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Volunteer of the Month: February 2017

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Sitaram (Ram) Gundapaneni

CFA Society Chicago would like to send a heartfelt thanks to all of its volunteers who share their time and talents with the Society.  Today, we’re extending a very special “thank you” to Sitaram (Ram) Gundapaneni.  He’s the Membership Engagement Advisory Group’s Volunteer of the Month.

Ram has been a CFA Society Chicago member for more than four years, serving on both the Communications and Membership Engagement advisory groups since joining the Society.  Ram has led a small group of volunteers and organized Welcome Calls to over 500 new members, trained volunteers to make Welcome Calls by holding orientation conference calls, and attended society events to greet new members in attendance. Ram has also prescreened membership applications to be presented to the CFA Society Chicago Board of Directors, taken minutes at the Membership Engagement Advisory Group meetings, and assisted with the CFA Institute Research Challenge hosted by the Society.

Thank you Ram! We’re lucky to have you as a part of our society!

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).

Overview

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 (http://www.ssa.gov/retire2/estimator.htm).

(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 www.dcdbbenchmark.com (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.

CFA Society Chicago Blog Launches

Dear Colleagues,

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

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

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

Sincerely,

Communications Advisory Group

CFA Society Chicago

Claritas Prep Program

Claritas is a Latin word which in English denotes clarity or brightness. The CFA Institute began the Claritas Investment Certificate as a global education program designed to give a clear understanding of the essentials of the investment industry. This program is geared toward all professional disciplines not including those who are investment decision makers.  There are no education or experience requirements needed to enroll.

On Sept. 10, 2014, CFA Society Chicago kicked off the Claritas Prep Program.  The program is being taught by the following instructors:

Michael Falk, CFA – Falk is a partner at Focus Consulting Group and teaches as an adjunct professor at DePaul University in their Certified Financial Planner program.

Joseph Vu, Ph.D, CFA – Vu is an associate professor of finance at DePaul University, he has also taught at the University of Chicago.

Andrew Kominik, CFA – Kominik joined William Blair & Co in 2003, his current role is as a quantitative portfolio analyst serving equity management teams.

Brian Langenberg, CFA – Langenberg serves on the Career Management Advisory Committee and is adjunct professor of finance at Southern New Hampshire University.

There were approximately 40 participants gathered for the first class who were welcomed by Michael Falk, CFA. Falk had prepared 70 slides to cover the first four chapters (Module 1) of the prep course. The CFA Chicago Fundamentals of Investing Course has been adapted and used as a guide for developing the new Claritas Prep Program. Each candidate is supplied with an e-book and hard copy of the instructors’ presentation.

The course will be 7 weeks in length and consist of 7 modules (2-4 chapters) followed by a mock exam on the 8th week.  The 7 modules aim to cover the essential characteristics of all aspects of the investment industry.  It is estimated that 80-100 hours of study will be required over a 3-6 month period to prepare for a 2-hour multiple choice exam.

The successful completion of the course and the attainment of the certificate will benefit both the employee and the employer.  The shared understanding of the “big picture” will improve performance of investment teams.  Holders of the Claritas Investment Certificate will attain knowledge above their peers and demonstrate a commitment to the industry.

Energy Investing: Made in America

CFA Society Chicago hosted approximately 140 people at the University Club of Chicago overlooking Millennium Park on Sept. 23, 2014, to discuss energy investment opportunities at a thought-provoking conference entitled “A Seismic Shift: The Changing Dynamics of the Global Energy Scene.” I served on the planning committee for this event and can tell you that we were thrilled to have two panels of experts who provided insights ranging from global, macroeconomic and geopolitical energy issues all the way down to sector-specific investment ideas across the energy value chain. The dramatic increase in U.S. proved oil and gas reserves due to fracking is expected to drive a reindustrialization of North America. It should be noted that the panelists did not provide specific recommendations to buy or sell particular securities or provide investment advice.

