, decreased institutional credibility, political gridlock, increased trade imbalances and tensions between the core and the periphery of the global economy, the rise of shadow banking, decreased liquidity (the pipes mentioned above), and finally the increased complacency among market participants due to a perceived central bank put.  In that exposition Dr. El-Erian touched on several insightful points.  For example, he noted the Bank of International Settlements (BIS) meetings allowing for back-channel discussions and problem solving between the monetary authorities of different economies.  A similar mechanism for averting armed conflicts through international organizations such as the United Nations has been noted in Bruce Russett and John O’Neal’s Triangulating Peace.  Perhaps a longer book would have allowed those points to be developed further.  The Only Game in Town is only 296 pages, including appendix.

That largely concluded the exposition of the problem, where Book Club Members gave Dr. El-Erian high marks.  The remainder of the book was a meandering attempt to solve the problems noted in the first part of the book, which left members disappointed.  The desultory journey covered bi-modal distributions, behavioral finance, several other topics, and even a section on diversity in the workplace.  One member quipped that the last chapter of the book was probably a last-gasp effort to fulfill a contractual minimum page requirement with the publisher.  Dr. El-Erian had a similar chapter on organizational leadership at the end of When Markets Collide.  In that book he also noted the failure of macro-prudential regulators such as the IMF, his former employer, to balance their academic training with technical knowledge gleaned from actual market participants.  Perhaps better institutional leadership and reforms, including more diversity, could foster economic stability and growth, but Dr. El-Erian failed to argue the point persuasively, at least in the judgement of the participating Book Club members.

The Only Game in Town is a worthwhile addition to the discussion about the continued role of central banks in the current economy and the potential pitfalls of continuing down the current path.  Even though Dr. El-Erian ultimately failed to solve the problems he elucidated, he’s hardly alone in that regard.

Distinguished Speaker Series: Charlie Dreifus, CFA, The Royce Funds

DSC_2907“The proliferation of non-Gaap (financial measures) has added to the proliferation of growth,” said Charlie Dreifus, CFA.

Dreifus is a managing director and portfolio manager with The Royce Funds which focuses on providing small-cap, value mutual funds.  Dreifus is the portfolio manager for the Royce Special Equity Fund and the Royce Special Equity Multi-Cap Fund, with over 18 and 5 years on the funds, respectively.

Dreifus’ focus, for many years, has been on the value approach to portfolio management.   A key aspect of his approach is the utilization of accounting skepticism.  Dreifus shared his thoughts on the increased usage of non-GAAP measures and the resulting side effects.

He started with a story.  He had a conversation with a particular company to seek GAAP guidance.  Although the company already provided non-GAAP guidance, Dreifus was informed that “GAAP guidance is unavailable without unreasonable effort.”  Dreifus responded, “…but you need GAAP to get non-GAAP.”  And the attendees broke out laughing.

DSC_2918Dreifus reported that the number of S&P companies reporting non-GAAP measures has increased to 88%.  The consequences of the increased focus on non-GAAP include decreased clarity in reporting results and in increase in wiggle room to achieve desired results.  The desired results have, of course, have a direct linkage to executive and incentive compensation.  Executive compensation is being geared more towards non-GAAP and with the ability to front load expenses with non-GAAP measures, financial windfalls can be significant.  Audit committees have been strengthened by Sarbanes-Oxley.  Dreifus would like to see the committees act to disallow the gaming of earnings to beat analysts’ expectations.  They should take more responsibility for the reported economic stats.  Ideally, we would see “full, fair & balanced reportable numbers.”

Dreifus finds the number of times audit committees meet informative.  If the number is low or high, it raises a red flag.  He would like to believe that changes to our non-GAAP reliant system would develop within the audit committee; however, the challenge is sparking any involved person/party to take ownership of the responsibility.

On the other hand, Dreifus does grant that GAAP is not perfect either.  Nevertheless, his goal is to raise the level of consciousness within the industry and its participants.  Especially in the context of recent record-setting equity market levels, the talk has motivated deeper reflections on valuations.

