Sustainable Investing: Profit with a Purpose

The art of investing requires a broader skill set—more perceptive thinking, insight, intuition and even an awareness of psychology—things that Howard Marks, Co-Chairman of Oaktree Capital Management, refers to as “second-level thinking” in one of my favorite books on investing: The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor (46).

The purpose of this article is to stretch your second-level thinking skills. Specifically, we will explore how investors (private, institutional and asset managers) can make sustainable and responsible investment choices by carefully analyzing environmental, social and governance (ESG) issues within the investment decision-making process. In short, it’s about reducing risk and generating return while investing in firms that add value to society—producing profit with a sustainable purpose.

ESG for Alpha

On Feb. 19 CFA Society Chicago explored these issues at a conference entitled “ESG for Alpha” where top investment managers and institutional investors gathered to discuss the past, present and future of Sustainable, Responsible and Impact investing (SRI). As the conference title implies, a key question is whether ESG issues can be used to produce superior risk-adjusted returns (or alpha) that beat the market —but more on that later.

John Mirante, CFA, CPA, and Senior Relationship Manager, BMO Global Asset Management welcomed the audience and explained that there’s currently a plethora of terminology used to describe investments that take ESG issues into account including: sustainable investing, ethical investing, socially responsible investing, responsible investing, green investing and impact investing. While there are some distinctions between these terms they all generally emphasize two key factors (1) a long-term investment horizon and (2) ESG issues.

ESG Issues

Let’s start with the basics. Although there’s no “single list” of ESG issues, and not every issue fits neatly into just one category, we do have a general understanding of the major issues:

Environmental Issues: Carbon emissions, greenhouse gas emissions, climate change impact on company (risk exposures and opportunities), ecosystem change, facilities citing environmental risks, hazardous waste disposal and cleanup, pollution, renewable energy, resource depletion and toxic chemical use and disposal.

Source: CFA Institute, “Environmental, Social and Governance Factors at Listed Companies: A Manual for Investors” (May 2008).

Social Issues: Customer satisfaction, data protection and privacy, diversity and equal opportunities, employee attraction and retention, government and community relations, human capital management (including training and education), human rights, indigenous rights, labor standards (including freedom of association and collective bargaining, child labor, forced labor, occupational health and safety, living wage), product misspelling, product safety and liability, supply chain management.

Source: PRI, Principles for Responsible Investment (in partnership with UN Environment Programme Finance Initiative and UN Global Compact),”Responsible Investment in Private Equity: A Guide for Limited Partners,” 2nd ed. (June 2011): 25.

Governance Issues: Separation of CEO and Chairman roles, appointment of independent lead director, independent compensation and nomination committees, audit committee independence, ration of non-audit to audit fees paid to the assigned auditor, CEO compensation as a % of cash flow, fair value of share-based compensation expense as a % of cash flow, ownership blocks greater than 5%, staggered board, poison pill, unequal voting rights.

Source: Goldman Sachs Global Investment Research, “GS SUSTAIN: Challenges in ESG Disclosure and Consistency” (October 2009):6.

Why do ESG issues matter?

Bruno Bertocci, Managing Director and Global Equity Portfolio Manager, at UBS Global Asset Management (Americas) Inc.really put it all into perspective when he described ESG issues as “material non-financial factors.” In other words, ESG issues are rarely quantified in the cold, hard financial data of the annual 10-K or quarterly 10-Q. Yet, they can be material and significantly impact future cash flows and firm valuations. They are hard to quantify but can be incredibly important to the investment decision-making process. As one famous physicist once said:

“Not everything that counts can be counted and not everything that can be counted counts.” Albert Einstein

You might recognize Mr. Bertocci’s approach as solid fundamental analysis. It’s the part of investment analysis that’s more art than science. Bertocci explains, “I’ve really always thought about it this way.” He explains that he went to work for T. Rowe Price when he got out of business school. But Bertocci notes, “I didn’t know how to pick a stock with my chemistry background.” Then, he reviewed T. Rowe Price’s notebooks on DuPont in the company library on their new product—nylon. Price had gone to the dime-store and observed that, “The ladies loved nylon. It was cheaper and lasted longer.”

Mr. Price’s observation was not a financial factor but Bertocci reminds us that it must be material and it must impact the business product—otherwise you are just wasting your time.

Bertocci also explains that material non-financial factors are data that can confirm or deny your expectations in the tails of the distribution. In other words, the stock might appear cheap on a discounted cash flow basis but ESG factors may reveal it’s a deteriorating business model. He believes ESG factors are an extension of mosaic theory and should be ranked in conjunction with the financial data. By doing so, you improve your information coefficient.

Again, I’m reminded of Howard Marks who says,

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

Today, Bertocci expects his day-to-day analysts to gain access to ESG information because he believes it’s predictive of future returns. He wants a technology analyst to compare Intel to Taiwan Semiconductor and then to have a conversation about the energy efficiency of one versus the other. Bertocci goes on to explain, “In my experience, the really big money is made with a long-term perspective that the market does not recognize.”

Creating Shared Value

Time for a short commercial break. By now, you probably agree that evaluating material non-financial ESG factors can add value to the investment process. But which firms are good at creating value in a “sustainable” fashion? And what does that really mean anyway?

In this regard, Bertocci recommends reading “Creating Shared Value” by Michael E. Porter and Mark R. Kramer, Harvard Business Review, January 2011 issue. In short, Porter and Kramer argue that creating societal value is a powerful way to create economic value for a business. In fact, there are vast unmet needs in the world and businesses that meet societal needs will significantly differentiate themselves and enhance their competitive position.

Creating value for the business and the community does not have to be a zero sum game. It doesn’t have to be an either or dilemma of profit that comes at the expense of the community. Think about expanding the pie rather than slicing it up and you have a positive sum game. It’s about doing good and doing well at the same time.

Principles for Responsible Investment (PRI)

Sustainable investing is moving much faster on the other side of the pond. Vicki Bakshi, Head of Governance and Sustainable Investment, F&C Investments explained that the United Nations-supported Principals for Responsible Investment (PRI) initiative is ubiquitous! She reports that there has been more forward thinking on ESG issues in Europe than in the US for a long time. Bertocci agrees and says, “you can’t win a public fund mandate in Europe if you don’t know the ESG issues.”

Today, there are 1,325 signatories to the PRI initiative representing asset owners, investment managers and service providers with $45 trillion (USD) in assets under management. These signatories voluntarily commit to recognizing the materiality of ESG issues by adhering to the following six principles:

  1. We will incorporate ESG issues into investment analysis and decision making.
  2. We will be active owners and incorporate ESG issues into our ownership policies and practices.
  3. We will seek appropriate disclosure on ESG issues by the entities in which we invest.
  4. We will promote acceptance and implementation of the Principles within the investment industry.
  5. We will work together to enhance our effectiveness in implementing the Principles.
  6. We will each report on our activities and progress towards implementing the Principles.

Importantly, Bakshi describes F&C’s process of digging deeper in their requests for proposals (RFPs) to uncover the actual extent to which ESG factors are incorporated into asset manager’s investment decision-making process. Bakshi says, “we want to differentiate [ourselves] from tick boxes with six pages of questions on ESG factors. We ask (1) what is your process? and (2) give me examples of when your valuations changed as a result of ESG factors.” Today, Bakshi sees more engagement by institutional asset owners voluntarily reporting on stewardship in their mainstream reporting. In addition, she points out that the Dutch are the most advanced in this area today and it’s also spreading to even larger funds.

ESG Methodologies

Lucas Mansberger, CFA, CAIA, Consultant with Pavilion Advisory Group Inc., facilitated a panel discussion with asset owners to discuss how they incorporate ESG issues into their investment process. The audience agreed with Mansberger as he emphasized that ESG questions on RFP’s are becoming increasing more detailed and difficult to answer.

