Distinguished Speaker Series: David Booth, Dimensional Fund Advisors

In September of 1969, an MBA student took a course that would result in positively affecting the lives of countless people, a couple of universities, and how much of the investment industry would learn to view the world.

It started with two individuals, the University of Chicago professor Eugene Fama and student David Booth. The seed of one idea blossomed into a fifty-year friendship, a history of applying academic research to practical investing and formation of a multi-national investment firm of over 1,400 employees managing $586 billion.

Along the way, after David (student) had learned finance from Gene (professor), the circle was completed as Professor Fama likes to say he learned business from Booth.

It is the only time the professor had been asked to join a student’s business. It was a natural in this case, as the firm, Dimensional Fund Advisors (“DFA” or “Dimensional”) shared the same beliefs having been spawned by ideas Booth picked up in Professor Fama’s course.

Along the way, it should be mentioned that the intersecting worlds of academics, athletics and the arts have also benefited. The University of Chicago named its Booth School of Business in the MBA student’s honor. The University of Kansas named its David Booth Kansas Memorial Stadium in honor of its former undergraduate student (note, Booth has also funded the Booth Family Hall of Athletics in Allen Fieldhouse at KU while donating James Naismith’s original 13 rules of basketball). The Museum of Modern Art has benefited in naming the David Booth Conservation Center and Department in the same man’s honor. Another benefactor has been Georgetown University which named its Booth Family Center for Special Collections within its Lauinger Library. 

It is this story that was told through the voice of the student in the forum of the August Distinguished Speaker Series luncheon on August 14th at the Standard Club. David Booth himself provided the history of Dimensional’s roots, how its one philosophy initiated 50 years earlier, how the firm takes academic ideas and implements them into real world solutions for clients, as well as DFA’s 38-year track record of delivering outperformance versus their benchmarks.

The discussion began with a short video touting the highlights from Mr. Booth’s career which is synonymous with the formation of Dimensional. His friendship with Professor Fama is central to the story. The impact DFA had on the investing universe is also notable, with accomplishments including being pioneers in treating small cap stocks as an asset class and finding a niche between active and passive investing. Dimensional has been styled as “the original factor investors”.

The bulk of the program consisted of an interview/fireside chat with current chair of the CFA Society Chicago’s Board of Directors, Tom Digenan, CFA.

Once again, a chronicle of Mr. Booth’s 50 years in the industry was recounted: how he has inspired people, his mentors (again – Fama was both mentor and a mentee), use of academics, the very large weight put on implementation, and the tension between models and reality in conducting research. 

The importance of TRUST could not be emphasized enough. Especially as it pertained to client relations and the ability to successfully navigate the ups and downs of markets.

Questions were asked about Booth’s thoughts about the significant reduction in the number of publicly traded stocks, his bias toward either active or passive, how DFA utilizes fundamental research, how his firm’s definition of value may have changed over time, and about any change in their thinking now that a new phenomenon of negative interest rates has emerged. His answers to all questions revolved around a single core philosophy that markets are efficient and over long haul there are some simple things an investor can do that will provide a very good experience long term without trying to outguess the market.

Distinguished Speaker Series: Michael O’Grady, Northern Trust

On June 13th local investment professionals gathered at the Chicago Club to hear a “fireside chat” with Michael O’Grady, chairman and CEO of Northern Trust. Marie Winters CFA, past chair of the CFA Society Chicago served as host and interviewer. To begin, O’Grady outlined Northern Trust’s core values that he said were the prime reasons the firm is about to celebrate 130 years of success, and why it remains independent at a time of rapid consolidation in financial services. These values are: service, expertise, and integrity. Northern Trust has focused on these since its inception, with the interpretation, or application, of them evolving to fit the times.  O’Grady expanded as follows:

  • Service applies not just to clients, but also to employees (or partners as Northern refers to them internally), and the community. A commitment of service to these constituents has always driven Northern‘s strategy. While the firm is known publicly for its key products (such as wealth management and asset servicing) it sees itself as a service organization.
  • Expertise is a point of pride for Northern Trust. It employs over 300 charterholders (the most of any firm based in Chicago) but the expertise the firm embraces extends beyond investment management to include other functional areas such as technology, and banking.
  • Integrity, put simply, means always doing the right thing, no matter how difficult. Again, the firm applies this broadly to relationships with partners and the community as well as clients.

Winters’s first question had to do with strategic changes that O’Grady had made since becoming CEO at the end of 2018 (or that he had planned for the near future). He did not answer specifically, but instead listed three drivers of success that he intends to emphasize: 

  1. Service excellence, a combination of his first two core values, which requires understanding the constant change in the business.
  2. Productivity, an absolutely critical need in a time of low revenue growth. Productivity improvements have been a focus at Northern for several years in a program called “Value for Spend”, which seeks to get more out of each dollar of expense.
  3. Investing for growth–determining where the firm should invest now to generate growth in the future.  Again, this reflects the recent history of slower revenue growth. 

Responding to a question about how Northern Trust is addressing the secular shift from active to passive management, O’Grady noted that Northern provides products that follow both strategies. The focus on efficiency is his key to success within passive products because of the low fee levels. Within active strategies, the focus is on leveraging Northern Trust’s expertise in factor-based analysis. Both of these product lines appear in their lineup of multi-asset class solutions.

When asked about investing for ESG (Environmental, Social, and Governance) factors, O’Grady said Northern Trust sees a clear and growing interest from clients. Designing and building such products requires a vast amount of new information and we are only in the early days of reporting that. Gathering accurate information consistently, and analyzing it thoroughly, will be key to success in ESG investing. This is made challenging by the changing nature of our economy.  The number of publicly-traded companies is shrinking, in favor of private companies. Obviously, public companies are more likely to report relevant data pertaining to ESG factors (and in a more consistent manner) than are private companies. So, even for the private equity investor, following ESG strategies is a challenge.

