Distinguished Speaker Series: Jean-Marie Eveillard, First Eagle Funds

Value investing makes sense; it works over time, so how come there are so few of us?

On August 9th, CFA Society Chicago welcomed Jean-Marie Eveillard, senior investment adviser to First Eagle Funds, at the Chicago Club. The famed investor behind $110 billion First Eagle Investment Management has long believed that value investing can be a lonely place.

The septuagenarian still follows the advice of Warren Buffet and his predecessor Benjamin Graham. “The best book on investing ever written is [Ben Graham’s book] Intelligent Investor,” he said. Despite the sustained popularity of those pioneers today, pure value investing is becoming increasingly rare, Eveillard said.

Value investors must shun the wisdom of the crowds, and more importantly, they must be right. Sometimes value investing is fashionable, oftentimes it is not. Eveillard estimates that only 5% of the investment industry practices value investing. The limited embrace of a value tilt is partially due to the career risk portfolio managers face when choosing out-of-favor stocks. Sometimes investing in these stocks may take years for an investment thesis to play out, and asset owners are frequently less patient. The fear of losing a job causes herding into more socially acceptable stocks, and this dynamic makes it very hard for an investor to commit to value. This often tilts mutual funds towards becoming “closet indexers”, said Eveillard.

Eveillard discussed how he uses both qualitative and quantitative in his process. As a value investor, he marches to the beat of his own drum, eschewing the tactics used by marketing-focused money managers.

Jean-Marie Eveillard, First Eagle Funds

“I never spent a penny on advertising,” said Eveillard, contrasting his near singular approach to investing to more commercially-minded mutual fund companies. In his talk, which connected his years working in the industry with the thinkers that most influenced him, one area mentioned was the Austrian school of economics, particularly its 1974 Nobel Prize winner Von Hayek. Margin of safety was also mentioned, with Eveillard saying that it was the secret of strong investors.

Interestingly, Eveillard reckoned that a great deal of his success as a portfolio manager didn’t come from the stocks he picked; it came from what he didn’t own. Eveillard cited a number of examples such as Japanese stocks in the late 1980s, tech stocks in the late 90s, both of which he avoided. Eveillard was asked if he thought there is currently a bubble reminiscent of the late 1990s in today’s tech stocks, and Eveillard opined that today isn’t as bad as the dotcom bust era defined by the epic failures of Webvan and Pets.com.

Covering his use of qualitative data, Eveillard told a story about Enron, saying that he asked a research analyst on his team to look into the firm for a possible investment. The analyst found Enron’s statement footnotes incomprehensible, to which Eveillard responded that if that was the case, they’d move onto something else and wouldn’t invest.

Eveillard noted that so many of the numbers you see in accounting estimates are estimates. He said that in the late 1990s, he would often spot crafty CFOs who would observe the letter of the regulation, but not necessarily the spirit. In some ways, Eveillard said, accounting is more a reflection of a cultural mindset, with more conservative, risk-averse cultures taking earnings provisions on potentially low risk items. A good international investor needs to be mindful of the cultural differences in preparing accounting statements.

On the Efficient Market Hypothesis, Eveillard said that “it denies human nature.” He’d often debate the EMH with his academic friends and they would say that although they might agree, they needed to find a new theory before abandoning an old theory.

He mentioned the topic of moat, a means of ensuring that a company has a long run sustainable advantage. One reason that Warren Buffet rarely sells stocks is because it is hard to find companies with sustainable advantages, and once one is identified, an investor simply needs to be patient.

Given the strong outperformance of growth vs value stocks in the US over the past decade and the dearth of dedicated value investors, a change in investor mindset might be needed before value investing returns to vogue. But patient investors such as Jean-Marie Eveillard will be willing to wait it out.

Distinguished Speaker Series: Brian Singer, CFA, William Blair

CFA Society Chicago hosted Brain Singer, CFA, on July 19, 2017 at The Standard Club to present on the topic – Riding the Waves: Dynamic Asset Allocation (DAA) and Evolution of Top-Down Investing.

Singer is the head of the Dynamic Allocation Strategies team and a portfolio manager at William Blair where he shares responsibility for strategy setting and portfolio construction across all DAS portfolios. He serves on the endowment investment committee for Exeter College at Oxford University and on Rehabilitation Institute of Chicago Foundation’s board. He is also the chairman of the “Free to Choose Network.”

In 2015, Singer received CFA Institute’s Distinguished Service Award and has formerly served as a board member and chair of the CFA Institute board of governors. He has written extensively on global portfolio, currency, and performance issues. In 2015, he was also inducted into the Performance and Risk Management Hall of Fame by The Spaulding Group.

While the hot debate of traditional active vs. passive consumes most talks in the investment industry, Singer focused on the other leg of liquid investment strategies, Liquid Alternative Investing. He focused his presentation on the following four broad strategies:

  • Risk Parity;
  • Smart Beta;
  • Risk Premia; and
  • Active currency.