Given the incredible economic and social importance of ESG issues, not to mention the growing scale of ESG investing ($45 trillion), it’s critical for asset owners and managers to be proficient in applying practical methods to address ESG issues within their investment decision-making process. The most common “ESG methodologies” to accomplish this are:

  • Active Ownership
  • Best in Class Selection
  • ESG Integration
  • Exclusionary Screening
  • Impact Investing
  • Thematic Investing

For most people, exclusionary screening is the first thing that comes to mind. Simply put, it’s avoiding certain companies based on ethical concerns or norms. Kristy Jenkinson, Managing Director Sustainable Investment Strategies,Wespath Investment Management, explained that Wespath excludes firms that earn significant revenues from gambling, alcohol, tobacco, pornography, weapons and the operation of prison facilities as part of their ethical exclusions. Wespath is a division of the General Board of Pension and Health Benefits of the United Methodist Church with approximately $21 billion under management.

Likewise, William Atwood, Executive Director for the Illinois State Board of Investment (ISBI), indicated that the State of Illinois has a number of statutorily mandated investment exclusions. These include a Sudan Divestment Policy for human rights violations and exclusions of oil-related and mineral extraction sectors in Iran due to current US sanctions against Iran for seeking to acquire weapons of mass destruction and for supporting international terrorism. The ISBI is responsible for managing the over $ 15.1 billion in assets for Illinois’ General Assembly Retirement System, Judges’ Retirement System and the State Employees Retirement System.

Atwood also explained that ISBI’s investment managers proactively look for buildings that meet LEED green building standards because they add value to the portfolio of properties and have an impact on the bottom line. In addition, ISBI looks for minority and female-owned brokerage firms and investment managers as well. In this regard, Atwood notes that the inclusion of “non-Wall Street” managers provides ISBI with additional diversification of investment and operational risk.

In addition, both Jenkinson and Atwood are engaged in active ownership in which they aggressively vote on proxy issues and engage with management on key issues. Atwood’s been involved in “say on pay” issues to address executive compensation and Jenkinson mentioned engaging on climate change and human rights issues. Bertocci also pointed out that the very best analysts think about management quality, governance and how management incentives benefit shareholders and drive behavior.

ESG Integration refers to making explicit inclusion of ESG risks and opportunities alongside traditional financial analysis but does not necessarily require a peer group comparison like best in class selection. And best in class selection prefers companies with better ESG performance relative to their sector peers.

Wespath was a primary signatory to the United Nations Principles for Responsible Investment (PRI) and asks all of their money managers to adopt it—and about 80% of them have. Wespath then benchmarks its managers against their peers to assess their ESG integration. This assessment includes comprehensive questions on who reviews and approves the ESG policy, how often it’s updated and how it’s incorporated into compensation, training and performance.

Impact investing attempts to generate and measure social and environmental benefits along with a financial return. Finally, thematic investing is based on emerging trends such as social, demographic and industrial trends. But how can a money manager or an institutional investor effectively measure “sustainability?” The good news is that new standards for sustainability reporting are improving dramatically.

Sustainable Accounting Standard Board (SASB)

Jenkinson points out that many corporate sustainability reports are “murky at best and terrible at worst.” Often, corporate sustainability reports simply highlight only corporate charitable contributions and the annual volunteer day in the community. Fortunately, Bertocci and Jenkinson point out the value of SASB and its work to help organizations identify material, decision-useful information for investors.

The Sustainable Accounting Standards Board (SASB) is a 501(c)3 non-profit that helps corporations disclose sustainability information that’s useful to investors. Importantly, the SASB Materiality Map can help companies and investors identify issues that are most likely to be material on an industry-by-industry basis (e.g. health care, non-renewable resources, financials, technology and communications, transportation and services). Then, for example, within the non-renewable resources industry the map identifies the sector (e.g. oil and gas midstream) and then identifies certain environmental issues (GHG emissions, air quality, biodiversity impacts) and, in this case, governance issues (accident safety and management, competitive behavior) that are most likely to be material for more than 50% of the industries in the sector.

Ultimately, Bertocci would like to imagine a world where there is a willingness of the company to adhere to SASB standards and willingly move sustainability data into the body of mock 10Ks. Then, Bertocci says the information must be provided to the firm’s external auditors so that reasonable assurance can be provided on the materiality of the reporting.

Jenkinson expressed less interest in the form of the reporting (e.g. integrated as one report or as a separate ESG report) but emphasized that she wants to know if the firm is really integrating ESG issues in the actual strategy and risk management activities of the firm.

The Elephant in the Room – Alpha

Linda-Eling Lee, Ph.D., Global Head of Research for MSCI’s ESG Research Group, who moderated the asset manager panel discussion, addressed the elephant in the room by asking, “Does ESG hurt your returns? Yes or No?”

Let’s face it, professional investors and academics know its difficult to generate alpha and consistently outperform the market due to skill rather than luck. TheEfficient Market Hypothesis (EMH), in all of its forms, suggests that all available information is already incorporated into the price of a security and suggests that it’s essentially impossible to beat the market. Bertocci points out that even large asset managers still question active management. Even worse, there can be a general perception that ESG hinders returns.

Yet, Sir John Templeton, CFA, was an extremely successful investor who did not invest in businesses engaged in tobacco, alcohol, gambling and tobacco based on moral grounds (exclusionary screening). In addition, CalPERS (the California Public Employee Retirement System) has effectively engaged with underperforming companies and generated excess returns relative to their benchmark (CalPERS Towards Sustainable Investments & Operations – 2014 Report (15).

The short answer is that academic research studies on investments that take ESG factors into account show no consistent outperformance or underperformance (CFA Institute – ESG-100 Question #69). In other words, the studies have found no systematic bias either way. But clearly, the academic difficulty of attributing abnormal excess return (alpha) specifically to “E, S and G” factors alone won’t discourage successful investors from identifying incredibly valuable ESG issues (material non-financial factors) that can reduce investment risk, avoid losses and exploit opportunities for higher returns. Here are some examples:

Adam Strauss, CFA, Co-Chief Executive Officer of Pekin Singer Strauss Asset Management and Co-Portfolio Manager of theAppleseed Fund (APPLX, APPIX) says, “There are two important rules to remember about investing: Rule #1: Don’t lose money and Rule #2: Don’t forget rule #1.”

Strauss offers two examples of successful ESG investing. First, he explained that Pekin Singer Strauss looked at investing in BP in 2009; however, their analysis concluded that the company had a safety culture problem based on the March 23, 2005 BP Texas City Refinery explosion, the 200,000 gallon Prudhoe Bay oil field spill in March of 2006 and several other incidents. Therefore, Strauss avoided the 52% drop in BP’s stock price (from $60 to about $29) 50 days after the Deepwater Horizon accident on April 20, 2010. Strauss noted that the safety culture issue was not on the balance sheet but it was a material issue.

Secondly, Strass cited John B. Sanfilippo Inc. (JBSS) as having positive ESG factors prior to Pekin Singer Strauss’ investment five years ago. According to Strauss, JBSS has a responsible management team that’s well aligned with shareholders and stakeholders and an environmentally sustainable food product that’s good for human health that offers a high-quality source of vegetarian protein. Their nut products even take less water and land per pound of protein to produce than other sources of protein.

Vicki Bakhsi added that F&C Investments excluded Brazilian oil giant Petrobras for investments in 2012 due to their poor protection of minority shareholder voting rights. And, as we all know, corporate governance issues have continued to plague Petrobras as they are currently involved in a corruption scandal. F&C actively engaged with Hon Hai (Foxxcon), the largest manufacture of Apple products, by visiting their factories and found that their labor polices were generally good but monitoring and implementation was weak. One year after F&C engaged Hon Hai management on these issues their processes improved. That’s effective engagement on an important governance issue.

Finally, Bertocci reminds us that the incremental benefits of the “E” and the “S” (in ESG) really depend on the business. For example, at Adobe energy costs are not material but at a steel company they obviously would be significant. He says, “we must not paint the analytical process as the same for everyone.”

Fiduciary Duty

In the investment world, institutions like universities, hospitals, foundations and public and private pension plans have a fiduciary duty to the beneficiaries of their plans.

“A fiduciary duty is a legal duty to act solely in another party’s interests. Parties owing this duty are called fiduciaries. The individuals to whom they owe a duty are called principals. Fiduciaries may not profit from their relationship with their principals unless they have the principals’ express informed consent. They also have a duty to avoid any conflicts of interest between themselves and their principals and the fiduciaries’ other clients. A fiduciary duty is the strictest duty of care recognized by the US legal system.” Legal Information Institute, “Fiduciary Duty: Definition,” Cornell University Law School.