When asked about the importance of technology and digital innovation, O’Grady turned to data security. At front of mind for him was protecting clients’ private information. Technological innovation changes our world faster and faster (blockchain and cloud computing were two drivers of change he mentioned). With this change, clients demand more information, delivered more quickly, but the more we rely on technology to satisfy that demand, the greater the exposure to cybersecurity threats. Ironically, technology will have to be the principal tool in protecting against this risk. O’Grady then made an observation about technological innovation that illustrated one big way it has changed our world. He turned around the saying that “necessity is the mother of invention” to innovation being the mother of necessity. So, not only does technology allow us to do more with less, it also allows us to do things we never thought possible, never knew we could do, and even never knew we needed to do. This gets to the heart of the fears that technology destroys job opportunities. Rather, it creates more than it destroys.

The final area that Winters asked about was how Northern Trust is addressing diversity and inclusion. O’Grady said he’s proud of what Northern Trust has done so far, while acknowledging that the process continues. He specifically noted success in improving diversity metrics in hiring, especially for entry-level jobs, but sees more improvement needed further along the career path. That improvement requires new information that will inform the company on the causes of this shortcoming, and define the corrective actions. So far, they have learned that male managers tend to change roles more often early in their careers, giving the appearance of broader experience when they are considered for promotions. By measuring this and reporting it to managers Northern Trust can hold them accountable for removing any gender-based biases. Further, he noted the firm needs to be more active in assuring that development programs are open to women and people of color and the firm’s culture, which has served it so well for so long, may also have served as an obstacle to advancement. It must evolve to embrace a new commitment to improving diversity.

Diversity improvement was the subject of the first question from the audience about the differences in the various countries where Northern Trust has a significant number of employees. O’Grady acknowledged that policies and actions need to be tailored to the customs, regulations, and existing circumstances in each country. Gender equity is easier to address with consistent policies and programs around the world. However, ethnic diversity requires more customized solutions.

When asked how Northern Trust “walked the talk” on integrity. O’Grady listed three steps: 1) he repeated his rule of always doing the right thing; 2) being transparent, both internally and externally, so your stakeholders understand what you’re saying and doing, and can judge you correctly; and 3) leading by example because telling people how to behave is ineffective. They need to embrace the rules or customs.

When asked what companies O’Grady considers to be his most formidable competitors, he mentioned a few well-known financial services providers but his general comment was more insightful: they need to be mindful of the firms that are excelling at the things Northern Trust also needs to do well. The final audience question asked about Northern Trust’s strategy for growth. O’Grady summarized the firm’s revenue stream as about two-thirds from fees directly connected to the value of the assets they manage or service. They have no control over the value of those assets. The other one-third of revenue comes from earnings on the balance sheet, which are highly correlated to interest rates. Again, they have no control over the level or direction of change in interest rates.  So, they focus on the growth of new business because it’s the factor affecting profit growth that they have the most control over. Secondary factors include productivity improvements (that they see as an offset to inflation), and prudent investments in new businesses or technology.

Distinguished Speaker Series: Charles K. Bobrinskoy, Ariel Investments

Some investors have great analytical skills in assessing current and potential future investments, but the best investors also possess an uncanny ability to both recognize and combat their own behavioral tendencies when making investment decisions. This was the topic of Charles “Charlie” Bobrinskoy’s presentation to a packed room of eager members of CFA Society Chicago and local investment professionals at the Society’s Distinguished Speaker Series luncheon held on May 15, 2019. The program titled, “Combating Unhealthy Behavioral Tendencies in an Investment Firm” discussed how Bobrinskoy’s firm Ariel Investments has adjusted its investment process to incorporate the latest academic findings in the field of Behavioral Economics, and how these process improvements have helped Ariel’s flagship Mutual Fund, The Ariel Fund, become number #1 in its mid-cap value category over the last 10 years.

As way of background, Charles Bobrinskoy is the vice chairman and head of Investment Group for Ariel Investments. Headquartered in Chicago, the firm offers six mutual funds for individual investors and defined contribution plans as well as separately managed accounts for institutions and high net worth individuals. He manages their focused value strategy—an all-cap, concentrated portfolio of U.S. stocks. Bobrinskoy also spearheads Ariel’s thought leadership efforts and takes an active role in representing Ariel’s investment strategies with prospective investors, clients and major media. Additionally, he is a member of the Ariel Investments board of directors. Bobrinskoy is frequently quoted in various news publications such as The Wall Street Journal, Barron’s, Money and USA Today, is a regular contributor to CNBC, and is frequently a guest on Bloomberg Radio.

Many in the room with a CFA curriculum under their belts were familiar with the inherent behavioral biases in our decision making, but Brobinskoy started off by suggesting that he not only was going to share with us the most influential biases, but more importantly, he was going to teach us how to combat them.  Some economists believe that no matter how much we recognize behavioral biases, we are helpless in trying to combat them.  Bobrinskoy and Ariel Investments don’t believe this, and they have purposefully instituted structural processes to combat each bias.

Before jumping into each bias, there are four common observations in the markets that defy efficient markets. The existence of behavioral finance is why each of these market anomalies exist.

  • Stocks beat bonds over the long term.
  • Until the last 10 years, value has consistently outperformed growth.
  • Small caps outperform large caps.
  • And finally, there is momentum in every asset class.

Here is what we learned by bias, in no particular order.

  • Confirmation bias. The tendency to seek data that is compatible with beliefs currently held and to reject conflicting data. Unfortunately, the smarter you are, the more susceptible you are to confirmation bias. A common example is people watch Fox News if they are a Republican and MSNBC if they are a Democrat.

Ways to combat: Appoint a fellow research analyst to play Devil’s Advocate. Challenging another analyst’s assumptions is inherently difficult because it creates conflict. Official appointment of a devil’s advocate actually removes the conflict inherent in challenging someone else’s assumptions because it is his/her job to contradict initial assumptions.