Quest for a superior investment strategy has given birth to many new ideas and terms that have changed the investment landscape as it was known two decades ago. After the advent of efficient market hypothesis and rise of CAPM, we now live in the world of smart beta and where CAPM is seen as dead by many. However, Singer believes CAPM is not all that dead. He advised to consider long-term horizons rather than the short-term when evaluating the relevance of CAPM as his initial remarks. He expressed how Modern Portfolio Theory post financial crisis has been seen as wounded where risks are known to be non-static and non-symmetric and that tail size does matter. He recommends focusing on the Macro investing models with dynamic allocation strategies for dealing with systematic risks in line with return expectations.

He re-iterated validity of CAPM while discussing risk parity strategies from a passive (35% Global Equity – 65% Global Fixed Income) and an active (traditional asset allocation) standpoint.

He also presented how the understanding of betas and alpha in the pre and post CAPM world has changed. In the advent of Smart Beta – Systematized Alpha, he cautioned against considering it as a free lunch and discussed smart beta strategies. He noted that such strategies aim at exploiting “Persistent” systematic risks following an auto-pilot strategy. He also cautioned against them as being static in nature relying on back tested rule sets. Further along in the presentation, he explained how such narrow rule sets can bring about volatility and fragility in the investment process and later provided recommendations to overcome such issues.

While discussing the risk premia strategy, Singer stressed on macro diversification based on fundamentals with a long term focus. For the short term, he advised to utilize unique rule set disciplines to navigate a dynamic path and ignore the media ripples which tend to make investment management process more fragile. He explained differing strategies using an example of a village at the foot of a mountain facing the risk of an avalanche taking extreme actions such as complete evacuation of the area vs. building fences to contain the snow to tackle the risk. He discussed different strategies to cope with risks faced in the investment world based on narrow vs. broad rule sets and impact of such rule sets on the overall investment process and asset allocation.

The speaker also spent a fair amount of time to share the active currency investment strategy. Despite not being an asset class, Singer explained that active currency investment is an effective alternative investment strategy as correlation of passive and active currency with assets is very low. He noted that currencies tend to converge to equilibrium prices (using PPP and IRP) faster (average of ~4-5 years) compared to assets (average of ~8-10 years). He presented varying half-life of currencies and asset classes along with correlation of USD index with monthly MSCI returns being as low as 30%.

He shared his Antifragile Investment Process methodology consisting of identifying and assessing opportunities of value to price discrepancies and designing portfolios with integrated risk exposures. He noted that such investment processes are dynamic, imperfect, progressive and make use of evolving tool set stating it to be analogous to growth of a living organism.

Singer also shared the idea of forming an Antifragile Investment Team for which “cognitive diversity” is key as he believes such team resources back multiple ideas using “wisdom-of-crowd framework” for survival. Such teams work continually to Research, Implement, Perform and Review numerous ideas as opposed to fragile teams which resources back few ideas that cannot afford dismissal.

He concluded by making a recommendation to identify market inefficiencies as dynamic investment opportunities stating: “There needs to be a level of market inefficiency to have market efficiency”. He again stressed on following wider rule sets for asset allocation decisions for a less fragile investment process.

At the end of the presentation he commented on the following questions from the audience:

Big Geo-Political risks to consider

  1. Domestic to US – Impact of proposed regulatory changes to Volcker Rule which may cause tail risk.
  2. International – Follow European Union market especially outcomes of the Italian Election and monitor the risk of national banks going bankrupt.

How to tackle Behavioral Risk?

  1. Incorporate it in Risk Premium.
  2. Since behaviors cannot be predicted, focus on identifying significant behavioral shifts – both frequency and magnitude of signature behavioral shifts.

Near term opportunities in Active Currency

  1. Short on Developed market currencies including USD (currently expensive).
  2. Long on Emerging market currencies.

Distinguished Speaker Series: Gary P. Brinson, CFA, The Brinson Foundation


On May 24th, a packed hall gathered for lunch at The Standard Club in Downtown Chicago to listen to renowned value investor Gary P. Brinson, CFA, while he shared his latest thoughts on the markets. Brinson founded Brinson Partners, a Chicago-based asset management firm that was acquired in 1994 by Swiss Bank, the predecessor of UBS, for $750 million. After the sale to Swiss bank, Brinson ran the asset management division of Swiss Bank to what later became known UBS Global Asset Management. Many consider Brinson to be one of the investment industries greatest thought leaders, although likely by design, he left the audience lots to ponder in his Investment Market Conundrums presentation.