Atwood explained that ISBI has a fiduciary duty to maximize the risk-adjusted rate of return their pension plans. Ten years ago, Atwood noted that many asset managers felt it would be inappropriate to incorporate ESG issues into the investment-decision making process out of fear of violating fiduciary duty. Those who take this stand typically argue that it adversely affects financial performance. However, this view is changing today.

Notably, the international law firm Freshfields Brockhaus Derringer produced a report entitled “A Legal Framework for the Integration of Environmental Social and Governance Issues into Institutional Investment” in 2005 which covered nine jurisdictions (Australia, Canada, France, Germany, Italy, Japan, Spain, the United Kingdom, and the United States) and concluded that:

“…integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions.” (13)

Constituent Demands – Fossil Fuels

At the same time, institutions can face demands from their constituents (and organizations like 350.org) to divest from areas like fossil fuels out of concerns for the environment and global warming. In this regard, Australian Natural University (ANU), Stanford, University of Dayton, University of Glasgow (U.K.), Pritzer College and San Francisco State have opted to sell either their coal or fossil fuel investments. (See “Fossil Fuels Stir Debate at Endowments” by Dan Fitzpatrick, The Wall Street Journal 9 Sept. 2014) Furthermore, at the U.N. Climate Summit in September of 2014, more than 800 institutions and individual investors, with more than $50 billion in assets, vowed to divest from fossil fuels. On the other hand, Harvard, Yale, Cornell and Brown have elected not to divest.

The arguments for divestment are often for either moral or financial reasons. From a financial standpoint, some wonder if we are creating a “carbon bubble” from excess fossil fuel reserves on balance sheets that may never be burned and later resulting in stranded assets.

On the other hand, as reported by the Associated Press, Harvard’s Robert Stavins argues that divestment is largely a symbolic act—without much direct impact on CO2 emissions—that can distract from more meaningful activities. (See “Should Endowments Divest Their Holdings in Fossil Fuels?The Wall Street Journal 23 Nov. 2014.)

Moving Forward

In my opinion, the significance and materiality of ESG issues cannot be ignored in the investment decision-making process. They must be integrated into the process. We may debate the risks of global warming but few would argue that the air quality in Beijing or Shanghai is any good—so one way or another things will have to change. (See Chai Jing’s Under the Dome – Investigating China’s Smog) As a result, failure to understand how sustainability issues impact your investment portfolio can lead to significant risks and missed opportunities.

As Howard Marks says,

“Inefficiencies—mispricings, misperceptions, mistakes that other people make—provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance. To distinguish yourself from the others, you need to be on the right side of those mistakes” (342).

Additional ESG Resources

ESG-100 – CFA Institute, CFA Institute – ESG Resources, Environmental Markets: A New Asset Class

Dow Jones Sustainability Indicies, FTSE4Good Index Series, MSCI ESG Indexes,MSCI ESG Research Products

UNEP Finance Initiative, Carbon Disclosure Project – Driving Sustainable Economies, ISO 14000 Environmental Management Certification, GRI – Global Reporting Initiative

8th Annual Industry Roundtables for Investment Professional

By Calvin Chung, CFA, Bob Cohen, CFA, Peter Vinzani, CFA and Don Duncan, CFA

On Feb 10th, the Career Management Advisory Group organized the 8th Annual Industry Roundtables for Investment Professionals event.   This event is an opportunity to hear about different careers in investment management and to ask CFA Chicago members about their career paths and the challenges of working in their respective fields.

 

Business Valuations – Paul Clark, CFA; Houlihan Capital.

Paul Clark focuses on business valuations. His undergraduate degree in engineering taught him to focus on problem solving.  90% of what he values does not have a public market price, so the values they come up with are based on financial fundamentals. The end users of his services are not the public, but rather boards of directors, the SEC, hedge funds and the IRS.  The keys to success in his field are organization, preparation and being analytical. Their deliverable is a valuation with a tight range typically + or – 10%.

 

Consultant Relations – Rebecca Smith, CFA; SouthernSun Asset Management

A testament to the power of the Industry Roundtables event and membership in the CFA Society Chicago is that one participant made a connection at last year’s event that resulted in landing a job in the individual’s field of choice. Rebecca Smith led an engaging discussion around the consultant relations position within an investment management firm. Within a smaller firm the consultant relations position expands beyond strictly sales and distribution and has evolved over the past 10 years. Whereas at one time the role was all about relationships, now it is a distinct advantage to have the breadth of knowledge and analytical skills that go along with the CFA curriculum. It is also helpful to have had a diversified experience on the other side of the table working in manager research, due diligence and having exposure to asset management. It was recognized that especially in small firms there are a few people who are really making an impact. A consultant relations representative who has a well-rounded background in other areas of the investment management business might have an advantage when it comes to placement in the databases, communicating regarding style box fit, articulating how the fund invests, identifying areas of differentiation and making suggestions to the investment managers about what works and does not work. Analytic and other experiential skills can especially be helpful in areas of institutional sales, customer relations and retail sales.

 

Emerging Markets – Casey Preyss, CFA; William Blair

Casey Preyss outlined his career as having started at William Blair right after college as a trading assistant before moving to quantitative research and then becoming the global industrial analyst within the fundamental equity research group.  In addition to covering industrial companies globally, Preyss manages the William Blair China A Shares Fund ($300m AUM), and is a member of the emerging markets portfolio management group. Preyss described the China A Share market as the second most liquid equity market in the world, after the U.S., with over 1000 companies having a market cap larger than $1b.   Although the China market is dominated by large cap bank, real estate, and industrial companies, sell-side research is still in its infancy with only 4-5 U.S. investment banks publishing research on Chinese companies. William Blair has a deep international research team with 15 international analysts. William Blair’s investment strategy is quality growth, looking for companies with accelerating earnings revisions.  The investment process starts with a top down view by sectors, looking for industries in countries with a favorable regulatory environment. Questions from attendees included the challenges of language when conducting research on emerging markets companies, the quality of data and financial statements, and trading costs affecting returns.  Preyss remarked that most international companies will present in English either with a translator or with an English speaking investor relations representative. William Blair does have 2 local analysts in Shanghai to facilitate local research.  China A share companies must report to IFRS standards, which is a major difference from listings on other Chinese exchanges. Trading costs are a factor in every country, with the transaction costs for China A shares being very transparent while exchanges in Russia would be an example of some of the most uncertain and opaque.

 

Equity Analysis – Brian Langenberg, CFA; Langenberg & Company

Brian Langenberg has had a 25-year career in equity research, starting as a sell-side analyst and eventually landing at Credit Suisse First Boston, from 1995-2001 where he made the Institutional Investor All-America research team covering conglomerates.  Langenberg was also a research analyst on the buy-side at Ohio Public Employee Retirement System before starting Langenberg & Company, an independent provider of equity research. Langenberg entertained Roundtable attendees with several anecdotes throughout his career working on different aspects of equity research and highlighting the differences between sell-side and buy-side research.  He outlined Chicago area asset management firms with fundamental research groups and also gave examples in the mutual fund industry where research has fallen short of expectations. One of the challenges for equity research is that financial information has become widely available and that the gap in data between professional analysts and the investing public has become narrower. However, there will always be a role for fundamental research focusing on the non-quantifiable intangibles of company strategy and evaluation of management teams. For people early in their careers, Langenberg advised that the path to the sell-side begins with networking with people who already work at brokerage firms. Often, entry level positions are obtained via a personal referral from someone who knows the hiring manager.

 

Equity Portfolio Management – John Jostrand, CFA; William Blair

John Jostrand is a Partner at William Blair where he is Portfolio Manager for the William Blair Funds All-Cap Growth team. Jostrand began his career in 1978 as a research analyst for a regional bank.  He has been with William Blair since 1993. Jostrand strongly believes that portfolio managers need to be able to express themselves clearly. This expression needs to be through writing and speaking. Clients must know what the deliverable is and know why the portfolio is behaving as it is. The message to the client needs to be interpreted in the right way, and their questions need to be answered in a direct manner that is easily understood. He believes a successful portfolio manager must be able to have a “good conversation” and be able to collaborate with other professionals on many facets of the job.

 

Family Office – Stephanie Szymanski, CFA; Sawdust Investment Management.