Douglas Brown, Senior Vice President and Chief Investment Officer of Exelon Corporation (EXC) and CFA Chicago Board Member, gave a warm welcome to the attendees and emphasized that this is an important time of energy transformation for North America. Tim Greening, formerly Managing Director at Fitch Ratings, moderated our first panel discussion with Olga Bitel,Portfolio Strategist at William Blair, Rachel Bronson, Senior Fellow for Global Energy at The Chicago Council on Global
 Affairs and Jan Kalicki, Public Policy Scholar at the Woodrow Wilson International Center. Read more about all of our panelists here.

Geopolitical and Macroeconomic Issues (Panel 1)

The energy environment is in a state of revolution.

Jan Kalicki, Public Policy Scholar at the Woodrow Wilson International Center, started the program out at a sweltering pace by announcing that the “energy environment is in a state of revolution” as world energy production is shifting from the Middle East to North America. Drawing from his published expertise on “Energy and Security: Strategies for a World in Transition,” he quickly pointed out that the newfound oil and gas supplies in the United States has made the country more energy secure but not necessarily “energy independent.” Rather, it’s better to use the term “energy interdependence” to describe today’s situation because energy is a global commodity and the idea of energy isolationism is an illusion. Kalicki pointed out that the U.S. still needs to develop a national and global energy strategy that should include “free trade in energy” like LNG exports to Japan while noting that Japan does not have a Free Trade Agreement (FTA) with the United States. Furthermore, 85% of the Outer Continental Shelf still remains off limits for development. He stated that the Keystone XL Pipeline Project by TransCanada (TRP) is a good idea for the U.S., safer and more effective than attempting to ship oil by railcar and a better alternative than allowing it to go to other markets abroad. The shale plays in the U.S. have been successfully developed by private, rather than governmental, investment and the U.S. is now at a competitive advantage to other nations with less favorable land use/access policies for energy development. Finally, Kalicki noted that Russia is facing a major threat of economic recession and huge flights of human and financial capital. GazProm is the largest energy monopoly in the world and only recently has the European Union begun to move against it. Also, Eastern Europe remains far more susceptible to gas shortages from Russia than Western Europe.

A global disruptive energy boom will drive economic growth where resources are exploited.

As an economist, Olga Bitel, Portfolio Strategist at William Blair, quickly pointed out that economic growth is always subject to resource constraints. A decade ago horizontal drilling and fracking in North America was just getting started but through a favorable regulatory regime and “lucky” geology the U.S. is experiencing an unprecedented energy boom which will eventually be a global phenomenon that will affect every country in the world. Secondly, there have been continuous changes in renewable energy technology that will be just as disruptive to energy markets as we’ve seen with fracking. Thirdly, people are actually starting to talk about decarbonization of the global economy. On environmental issues, Bitel emphasized that they are far too important to ignore – especially as it relates to coal usage and the health issues associated with air pollution. She explained that the market will eventually find a way for the energy to flow – even if it’s not along an optimal path. Therefore, it’s important to get the regulation right on things like the Keystone XL Pipeline project where a pipeline through relatively unpopulated areas would be a safer alternative than railcar transportation. Bitel believes the environmental issues associated with fracking (water pollution, etc.) can be properly resolved with the right regulation and protections when properly considering the economic costs and benefits. Finally, Bitel made a variety of points regarding energy markets, prices and trade including:

LNG: The U.S. has gone from contemplating more LNG import facilities to approving LNG export terminals. This wasn’t in anybody’s playbook a decade ago. The approval of U.S. LNG exports was so significant that it was felt in foreign exchange markets!

Natural Gas: Geology and water access issues may delay development across the globe but China and other parts of the world will develop new gas resources this decade. BASF has announced plans to invest in a specialties chemicals plant in Louisiana which demonstrates the market’s view that natural gas prices will be cheaper in the U.S. for a considerable period of time. And that the U.S. is the best place to make significant energy investments. Yet, gas prices will eventually start to move closer to a more central world market price as time goes on … in the 3, 5 or 10-year time frame.