  • Overconfidence bias. The tendency to overestimate what one knows and underestimate the uncertainties of the future.

Ways to combat: Place probabilities on outcomes, and ask for feedback on those probabilities. Ask questions to narrow down the range on probabilities.

  • Anchoring on prior estimates. The tendency to adjust prior estimates insufficiently when presented with new information.   This is why momentum exists in the markets. 

Ways to combat: You need a culture that does not penalize analysts for revisions. Encourage analysts to change their views based on new information that is learned in the market.

  • Loss Aversion. The tendency to overweight losses relative to gains.  This is why there an equity premium.  Investors are willing to accept a certain $5 gain, versus an expected return of $10.

Ways to combat: Ignore your costs basis. Examine each investment decision as if you didn’t own the stock.  Ask yourself, “Would you buy it again today?”

  • Endowment Effect. The tendency to overvalue that which one owns versus that which one doesn’t own.  

Ways to combat: Keep a watch list of what you don’t own that is comparable to what you do own. Look at the data as if you didn’t have any portfolio positions in play and ask, “If I had fresh capital, what would I own today?”

  • Reliance on Intuition over Data. The tendency to think one’s gut instinct is superior to data and to overestimate the significance of very small samples. Model based decisions are always better than guy instinct.

Ways to combat: Always trust the data over intuition. Ask yourself if a decision is data based or on gut instinct. 

  • Vividness/Recency effect. The tendency to measure frequency by one’s ability to think of example which in turn produces a tendency to overweight recent examples.

Ways to combat: Be required to have several examples to prove your point.

For further reading, Brobinskoy suggested three books:

  • Thinking in Bets by Annie Duke.
  • Thinking Fast and Slow by Daniel Kahneman
  • Misbehaving: The Making of Behavioral Economics by Richard Thaler

Last but not least, if you’re a Republican, challenge yourself to watch MSNBC.  If you’re a Democrat, challenge yourself to watch Fox News!

Distinguished Speaker Series: Sheila Penrose, Jones Lang LaSalle

On April 9th, CFA Society Chicago’s Distinguished Speaker Series Advisory Group welcomed Sheila Penrose at The Metropolitan. Penrose is Non-Executive Lead Independent Chairman of the Board at Jones Lang LaSalle, a global real estate services company, and also serves on the Board of Directors for McDonald’s. Penrose retired from Northern Trust in 2000. In her 23 years at Northern Trust, she served as President of Corporate and Institutional Services and as a member of the Management Committee, where she was the first woman to serve. Subsequently, she served as an Executive Advisor to The Boston Consulting Group from 2001 to 2007. She has been on the boards of Entrust Datacard Group, eFunds Corporation, and Nalco Chemical Corp. She has also served on the advisory board of the Gender Parity initiative of the World Economic Forum, the board of the Chicago Council on Global Affairs, and as a founding member of the US 30% Club, a group whose initiative is to achieve female representation of at least 30% on corporate boards.

After detailing some of her credentials and experience, Penrose highlighted three topics she wanted to explore:

  1. What issues are boards of directors discussing the most?
  2. How are boards of directors handling the evolution of the business environment?
  3. How do a group of highly ambitious, competitive and capable people, all of whom are used to leading others, form a functioning team that can effectively oversee a company?

She emphasized that in each topic, boards are fiduciaries for both shareholders and stakeholders, and need to understand how to balance the needs of both groups. She also emphasized that individual board members should be listening and learning all the time, while contributing and remaining objective.

Penrose expounded upon the recent transformation of the business environment as it relates to the board of directors.  Recently, boards have become less dominated by the executive. The CEO/Chairman dual role that was so common in previous years is now no longer as accepted as it once was. This was spurred by Sarbanes-Oxley, but also investors and employees who now have more of a voice shareholder activism has increased. Digital disruption has also been a major category for boards to tackle, and relatedly, managing corporate reputation in an age of social media, where all voices have access to the public. Diversity on boards, and not just different kinds of people, but different viewpoints, has also been an important topic. Boards have been seeking to find people who have different types of experience and different types of expertise, as opposed to finding a group of CEOs for the board. Boards need to develop consensus, not groupthink. She brought up the dilemma of cybersecurity. Boards must wrestle with the questions of how much cybersecurity is enough and how quickly the company can react in the event of a breach. Boards must also consider the impact of global events, as almost all large corporations are now global in reach. Lastly, and importantly, she discussed the issue of talent and corporate culture. Boards must grapple with the future of work and the changes in expectations of their employees. Companies assume they will be able to find the skills they need in the labor market, but they are not doing much to develop those skills in employees and not moving quickly enough to develop people whose jobs might be redundant in the future.

Boards also have to understand how best to find directors. With the changing business environment, new skills are often necessary, and boards have begun looking for people who have those skills, such as digital experience, to help them stay current.

The composition of the board, its dynamic, and its leadership are all critically important. The board should be “collegial but not clubby”, and board decisions should be made in the room, not in private meetings.  Board members should maintain a healthy balance of both listening and contributing.

Individual board members should have what Penrose called “The Four Cs.”

  • Curiosity
  • Conviction
  • Courage
  • Compassion

During the Q&A portion of the event, Penrose described how she believes someone can become a member of a board of directors. She said the individual must have a good reason for why they want to join a board, should be strongly curious and constantly learning, should have experience trying to manage a business on some level, and should be wary of joining a board too quickly. Joining a board too quickly usually means that board is likely of lower quality, and the first board you join dictates one’s future opportunities.

Distinguished Speaker Series: Howard Marks, CFA, Oaktree Capital

Howard Marks, CFA, is co-chairman of Oaktree Capital, where he contributes his experience to big-picture decisions relating to investments and corporate direction. He shared his insights on investing and managing the business cycle for the CFA Society Chicago community on February 22, 2019. His presentation, entitled “Investing in a Low-Return World,” touched on some of the big questions investors are asking themselves today: Should we lower our return expectations? And if so, how do we make money in a low-return world?