Their family office staff is heavy on accounting and less on investments because of their utilization of funds.  They focus on asset allocation. They use products they can understand and do their own due diligence on.  For this reason they do not invest in quantitative hedge funds. The skill set to be successful in this setting is a wiliness to learn and attention to detail.

 

Fixed Income/Bank Loan Trading – Bill O’Connor, CFA; Neuberger Berman      

Bill O’Connor is a Senior Vice President with Neuberger Berman Fixed Income. Specifically, he is responsible for the firm’s bank loan capital markets activities. According to O’Connor, as an asset class, bank loans are highly inefficient requiring additional due diligence and monitoring not required in more liquid and standardized markets. Additionally, each bank loan can subject to a myriad of structuring idiosyncrasies which requires a thorough reading of loan documents. This additional oversight often requires O’Connor to being his work-day around 6:30am and work a full twelve hours in order to properly monitor the portfolio. He spends much of his day on the phone negotiating with various stakeholders and counterparties. On new issuances, he is often negotiating with the bankers that are working to structure the loan offerings for clients. On the secondary market, O’Connor negotiates with other investors to agree on terms to acquire or liquidate positions, in line with the strategy of the portfolio. Neuberger Berman has a variety of investment vehicles that hold bank loans, including retail funds, collateralized loan obligations and separately managed accounts. The Chicago finance community has a strong reputation for bank loan expertise, given the breadth of lending experience established in the Loop. Over the years, some of this talent has migrated to other parts of the country, further expanding the appetite for bank loans. For a role in bank loan capital markets, a solid understanding of credit analysis is essential. Ultimately, the value of the loan is determined by an issuer’s ability to make interest payments and return the borrowed principal at maturity. An understanding of credit risks provides insight into the future value of the loan.

 

Fixed-Income/High Yield Research – Jared Feeney, CFA; Neuberger Berman

Jared Feeney’s career as a high yield analyst started at JP Morgan working in the leveraged finance group in New York.   After a short stint in sales, Feeney became a credit research associate working with a senior JP Morgan High Yield analyst. Feeney moved to Chicago and the buy-side, joining Neuberger Berman’s high yield team. Neuberger Berman has one of the largest high yield research platforms with over 20 high-yield credit analysts, organized by industry and asset class. Publicly traded high yield bonds make up the majority of the investment universe but the leveraged loan market has grown to become a substantial asset class for most high yield investors.  Unlike bonds, leveraged loans are issued by private companies and are not technically securities, although loans are widely traded on the OTC market. Due to limited information flows from private companies and lower liquidity, credit research is critical for investing in this asset class. High yield research can be a cross between traditional credit research and equity analysis. Knowledge of a company’s capital structure and an ability to carefully read through loan documents are important aspects of the high yield analyst. Feeney covers about 50 companies and must have a strong knowledge of the credit risks and opportunities associated with his coverage universe. An analyst can expect to spend weeks putting together an investment direction, only to be dismissed by portfolio managers, which can be frustrating. The investment recommendation presentation is given to a panel of decision makers that ultimately decide on whether to invest capital, or pass on a recommended opportunity. The ability to prioritize is a key skill for a research analyst, as several companies may be releasing public information nearly simultaneously, or issuing debt during a similar timeframe, requiring model updates and new recommendations. High yield research can be a cross between traditional credit research and equity analysis.  Knowledge of a company’s capital structure and an ability to carefully read through loan documents are important aspects of the high yield analyst.

 

Fixed Income/Portfolio Management – Eric Bergson, CFA; J.P. Morgan

Eric Bergson is the Midwest and Southeast Director of Fixed Income at J.P. Morgan Securities. In his current role, he spends much of his time advising the bank’s high-net worth and family office clients on appropriate fixed income investing strategies and communicating portfolio performance. He also spends time working with internal teams to implement client strategies and glean market information from traders, analysts and portfolio managers, which informs his conversations with clients. His work day often starts very early, as it is not uncommon to receive client inquiries via e-mail overnight from his U.S.-based clients. Responding to his clients with immediacy is a top priority for Bergson and should be for anyone with client-facing responsibilities. His firm hosts a 7am conference call for employees in the bank’s securities unit. The conference call covers nearly all asset classes, but is followed by discussions specifically focused on the team’s respective focus. It is important that the teams communicate with one voice and have an aligned market outlook. After the conference calls, he reaches out to clients to discuss current investment positions and potential portfolio impacts based upon economic factors. Bergson offered his advice on staying market-informed by continually reading and absorbing information from a variety of resources that include both print media, as well as the multitude of on-line offerings. He also encouraged the table participants to develop both formal and informal mentor/mentee relationships with senior leaders in professional roles of interest. Senior leaders are often interested in developing a deeper bench and can make hiring recommendations for open positions. Bergson is originally a native of Cleveland, but moved to Chicago to attend the University of Chicago.

 

Hedge Funds – Krista McLeod, CFA; Silverpath Capital Management

Krista McLeod facilitated the discussion on hedge funds with a focus on starting a hedge fund, key trends affecting the industry and challenges in running a hedge fund. As a founding partner of a recent startup, she has firsthand knowledge of the challenges and opportunities of running a hedge fund business. It is imperative that you have good business partners. This includes choice of software for key functions such as operations, finance, accounting and marketing, hiring a good broker, compliance consultants, and other service provider partners. Questions that need to be decided include how to initially seed the fund, raising funds prior to launch, or seeding the hedge fund yourself. Working through the client due diligence process was discussed. This can often be a drawn out affair looking into operations, compliance and investment process. Choice of clients to target can matter as philanthropies or family foundations can have a quicker timeframe than other institutions. It was pointed out that SEC registration is not necessary on Day 1, and only required after $100M AUM. Required documentation can take a long time so it is advised to be very prescriptive and organized. Separately managed accounts are a trend that must be addressed. Other trends or best practices discussed included technology that is more algorithm driven, and having a well performing and cohesive research team.

 

Private Equity – Gary Stark, CFA; Iron Range Capital Partners

Gary Stark presided over a discussion of the private equity industry. Iron Range is a small independent that raises capital for each deal executed as opposed to establishing a ready fund from which to make investments. It is currently a very competitive marketplace with many players and a large supply of funds all looking to source deals. In order to gain access to the potential deal flow it is very important to stay on the radar screens of the investment bankers, brokers, etc. Financing a deal as an independent can vary. The typical Private Equity fund has an expectation of liquidating the fund within 4-6 years. One advantage of being an independent is that there does not need to be a fixed exit plan and you can maintain an investment for a longer period, especially as your knowledge continues to grow of the business, its market, the management team, etc. In looking at multiple deals, the cream rises to the top. With limited deal flow and an overabundance of capital on the sidelines while the cost of debt cheap, it is possible that many good deals will not make it to the letter of intent stage. You never know when a deal will fall apart. So hustle and perseverance are very important.

 

Real Estate – John Lindell; Heitman

John Lindell is Vice President at Heitman overseeing debt and structured finance portfolios.  He is experienced in multiple sectors of the commercial real estate market and has been responsible for over $2 billion of transaction volume.  Lindell is a former attorney who used an opportunity at Heitman to make a career change into commercial real estate finance. Lindell structures real estate deals for both internal funds which he manages and external funds.  The market dictates the difficulty of raising capital from investors and finding deals to fit that capital.  In the current market, raising capital is relatively easy however finding deals have become increasingly difficult.  For those seeking careers in real estate, Lindell stressed that resilience and the ability to tackle uncertainty is extremely important.  Deals can encounter unexpected roadblocks and markets can change rapidly, the professional who can thrive under those conditions will succeed.

Book Club Discussion: “The End of Copycat China: The Rise of Creativity, Innovation, and Individualism in Asia”

The CFA Chicago Book Club met on Feb. 17 to discuss The End of Copycat China: The Rise of Creativity, Innovation, and Individualism in Asia by Shaun Rein.  Below is a summary of the discussion based on the reading:

The End of Copycat China by Shaun Rein is a sound read.  We started off our discussion by opening it up to the members of the CFA Society Chicago book club and let each individual share a little bit about them and what they found interesting in the book.