Renewables: Wind and solar power are commercially available and costs on par with fossil fuel energy. It’s not just being developed in the desert anymore. Germany is producing 20% of their electricity from wind today and Denmark has been exporting energy for a decade. During the first six months of 2014 the U.S. has seen tremendous growth in new utility-scale solar ad renewable power development.

Source: U.S. Energy Information Administration, Electric Power Monthly, August 2014 edition with June 2014 data

Note: Data include facilities with a net summer capacity of 1 MW and above only.

Oil: About 80% of net new oil production compensates for the decline in field production alone while only 20% provides for new demand. Therefore, each new oil well costs more to develop. Globally, risks in Argentina and Venezuela continue to be significant where assets could be confiscated on a dime. Oil prices are expected to be broadly stable and declining in real terms.

Utilities: The utility industry has been about as stable and staid as you can get for the last 100 years with a regulatory environment that is still stuck in first part of 20th century. There is no forward-thinking regulatory policy in Germany and Japan at this time. We need a new electricity market to properly compensate for different and changing sources of electricity. If we get this right, then the required investment will come forward.

U.S. Dollar: The U.S. dollar is the global reserve currency and the source of global liquidity. We’ve seen lower levels of U.S. dollars flowing abroad, and a lower current account deficit, because energy imports are shrinking quite rapidly and over the next three years the U.S. will begin exporting LNG. In light of fewer dollars flowing out of the country there will be a higher premium for U.S. dollars that will lead to a rising value of the dollar. The energy boom will create more stable oil and commodity prices globally. As monetary conditions tighten, the Federal Reserve may not have to move as fast on increasing interest rates due to the reduced impact of energy on inflation.

The geopolitics of energy is changing on a daily basis.

Rachel Bronson, Senior Fellow for Global Energy at The Chicago Council on Global
 Affairs, is an expert on energy issues in the Middle East and author of “Thicker than Oil – America’s Uneasy Partnership with Saudi Arabia.” She emphasized that changing energy geopolitics are everywhere in the press today. Examples include, territorial disputes between China and Vietnam in the South China Sea, driven by potential oil and gas under the waters, and ISIS capturing oil resources in Iraq and selling it on the black market. Nations throughout the world are now aggressively seeking access to energy resources. China’s huge demand for energy and air quality problems are driving its energy resource development. Although Russia can meet a lot of Chinese demand, the Chinese are trying to make themselves as self-reliant as possible and seem to be managing it quite well. China’s demand is so large that it will be importing coal for a long time and it remains to be seen who else would be willing to finance infrastructure in China – other than the Chinese. Poorer countries, like Morocco, are developing new energy resources to make them more economically competitive by exploiting their solar resources, reducing energy imports and possibly exporting energy in the future. The energy landscape continues to change dramatically across the globe as the U.S. moves from being an energy consumer to a producer, China transitions from an energy exporter to an importer and Israel develops new resources in the Mediterranean Sea.

Bronson also emphasized that the U.S. is more energy secure but not energy independent. Although there are 3 million more barrels of oil going on the market per day from new resources the market has lost just as much from political turmoil in other parts of the world. Even if oil from the Middle East doesn’t flow to the U.S. it will flow to Asia and the Middle East will remain a strategically important place in the energy landscape. For example, Saudi Arabia has been the global “swing producer” of oil because it doesn’t produce to capacity and has been able to put more oil on the market in response to a crisis. But if, for some reason, Saudi Arabia can no longer play this role as the swing producer (i.e. due to the lack of a smooth political transition, etc.) oil prices could still shoot to $200 per barrel.