Using mean reversion with a 90-year historical lens. Brinson started off his presentation with a simple question: “What perplexes you?” and undoubtedly we moved on to what perplexes the investing legend himself. Despite volatility being at stubbornly low levels, the securities market today presents some very unique challenges and opportunities with macroeconomic datapoints that currently have meaningful deltas to their long-run mean. To start, real interest rates on long duration assets have turned negative in some countries across the world. Notably Germany (-0.9%), the United Kingdom (-2.0%), and Sweden (-1.2%) all have 10-year real interest rates that are in negatively territory and Switzerland, even further down the curve, with a negative -0.2% nominal 10-year interest rate. Theoretically it is an investment conundrum to hold capital to invest and to consider where you loan money to a government that inherently isn’t a risk free investment for a return that would leave you with less capital than when you started—and that is without a default!  Theoretically, it is very hard to compute the existence of long term negative nominal rates.

20170524_123647Europe has all sorts of problems; what about the U.S.? The U.S. has a 30 year nominal rate of 2.9% and after backing out a 2.0% inflation target a 0.9% real rate of return. Historically, from 1926-2016, the real return on a 30-year bond in the U.S. was 2.6% vs. 0.9% where it stands today. Mean reversion would call for this 0.9% real rate of return to increase 70bps closer to 1.6%. Turning to inflation, historically, inflation as averaged 2.9% from 1926-2016 and today stands at 2.0% as the difference between TIPS (Treasury Inflation Protected Securities) and the nominal yield. Semi-mean reversion says the likely inflation rate should be somewhere around 2.4%.  Inflation is largely governed by the velocity of money which beginning since the start of the financial crisis has plunged. This may or may not be permanent. If permanent, that estimate of inflation at 2.4% is woefully too low.  No economist seems to know why the velocity of money has slowed so meaningfully. Combining the mean reversion estimations, we should be observing a 30 year treasury rate closer to 4.0% real rate of return (1.6% nominal return + 2.4% inflation).  If the 30 year today (at 2.69% at the time of this publication) were to re-price to 4.0%, the value of that bond trading at a par value of $100 would fall to $81 market value.

Market expectations assuming mean reversion.  Now taking these mean reversion theme and looking at the equity market—one can estimate a nominal return for the S&P 500 at 10.0% with 5.8% in capital appreciation including inflation and 4.0% in income including dividends and share buybacks from operating cash flow (Note: ((1 + 5.8%) * (1 + 4.0%) – 1) = 10.0%). One can expect bonds to offer a 5.5% return, and net of a 2.7% inflation assumption a 2.6% real return compared to a 6.9% real return for US stocks. Comparing where we are today to 1926, P/E ratios are much higher, and dividend yields are much lower. There are a number of factors for this, but if one were to only consider mean reversion, one would expect a 2.2% real growth in earnings, leading to a lower market P/E ratio and a higher market dividend yield. If we consider the path were are on as a new investment equilibrium level and ignore the trends of the early 1900s, one could consider stocks to be fairly valued in this environment. Elevated P/E ratios shouldn’t be of concern and real growth rates of 4.8% (6.8% nominal) with real interest rate debt at 0.9%. However, if we believe real interest rates will increase to the long-term average of 1.6% and inflation to 2.6%, we should model returns on stocks to equal 8.0% (3.2% income and 4.6% capital appreciation) and the return on long term government bonds to be 4.0%. What is rather frightening is the market reaction we would see for the 30-year to trade at 4.0%– long term bonds would fall 19% in principal value and stocks would fall 25% in creating these forward desired return objectives.

20170524_130958Volatility expectations assuming mean reversion.  Standard deviation of large cap stocks was 19.9% from 1926 to 2016.  Over the past year, the markets have average 13.3%. Again if we assume semi-mean reversion, volatility should increase to 16.8%. The risk premiums have also been subdued across all asset classes and in a similar manner these should also increase. The conundrum is what we are now finding is both volatility and correlations are remarkably unstable. These lead financial analysts and portfolio managers with a very tough question – what should we use as the input for volatility? The correlations of returns between the S&P and the 10-year has declined meaningfully and recently went negative.

Share buybacks – A return “on” or “of” investment? Share buybacks should be viewed just as a dividend – a return on investment for shareholders. Today the companies that make up the S&P 500 offer a 2.1% dividend yield, and if we add share buybacks as an additional return on capital this figure increases 40bps to 2.5%. However, how much of these share buy-backs are being financed with debt? Brinson pointed out that using debt to subsidize share buy-backs is a return “of investment, not a return “on investment.

Active vs. Passive Management. To conclude, Brinson switched gears and discussed the hotly debated topic of active versus passive management that left many wondering if he and his firm was either an “expert” or “lucky” coin flipper. He gave the example of 10,000 people in a room where each person was tasked to call their coin flip correctly ten times in a row. Out of the 10,000 people in the room, only nine would be able to accomplish the feat of calling heads or tails correctly ten times in a row. Now these nine coin flippers were clearly one of the 10,000 that got lucky – randomness makes one think you’re looking at something meaningful when you’re really only lucky. Randomness is pervasive in the securities marketplace, and if you make the wrong assumptions thinking data has statistical significance is can lead investors to make very poor decisions.