We discussed the innovation cycle which you can isolate into three stages.  The first being the copycat stage.  This is where an emerging economy takes developed economies technology and implements into their own markets to initiate growth.  This is a natural process of economic evolution where there is plenty of low hanging fruit.  When there is plenty of low hanging fruit coupled with poor intellectual property rights, individuals will not have the incentive to innovate hence stage 1 of the innovation cycle.

Stage 2 of the innovation curve is when companies start to innovate specifically for their target market.  For example, stage 2 would involve taking advanced technologies and tailoring to the Chinese people.

Stage 3 is innovation for the world.  There is no longer the low hanging fruit, the advanced technologies have been tailored to the emerging economy, and now companies engage in R&D, intellectual property rights are strong, and innovation becomes the way to new long term sustainable growth.

Pollution was obviously a hot topic.  There was a point when Beijing had an AQI (Air Quality Index) of 700!  To put that in perspective, Los Angeles hovers around 20 and Paris officials will stop half of the city’s traffic if AQI hits 50.  China has an abundance of coal.  70% of their energy needs come from coal.  Increased auto sales have also added to the pollution problem.  They have only recently begun uncovering possible shale formations which they will use U.S. advanced technologies in hydraulic fracturing and horizontal drilling to uncover oil & natural gas.  Alternatives to coal are solar, wind, or nuclear power.  China is in the process of building nuclear reactors to promote clean energy though it is going to take many years to get up to their target.  Solar and wind are both not as stable as coal and given coal is in abundance, coal is relatively inexpensive which further promotes toxic carbon dioxide emissions.  The air can be so bad that many people plan their entire day around the AQI while checking their smart phones like they check the stock market.  E-commerce is soaring because people don’t want to go outside.  They rather hire a delivery guy to bring them groceries than risk going outside.  There are 8-year-old girls developing cancer from the poor air quality.  N95 masks are what everyday people need to protect themselves.  Several marketing strategies result from this.  For one, you start to see designer or Sponge Bob N95 masks on an everyday basis.  Another example is having malls that offer garage parking that allow for consumers to spend the entire day at one location.  For example, having a movie theater, restaurants, shopping, gym, and many other options to avoid having to go outside.  Expatriates described it as living on Mars.  Given the excess natural gas production in the U.S., the U.S. will be at an exporting advantage as the U.S. begins to liquefy natural gas or convert it into methanol to sell to the Chinese to promote clean energy.  The Chinese will be spending billions over the next 50 years investing in clean energy for land, water, and air.

The Chinese are evolving in their brand taste.  They are saying good bye to the flashy giant Gucci and Louis Vuitton logos and focusing more on brands that better represent China and their culture.  In addition, they are saying goodbye to the mainstream brands and moving towards a higher degree of exclusivity.  The knockoffs are starting to fade.  Status seems to be important throughout the history books.  The new status symbol is sending your kids to elite boarding schools in the U.S.

The emerging middle class in China is growing strong at 875M people.  The growth rate is high and they have a higher degree of confidence than the middle class.  They plan on buying houses, cars, and traveling in the future.  There is a changing dynamic going on in travel.  Its seems as though the middle to upper class are looking for places that are more exotic where other Chinese haven’t been.  Think New Zealand, Maldives, Mauritius, or South Africa.  Paris and Rome have become too common just like the mainstream clothing brands.  They don’t want to just copy westerners any longer.  They want brands specific to China.

Food safety is a driver of consumer spending.  KFC in the 90s is a great example.  The Chinese are going to pay a premium for food and health to help offset the issues with pollution.  Stay far away from the street vendors, at least the ones that don’t have anyone in line.

 

Upcoming Book Club Schedule:

March 17, 2015: Bust: Greece, the Euro and the Sovereign Debt Crisis by Matthew Lynn

April 21, 2015: The Forgotten Depression: 1921: The Crash That Cured Itself by James Grant

May 19, 2015: How Latin America Weathered the Global Financial Crisis by Jose De Gregorio

Sign up for a future book club event.

New Member and Volunteer Recognition

On Jan. 22, 2015, CFA Society Chicago held its annual New Member and Volunteer Recognition Party in the amazing rotunda of the Chicago Cultural Center. Hors d’oeuvres and cocktails were served beneath the world’s largest Tiffany glass dome—measuring 38 feet in diameter! The dome was restored in 2008 to reflectdome its original 1897 splendor that includes Tiffany Favrille glass cut in the shape of fish scales with signs of the zodiac lighted electrically at night. Originally used as the first Chicago Public Library, the dome contains an inscription by British essayist, poet, playwright and politician Joseph Addison which reads, “Books are the legacies that a great genius leaves to mankind, which are delivered down from generation to generation as presents to the posterity of those who are yet unborn.”

Christopher Vincent CFA, Chairman – CFA Society Chicago, welcomed 128 members, staff and volunteers to the evening’s festivities and recognized 48 new members to the Society. Chris discussed the critical importance of volunteering for CFA Chicago and gave a tip of the hat to Alan Meder, CFA, who once displayed his high regard for volunteers by simply saying, “You are a volunteer and volunteers make our organization work!”

Chris went on to say that our job is to be relevant in an industry that is mature and, at times, challenged. He encouraged the members to do this by identifying, leading, recruiting and mentoring new volunteers. He also recognized several of the incredible women leaders within the Society for their amazing contributions including leaders like Kerry Jordan, CFA, CFA Chicago Vice Chair, RMB Capital Management, Joan Rockey, CFA, CFO Castleark Management LLC, and Heather Brilliant, CFA, CEO Morningstar Australasia to name a few.

The volunteers listed below were recognized for their outstanding 2014 contributions in the following areas:

  •  Annual Dinner – Tim Holt, CFA
  • Candidate Services – Rebecca Smith, CFA
  • Career Management – Jenifer Aronson, CFA
  • CFA Women – Marie Winters, CFA
  • Communications – Bob Mudra, CFA
  • Education Seminars – Andy Feltovich, CFA, Garret Glawe, CFA and Tom Hillman, CFA
  • Distinguished Speaker Series – Patrick Bourbon D’Ingrande, CFA
  • Outreach & Member Development – Sitram “Ram” Gundapaneni
  • Social Events – Daniel LeKan, CFA

The evening concluded with a raffle and door prizes from a variety of Chicago favorites including Chicago Marriott Downtown Magnificent Mile, Giordano’s – Famous Stuffed Pizza, Jason’s Deli, Phil Stefani Restaurants, Potbelly Sandwich Shop, The Metropolitan Club, The Standard Club, and Union League Club.

CFA Staff members Larisa Bezak and Kim Augustyn, CMP ensured that only one raffle entry per person was allowed (this is still Chicago after all). And they even provided impromptu childcare for a portion of the program. Thanks again to our dedicated CFA Staff who will do (and have done) almost anything to keep things running smoothly!

Distinguished Speaker Series : James Bullard

James Bullard, President and CEO of the Federal Reserve Bank of St. Louis, spoke to a packed room at the Standard Club on Jan. 16 about Federal Open Market Committee macroeconomic forecasts. His presentation was also transmitted via a live webcast.

The first problem is that all forecasts are required to be based on “appropriate monetary policy assumptions.” But what assumptions are appropriate, asked President Bullard? One could assume that no policy changes occur. Another forecaster could instead include the monetary policy changes that she prefers—and maybe have overly rosy scenarios to show that those policies would work very well. To the contrary, another forecaster could try to incorporate his expectations of the FOMC decisions—and predicting a dire economic situation if he does not agree with the FOMC consensus.

Clearly, there is no perfect way. But this is not an academic endeavor, the speaker emphasized, because these forecasts are necessary to inform monetary policy decisions.

Bullard went over the FOMC forecasts on GDP, inflation, and unemployment for the last few years. There are 12 Fed Presidents and up to seven Governors, providing 19 forecasts. Looking at averages, the FOMC for the last two years got GDP about right, while its forecasts for unemployment were pessimistic and those for inflation too high. The speaker joked that erring on the same side for two years in a row is pretty bad.

The implications for monetary policy, given low inflation and shrinking unemployment, are that there is no change expected to the FOMC rate-raising path because inflation and unemployment balance each other.