Bronson concluded with a sobering warning on the riskiness of Germany’s huge bet to transform its economic base through its tremendous shift to renewable energy sources and a more climate-sensitive economy. She indicated that we should be paying daily attention to Germany’s energy plan because if it doesn’t work then it could pull down the German economy and much of Europe as well. The problems include the fact that the energy resources are far away from the demand centers and Germany lacks the infrastructure to get the energy to where it’s needed. In addition, electric prices in Germany are currently twice the cost of the U.S. and that may push more energy intensive companies out of the country. As Germany attempts to replace its nuclear power resources with renewables it’s incurring huge costs, with no guarantee of a reliable outcome, and increasing its reliance on coal. Japan is wresting with the same issue in a country where they rely on energy imports for over 90% of their demand and finding that it’s very difficult to turn off the nuclear plants.

Investment Opportunities Across the Energy Value Chain (Panel 2)

Herve Wilczynski, Partner at A.T. Kearney in Houston with over 20 years of oil and gas experience, moderated the second panel and transitioned the discussion from the geopolitical and macroeconomic environment to sector-specific investment ideas. Wilczynski underscored the magnitude of the shift in energy to North America with the fact that Exxon/Mobil, one of the global super majors, is relocating its headquarters to a massive facility in The Woodlands near Houston, Texas. He observed that it’s hard to image that on April 5, 2005 Federal Reserve Chairman Alan Greenspan said, “North America’s limited capacity to import liquefied natural gas (LNG) has effectively restricted our access to the world’s abundant gas supplies.” And today the U.S. is playing in a global energy world with Russia and Qatar. Wilczynski introduced the members of Panel 2 which were Mr. Mark Ermano, Vice President Chemical Market Insights at IHS Chemcial, Mr. Terry Smith CFA, Executive Director, Head of Credit Research – Americas at UBS Global 
Asset Management, Mr. Anthony “Tony” Lindsay P.E.R&D Director – Advanced Energy Systems Group – Gas Technology Institute (GTI) and Mr. Ron Mullenkamp CFA, a professional investment manager and founder of Mullenkamp & Company, Inc. The panel probed the factors that could impact the sustainability of the U.S. energy revolution including regulatory, infrastructure, labor shortages, etc. and were generally bullish about the the prospect of significant demand growth in areas like chemicals, transportation, power generation and a number of other areas noted below.

Base chemicals and plastics drive a renaissance in U.S. manufacturing

Mark Ermano, Vice President Chemical Markets Insights at IHS Chemical, quickly made the connection to our day-to-day lives on the “far right hand side of the energy value chain” and explained that chemical industry is producing plastics which enable modern living through thousands of durable and non-durable goods like cars, phones, trash bags, etc. all derived from energy feedstocks on the left side of the energy value chain such as oil, natural gas, coal or biomass which are transformed into different chemicals and eventually into the retail goods we use every day.

The energy revolution has created a North American manufacturing renaissance in the United States. Chemical plants require three basic things to beat the competition. First, access to a low cost Btu feedstock for a long period of time that allows the plant to earn its return on and of capital. Importantly, the cost of new refining or derivative complexes can range from $20 million to $50 million per plant. Second, locating new plants where demand is growing the fastest reduces logistics costs and provides a competitive advantage. Third, use of the right chemical manufacturing technology provides a competitive advantage. BASF’s announcement that they will not use steam cracking but go directly from natural gas to propylene in a world-scale methane-to-propylene complex in the U.S., which requires three times the conventional investment, clearly demonstrates their favorable long-term market view of U.S. natural gas supplies and pricing.

Today, due to the abundant new supplies of low cost natural gas in the United States, we are seeing a massive wave of new investment in the U.S. petrochemical industry to bring new capacity on line in the 2015-2020 timeframe. Previously, the petrochemical industry was building abroad and the U.S. had not added a new cracker since 2000. However, we now expect to see an ethylene-based cracker built in the United States by the end of 2015. These investments will require huge amounts of basic infrastructure, labor, iron, ironworkers, welders, electricians, etc. Furthermore, since demand in the U.S. market is forecasted to be relatively stable most of the new products derived from these chemicals will be exported and new infrastructure companies will be needed to support that function. China’s emerging middle class is expected to reach the purchasing power of the U.S. consumer in the next 5, 10 or 15 years and other emerging economies will drive demand. Finally, watch for new foreign flows of investment capital into the U.S. chemical market.