Marks describes today’s environment as a “low-return, high-risk world.” Prospective returns and safety are hard to come by in the current over-optimistic climate where people have great trust in the future. Combined with higher risk-aversion, such sentiments lead to asset price appreciation, which means lower future returns, without any lower risk.

Let us follow Marks back to basics to consider what lower returns actually mean. Consider the CAPM model, which shows the trade-off between risk and return. As central banks have lowered interest rate, this line has shifted down. For the same level of risk, you now have lower returns, whether you are investing in T-bills or equity. The CAPM model hints at two reasons why taking more risk is no surefire way to higher returns. For one, the downward shift in the CAPM-line means that returns are lower even for such risky ventures like private equity. Secondly, and more fundamentally, the CAPM does not ensure higher return for riskier assets. As Marks explains, if higher returns were guaranteed for these assets, they would not be risky. For risky assets, therefore, while required returns appear to be higher, there is a wide range of possible outcomes that offer no safe way to high returns.

In Marks’ view, the seven worst words are ”too much money chasing too few deals.” This is what we are seeing today, with returns lower across the board. As Marks clarifies in a memo, “too much money” does not mean investors have more money on their hands to invest, but that they are moving resources out of cash, where returns are low, to seek more risky opportunities, and as such, push down required returns on riskier investments.

What, then, is an asset manager to do in this environment? You cannot both position yourself correctly in a heated bull market and be positioned for reversal at the same time. Counting on historical returns being the same in the future is foolish but settling for today’s low returns contradicts the business plan of most organizations. You may not survive in the business if you go all into cash and wait for a better environment.

As an asset manager, argues Marks, you have two jobs, that of asset selection and cycle positioning. You cannot give up on timing when to be aggressive because then you cannot ever be defensive. Cycle positioning does not mean forecasting economic growth for the next year. Marks makes very clear that he does not believe in forecasting. Instead, you need to understand where you are in the relevant cycles, such as the business cycle, credit cycle, and the market psychology cycle. Knowing where you are gets the odds on your side. It does not mean you can predict what will happen tomorrow but it should tell you whether to be more aggressive or more cautious. Marks explains that there are times for aggressiveness and times for caution:

  • When prices are low, pessimism is widespread and investors flee from risk, it is time to be aggressive.
  • When valuations are high, enthusiasm is rampant and investors are risk-tolerant, it is time for caution.

It seems Oaktree’s view is that the current environment is a mixed bag. For the past three years, their mantra has been “move forward but with caution.” This, as Marks explains, means being fully invested while biasing the portfolio towards defense rather than offence.

In addition to getting the cycles on your side, explains Marks, there are opportunities for alpha also in the current environment. Despite low returns overall, there are mispricings to exploit. You do have more and less efficient markets, and with the right set of skills, you can identify them. This is harder than it used to be, when there were more structural and persistent inefficiencies to exploit. Nowadays, most inefficiencies are cyclical, and emerge only once in a while.

In inefficient markets, some investors will earn positive alpha, and some negative alpha, so you should enter these markets only if you think you can be on the right side of the trades. You can do this only if you dare to be a contrarian. Going this rout is risky and costly but it is the right way to invest if you have the skills to do it.

For additional reading, see Howard Mark’s memo “Risk and Return Today.” You can find all his memos while at Oaktree here. You can also view the CFA Society Chicago luncheon presentation below.

Distinguished Speaker Series: Joel Greenblatt, Gotham Asset Management

Joel Greenblatt, the legendary author, Columbia B-school professor and hedge fund manager, presented his thoughts and methodology on investing to CFA Society Chicago and local investment community on Wednesday, December 5, 2018.

The title of his presentation compared value investing to the New York Jets, i.e. unpopular and out of favor. Per Greenblatt, where we stand today on a valuation basis relative to the past 25 years is that about 25% of the S&P 500 could be considered “undervalued” versus just 7% of the Russell 2000, if we assume the S&P 500 earns its long-run average forward return of 7%. Greenblatt also thought that the S&P 500 could earn a below-average 3%-5% return for the next few years.

In a statement that was likely no surprise to anyone in attendance, Greenblatt noted that “Growth” has outperformed the market the last 5 years. Greenblatt defined for attendees what the parameters were for a value investor (with all of these definitions supported by the Russell and Morningstar definitions:

  • Low price-to-book
  • Low price-to-sales
  • Low cash-flow valuation

What Greenblatt admonishes his students to aspire to, “Do good valuation work, and the market will likely agree with it”. Greenblatt noted he just wasn’t sure when the market would agree, but in theory at some point it will.

Greenblatt put up the chart that showed the classical individual stock return versus company valuation, and to no surprise to anyone, the overvalued stocks typically had the lowest forward returns relative to the lowest valuation. He also used the examples of two lectures he gave to a group of NY doctors who only asked what he thought the market would do over the next few years, versus the Harlem high school jelly bean test, and asking the kids to guess as to the number of jelly beans in the jar. Joel Greenblatt used the story to lead listeners to the conclusion that the kids in Harlem were closer to the right answer in terms of the accurate number of jelly beans in the jar, when doing their own homework versus listening to “word-of-mouth” guesses by the class.

It was clear that Greenblatt was more impressed by the analytical rigor of the Harlem high school class than the group of doctors, but he also used the story to illustrate the power of impression and what is heard by the retail investor and how emotion and psychology play important roles in investing. Greenblatt also talked about one of first books, i.e. The Big Secret for the Small Investor and the two most important points from the book:

  • 41% of the investment managers with the best 10-year track records also spent at least 3 of those years in the bottom decile of performance rankings.
  • The “Big Secret” is really just patience. Find an investment strategy that you are comfortable with and stay with it.