Bullard allowed plenty of time for questions. Here is a summary:

  • The FOMC would prefer to arrive at the next recession with a non-zero Fed Funds rate, but if this does not happen they can do another QE. He would prefer to be able to cut rates so he’d rather increase rates in 2015 and if the economy slows down they can always cut.
  • Wages are a lagging indicator because unemployment must move a lot before wages move. Moreover, corporations do not cut wages in recession and therefore are slow in raising wages in expansions.
  • The fall in participation rate is largely explained by demographics. Participation peaked around 2000 and is expected to not increase by a lot.
  • Headline inflation is a better measure than core inflation because food and energy are what people buy every day. If we are concerned about volatility we should use trimmed measures such as the Dallas Fed’s and not exclude stuff that people buy regularly.

Chairman’s Message

I hope you enjoyed a great holiday season, and 2014 was a fulfilling year for your career.  It is the halfway point of CFA Chicago’s fiscal period, which makes a good time for us to review the strategic themes we established in July; and also to tell you about changes underway and upcoming events.

From the staff direction viewpoint, Shannon Curley, CFA, joined us in mid-December as Executive Director of CFA Chicago.  He brings a wealth of financial services knowledge to our organization.  In addition, he has had a distinguished career in the investment management profession.  I encourage you to introduce yourself to him at an upcoming event.

With respect to creating original content for our members, I want to highlight the Career Management Advisory Group’s work.  In particular, Co-Chairs Joan Rockey, CFA, and John Mirante, CFA, and their talented group, have undertaken a long-term project called “Career Map.”  This is an ambitious idea with multiple stages.  Importantly, it is designed to outline the industry jobs and career opportunities in our Chicago market.  Given the mature nature of domestic asset management, creating a taxonomy of companies, industries/asset classes and newly evolving job assignments will have multiple uses, including assisting you in navigating and maximizing your investment career.  More information will be shared as the project develops.  We welcome CFA Chicago members that are interested in participating in this project with the Career Management Group Advisory Group. Sign up today.

Another team pursuing a big agenda is our Education Advisory Group.  Under the direction of Marie Winters, CFA, and Larry Cook, CFA, we will host a Latin American Investment conference this May.  As you know the global nature of our profession warrants our continual search to learn, grow and seek evolving investment opportunities.  I hope you are able to attend this unique, mid-west opportunity to expand your acumen of countries, industries and companies in South America.  I view this single event in the context of a longer term portfolio of seminars which CFA Chicago will pursue over the next decade.

I would be remiss if I didn’t mention CFA Institute’s upcoming first Annual Women in Investment Management Conference in San Antonio, June 2015.  Our society has been at the vanguard of advancing women in finance and has made demonstrable progress in this effort. CFA Chicago Vice Chair, Kerry Jordan, CFA, has been instrumental in this endeavor. Among those speaking at the conference will be CFA Chicago Past Chairman Heather Brilliant, CFA, and CFA Chicago Secretary/Treasurer Carmen Heredia-Lopez, CFA.

Lastly, let me acknowledge our Immediate past Chair Gautam Dhingra, CFA, and his wisdom in leading our Governance & Nominating committee.  The work of our Governance & Nominating group is vitally important, and in great hands as we build a future team of leaders.  If you know someone that would make a great leader – or if you’re interested in serving, please review the nomination process and selection criteria and complete the nomination form. To be considered for the 2014-2015 Board of Directors, complete the nomination form before 5:00 p.m. Wed., Jan. 14, 2014.

A Balancing Act: Career Management and Searching for a New Role

On Dec. 9 the University Club in downtown Chicago was the venue for this event geared toward job DSC_1478seekers in the investment profession hosted by CFA Chicago and the Career Management Advisory Group.

The panel members and moderator consisted of:

Panelists:
Katie Banks – Senior Vice President & Director of Human Resources, Institutional Capital LLC
Danielle Dutcher – Vice President, Global Talent Acquisition, Northern Trust
Laura Pollock – Founding Partner, Third Street Partners
Jim Schroeder – Executive Vice President, DHR International

Moderator:
Jacqueline Benitez – HR Director; Segall, Bryant & Hamill

Jacqueline Benitez served as moderator.  She made it clear that the panel would focus on four key issues when searching for a new role.

  1. Resumes
  2. Networking
  3. Interviewing
  4. Compensation

Resumes

The consensus of the panel was that the resume should be brief and preferably bullet point. The recruiter should be able to evaluate the resume in less than 15 seconds.  Several of the panelists did not think a “summary” section was necessary, as that information should be found in the cover letter.  All panelists preferred information on resumes that were more quantitative than qualitative. Panelists stressed that for those candidates who have spent many years at the same firm, career progression in the form of responsibilities or job title changes should always be included.

Networking

The panelists viewed networking as a practice that should take place throughout a career because you never know when you need your network. One of the most optimal ways to find a position is to network with someone at a firm you would like to work for. Linked-In can also be an essential tool in your network.  It is important to do your homework concerning your target company when networking.  Do not be shy about the using the phone once you find who the key people might be, and if available use a land line.

Interviewing

When answering questions, it is important for the candidate to think not only about the question but also about the audience.  The panelists advised candidates not to be afraid to pause to collect their thoughts prior to answering.  It is a good idea to ask “was that helpful?” at the end of your answer.  The candidate should always have some questions prepared for the interviewer and rehearse answers to questions that the candidate should expect from the interviewer.

The recruiters stressed that conservative dress is very important.  The panelists suggested that women not use a lot of makeup, always wear a jacket, and that heals not be over two inches.  Men are encouraged to wear a white shirt, red tie and dark suit.   It is always a good idea to ask the recruiter about dress prior to the interview.

Compensation

Most positions will have price range bands that vary with geographical region. Panelists advised that to get the most out of this negotiation it is best to be transparent and confident. If your compensation requirements do not fit into the band, it is important to know that upfront.  Compensation may also feature a significant amount of deferred compensation which is also critical for the candidate to evaluate.

Once you obtain an offer it is important to express your excitement about starting in your new position.  You then should have an “ask” concerning compensation with a reason why you need it.  When negotiating salary, it is important that you be concise and have a number in mind.  Some recruiters will ask for a pay stub from your current job to verify salary.

CFA Exam Study Group Kick-Off Party & Open House

For the 11th consecutive year, signaling the start of another exam preparation season, CFA Chicago and the Candidate Services Advisory Group, along with Kaplan Schweser hosted a Study Group & Exam Preparation Party at the Standard Club on Dec. 11.DSC_1499

The reception gave chance for approximately 60 candidates comprising all three exam levels to mingle over light refreshments.  Patrick Hager, CFA, began the formal agenda with a description of how the Study Group program works, timeline for formation of groups and application for exam scholarship. He emphasized the importance and benefits of the CFA Charter and becoming a candidate member in the Chicago Society. Benefits of membership include the chance to participate in mock exams as well as two scholarship opportunities offered by offered by CFA Chicago.

An important exam reminder shared was to bring a passport to the exam, because a driver’s license is not accepted as a form of identification.

Dr. Tim Smaby, CFA, FRM, who heads the CFA exam DSC_1504section for Kaplan Schweser, gave an informative overview of the CFA Level 1 exam, while also acknowledging the nuances of Levels 2 and 3. He believes it is important for candidates to support one’s preparation by emphasizing practice and performance. In his opinion, too many candidates over-prepare yet under-practice answering questions. Smaby’s advice is to take advantage of the volume of practice questions available once the core readings are completed and to simulate game day conditions in taking practice exams.

Following Smaby’s talk, a Q&A session was held. CFA Chicago members and charterholders Jim Meixner, CFA; Rebecca Smith, CFA; and myself fielded questions from the candidates. After an introduction and each panelist giving their key tip for success, questions were asked regarding exam and study strategies including how to best approach structured response questions on the Level 3 exam.

Learn more about exam preparation and discounts.

Chinese Shadow Banking: Crisis or Correction?

© leungchopan, Fotolia

© leungchopan, Fotolia

CFA Society Chicago recently worked with the Chinese Finance Association and The Paulson Institute to explore the risks and rewards of the Chinese shadow banking system. On behalf of CFA Chicago’s Education Advisory Committee, Peter Cook, CFA, welcomed the audience to The Conference Center in UBS Tower for this exceptional opportunity to hear straight talk from three leading experts on China’s economy—while asking if Chinese shadow banking is “a valuable new source of funding, a replay of US subprime lending or somewhere in between?”