Potential Winners: Midstream companies. Feedstock companies. North American fundamental gas, ethane and chemical derivatives manufacturers – now seeing the highest levels of profits ever experienced as higher-cost producers abroad set the price and low-cost U.S. producers extract high levels of margin in that chain. Winners may include base chemicals and plastics manufacturers like BASF and SABIC. Also, infrastructure providers, pipe, valves, iron, welders, electricians, etc.

U.S. energy infrastructure expands in many directions…

Terry Smith CFA, Executive Director, Head of Credit Research – Americas at UBS Global
 Asset Management, believes that North America will have an economic advantage from shale gas for at least the next two decades. Furthermore, the U.S. will be in a position to export its shale gas/oil intellectual property, engineers, patents and designs to the rest of the world. He sees more natural gas liquids (NGL) fractionation plants being built and noted that there are 14 new LNG facilities currently being planned.

This reindustrialization of North America drives demand for everything from infrastructure and labor to chemicals, coatings, and technology start-ups unrelated to IT. And many of those workers buy new pickup trucks, which boosts the auto industry, as well. Solar and wind farms also benefit from low cost natural gas prices because these facilities need a reliable source of backup power from a combined cycle gas turbine. The transportation sector will see more long-haul trucking converted to LNG while ethanol producers may transition to isobutenol as an oxygenator. Smith suggests that water handling will be an area of enormous opportunity due to the amount of water necessary for fracking and the difficulty to transport this amount of water by truck which could lead to new long-haul fresh water pipelines. And more water will also be needed to clean the solar panels and wind turbines. That revolution in water technology will also provide a boost to agriculture, and to potable water for cities and industry. Finally, Smith observes that most of the new solutions will not eliminate the others so investment analysts should focus their research on the cost/benefit of the opportunity, the market size and the competition.

Potential Winners: Wind and solar farms. Combined-cycle gas turbines. Natural gas liquids (propane, butane, ethane, etc.). U.S infrastructure and labor providers. LNG tank manufacturers for long-haul transportation (tanks, valves, hoses, etc.), LNG for locomotive engines, tugs, barges and ferries. Increasing demand for carbon fiber. Water handling and transportation.

The third time’s a charm … natural gas as a transportation fuel.

Anthony “Tony” Lindsay P.E.R&D Director – Advanced Energy Systems Group – Gas Technology Institute (GTI), explained that the U.S. is currently in its third major “wave” of developing natural gas as a transportation fuel. The first wave occurred as a result of the perceived oil shortages in the mid 1970s and some new natural gas vehicle products were developed at that time. However, when gasoline prices dropped, the wind was taken out of the sails of the first wave. The second wave was driven by two key pieces of U.S. legislation: the Clean Air Act Amendment (CAA) of 1990 and the Energy Policy Act of 1992 (EPACT-92). The tighter vehicle emissions standards of the CAA led the big three automakers to produce a number of new natural gas vehicle offerings including the Ford Crown Victoria, F-150 pickup trucks, cargo and passenger vans, Chevy Cavalier, pick-ups and full-size vans, and Chrysler also introduced its B-series vans for compressed natural gas (CNG). In addition, the EPACT-92 mandated certain fleets of vehicles to switch from gasoline or diesel to alternative non-petroleum energy sources like natural gas. However, the legislation lacked significant penalties, there was not much “pull” from fleet owners because the economics were only marginal, and the second wave also crashed to the shore. Today, we’re in the third wave and Lindsay believes it’s a “perfect storm” for natural gas vehicles (NGVs) because the economics are favorable, environmental concern is high and the U.S. has an abundant, low-cost supply of natural gas from the shale revolution that can finally provide the U.S. with the energy security that was previously lacking.

