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.

Distinguished Speaker Series: Mario Gabelli, CFA , Chairman and CEO, GAMCO Investors

Nicknamed “Super Mario” by financial media pundits, Mario Gabelli, CFA , Chairman and Chief Executive Officer of GAMCO Investors, Inc., presented his ideas on shareholder activism to a sold out crowd at the University Club on Aug. 12, 2014.

The idea that activists are catalysts was center to this Charterholder’s presentation. Teeing up that idea, he gave us insight into the philosophy and investment thesis that GAMCO follows with several quotes: “If you drink it, we follow it, and if you watch it anywhere, we follow the content”.  What and who have influenced him?  He noted Graham and Dodd and Security Analysis as being the definition of value investing and Roger Murray, his professor at Columbia Business School as having a large influence on his decision to go into investment management.  Gabelli’s unique sense of humor bubbled through as he compared Mount Rushmore to the four professors who created value investing.

Given these influences, his investment process is very similar to what Graham and Dodd taught in the 1930s.  So, what twist does Gabelli put on value investing?   He looks at private market value – intrinsic value plus a control premium with a catalyst.  Catalysts bring underlying value to the surface and include regulatory changes, industry consolidations, death of a founder, share repurchases, division sales, management succession and finally, shareholder activism.

Activist hedge funds net asset inflows were 5.3 billion in 2013 with 59% of activist objectives achieved in 2013.  Gabelli walked us through various models of shareholder activism touching on big names and big results such as Carl Ichahn, Jeff Ubben, George Hall and David Einhorn.  He pointed out that Carl Ichahn’s model works because there is demand for it.  When discussing shareholder rights and the “poison pill”, Gabelli advocated that GAMCO votes against it per their Magna Carta of shareholder rights. After all, it is all about the shareholders who own the company.

The presentation wrapped up with a discussion of companies in our own Chicagoland backyard who have either split and created value or have the potential to create value with a split.  As a final nugget of wisdom before the Q&A, Gabelli recommended The Graduate as an important movie because as you watch a young Dustin Hoffman receiving advice on what he should do with his career, you realize this is defined the attitude of people in the ‘60s or ‘70s.  What movie will define the times we are living now?

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.

Distinguished Speakers Series: Rob Arnott, Chairman & CEO, Research Affiliates

A provocative presentation entitled Conventional Wisdom and Pseudo-Science: Are we Blinded by Theory? took place in front of a sold out audience of 176 on June 19 at the Metropolitan Club. Rob Arnott, Chairman & CEO, Research Affiliates was the speaker who generously shared his unconventional thoughts in debunking several core theories of finance.

His objective was to take us on a whirlwind tour of areas where conventional wisdom can often lead one astray. The premise of Arnott’s talk is that much in the world of finance masquerades as science, but is not. When theory and data conflict the standard reflex is to dismiss the data.

In assuming that theory is correct, one must tacitly assume that all assumptions are correct. Unfortunately, assumptions are oftentimes incorrect, and is the cause of the fissures between theory and reality.

Almost every popular theory of finance can be debunked in some way based on a flaw in the assumptions required to make the theory work.

Efficient Markets, Miller-Modigliani, Modern Portfolio Theory, CAPM, Black Scholes, Cox-Ingersoll-Ross, Behavioral Finance, etc.  –- they all can be taken down in an imperfect world where reality does not cooperate with the assumptions.

An easy example to refute the efficient market theory in the equity markets considers empirical data involving the Top Dog in a sector.

The Top Dog is ranked #1 by market capitalization in a sector, a market, a country, or the world.

To get to Top Dog status requires outperformance. Over the preceding 5 year period, the Top Dog in the US outperforms the broad market by 20%. A global Top Dog outperforms the average stock in the world market by an even more impressive 40% in the 5 years leading up to becoming the Top Dog.

Going forward one might expect equal performance by the Top Dog according to the Efficient Market theory. However, reality suggests underperformance. And not just a modest level of underperformance, data suggests the Top Dog underperforms the market vastly in the ensuing 5 year period. In fact, the entire gain that got them to Top Dog status is often given up as the Top Dogs generally deliver less than bonds and cash. Is this a peculiarity? Or simply evidence that markets are not as efficient as theory suggests?.

Arnott suggested that history could taken a different course. What if, instead of advancing efficient markets in 60’s, there was a promotion of deranged markets. The market is always missing and trying to mean revert?  It would explain anomalies.   What if a DAPM (disorderly asset pricing model) involving mean reversion was advanced? The Nobel Prize might have never been granted to William Sharpe for CAPM and his extension of Markowitz’s portfolio theory.

Refuting CAPM was an easy target as the theory assumes everyone on the planet can borrow or lend at the risk free rate while ignoring taxes and a host of other real factors.  If all of the CAPM assumptions rang true, the theory proves you cannot beat a cap weighted market. Because the assumptions are not true, the conclusion of CAPM theory must be taken as only an approximation of fact.

Working backwards, the assumptions allow for the mathematics to work out. Do not make the mistake of believing the theory proves that is how the world ought to work. Rather, the theory is totally expected given the assumptions. When empirical gaps exist between data and theory, do not automatically assume the data is wrong or bend it in order to justify the theory. Just as important as knowing the theory is to perform a judicious search for gaps in the assumptions.

In summary, Arnott left the audience with a prudent message. Theories are wonderful, and it is not necessary to disregard theory. However, please do not confuse theory with fact. It is not.