The discussion was moderated by Evan Feigenbaum, Vice Chairman, The Paulson Institute, who holds a PhD in Chinese politics from Stanford University and has served at the US State Department as Deputy Assistant Secretary of State for South Asia and as an adviser on China to Deputy Secretary of State Robert B. Zoellick. Feigenbaum orchestrated the dialogue between Patrick Chovanec, Managing Director and Chief Strategist, Silvercrest Asset Management which manages $16.6 billion on behalf of wealth families and selected institutions and Andy Rothman, Investment Strategist, Matthews International Capital Management, LLC which has $27.9 billion in assets under management with a focus on investments in Asia.

Before joining Silvercrest, Chovanec was an Associate Professor of Practice at Tsinghua University’s School of Economics and Management in Beijing, where he also served as Chairman of the Public Policy Development Committee for the American Chamber of Commerce in China, and advised numerous governments, investment funds, and Fortune 500 corporations on the Chinese economy. Rothman spent 14 years as CLSA’s China macroeconomic strategist where he conducted analysis into China and delivered his insights to their clients and spent 17 years in the U.S. Foreign Service, with a diplomatic career focused on China, including as head of the macroeconomics and domestic policy office of the U.S. embassy in Beijing. You can also follow “Sinology by Andy Rothman” at Matthews Asia.

What is shadow banking?

Shadow banking sounds menacing and even experts disagree on a common definition. Yet, shadow banking is generally understood to include a wide set of “non-bank financial intermediaries.” These alternative financiers include asset managers, money market funds, real estate investment trusts, and leasing companies that provide non-bank lending to a variety of customers. Jamie Dimon, CEO JPMorgan Chase, described shadow banking in his 2013 Letter to Shareholders as follows:

We really should not call them “shadow” banks – they do not operate in shadows. They are non-bank financial competitors, and there is a wide set of them. They range from money market funds and asset managers, mortgage real estate investment trusts and mortgage servicers, and middle market lending funds to PayPal and clearinghouses. Many of these institutions are smart and sophisticated and will benefit as banks move out of certain products and services. Non-bank financial competitors will look at every product we price, and if they can do it cheaper with their set of capital providers, they will. There is nothing inherently wrong with this – it is a natural state of affairs and, in some cases, may benefit the clients who get the better price (p. 18).

As a primer on shadow banking, I’d recommend the 14-page special report on international banking entitled “The lure of shadow banking” in the May 10th-16th edition of The Economist which provides a thorough discussion of the key terms, players, instruments and macroeconomic issues. The report explains that “shadow banking” was originally coined by PIMCO’s Paul McCulley in 2007 to describe the legal structures used by Western banks to keep complicated securitized loans off their balance sheets. As we painfully learned during the financial crisis, many of these securitized loans went bad and had to be bailed out by the banks—and then the banks needed to be bailed out by taxpayers. Today, many regulators view shadow banking as a positive way to shift risk away from banks to other entities that are willing to assume that risk.

Some of the major “private-debt” market players cited in The Economist report include Apollo Global Management, BlackRock, the world’s biggest asset manager with $4 trillion under management, Blackstone, The Carlyle Group, Cordiant, KKR,M&G -Prudential plc and Oaktree Capital. See also Private Debt Investor Magazine. Furthermore, bond markets continue to grow as the largest source of non-bank financing. Peer-to-peer (P2P) lenders like The Lending Club are finding their own niche. And Alibaba, the Chinese e-commerce giant, launched a new money-market fund last June which raised 500 billon yuan ($81 billion) in its first nine months.

Chinese Shadow Banking Instruments

Turning to China, Chovanec explained that four years ago Chinese shadow banking was referred to as “informal lending.” And he pointed out that shadow banking isn’t necessarily from an entity that’s separate from the formal banking system in China. As Rothman noted, “every bank in China is a ‘fake’ bank because they are all controlled by the communist party.” To the extent that the Chinese government bails out its shadow banking system then risk is not properly priced and moral hazard continues to exist. With that in mind, instruments of concern within the Chinese shadow banking system include trusts, entrusted loans and trust beneficiary rights products (TBRs). (See “Shadow banking in China: Battling the darkness” The Economist, 10 May 2014 “Every time regulators curb one form of non-bank lending, another begins to grow” Web. 10 May 2014.)

Trusts: Risky investments promising returns of 10% – 13% with no guarantee of a return on investment or even the return of principal. Often sold through banks, like the China Construction Bank, with an air of respectability, however, investors may generally still believe that the government will step in and protect them in the event of a default. Trusts have fueled the expansion of credit and swelled from 3 trillion yuan at the end of 2010 to almost 11 trillion yuan at the end of 2013. Over $400 billion of trust products are due to mature this year which are primarily secured by property. See the discussion of Jilin Trust, a Chinese shadow bank, which sold securities to Chinese investors backed only by loans to Liansheng Group which owns the struggling Zhuang Shang coal mine in Liulin and is now restructuring 30 billion yuan of debt in “China: A question of trust. Or not, as the case may be.” The Economist, 10 May 2014 p. 13.

Entrusted Loans: Cash rich companies, often state-owned enterprises (SOEs) lend directly to less well-connected firms. These loans often use banks as intermediaries to get around regulations forbidding such lending.

Trust Beneficiary Rights Products (TBRs): Chinese banks set up firms to buy loans from a trust and then sell rights to the income stream from the loans to a bank. Riskier corporate loans look like safer lending between banks and provide a way around the restrictions between banks and trusts. TBRs may be sold to other banks.

The Unstoppable China Growth Story: Evan Feigenbaum

Feigenbaum set the stage by emphasizing, “for all of its successes the unstoppable China story must be more balanced.” He observed that China’s own leaders have recognized imbalances, distortions and structural weaknesses in the economy. Feigenbaum says, “the popular story of China moving from growth to growth to more growth must be moderated.” Chovenec agreed and noted, “lots of legitimate economists question the GDP numbers in China.” There are a lot of truths in the China growth narrative but Feigenbaum points out, “it’s being driven by a state capitalist juggernot.” To that end, Feigenbaum warned, “in China, the politics of reform is an execution challenge of monumental proportions.” He then directed the conversation to Andy Rothman who provided the more optimistic view of China’s economy and shadow banking system followed by Patrick Chovanec who shared a more cautious view.

I would add, as shown below, that China is the second largest economy in the world and its GDP has grown from about $2.5 trillion dollars per year in 2005 to $9.2 trillion in 2013 at a compound annual growth rate of nearly 17.7% over the eight-year period.

Andy Rothman: “The Bull”

Rothman quickly pointed out that China has become a very competitive entrepreneurial economy over a very short period of time. In fact, the rise of private sector employment vis-à-vis state-controlled employment is China’s most important trend and now represents 80% of urban employment. Although China’s GDP growth must inevitably slow, Rothman says remember the “base effect” which means that slower growth on a larger economic base is still a very good thing. And China is already the world’s best consumption story with 9.1% YoY real annual consumption growth between 2009 and 2013. However, consumption was a small portion of GDP due to investment growing even faster than consumption. And Andy noted that investment growth has been slowing, from an average of about 25% for the nine years through 2011 to about 16% this year. He points out that China has more than 150 cities with a population of 1 million or more and the United States has only 9 cities of that size.

Property Market

In regards to the widely publicized stories about Chinese “ghost cities” (See Leslie Stahl’s CBS 60 Minutes report on China’s Real Estate Bubble) where properties are built but lack occupancy, Rothman says it’s greatly exaggerated; there are some failed projects, but the number is not large enough to signal a systemic problem. He also pointed out there is a different business model in China; properties are pre-sold one to two years before completion and then occupancy lags 3 to 5 years as additional infrastructure is completed. And he observes that 90% of new home buyers are owner-occupiers rather than speculators as shown below:

Shadow Banking Scale and Scope

Rothman explained that trust lending was essentially shut down by regulators during the first three quarters of 2014. Since The China Banking Regulatory Commission(CBRC) regulates both banks and trusts many feel the government has the necessary oversight to control trusts. Rothman clarified that there are only 69 trust companies operating in China and they are highly regulated, not allowed leverage and have loan-to-value ratios of 30% at most. Given the scope of the sector, he does not predict a major financial crisis in the trust sector. Some trust products will continue to fail, but given their relatively small size, as well as the absence of leverage and secondary securitization, a systemic crisis similar to that in the US is very unlikely. As shown below, shadow banking in China is just below 20% of broad money liabilities and most “shadow” institutions are Party-controlled, whereas it represents about 60% in the Eurozone and about 100% in the US.