Lindsay explained that approximately 26% of the energy consumed in the United States each year is from natural gas. And the U.S. uses approximately 95 quads (quadrillion BTUs) of energy per year. Yet, the transportation sector uses less than 1% in vehicles (which is only about 140,000 natural gas powered vehicles) while the top five nations using natural gas vehicles are Iran, Pakistan, Argentina, Brazil and India, each with over 1 million NGVs on their roads! After evaluating the U.S. NGV market, Mr. Lindsay believes that high-usage, heavy-duty vehicles represent the best opportunity for near-term growth because these vehicles consume from 5,000 to 30,000 gallons of fuel per year and that produces enough savings to justify the incremental vehicle and fueling investment cost thereby creating a 1.3 Tcf/yr growing market for gas as a transportation fuel. Notably, Waste Management’s (WM) fleet of about 1,700 CNG and LNG vehicles is the largest in the waste industry. Although the light-duty car and truck market is as large as 16 Tcf/year those vehicles typically consume only about 1,000 gallons per year and the U.S. currently lacks a robust compressed natural gas refueling infrastructure to conveniently support them. However, if a low-cost natural gas home refueling device could be developed then it may be a significant game changer in the light-duty market.

Potential Winners: Refuse haulers, cement mixers, regional fleets with the ability to refuel at a central location, fleets of taxis serving airports, CNG/LNG storage tank manufacturers and those that make the materials that go into the tanks, lighter weight higher strength composite cylinders with carbon fiber wrap, high pressure gas components, hoses, fittings, meters and valves. Manufacturers of heat exchangers used in the LNG industry as well as engine manufacturers serving medium and heavy-duty truck applications.

Natural Gas: An Energy Game Changer

Ron Muhlenkamp CFA, a professional investment manager, founder of Muhlenkamp & Company, Inc. and author of “Ron’s Road to Wealth: Insights for the Curious Investor,” provided an astounding range of perspectives from his experience as a farmer, investor, engineer (M.I.T) and Harvard M.B.A. Mr. Muhlenkamp’s farm sits directly on top of the Marcellus Shale in Butler County, Pennsylvania and he began by providing the audience a real education on natural gas from his booklet entitled “Natural Gas: An Energy Game Changer” 

First, in Figure 1 below, he points out that natural gas has been priced significantly below crude oil on an equivalent price per MMBtu basis since 2009. This dramatic divergence in price is huge since the two have been fairly close on a $/MMBtu basis since 1995. While many in the Northeast still heat their homes with oil those who have converted to natural gas are now realizing significant savings due to the availability of low cost natural gas.

Figure 1 Natural Gas and Crude Oil Prices, 1995-2013

Source: Bloomberg; Oil; Generic 1 ‘CO’ Future, Natural Gas; Generic 1 ‘NG” Future delivery to Henry Hub

Second, in Figure 4 below, he shows the steadily increasing use of natural gas for U.S. electric generation since 1996 and the corresponding decline in the use of coal-fired generation. Utilities switch from coal to gas-fired generation at about $3.00 per Mcf so more access to lower-cost gas supplies reduces both home heating costs and electric bills.

Figure 4 Percent of Total U.S. Electricity Net Generation: Electric Power Sector by Energy Source, 1960–2012

Source: U.S. Energy Information Administration; Electric Power Monthly. Table 7.2b and 8.2b

Third, Figure 5 shows that Barnett Shale fracturing began in 1997, Marcellus shale in 2005 and Bakken Shale in 2008. Importantly, U.S. oil and dry natural gas proved reserves began increasing dramatically after these events reaching 29 Tcf of gas and almost 27 (bnb) billion new barrels by 2011. Muhlenkamp notes that the U.S will be drilling the Marcellus Shale for a long time and in fact has more supply than available pipeline takeaway capacity to deliver it to New England. Bottom line, the last five years have been an energy game changer!