Greenblatt noted that the press’s preoccupation with Tesla is the “tyranny of the anecdote” contrasting that with deep value investing strategies and how they work over long periods of time.

The Q&A session noted that – not surprisingly – Greenblatt finds more opportunities in the smaller-cap universe despite the valuation comments from above. The valuation metrics aren’t “weighted” in that price-to-sales isn’t weighted more heavily than price-to-book although from his side comments and what were more impromptu thoughts by Joel, price-to-cash-flow and cash-flow health was rather significant.

Greenblatt did note that with “international” investing, the Professor’s fund trades long-only since with international there are trading costs, different forms of regulation, liquidity and other notable differences between US and Non-US investing.

 

*If you missed the event the webcast of the full presentation is still available to watch on the CFA Society Chicago website.

Distinguished Speaker Series: James Grant, Grant’s Interest Rate Observer

James Grant has a resume. Navy man. Journalist. Founder and editor of Grant’s Interest Rate Observer. Author of books that range from the Great Depression, financial histories, a presidential biography, a forthcoming biography about Walter Bagehot, and appearances on numerous financial programs. Grant was the featured guest speaker at CFA Society Chicago’s Distinguished Speaker Series on November 14, 2018. Over lunch at the JW Marriot, Grant gave his views on topics ranging from interest rates to asset valuations and finished with questions from the audience.

Grant started with a U.S. economic review of the past 10 years concentrating on the progress and consequences of the monetary / fiscal policies applied over this period. Grant noted in 2007/08, the largest banks were leveraged around 29/1. The same group of banks are now levered approximately 13/1. While the risk these banks pose to the financial system has been reduced by de-levering over the past ten years, the leverage ratio of the Federal Reserve Bank has moved in an opposite direction, now standing at all-time highs. Fed policies have created a risky and perhaps fragile economic situation. Although the Fed has the ultimate backing of the U.S. government, at some point the investing public could say “enough” as ultimately the term “risk-free asset” will come into question. Grant then compared debt loads to GDP, asking rhetorically what is the level of debt that inhibits a country from issuing new debt at any price? Japan’s ratio of public debt to GDP is around 228%, Italy’s is 130%, while the U.S. stands at 105%. None of these countries currently have a problem issuing or servicing their debt. However, Grant explained that the level of debt is not the key, but how a country is viewed in the eyes of the world markets. For example, in 1978 the U.S. was in the midst of a funding crisis and the debt/GDP ratio was at only 26%. While finances and balance sheets matter, it is the cycles of interest rates that dominate a countries ability to raise debt and the world economies appetite for it. An alarming fact is the level of U.S debt issuance (in terms of percentage of GDP) is at its highest point since 1945. Grant pointed out the incongruity of the U.S. bond market activity and the overall economy. The economy by any measure has exhibited steady and reasonable growth in the past 10 years. Yet the U.S. government continues to issue more debt and increase the overall deficit in the face of increasing GDP.

Next, Grant addressed the value of risk-based assets. The past ten years of near zero term rates has created a perversely low cost of capital. By holding interest rates to artificially low levels, asset prices have inflated abnormally. Companies have exhibited a vicious cycle of issuing debt and using the proceeds to buy back their stock thereby propping up valuations. Fed policy is the main reason why there are a number of mega-sized companies that have recently gone or are about to go public. The commonality among these companies is that they typically make no money, have remarkably high valuations, and have easy access to cheap capital. Think Uber – it has never been profitable, year-over-year growth is decelerating, and it continues to lose market share. Despite this documented financial condition Uber has been recently valued at an enterprise value over $70 billion.

To underscore his points, Grant cited the works of two other authors. The first was Ed McQuarrie, Professor Emeritus at the Leavey School of Business, Santa Clara University. McQuarrie is a part-time market historian who takes particular issue with the views popularized by Jeremy Siegel of a 6-7% average return in the stock market over time. McQuarrie’s position is that for decade long periods the stock market has had negative returns and there is not necessarily a reversion to the mean. Grant strongly advised the audience to read Dr. McQuarrie’s paper Stock Market Charts You Never Saw.

When Grant finished his prepared remarks he fielded questions from the audience.

Q – Given your outlook on interest rates and asset valuations, is the pricing of private equity realistic?

A – Grant answered with a quick “No”, and pointed to a recent disagreement between Palantir Technologies and Morgan Staley which has a stake in the company. Palantir has been valued in the $30B – $40B range and is looking to launch its IPO in 2019. Morgan Stanley has lowered the valuation of the company to a fraction of its private market $30-$40B valuation. What does it say to the current state of private equity valuations if the very banks that are to take a company public cannot agree with the company on valuation?

Q – In the current market environment where would you put capital?

A – As bond yields go up (a certainty in Grants eyes), gold will also go up. When the public losses confidence in a country’s fiscal management, there will be a flight from that currency.

Q – Given the state of the U.S. finances, what is the answer – raise taxes, lower spending?

A – The first step to fixing our financial crisis is something akin to a person dependent on drugs. Admit there is a problem. Setting aside the lawmaker (or the out of power political party) that calls for fiscal responsibility, the U.S. government as a whole must tackle the problem. It is more likely that there will be monetary disorder before the problem is addressed. If this is the most likely scenario, then investors should consider gold as hedge.

Distinguished Speaker Series: Rick Waddell, Chairman of Northern Trust

Who better to teach management during a crisis than a former bank CEO who began his job in the midst of the 2008 recession? Rick Waddell has one of the most extensive resumes you’ll find in banking and dedicated his career to growing Northern Trust from a sleepy custody and wealth management firm into the technology-driven asset management and banking leader it is today. Waddell was CFA Society Chicago’s guest speaker on October 10th for its Distinguished Speaker Series luncheon.

He noted proudly that he saw many former and current Northern Trust employees in the audience. “The CFA Society is really important to us at Northern Trust,” he said. Waddell said that he was told not to make his speech a commercial for his bank, and joked that “this eliminates about 95% of my content” and made him ponder what would be a good topic for him to address, ultimately deciding on “5 Things I Learned From the Global Financial Crisis of 2008”.