Finally, Rothman notes that the toxic collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs), asset-backed securities (ABS) and mortgage-backed securities (MBS), at the heart of the 2008 financial crisis don’t exist in China so he doesn’t predict another “Lehman Moment.”

Patrick Chovanec: “The Bear”

Patrick Chovanec spent more than a decade living and working in private equity in China. He has been a “China bull” but now reports that most of his hedge fund friends are very bearish on China. Chovanec’s concern is that, in the wake of the 2008 financial crisis, China did not adapt but rather continued to engineer a credit and investment boom.

Chovanec asserts that China’s export-led growth model isn’t really about net exports driving growth as much as it is about “turbocharging” investments. The model works like this: poorer countries use their poverty and low wages to tap into gross exports and, given the low domestic consumer buying power, they can then justify more investment in the economy. Significant Chinese imports of machinery and raw materials are then used to meet external demand. It’s the same model used in Japan, Southeast Asia and Taiwan. However, Chovanec points out that if you produce more than you consume someone else must consume more than they produce. So the model can reach its limits as we’ve seen with China’s recent decline in GDP growth as US and European demand has declined. Chovanec feels it’s very problematic for China to continue fueling investment with credit when it can’t tap external demand.

Market Reform, or not?

At first, Chovanec believed that Chinese shadow banking was a positive story that would address issues the formal banking system could not. In theory, since private investors could lose money, there would be more accountability. Therefore, risk should be priced properly and the cost of capital would appropriately reflect those risks.

Yet, Chovanec says, “the PBOC thinks this is market reform and a backdoor method of creating a bond market to move away from bank-centric loans. However, it’s taking place in the context of moral hazard.” Chovanec goes on to say, “issuing lots of bonds does not a bond market make.” Chovanec explains that risk must be priced properly to make a bond market function well. And if the only question people ask is whether or not their investments will be bailed out then they are asking the wrong question. He says, “very few people care about the underlying asset. Instead, they are just investing and expecting those investments to be guaranteed by the state balance sheet—and that creates moral hazard.”

Chovanec is also concerned about the issuance of the corporate bonds, which are held to maturity by the banks, as local government financing vehicles. He points out that they are just like a bank loan without the capital requirements and deposit support behind them. Since interest rates are too low to attract deposits to make loans the trust sector originates the loans, and collects a fee, but is no longer responsible for credit. Chovanec’s concern is that these losses are not allowed to flow through the system and that people need to lose money for the system to function properly.

Property Markets

In the property market, Chovanec questions Rothman’s data that 90% of new home buyers are owner-occupiers. Chovanec believes the figures are too high and says, “selling agents report the data.” He believes real estate is widely used as a speculative investment because the Chinese don’t have alternative investment options. Ultimately, Chovanec says there are “hot zones and dead zones” in the real estate market and many people are speculating on the next “central business district” (CBD). He believes the market-clearing price to move into many of these properties is well below what a lot of people have paid in and they are not profitable for developers.

A Correction Without a Correction

Chovanec thinks the China Banking Regulatory Commission (CBRC) knows the right thing to do but says, “they want a correction without a correction.” Chovanec notes, “the CBRC said they were going to crack down on pooling but pooling has never ended.” Pooling is the practice of paying out on existing investments using money coming in from new investments—essentially a Ponzi scheme. Chovanec maintains that China’s banks have to pool or else default so the CBRC continues to allow pooling. On the bright side, he feels China’s recent Third Plenum, which called for 60 market reforms, is directionally correct.

Fundamentally, Rothman and Chovanec disagree about the level of bad debt in the Chinese economy. Chovanec says there is mounting bad debt that is repackaged, reissued and recycled—causing dead weight. And he feels Rothman underestimates the extent to which the banks are playing with their balance sheets. He points out that cash obligations are not properly reflected on balance sheets and we can only guess at them. In fact, there has not been enough liquidity to meet those needs. And Chovanec points to June and December of 2013 when the interbanking system nearly broke down. He observes leakage to off-balance sheet “stuff” such as interbank loans that are renamed as something else – then brushed under the rug. Chovanec feels all of the banks need to be recapitalized and that the losses can be socialized.

Chovanec doesn’t think there will be a “Lehman moment” in China because “they are all backed by a state-owned bank.” Instead, Chovanec thinks the steady stream of defaults will lead to the creation of a “zombie bank” like The Long-term Credit Bank of Japan (LTCB). Chovanec explained that LTCB sat on bad debt and was an immense drag on Japan’s economic growth. And he quipped, “a loan isn’t bad if you don’t insist on repayment.”

Chovanec maintains that the qualitative story on Chinese shadow banking is even more important than the quantitative story. He reminds us that many people thought the size of the US subprime sector was not too bad but they missed all of the interconnections to other parts of the financial system that were so important. Chovanec explains that nearly all Chinese lending was from banks four years ago and now even businesses and wealthy individuals are making loans and extending credit.

In conclusion, Chovanec believes, “a significant and disruptive adjustment needs to take place to put them [China] on the right path.” He feels an economic adjustment would be a positive thing for China and that it can afford to consume more than it produces. Chovanec wishes that this adjustment had begun in 2010 but instead believes the explosion of financial instruments we’ve seen in China will be problematic.

Distinguished Speakers Series: Barry Sternlicht

Distinguished Speakers Series: Barry Sternlicht

Distinguished Speakers Series: Barry Sternlicht

Barry Sternlicht was the featured guest at the Distinguished Speakers Series held on Nov. 21 at the Standard Club.  Sternlicht is the Chairman & Chief Executive Officer of Starwood Capital Group, a private investment firm he formed in 1991 focusing on global real estate, hotel management, oil and gas, energy infrastructure, and securities trading.

Using an inordinate number of slides Sternlicht gave a sweeping account of just about everything that related to the global economy.  His remarks covered a range of investment topics including; the domestic housing market, New York City property prices, currencies, quantitative easing, oil prices, global real estate valuations, and the 2015 outlook for the U.S. and global markets.

A subset of Sternlicht’s presentation comments included:

  • The top 1% are getting richer in all markets. This subgroup of the investing population is no longer willing to solely invest in domestic or global markets.  Instead, these investors are now buying up real assets in prime locations – South Americans investing in Miami, Asians investing in New York, Russians investing in London, etc.  These global buyers are pushing higher purchase prices in these ‘world class’ cities.  As a result, buyers looking for reasonably priced real estate will have to look to ‘second tier’ cities.
  • The U.S. government deficit will continue to grow despite the spending bill passed at the start of 2014. Entitlements – Medicare, Medicaid, and Social Security will increase the deficit dramatically over the next decade.  To combat this the retirement age will be raised, and benefits will be reduced.
  • The movement of populations from high tax states to low tax states will accelerate as more baby boomers retire. This will drive real estate growth in those low tax states and provide for slow or even negative growth in high tax states.
  • Growth in retail rents is and will continue to be bifurcated. Luxury retail malls will continue to outperform in terms of high occupancy rates, and growth in rents.  Properties that are not at the A level will likely exhibit slow or flat growth in rents.
  • The Euro zone and Japan will institute their own form of quantitative easing. This will cause the dollar to rise against the Euro and Yen.  The U.S. has promoted a weaker currency over the past several years with lower interest rates and growth in the money supply.  The stagnating economies in Europe and Japan will push policy makers to weaken their own currencies in an attempt to reflate their respective economies with increased exports.  Even so, a greater currency war will be fought over the next several years with many nations fighting to have a weaker currency.
  • The Federal Reserve will keep interest rates lower for a longer period due to a lack of any inflation on the horizon and lower energy prices. In addition U.S. yields are higher than in Europe and Japan, which will cause flows into the U.S. market, keeping the long end of the curve depressed.

Sternlicht ended his presentation by taking questions from the audience and sharing details of his latest hotel and apartment project – the ultra-luxury Baccarat Hotels and Resorts development in midtown Manhattan.  This development underscored several of the points Sternlicht made earlier – premium properties commanding outsized rents, and investing in world-class cities for outsized returns.