CFA Society Chicago’s 2016 Annual Business Meeting

DSC_2952Beginning with a cocktail and appetizer hour, CFA Society Chicago’s annual business meeting was held at the Virgin Hotel on June 20th. Chief Executive Officer, Shannon Curley, CFA, led off with a summary of this past year which he labeled under the major theme of “Building the Base”.

The four major activities of focus were:

  1. Redesigning the website
  2. Working with CFA Institute to rebuild the CRM database
  3. Improving outreach to local universities and employers
  4. Preparing the office move to 33 N. LaSalle Street, Suite 910, Chicago, IL 60602

Following Curley’s remarks, Chicago Chairman Kerry Jordan, CFA, highlighted some of the accomplishments of this special 90th anniversary year:

  • The Society hosted over 130 events (with 9 sellouts!)
  • Record attendance at the 2015 Annual Dinner
  • Membership is up to 4,524 total members

Jordan complimented the invaluable contributions of the Advisory Group Co-chairs, and made special mention of the increased program offering of the Professional Development Advisory Group.

Examples of new or expanded initiatives include:

  • Creation of a new task force to determine how the CFA Society Chicago can be more helpful toward advocacy:
  • Launching of the CFA Women’s Network
  • The financial literacy program
  • Education of pension trustees
  • Branding campaign
  • Community service

Jordan then spoke about a few global initiatives involving the CFA Institute. Paul Smith, CEO of CFA Institute, has scheduled visits at over 140 local societies across the globe and was in Chicago to attend the regional and global finals of the CFA Institute Research Challenge.  Over the past year the CFA Institute has redesigned how local societies can receive funding for building brand awareness.

Jordan participated in the global brand campaign as part of a committee including six other charterholders to discuss the charter, what it means and how it can be made more prominent in the future.

Jordan then concluded by thanking the CFA Society Chicago staff and Shannon Curley, CFA, for his effort to grow the Chicago Society.

Marie Winters, CFA, Treasurer of CFA Society Chicago, was introduced next. Her remarks were brief, but included the society’s current financial standing including reserves sufficient enough to cover 14 months of operating expense. Recently we have used reserves strategically to upgrade technology and quality of programming.

After the 2015-2016 executive committee was thanked, Doug Jackman, CFA, was introduced as the incoming Chairman.

In the business portion of the meeting, the by-laws were approved, as well as the new slate of directors and officers for CFA Society Chicago.

Awards for amazing service were given to Justin Shepard, CFA, and Chris Vincent, CFA, and a special thanks was given to Larry Cook, CFA, who is departing as the Education Advisory Group co-chair.

Finally, Jackman was introduced as the next Chairman of the Board of Directors. Jackman spoke about not having a personal agenda, just his privilege to oversee the overarching agenda to build a strong Society which thrives on its volunteer system. Toward this goal CFA society Chicago plans to invest in upgrading systems and generating more active participation by members and member firms.

CFA Society Chicago is open to any ideas on how the Chicago society can further strengthen its brand and reputation.

The evening concluded with a reception that was a great opportunity to reconnect as well as meet new and interesting members.

CFA Society Chicago Book Club:

Age of Ambition: Chasing Fortune, Truth, and Faith in the New China by Evan Osnos

age of ambitionMost of us have a well-formed macro perspective on China. It’s the world’s second largest economy and a key U.S. trading partner with growing influence in Asia and globally. In Age of Ambition Evan Osnos takes us beyond the statistics, building a complex portrait of China through its people. The author introduces us to citizens from all walks of life with widely different views on politics, the economy, social issues and the Country’s future. He reveals the monumental changes, challenges and contradictions China faces by telling their stories, tracing their lives over the years and exploring their goals, aspirations and attitudes. It’s an up close and personal look that’s highly engaging.