In Waddell’s mind, the following five key features made the difference between success and failure during the financial crisis.

Capital matters. For any organization with a balance sheet, both the quantity and quality of its capital during ’08 were incredibly important. He noted that capital ratios had been too low in Europe, but generally were roughly OK in the US. He still sees problems with bank capital transparency in Europe today.

Liquidity matters. Again, both the quality and the amount of liquidity are important. Waddell said that he believed that the fall of Lehman Brothers was not due to lack of capital, but to lack of liquidity. The Fed was much more focused on capital during the global financial crisis than liquidity, but the latter was just as important. One of the earliest warning signs Waddell saw that all was not right in the financial world was when HSBC wrote down $11 billion worth of subprime mortgages in March of 2007. Waddell wanted to know if any part of Northern Trust had exposure to subprime lending and found that, while they didn’t make the loans themselves, they still had subprime-related instruments in some of their investment pools. Another warning sign came in August 2007 when Waddell learned that a securities lending collateral pool was facing losses when a number of banks withdrew from the niche Auction Rate Securities (ARS) market and banks holding the formerly liquid instruments suddenly faced losses.

Leadership and management during a crisis matter. Waddell said that during a tumultuous period, “the good and the not so good in all of us comes out.” With his background focused on commercial banking, he had to learn a lot of things quickly during the crisis as a new CEO leading a diversified financial firm. At the same time, Waddell had consultants and executives coming to him asking who he was going to fire in order to shed costs. Firing people immediately after the bank’s best year on record (2007) didn’t make sense to Waddell. He didn’t want to go down that route, and it turned out that staying the course and not making widespread headcount reductions was the right decision.

Culture matters. “At Northern Trust, our values are service, expertise and integrity,” said Waddell. Having that culture in place before a crisis hit was extraordinarily important. While Waddell admitted that Northern Trust has its share of problems like any firm, and its culture needs to evolve while holding employees more accountable, having a set of values that the team buys into was one of the main reasons the firm navigated the crisis so well. “Culture is more important than strategy,” Waddell said, echoing management consulting pioneer Peter Drucker. Despite the bank’s commitment to its partners and Waddell’s desire to avoid mass layoffs, its ROE fell to 8.2% in 2011, below its cost of capital, so the bank went on a mission to cut costs while still avoiding large layoffs that could have demoralized staff.

Strategy matters. Waddell said that having skin in the game was important during the recession. He found that the trend of banks securitizing assets and immediately getting them off their balance sheet led to a lack of skin in the game with financial institutions, and this made the crisis even worse.

Waddell continued on at length about his experience during the financial crisis. In 2009, large US banks were forced to accept a capital injection as part of TARP. Northern Trust was well-capitalized and didn’t need the money, but regulators hinted that they needed to comply or there could be consequences. Waddell said that the TARP program was in theory a good idea that could act as a stimulus, but the problem was that there weren’t enough borrowers demanding capital for it to have much of an impact. What was originally termed the “healthy bank program” soon became “the bailout” in the public’s eyes, which led to protest movements such as Occupy Wall Street, some of which were held immediately outside Northern Trust’s headquarters at LaSalle and Monroe. This populist take on the government bailing out fat cat bankers hurt the perception of Northern Trust, despite the firm’s insistence that it didn’t need capital and its desire to quickly repay the money. Waddell said that the terms of the loan Northern Trust was forced to take netted taxpayers a 15.5% return, and TARP overall was one of the most successful investments for taxpayers in recent history and very profitable for the government.

Blame for the crisis is difficult to assess, but Waddell said that the Fed was responsible for missing some of the warning signs, banks were also responsible to an extent for lax standards, and consumers were also responsible by borrowing far more money than they were able to repay. Waddell said that eventually there will be a recession in the US but the banking system will be in a much better position to not only withstand it, but even be a positive force for stability. One thing that remains unresolved is the issue of “too big to fail”, but bank capital and credit quality have greatly improved overall. While he noticed some clues that markets were starting to crack back in 2007, Waddell sees few red flags on the horizon today. He said that usually problems will manifest early on in the mortgage market, but that the industry appears to be functioning fairly normally now. There could be some issues with Brexit next year, and Northern Trust continues to monitor that situation closely, as well as the Chinese economy and issues around cybersecurity. In his Q&A, Waddell said that young professionals considering a career in banking will still find opportunities in the future, as the practice of safeguarding assets and allocating capital will be around for a long time. He was slightly less upbeat about the prospects for the asset management industry in light of the disruptions faced by robo advisers, low (and sometimes free, in the case of Fidelity) account fees, and the trend towards passive investing.

True to Northern Trust’s values, Waddell finished his speech by encouraging the audience to get involved in a philanthropic endeavor that aligns with their interest, saying “to much is given, much is expected”. Lastly, he noted the firm’s long history of collaborating with United Way and said that there’s still much work to be done.

Distinguished Speaker Series: James Bullard, President and CEO of the St. Louis Federal Reserve Bank

On September 12th, CFA Society Chicago welcomed James Bullard, president and CEO of the St. Louis Federal Reserve Bank. Members and guests heard Bullard’s remarks over breakfast at The University Club.

The focus of the discussion explored a possible strategy to extend the U.S. economic expansion. Bullard noted that historical signals used by monetary policy makers have broken down, specifically the empirical Phillips curve relationship. As a result Bullard suggested putting more weight on financial market signals, such as the slope of the yield curve and market -based inflation expectations. Handled properly, these signals could help the Federal Open Market Committee (FOMC) better identify the neutral policy rate and possibly extend the U.S. economic expansion.

Following are excerpts from Bullard’s presentation “What Is the Best Strategy for Extending the U.S. Economy’s Expansion?