Figure 5 U.S. Oil and Dry Natural Gas Proved Reserves, 1979-2011

From an environmental standpoint, Mr. Muhlenkamp points out that by switching from coal to natural gas the carbon content of the fuel source is cut by more than 50%. From a land use perspective, if we consider the fact that 80 windmills are equivalent to about 10 gas wells then wind farms are not be as “clean” as we might think. In addition, although fracking requires significant amounts of water most people don’t know that burning 1 Mcf of natural gas produces 11 gallons of fresh water in vapor form. Mullenkamp turns the equation on its head by stating that by burning natural gas you produce fresh water at 8 cents/gallon and you get the energy for free. Going further, if you use salt water for fracking (subject to salinity limits in the wells) the well effectively becomes a desalinization plant. Agreeing with many of the other speakers, Mr. Muhlenkamp also believes we are taking a step “backward” when we produce fuel (ethanol) from food (corn) since historically farmers increased food production only after moving from horses (which required acreage to feed them) to tractors.

Potential Winners: Natural gas pipelines. Labor markets where skills to work in the oil and gas industry can be acquired in 12 to 18 months at junior colleges. Natural gas consumers – benefiting from prices at $3.00 to $5.00 Mcf but putting pressure on producers where break even is at about $3.00 per Mcf. Producers benefiting by drilling horizontally 5 to 8 times, in different directions, from the same gas pad saving approximately $500,000 per well. Also see p. 52 of “Natural Gas: An Energy Game Changer.

Chairman’s Message: Society Update

Let me begin with a thank you to CFA Chicago’s Governance & Nominating Committee for entrusting me with the role of Chairman.  It’s a distinct honor to lead the oldest Investment Analyst Society in the world.  Positioning our 89-year-old brand for the future, delivering relevant and cutting-edge programming, and enhancing member value are our top priorities.

As our board and officer volunteers change annually, I have worked extensively with our Vice Chair Kerry Jordan, CFA, to create a long-term vision for our enterprise.  Kerry and I are just back from a CFA Institute Society Leaders Conference in London where best practices and future opportunities for our profession were exchanged.  The key takeaways from London for me are:  the U.S. asset management business is very dynamic and mature, and globalization remains apace at an increasing rate.

With respect to international financial services and investing, the five newest Societies in the CFA Institute family are Qatar, Norway, Peru, Lichtenstein, and East Africa.  And while the U.S. base of Charterholders remains the core membership, the candidate population and growth rates in international markets are much higher, and more diverse, than in the United States.

As I write this, the Chinese e-commerce firm Alibaba’s IPO is set to price this evening.  On a market cap basis, four of the top 10 internet companies will be based in Asia, up from two in 2004.  One of my London partners said this is evidence of “China’s capitalistic system writ large.” We are an international profession and we must continue to think globally.

Our Society is positioned quite well with 4,300 members, talented volunteers, dedicated staff, and because of thoughtful stewardship, strong financial resources. Resting on our laurels, however, is not what Kerry and I and the board can or will do.  As the 6th largest and original Society, we must be strategic about our industryand what role Chicago’s financial services community and professionals will play as we move toward our 90th year and beyond.  Thankfully, our leadership team and board are embracing the challenges we face in this dynamic environment.

Lastly, let me express great appreciation for an outstanding membership.  Your time, energy, ideas, and ethical practices are the most valuable asset we have.  Please get involved, stay committed, and then recruit a fellow professional to take your place in the future.  I hope to see you at our annual dinner in October.

Navy Pier Tall Ship Networking

An intrepid group of approximately 50 seafaring CFA Chicago members and guests boarded the Tall Ship Windy at Navy Pier for a memorable evening architectural tour of the Chicago skyline and networking voyage on July, 22, 2014. The event was hosted by the Social Advisory Group.

Tall Ship Windy at Navy Pier

Tall Ship Windy at Navy Pier

The Windy is the only 148-foot traditional four-masted gaff topsail “pirate” ship in Chicago. Before departing, our pirate guide “Trooper” informed all passengers of the safety precautions and enforcement policy …“No smoking or you will be thrown overboard!” And then, he competently guided the tour, which lasted just over one hour, from Navy Pier to the Adler Planetarium (and back) while providing an entertaining history of Chicago and its architecture including both legend and lore.