We follow several progressive reformers like Ai Weiwei, a famous artist who publicly mocks inequities; Han Han, a snarky and wildly popular blogger who takes aim at rampant hypocrisy; Liu Xiaobo, a leading voice for human rights who won a Nobel Peace Prize while imprisoned for advocating political reforms; and Chen Guangcheng, the “blind peasant lawyer” who helps his poor rural neighbors fight injustice by local officials.

We also meet conservative nationalists like Lin Yifu who defected from Taiwan to China in 1979 with the dream of helping China reclaim its greatness. He became a chief economist at World Bank and evangelized China’s central planning methods. Tang Jie is a graduate student whose viral patriotic video inspired Chinese people to stand against protests of China’s repression in Tibet. He and other nationalists view foreign criticism as part of an ongoing plot to encircle and weaken China. Interviews with these and other personalities span years and it’s fascinating to observe how their views develop as the country rapidly evolves.

The author takes us beyond the headlines of scandals and disasters like China’s real estate boom, organized crime and explosive growth in Macau, riots in the Uighur region, earthquake in Sichuan, conflict with Japan over the Diaoyu Islands and the “Harmony Express” bullet train crash. State controlled media tries to shape these stories but is often undermined when details emerge. The collapse of schools in the Sichuan earthquake and the “Harmony Express” crash were eventually linked to corruption that allowed shoddy building practices. Fraud was so widespread in the railroad ministry that its chief Liu Zhijun was convicted of taking kickbacks and bribery to win a Party Central Committee post. However, the truth-seeking public also can pay a price. After the Sichuan earthquake, parents who demanded information about missing children were detained.

Several book club attendees thought the author could have quantified the material better. And we also noted he doesn’t take a position or recommend action to resolve the country’s challenges. It’s true, Age of Ambition isn’t China-by-the-numbers, but it does offer rich insight into the Chinese worldview and their perspective on the country’s challenges. Our discussion was made especially interesting having Yunjin Wang and Yang Xu, CFA, add clarity and context about their home country. Both felt the book was accurate, but also noted significant changes have occurred in the short time since it was published in 2014, including the crack down on fraud and tightening of the “Great Firewall” by incoming President Xi Jinping, as well as the profound effects of ongoing economic shifts.

Key takeaways from Age of Ambition were the existential threats facing the Communist Party and their hold on power:

EXTREME WEALTH INEQUALITY

Market-based policies have created dramatic growth, but the benefits have gone mostly to politically connected businessmen and officials. China’s true Gini coefficient of wealth distribution is estimated at 0.61, among the world’s worst. This inequality stands in stark contrast to the Party’s ideal of a classless society. There’s growing frustration with the lack of social mobility. Wages for college grads have been flat since 2003 and there are six million new college grads per year. Meanwhile economic growth is slowing. “Parental connections” were found to be the most decisive factor in a child’s earning potential instead of “parental education,” the typical factor in other countries.

THE INTERNET

The Party is wary of fast-moving ideas, even those that support the government. Control of information is absolutely crucial to them and the book gives a fascinating look at their methods: the “Great Firewall,” text message monitoring, “Fifty Centers” paid to disrupt sensitive online conversations, orders issued to news outlets and publishers on forbidden words and topics, etc. But despite this censorship we see how artists, bloggers and activists use the internet to expose corruption and express their views, often with tragic consequences. Internet and mobile phone penetration are growing fast, so this challenge will continue.

INNOVATION

To transition its economy toward domestic consumption and grow its service industries, China needs to foster innovation, but official propaganda aiming to have citizens “sing as one voice” and a deeply-rooted requirement for conformity work directly against building a culture of creativity and innovation.

INDIVIDUALITY

The Party controls the legal system, education, industry, media, communications and faith groups, but as Chinese people become educated, urbanized and wealthier they’re craving more autonomy in their work, family and spiritual lives. This works against Party efforts to “harmonize” society.

Overall, Age of Ambition is a well-written and highly insightful book that’s sure to enrich your understanding of China’s people, challenges and future.