The Disappearing Phillips Curve

Prior to 1995 inflation expectations were not well anchored. Around 1995, the U.S. inflation rate reached 2 percent, and U.S inflation expectations stabilized near that value. Bullard interpreted this as the U.S. having an implicit inflation target of 2 percent after 1995, calling it the inflation-targeting era. The FOMC named an explicit inflation target of 2 percent in January 2012, but Bullard said he believes that the Committee behaved as if it had a 2 percent target well before that date. The post 1995 period in the U.S. coincided with a global movement among central banks toward inflation targeting beginning in the early 1990s. During this period, the 2 percent inflation target became an international standard.

Once inflation expectations stabilized around this international standard, the empirical relationship between inflation and unemployment– the so called “Phillips curve”–began to disappear. Bullard provided a chart showing the slope of the Phillips curve has been drifting toward zero since the 1990’s and has been close to zero for the past several years.

Current monetary policy strategy

The conventional wisdom in current U.S. monetary policy is based on the Phillips curve and suggests that the policy rate should continue to rise in order to contain any increase in inflationary pressures. However, in the current era of inflation targeting, neither low unemployment nor faster real GDP growth gives a reliable signal of inflationary pressure because those empirical relationships have broken down. Continuing to raise the policy rate in such an environment could cause the FOMC to go too far, raising recession risk unnecessarily.

Given that, Bullard suggested using financial market signals such as the yield curve as an alternative to the Phillips curve. The slope of the yield curve is considered a good predictor of future real economic activity in the U.S. This is true both in empirical academic research and in more casual assessments. Generally speaking, financial market information suggests that current monetary policy is neutral or even somewhat restrictive today. Specifically, the yield curve is quite flat, and market based inflation expectations, adjusted to a personal consumption expenditures basis, remain somewhat below the FOMC’s 2 percent target. Financial market information also suggests the policy rate path in the June 2018 summary of Economic Projections (SEP) is too hawkish for the current macroeconomic environment.

A forward-looking strategy

More directly emphasizing financial market information naturally constitutes a forward looking monetary policy strategy. One of the great strengths of financial market information is that markets are forward looking and have taken into account all available information when determining prices. Thus, markets have made a judgment on the effects of the fiscal package in the U.S., ongoing trade discussions, developments in emerging markets, and a myriad of other factors in determining current prices.

Financial markets and the Fed

Financial markets price in future Fed policy, which creates some feedback to actual Fed policy if policymakers are taking signals from financial markets. This has to be handled carefully. Ideally, there would be a fixed point between Fed communications and market based expectations of future Fed policy, i.e., the two would be close to each other. Bullard said that generally speaking, markets have currently priced in a more dovish policy than indicated by the FOMC’s SEP – they expect the Committee to be more dovish than announced but still not enough to achieve the inflation target.

Caveats on financial market signals

Financial market information is not infallible, and markets can only do so much in attempting to predict future macroeconomic performance. The empirical evidence on yield curve inversion in the U.S. is relatively strong, and TIPS -based inflation expectations have generally been correct in predicting subdued inflationary pressures in recent years. Therefore, both policymakers and market professionals need to take these financial market signals seriously.

Risks 

Bullard suggested that yield curve inversion would likely increase the vulnerability of the economy to recession. An inflation outbreak is possible but seems unlikely at this point. By closely monitoring market based inflation expectations, the FOMC can keep inflationary pressure under close surveillance. In addition, financial stability risk is generally considered moderate at this juncture. Arguably, these are being addressed through Dodd-Frank and related initiatives, including stress testing.

Opportunities

The current expansion dating from the 2007-2009 recession has been long and subdued on average. The slow pace of growth suggests the expansion could have much further to go. The strong performance of current labor markets could entice marginally attached workers back to work, increasing skills and enhancing resiliency before the next downturn.

Uncertainty

Another long standing issue in macroeconomics is how to think about parameter uncertainty, or more broadly, model uncertainty. Bullard pointed to two studies: Brainard (1967) suggested that when model parameters are in doubt, policy should be more cautious than otherwise and, Hansen and Sargent (2008) suggested that, in some cases, policymakers might want to be more aggressive than otherwise. This is an unresolved issue, but how to handle parameter uncertainty has been a concern for the FOMC for years.

Conclusion

Bullard re-iterated his position stressing that U.S. monetary policymakers should put more weight than usual on financial market signals in the current macroeconomic environment due to the breakdown of the empirical Phillips curve. Handled properly, current financial market information can provide the basis for a better forward-looking monetary policy strategy. The flattening yield curve and subdued market-based inflation expectations suggest that the current monetary policy stance is already neutral or possibly somewhat restrictive.

Distinguished Speaker Series: Morton Schapiro, Northwestern University

How is your earnings trajectory impacted if you attend a top private versus a top public institution? How many students pay the full ticket price of tuition and what is the average tuition payment post-financial aid?  Should we be concerned about the levels of student loan debt in this country?

These questions and more were the topics of discussion at The Chicago Club where approximately 150 investment professionals gathered to hear Morton Schapiro, economist and the current president of Northwestern University, opine on the state of funding for higher education. For background, Morton Schapiro is currently the 16th president of Northwestern University for which his term began in September of 2009. He is a Professor of Economics at Northwestern and also holds appointments in the Kellogg School of Management and the School of Education and Social Policy. He previously served as the president of Williams College. Schapiro is among the nation’s leading experts on the economics of higher education, with particular expertise in the area of college financing and affordability and on trends in educational costs and student aid. He has written more than 100 articles, and he has written or edited nine books, his most recent Cents and Sensibility: What Economics Can Learn from the Humanities (Amazon). His most recent book challenges modern day economics and discusses how economics can be improved through reading great literature, and even taking a step further, how one can improve investment performance through being immersed in great literature.