Trooper began by asking the passengers about the cause of the Great Chicago Fire that lasted from October 8, 1871 to October 10, 1871. Although Mrs. O’Leary’s cow came to mind for most, even before cocktails, Trooper explained that the reporter who wrote the O’Leary account later admitted he made it up as colorful copy and the City of Chicago exonerated Ms. O’Leary in 1997. Half way through the voyage the crew suddenly shouted “Prepare to Jibe! Prepare to Jibe!” and relayed that message all the way from the ship’s stern to its bow. Hearing this command, several CFA Charterholders instinctively thought it was time to bust out their best dance moves but soon realized they were just preparing to turn the boat (Oh, they said jibe – not jive). The jibe, opposite of the tack, is a turning maneuver in which the stern of the boat passes through the wind rather than the bow.

Tall Ship Windy at Navy Pier

Tall Ship Windy at Navy Pier

Trooper went on to explain that Chicago is called the “Second City” because it was rebuilt on the embers of the first city after the Chicago Fire by architects and designers like Louis Sullivan (“the father of skyscrapers”) and Daniel Burnham (City Planner and Director of Works for the World’s Columbian Exposition in Chicago 1893). He artfully told a number of stories about a variety of buildings including the 311 South Wacker Building (the crown was redesigned to be a replica of the wedding ring given to the architect’s fiancé), Willis Tower (elevators traveling 1,600 feet per minute are among the fastest in the world), John Hancock Center (its trapezoidal structure and legend inspiring Harold Ramis’s diabolical building in “Ghostbusters”) and Lake Pointe Tower (standing alone east of Lake Shore Drive) to mention a few. Overall, the voyage was smoother than a metra train commute and provided a fun and educational networking experience.

 

Distinguished Speaker Series: Rick Rieder, Managing Director, BlackRock

The Distinguished Speaker Series hosted Rick Rieder whose other duties include Chief Investment Officer of Fundamental Fixed Income for BlackRock and Chairman of the BlackRock Investment Council. BlackRock is the largest asset management firm, now managing over $4.3 trillion for clients worldwide.  In 2013 Mr. Rieder was inducted into the Fixed Income Analyst Society Hall of Fame.  He was introduced by James Franke, Co-Chair of CFA Chicago Distinguished Speaker Series Advisory Group.

Rieder’s presentation was entitled “The New Economic and Investment Regime”.  His thesis is that economic forecasting and investing is now dependent on the following four critical factors; 1. Demographics, 2. Leverage, 3 Technology, and 4 Monetary Policy. He went on to demonstrate how each of these factors works to influence the economy and therefore interest rates. His thesis is that growth will be slow and the yield curve will continue to flatten.

Rather than simply alluding to an aging population, Rieder pointed out the employment problem and the financial burden of high student debt on the younger population. The demographics lead him to conclude that current consumption and spending trends will remain low. The implications of leverage in developed and emerging markets point to the continued availability of cheap financing. Rates in the US and UK could grind higher in the context of a flat yield curve. Rieder concluded that technology has created the biggest headwind against inflation and will continue to suppress levels of employment.   With respect to monetary policy, Rieder points out that an important by-product has been that long-dated Treasuries have become scarce due to less supply needing to be issued, continued strong foreign buying and demand for long-dated assets from pension funds and insurance companies.

Rieder concluded by suggesting which asset classes have the best potential for appreciation.  He strongly recommended long-dated municipal bonds as there is very little issuance.  Short dated ABS and CLO’s are also attractive in this environment. Rieder is bullish on the equity market given the cheap financing presently available to corporations, he predicts this will persist.

There was a brief question and answer period following the presentation. On the question of what affect exiting QE might have on the capital markets, Rieder stated that although history says differently, he did not think a big equity sell-off would occur. In response to another question, he thought that high-yield was fundamentally sound and although there would be a pause, it would not suffer big outflows.