Tying it all together – A Book Recommendation. Brinson concluded with a book recommendation – The Drunkard’s Walk: How Randomness Rules Our Lives by Leonard Mlodinow written in 2008. The book dissects statistical concepts such as regression toward the mean and the law of large numbers, while using examples from wine ratings and school grades to political polls.

Distinguished Speaker Series: Joseph Scoby, Magnetar


CFA Society of Chicago hosted Joseph Scoby on Thursday, June 8th at the University Club to discuss how markets may be in the early days of a third disruption. Scoby is the Head of Magnetar’s Quantitative Investments Group which includes Alternative Risk Premia and Tactical Trading and brings 30 years of market experience in investments and risk management.

The three stages of disruption can be thought of as 1) active vs. passive in long-only portfolios 2) the advent of smart beta and 3) improving transparency for asset allocation. Scoby then gave three larger themed disruptions in society today, the Human Genome, Horizontal Fracking, and Big Data then expanded to a number of companies which have also disrupted their respective industries, Uber, Amazon, and Netflix. Similar to these aforementioned examples, technology in the market place has allowed managers to see what is going into returns and may be causing a secular change in how we invest.

DSC_3784Scoby gave us three levers of a portfolio 1) asset allocation 2) the manager and 3) cost. When viewing what our portfolio actually mimics, the speaker argued that we could be paying too much for each respective exposure which could lead to increased transparency over time. For example, the systematic return stream of hedge fund managers produced a 0.45 beta, which in the old days or ‘hood closed’ cost investors 2 and 20. Today, the ‘open era’ (transparent era), investor may begin to pay for each part; Alpha, Alternative Risk Premium, Smart Beta, and Beta with varying fees. One may pay 100 basis points for Alpha, but only 0-15 basis points for beta as the Vanguards of the world can replicate comparable results for rock-bottom costs.

The speaker went on to say how alpha is harder to find today given crowding of knowledge and process, as well as capacity issues, which makes cost and execution that much more important (differentiation is harder to find). Going forward, more transparent portfolios may also begin to use alternative risk exposure (return stream derived from exposure to a specific alternative asset class) as a way to differentiate one’s portfolio, and as a result, may earn their higher fees. An example given of alterative risk premium was merger arbitrage; 7% of deals break but most are priced as if 13% break – enabling 5.02% annualized returns with 6.88% volatility for his defined period.

Purchasing alternative risk premium isn’t straight forward, Scoby said, a few firms like Magnetar, AQR, and DFA offer it as well as a few ETF’s.

Distinguished Speaker Series: T. Bondurant “Bon” French, CFA, Adams Street Partners

DSC_3661T. Bondurant “Bon” French, CFA, executive chairman of Adams Street Partners addressed a large gathering of CFA Society Chicago members on the topic of private market investments on April 5th at the University Club. Adams Street Partners is a Chicago-based manager of private market investments with over 40 years of history and $29 billion in current assets under management.

French began with a review of historical returns for private equity markets using industry data. Both categories he focused on, venture capital and buyouts, showed superior long term performance (ten years or longer) compared to public equity markets, but weaker relative performance for periods shorter than five years. He doesn’t consider the shorter term underperformance to be significant as success in private market investing requires a very long investment horizon, a feature deriving from the reduced liquidity relative to public markets.

French went on to provide a summary of recent market conditions and performance for both buyout and venture capital pools. His statistics showed that fundraising for buyouts rose sharply from 2005-2008 and then fell just as sharply during the financial crisis. Although there has been a rebounded since 2010, the $368 billion gathered in 2016 still hasn’t topped the pre-crisis amounts. The volume of buyout transactions has recovered much less so since 2009 leaving managers with considerable “dry powder” seeking attractive new investments. This is also reflected in data for buyout fund cash flows. From 2000 through 2009 calls for funding from borrowers regularly exceeded distributions out to investors. However, since 2010, distributions have far exceeded calls. Investors (and their managers) have been especially wary toward new investments since the crisis, a condition exacerbated by the high level of multiples on buyout transactions (similar to the situation in public markets). At more than 10 times enterprise value/EBITDA, these have passed the pre-crisis highs to levels not seen since before 2000.  This situation has driven Adams Street to focus on deals in the middle market which is less efficient, and consequently priced at lower multiples.

DSC_3654Also reflecting caution (and the effects of Dodd-Frank regulations), buyout deal leverage remains below pre-crisis levels (5.5 times in 2016 vs 6.1 times in 2007). However, terms of credit have eased as reflected in the market for covenant-lite debt. This has far exceeded the levels common in 2007 both in terms of absolute amount and share of the new issue market. DSC_3659This has helped the borrowing firms survive economic challenges and also allowed them an opportunity to remain independent for longer.