The industry of higher education is a fascinating one in that it is unlike any other industry in the world. In fact, some economists do not even consider it as an industry at all, however Shapiro argues the industry can be viewed with many similarities to a traditional business sector. Dissecting the industry of higher education, nationwide there are 4,400 colleges and universities that can be bifurcated into public and private, and for-profit and non-for-profit. As for students, or “customers” of the industry, there are 17 million undergraduate students and 3 million graduate or professional students. If you were to combine all the operating budgets of these 4,400 institutions, you would reach $600 billion dollars, or roughly 3% of this country’s GDP. Now this figure may seem large to some, but what one must also take into consideration is the multiplier effect of this 3%—the present value of future cash flows from the individuals that are bestowed with a great education and their respective spending impacts on other sectors of the economy.

Let’s dig in to take a closer look at the composition of these 4,400 institutions. Of these higher level education institutions, only about 350 schools (or 8%) have any admission standards whatsoever. Said another way, 92% of these higher education institutions accept anyone who applies. On the other end of the spectrum, for every twelve students who apply at Northwestern, only one is accepted equating to a less than 8% acceptance rate. Stanford, Harvard and Yale have even lower acceptance rates closer to ~5%. The reality is, the vast majority of students at higher education institutions are enrolled at schools that take everyone who applies. Further, of the 350 schools that do have admission standards, only about the top 150 schools get much publicity with the overwhelming attention going to the top 60 accredited research universities comprised of 26 private institutions including Stanford and Northwestern, and 34 of the public institutions including University of Illinois at Urbana Champaign, Michigan and Wisconsin.

This begs the question, how important is it to go attend to one of the top 60 accredited research universities? As most financial minded people would conjure, it ultimately comes down to a simple rate of return equation. Shapiro points out that we are at record rates of return for higher level education. The New York Fed looked at the direct costs of room and board and tuition plus the opportunity costs of entering the labor force immediately after high school. It took 23 years to cover the direct and indirect costs of a college education 25 years ago. Today, it takes less than 10 years to cover the direct and indirect costs—despite the rising cost of tuition that we’ve seen over the last 10 years. The return on higher education has increased much more rapidly than the rising cost of tuition. Simply put, higher level education is more important today than ever to maximize a student’s future expected earnings potential.

Let’s bring demographics into the analysis. Statistics show if you grew up in a household in the bottom 20% income range and you earned a degree from a higher level education institution, you had a 21% chance of jumping to the top 20% of income earners in the United States. The national average of a child growing up in the bottom 20% income earning household jumping to the top quintile is ~8%, leaving the non-attending high level education student in the low-mid-single digit percent range. This means that a lower-income student has roughly a four-times better chance at making the transition to the top quintile of household earners if he/she attends a higher level education institution versus if he/she does not attend. Further, if you went to one of the accredited public universities, the chances of moving from the bottom bracket to the top actually increased to 42%, roughly eight-times a child who does not attend any college or university. Taking it one step further, if a student attends one of the top private institutions, their chances of success (measured financially) moves to over 50%. Higher education matters.

This then begs the question, “Do the benefits of this higher education outweigh the costs?” Currently there is ~$1.4 trillion dollars of student loan debt outstanding in the United States. However, less than 1% of students have loan balances over $100,000. In fact, only 60% of college graduates have student loan debt (40% graduate debt free) and the average student loan balance for those that have loans is only $30,000. If you look at the rate of return on higher level education, particularly if you are attending a top 60 school, you cover the costs of your education very quickly. One area of concern is attendance at a less accredited “for-profit” school where we find the vast majority of student loan defaults.

What scares people from pursuing higher level education most often is the quoted “sticker price”. Although the sticker price of higher level education is what garners the most attention, the majority of students do not pay the full sticker price. In fact, only 25% of students attending four-year public universities pay the full sticker price. The average sticker price for in-state tuition is $10,000.  In fact, 75% of students receive some form of financial aid lowering the average student cost of attendance to ~$4,000/year for a public university. At the top private institutions, only 15% of students pay the full sticker price. The average tuition at these higher-level educations is $35,000/year and with the help of financial aid, the average student pays only $15,000 per year.   At Northwestern, roughly 40% of students pay the full $72,000/year sticker price and the remaining 60% of students pay on average $28,000/year. With the average student paying $28,000/year, Shapiro points out it is rather deceptive to only focus on the full $72,000 sticker price.

The event wrapped up with a Q&A session, where the focus was on top public schools vs. top private schools, financial aid, online education, and best advice for future students.

  • Top private school vs. top public schools. Penn State did a study that showed if a student could graduate through Penn State in four years and you paid full sticker price at both Penn State and University of Pennsylvania, your earnings potential was not dependent on which school you attended. However, if you attend a public school, graduation rates tend to be closer to 4.5 to 5 years, whereas the private universities are closer to 4 years. Demographically, the study showed that if you are a Caucasian coming from a wealthy family, you are just as better off at a top public school as you are at a top private institution. If you are a female, it tips marginally in favor of going to the top private. If you are a minority, you are much better off at a top private institution. There is a lot of debate on why these results are the way they are.
  • Financial aid and the rise of merit-based aid. Many schools have made a move towards merit-based aid versus needs-based aid; however Northwestern has not made this transition. Shapiro’s position is needs-based aid provides more value—the merit is being accepted into one of these prestigious institutions that changes the trajectory of your future earnings stream in a dramatic way. Shapiro doesn’t believe we should discount school for students who come from well-off households.
  • Online education. Despite a rise in popularity, it is impossible to disrupt the control the top 60 institutions have on the marketplace. Technology has made all higher level education better in terms of greater efficiencies, but Shapiro doesn’t envision the online degrees disrupting the premier institutions. Generally speaking, the higher institutions do not accept credit from online institutions.
  • Best advice for future students: Apply early. Northwestern takes 50% of their students through early admission. The school wants those students who would do anything to be able to attend their university. Find a school where your child will really thrive and not find himself/herself in over his/her head and apply early.