In the venture capital market (much older but smaller than the buyout market) new fund raising peaked in 2000 during the “tech bubble” and fell sharply when the bubble burst. The subsequent recovery was fairly muted, so the financial crisis had less of an impact on fundraising activity than in the buyout market. The $83 billion raised in 2016, while the highest since 2000, is consistent with the longer trend.  Cash flow in the venture market hasn’t been as persistently strong as in the buyout market because companies are choosing to stay private longer than in the past. Liquidity events, measured by number of deals and total value, peaked in 2014 for both initial public offerings (IPOs) and mergers and acquisitions (M&A). M&A, the larger of the two by far, has shown a smaller decline from the peak than has IPOs, and has held at levels consistent with longer term trend.

French concluded with a brief look at the secondary market for private investments (trades between private market investors as opposed to investors being taken out by IPOs or M&A). This market dates to 1986, but is showing healthy signs of maturing recently. Although the market hit a recent peak in volume in 2014 the decline in the following two years was slight—holding well above the prior trend.  Pricing, as a percent of net asset value, has also been rising. Transactions in 2016 were evenly distributed by the type of investor (pension funds, endowments, financial institutions, etc.) supporting liquidity. In 2016, transactions were more concentrated in newer funds because older funds (created before 2008) are shrinking from their natural positive cash flows, and have less need to trade.

Distinguished Speaker Series: Richard Driehaus, Driehaus Capital Management LLC


The Distinguished Speaker Series hosted Richard H. Driehaus at the Metropolitan Club Oak Room on March 1st, 2017. Mr. Driehaus is founder, chief investment officer and chairman of Driehaus Capital Management LLC. In 2000 he was named to Barron’s “All-Century” team whose players were deemed the most influential in the mutual fund industry over the past 100 years. Mr. Driehaus aim was to divide his presentation into three sections: Early Years, Investing, and Industry Trends.

DSC_3548He began his presentation by referencing the difficulties his father had in developing a residential lot his family owned. Although his father had a steady paycheck as a mechanical engineer, he was not able to afford his goal of developing the land for his expanding family. Mr. Driehaus at that point began thinking about how he would make sure to achieve his goals.

When he was 13, Mr. Driehaus spotted the NYSE quotes in a local newspaper. DSC_3533When informed about what the NYSE quotes meant, he became fascinated and soon found that his calling was the investment industry.

Mr. Driehaus argues that the principals of Taoism are applicable to the stock market. Taoism stresses living in harmony with the universal laws of nature. Nature has given man both a creative and analytic side to his brain. You must be able to use both sides of your brain to understand the market.

Mr. Driehaus shared the following market insights:

  • Stock price will almost always never equal a company’s intrinsic value. The valuation process is flawed.
  • It is better to concentrate in sectors as certain sectors will have better outlooks than the market as a whole.
  • More money is made by buying high and selling higher (positive relative strength).
  • Hit home runs, not singles and avoid striking out (cut your losses).
  • High turnover reduces risk; take a series of small losses but not a big loss.
  • Standard deviation is a poor measure of investment risk.
  • The greatest long term risk is not having enough exposure to risk.

Mr. Driehaus emphasized that continuous observation is needed for investment analysis.  Knowledge gained must then be applied in the context of a rapidly changing environment. You must maintain belief in your core principles for the long-term to succeed.

DSC_3541Mr. Driehaus had the following observations of the industry and current equity market:

  • A 60/40 equity/bond allocation will not be aggressive enough for retirees due to longer life spans.
  • As inflation becomes hotter bonds will be less attractive than stocks.
  • Active managers have been losing assets due to the lower fees associated with indexing.
  • Meaningful alpha generation is not easy in this environment but still doable.
  • Active management will outperform when interest rates normalize as equity dispersion will be greater.
  • Expect a greater shift to international equities.

Following his presentation Mr. Driehaus fielded questions on a number of topics:

  • Investing in growth stocks allowed him to prove himself more quickly.
  • Hedge funds are paralyzed because they want safety; they are not taking on enough risk to differentiate themselves.
  • Look closely at volume when you’re thinking about selling one of your winners.
  • His philanthropy emphasizes that architecture is very important. Big box retail has killed a number of small communities and failed to protect the “sense of place”.

Distinguished Speaker Series: Charles Evans, Federal Reserve Bank of Chicago

Evans 7_PingHomeric

Charles Evans, President and Chief Executive Officer, Federal Reserve Bank of Chicago (Photo courtesy of Ping Homeric)

Charles Evans, president and chief executive officer of the Federal Reserve Bank of Chicago, addressed approximately 250 members and guests of the CFA Society Chicago on Thursday, February 9th at the Standard Club. The event was also webcast for those who could not attend the luncheon. Mr. Evans spoke about the U.S. economy, fiscal stimulus and monetary policy. He completed his presentation with responses to questions from the audience.

Mr. Evans expects a modest acceleration in economic growth to the 2.0% to 2.5% rate, and a rise in inflation to near 2.0% over the next several years. As a result, the Fed’s most likely course of action is three 0.25% increases in the Fed Funds rate in each of the next three years. These increases would elevate this rate to near 3.0% by the end of 2019. The primary risk to this outlook is that inflation does not rise to 2.0%.

Evans Board_PingHomeric

Chicago Fed President Charles Evans and CFA Society Chicago Board Members (Photo courtesy of Ping Homeric)

Fiscal policy could positively impact growth by near 0.25% a year. Lower tax rates might contribute to higher growth over the intermediate term. Additionally, optimistic consumer sentiment, resulting from healthy employment data, should contribute to growth. Average monthly gains of 180K employees over the past year have reduced the unemployment rate to 4.8%. A constraint has been business investment during the recovery, which shows no real sign of improvement.

Mr. Evans expects a decline in the unemployment rate to 4.25% by late 2019. His forecast is slightly lower than Fed’s consensus of 4.5%. The natural rate appears to be near 4.7%. A decline to the 4.25% to 4.50% range would suggest a Fed move from ease to neutral to tightening over the next several years. The downside risk to this outlook is weak foreign economies. The upside would be a greater boost from fiscal policy and regulatory ease.

Inflation has averaged 1.5% since 2009. The “Core” rate has moved up to 1.7%. Mr. Evans expects core inflation to reach 2.0% over the next three years. The downside risk is low global inflation and a strong dollar.

The structural equilibrium neutral Fed Funds rate has fallen to a lower level. Low interest rates, throughout the world, provide the central banks with less room for ease in the next downturn. The Fed has typically lowered the Fed Funds by greater than 5.0%, during easing periods and currently believes that the neutral rate is near 3.0% (1% real and 2.0% inflation). Therefore, they may not have as much room to lower rates during next recession. The secondary tools would be quantitative easing and guidance for how long rates would remain low. These non-conventional methods are “second best” to the ability to lower rates.


Distinguished Speaker Series featuring Charles Evans


From 1960 to 2000, the economy grew at a 3.5% annual rate. Post 2000, the growth rate has been lower. The labor force participation rate has fallen over the past 15 years; because of retiring baby boomers, passing the peak inflow of women into the labor force, and a falling rate of employment for 18 to 24-year-old individuals. The potential real GDP growth rate has probably fallen to near 1.75%.

During the questions and answers segment, Mr. Evans addressed the following topics:

  1. CFA-Society-Cindy-Anggraini-from-Indonesia-010917-PingHomeric-0G1A5073

    President Charles Evans responds to questions from the audience.              (Photo courtesy of Ping Homeric)

    Long-term interest rates have risen 0.50% since the election, suggesting that the markets expect some positive impact from fiscal and regulatory policies. He noted that changes in tax policy (i.e. eliminate deductions, border adjusting tax, etc.) can be disruptive in the intermediate term, even though positive in the long-term.

  2. The Fed’s balance sheet grew from $800 M to $4.5 T. Eventually, this level is likely to fall back to near $1.5 T. The Most likely path would be through not re-invest principal payments.
  3. The impact of technology on productivity was apparent in 1995 to 2005 data. Since then, it has not been. He referenced the “gee-wiz” nature of more recent new technologies and quick obsolescence.
  4. The Fed chose not to use negative interest rates, even though the Taylor Rule suggested -4.0% at the low point. The Fed chose quantitative easing instead- sold short bonds and bought long. He noted some positive effect in Europe, which could influence future Fed boards.
  5. Finally, he noted that more global trade is better, provided it’s fair. Trade increases competition, which encourages higher productivity. The United Kingdom is likely to face a complicated period ahead to exit from the EU and establish new trade agreements.

Distinguished Speaker Series: Will McLean, CFA, Northwestern University


The Endowment Model in a Low Return World

On January 24th the Distinguished Speaker Series held its first luncheon of the year welcoming one of our own, Will McLean, CFA. Mr. McLean is Vice President and Chief Investment Officer at Northwestern University, and is responsible for managing the University’s $9.7 billion endowment portfolio. Mr. McLean gave an engaging presentation to a sold out crowd over lunch at the W City Center.

Mr. McLean’s presentation centered on the challenges endowments face given the low expected return environment. McLean explained that Northwestern University follows the Yale Model of endowment investing. The Yale Model is an investment philosophy developed by David Swensen, the Yale University Chief Investment Officer. This model deviates from the traditional asset classes (stocks, bonds, and cash) and uses modern portfolio theory to invest in alternative and non-liquid assets in the form of private equity and hedge funds.

Mr. McLean laid out five principles used to manage the University’s portfolio:

  1. Diversification – this concept is straightforward. As a portfolio becomes more diversified there is typically less correlation, and the risk of the portfolio is reduced. McLean advised issues could arise if a portfolio becomes overly diversified. Excessive diversification spreads capital thinly and causes an excellent investment to impart a marginal influence on the total value of the portfolio. Over diversification could also cause investment standards to be lowered – when anything can be added to the portfolio, standards are more likely to loosened.
  2. Equity oriented portfolios need to provide a higher than average return. Given the makeup of the portfolio and the annual needs of the University, the expected return of the portfolio is in the 7-8% range.
  3. Take advantage of the illiquidity premium. The time horizon of the University’s portfolio is near perpetuity. Therefore, it is reasonable to invest in illiquid / inefficient markets.
  4. Use active managers – invest in stock pickers in the right markets. Northwestern’s investment management team and board of trustees believe active management adds value, and more uncertainty should be good for active management. Different asset classes offer different dispersions. It makes little sense to invest in the large cap equity space when the difference between the top and bottom quartile manager is not significant. Seek out alternative asset classes with bigger dispersions of returns.
  5. Ensure that your manager’s interests aligned with your own. When engaging in manager selection find out who owns the investment management firm that is under consideration. What is the owner’s motivation? McLean advised that it had been his experience that when a manager takes their firm public with an IPO, the manager’s performance underperforms. Their motivation changes from client enrichment to self-enrichment.

Due diligence should also take into account other aspects besides the manager’s performance record. Consider the internal split of management fees; do they flow to a select few individuals? How much career advancement is available to junior employees at the investment firm?  Are employees likely to be nurtured and grow or leave the firm? Negative answers to any of these questions the long-term viability of the manager to produce alpha.

DSC_3299Once his prepared remarks were concluded, Mr. McLean took a number of questions from the audience.

How do you manage board expectations of returns?

Many board members are former money managers, thus they are well versed in the risk vs. return dynamic, and they have rational market expectations.

How do you manage spending over bad returns?

There is a spending policy, which is a board level decision. The portion of the University budget funded by the endowment does not vary much from year to year.

Does Northwestern University take a view on asset allocation?

The University does not believe in market timing or tactical investing.

What is the thought process of the allocating AUM to the hedge fund asset class?

The University’s current allocation is for a 20% weighting to hedge funds. In general, 1/3 goes to long/short, and 2/3 goes to uncorrelated macro and market neutral strategies. Overall Northwestern University views hedge funds as an uncorrelated piece of the portfolio.

How does one incorporate human phycology / behavior into choosing an investment manager?

The University has a standardized approach for manager selection. Behavioral patterns at the manager firm are collected and evaluated. The manager selection team has been trained (by outside sources) to ask the right questions during the interview process, and to evaluate the manager’s non-verbal answers. Current and former employees are also interviewed for their points of view. Overall, you must train yourself to consider the all aspects of the manager’s answers and behavior.

Vault Series: Melissa Brown, CFA, Axioma


Managing risk, specifically equity market risk, was the topic of CFA Society Chicago’s new Vault Series on January 11. The series brings noted investment experts to Chicago on a bi-monthly basis to share their thoughts and insights on the investment scene. The name comes from the common-area conference room in the Society’s new home at 33 North LaSalle Street, a space that was, indeed, once the safe deposit vault for a bank. The latest flat screen video monitors hang over the bare steel safe deposit boxes still line the walls. The day’s speaker was Melissa Brown, CFA, Senior Director of Applied Research at Axioma, a provider of risk management and portfolio analysis models and tools serving asset managers and institutional investors. Brown provides perspective and insight on market risks as measured and quantified by Axioma’s data and analytics.

Brown began by noting there are many types and measures of risks (e.g., Value at Risk, standard deviation, credit risk, liquidity risk, etc.) but Axioma defines it as the expected volatility of a market (they focus on equity markets) over a defined investment horizon. It is a function of volatility and correlations, both of which they see as being persistent over time, and therefore possible to forecast from the past. Currently, Axioma sees benchmark risks as low, but volatility is unlikely to decline further. In 2016, volatility declined in most equity markets around the world, despite a jump in mid-year following the “Brexit” vote. This was more pronounced in U. S. markets than other countries, and also in developed markets more than emerging markets. The level of volatility at the end of the year was not materially different from levels in 2000.

Axioma decomposes risk by looking at five components:

  • Portfolio holdings (generally are they more or less risky?)
  • Characteristics of the holdings (sector, industry, cap size, etc.)
  • Security-specific risks (which rose in 2016)
  • Factor volatility (an important component in Q4)
  • Correlations

The last one, correlations, is very low now and is the reason market volatility is low despite the relatively high volatility of individual securities.  Sector also plays an important role here. In the U. S. in 2016 there was a wide dispersion of risks and returns by sector. Consumer discretionary, Technology, Energy, and Materials all did well with declining risk. Finance, real estate, telecom, and utilities had very mixed results, but also with generally lower risk (except for finance). The dispersion of sector returns peaked in November at levels near records for Axioma’s database. Brown pointed out that the low correlations could provide an opportunity for active management to outperform passive.

Taking an international view, Brown noted that as of the end of the year, risk in developed markets is highly concentrated (see Italy, Greece, and Iceland) while in emerging markets, risk is more widely (and evenly) scattered. This situation developed during the fourth quarter and reflects the strength of the dollar, which is more of a challenge for emerging markets than for developed. Switzerland just nudged out the U. S. for the lowest risk by country at year end. Mexico holds the distinction as the riskiest country, again reflecting the weakness of the peso since the U. S. election.

Distinguished Speaker Series: Dan Clifton, Strategas Research Partners

“Angry is the New Hope” was the title and theme of the presentation on December 6 from Dan Clifton, Partner and Head of Policy Research for Strategas Research Partners. Hope was the watch word of the Obama administration, but the surprise election of Donald Trump reflects anger in the electorate. This anger stems from the persistent, subpar economic growth since the end of the financial crisis. In the eight years since, growth in GDP has averaged just 2%, versus the long term trend of 3%. That 1% annual shortfall, has created a cumulative GDP gap of $2.6 trillion dollars. The support that Bernie Sanders received late into the campaign indicates the voter anger extends across the political spectrum, not just within the Republican Party.DSC_3255

While Donald Trump’s election may have surprised many people, beneath the surface there were several indications that he would prevail:

  • Audiences for the Republican debates were three times what the Democrats attracted in 2008, the last time there was an outgoing administration. Ratings for these debates were even greater than popular reality television shows suggesting a great interest in making changes in Washington.
  • Weakness in the U.S. equity markets in the three months leading up to the election has a reliable history as an indicator for a loss by the party in power.
  • The finance and energy sectors outperformed the broad market in the last three months, also predicting a Republican win.
  • Support for populist, “non-traditional” parties, is gaining momentum around the world as confirmed by the Brexit vote in the United Kingdom. The push for change is global, not limited to the U. S.

This global shift toward populism is creating an urgency for governments to get their economies moving faster again. Hence, the victory for Donald Trump. Clifton listed several areas of emphasis for the new Trump Administration:

  1. DSC_3257Greater geo-political risk—as we have already seen from the phone call to the President of Taiwan, Trump has little concern for protocol and his use of Twitter increases the chance of off-the-cuff communications.
  2. Trade Policy—Trump made bold changes to trade policy a key part of his campaign and as president he will have the power to enact many of them unilaterally. Will he do so without seeking the guidance of his advisors or the congress?
  3. Fiscal Policy—the financial markets have quickly priced in everything Trump promised to do during the campaign (witness the sharp increase in interest rates and stock markets). In reality congress is unlikely to give him everything he wants and, even that, more slowly than the market expects. In particular, congress is likely to be more concerned about increasing the budget deficit than will be the president.
  4. Tax Reform—done correctly, tax reform (unlike a tax cut) will be neutral to the deficit in the early years, but achieving it is difficult and slow. True tax reform has only been done once before (1986).  A key question is whether it’s done via budget reconciliation, which is very partisan and leads to compromises that reduce the effectiveness, or dynamic scoring which accounts for the stimulating effect of the reduction in tax rates. Clifton called repatriation of foreign earnings the crown jewel of tax reform with a forecast of a potential $1 trillion coming into U. S. over fifteen months. This will add to the stimulus impact from tax reform and fiscal spending.
  5. Stimulus spending—also difficult to get done quickly–see Obama’s disappointing efforts in 2009. Clifton thought infrastructure stocks had run up too far, too fast since the election and that energy-related projects will get the emphasis from president Trump. He is likely to give a green light to several dozen projects currently being held up by the Obama administration over global warming concerns.

Trump made repealing Obama Care a signature feature of his campaign but the Republicans in congress are unlikely to repeal it without a viable replacement (which they don’t yet have). More likely they will start by cancelling the surtaxes included in the plan. This will provide a little more stimulus.  The Dodd-Frank law is likely to remain in place, but will also face revisions.

Finally, Clifton predicted that lobbyists will enjoy increased influence in the new administration. Trump will be much more susceptible to their approaches because he is not the ideologue that Obama is.

In response to questions, Clifton predicted that James “Mad Dog Mattis will get the waiver of the seven year rule to allow him to take the Secretary of Defense post and he will be a tough negotiator in that role. As a consequence, David Petraeus (another former general) will not become Secretary of State.

There are several big hurdles in the road to tax reform. One is whether to enact “border-adjustable taxes” (also called the out-sourcing tax) that would prohibit companies from deducting the cost of imported goods from taxable income. This would hurt import heavy industries (like retailers) and help exporters.  Momentum seems to be in favor of it, but it would likely draw a challenge from the World Trade Organization.

The second hurdle is a restriction on using repatriated foreign earnings for share buy-backs.  While it would enjoy political support, it would be very difficult to enact, as money is fungible. It would also be counterproductive by reducing the amount repatriated, and limiting the capital gains take from buybacks.

To the last question about raising the debt ceiling, Clifton called this an under-appreciated, but very important point. It will have to be addressed by this summer and could interfere with the tax reform efforts.