Impact Investing: A New Investing Paradigm

A large group of CFA charterholders and other interested investment professionals gathered at the Palmer House Hotel to hear the latest thoughts and techniques in Impact Investing from a distinguished panel on June 5. The moderator, Priya Parrish, is a leading proponent of impact investing in the Chicago community of investment managers and managing partner at Impact Engine, a venture capital and private equity manager with a focus on investments that generate positive outcomes in education, health, economic empowerment, and environmental sustainability. Prior to the event Parrish joined us for a quick podcast which can be found on the CFA Society Chicago website and SoundCloud. Her panelists at the event included:

  • Susan Chung CFA, Managing Director of Investment Management at Wespath Institutional Investments, the investment arm serving the United Methodist Church, and other faith-based investors.
  • Andrew Lee, Managing Director and Head of Sustainable and Impact Investing for UBS Global Wealth Management
  • Charles Coustain, Portfolio Manager of Impact Investments at the MacArthur Foundation

Parrish kicked-off the program with an introduction describing the development of impact investing across nearly fifty years of history. The first generation was Socially-Responsible Investing (SRI) dating as far back as the 1970s. Its primary objective was aligning investments with the owner organization’s mission or values. Popular originally with religious organizations, this version relied primarily on negative or positive screening to either exclude companies involved in businesses that were objectionable to the investor (e.g., alcohol, tobacco, or gambling) or to include firms pursuing something the investor sought to encourage. Investment returns often took a back seat to mission alignment. SRI evolved to incorporate consideration of environmental, sustainability, and governance (ESG) factors in an attempt to improve risk-adjusted performance. The reasoning being that companies that excelled on ESG factors were more likely to out-perform lower scoring peers. Impact investing is the latest generation of the model.  It seeks investments that not only generate strong financial returns, but also contribute to positive changes on social matters. Parrish provided a list of seventeen such social matters with education, health care, economic empowerment, and the environment, being the most important ones to Impact Engine.

Parrish noted that, while many people are aware of the social ills often blamed on corporations, the profit motive also gives corporations the power to change society for the better. They only need to recognize this and make it their intention to improve society while pursuing their profit-generating goal.  The element of intentionality is what defines impact investing. The challenge for the impact investor is to identify, select, and manage those firms that intend to make a positive social impact in their businesses, and do so successfully. The audience heard the panelists refer to this element of intentionality repeatedly throughout the event.

Before bringing the panel on stage, Parrish presented a graphic depiction of the spectrum of impact investments. Its vertical axis showed modest return expectations with market return at the top and declining down through return of capital to complete loss. Across the horizontal access ran the approach to impact, beginning with None, and including stages such as Passive, Intentional, and Evidence-based.  The body of the matrix listed the investment products and strategies used to apply the approach toward achieving the return goal.

Parrish then invited the panelists up on stage and asked each to make a brief statement about the involvement of their firms with impact investing. Susan Chung pointed out that Wespath is part of a religious organization and invests for both the church as well as for pension plans for church employees.  The former is primarily done in an SRI style (meaning exclusionary) because they are less concerned with the returns than avoiding investments that conflict with the organization’s values. The qualified funds are more return-seeking so they have adopted impact investing. Engagement with corporate management is their primary tool for effecting change. They sometimes partner with other investors with a like mind to increase their leverage.

Andrew Lee of UBS Wealth Management said the firm sees impact investing as a major trend with a lasting impact so they have embraced it very broadly.  This is driven both internally, by the Wealth Management CIO who is committed to the style, and externally by clients.

The MacArthur Foundation, being a philanthropic organization, takes a different approach. Its primary purpose is effecting positive social change to begin with, and it pursues that objective with direct grants to institutions working in its areas of choice. These aren’t intended to generate a financial return, however as far back as 1983, the foundation began investing in public banks that address special social needs (such as affordable housing) that were underserved by the market. Their involvement was trailblazing in that it encouraged regular, for-profit, banks to invest in the same manner to the point that they now provide more funding than philanthropic organizations. MacArthur’s impact investing has grown to encompass a separate carve out of the foundation’s endowment that seeks return-generating impact investments that further the goals of its grant program.

As to how to select managers who best align with the investor’s goals, both Chung and Lee stressed the need for vigorous research to understand a manager’s process and determine how committed they are to impact investing. Wespath uses a detailed assessment survey to help with this.

Chung outlined how Wespath found a way to incorporate impact investing into passive strategies. By partnering with Blackrock, they were able to access data to score companies on ESG factors. Searching for indicators of either positive or negative correlation to performance, they identified factors used to make slight adjustments to the index components and thereby, drive alpha. As an example, Chung said they discovered that the rate of decline in carbon emissions was a better performance indicator than the gross amount of emissions. So, firms demonstrating the greatest decline, even if from a high base amount, out-performed firms showing lesser declines (or increases) even if from a very low base. The resulting strategy is very neutral on sector and industry metrics, while benefiting from relatively small mis-weights in the individual stock positions. Indexing purists would consider this to be enhanced indexing (if not a quantitative active strategy) rather than true indexing.

All three panelists stressed the importance of collaboration with other firms interested in impact investing to stretch their resources and increase their leverage with managements. This is especially important in the governance area where engagement with company management has proven to be an especially effective way to effect change. Wespath joins with other investors (or asset managers) when they engage with firms to discuss corporate governance. 

Lee added that UBS has determined that engagement with management is the best way to bring about change—far more so than simply voting proxies against management recommendations. This is especially true in the public equity markets. The firm sets an engagement goal at the outset when making a new investment.  

MacArthur collaborated with the Chicago Community Trust (CCT) and Calvert Research and Management to increase the scale and focus of its impact investing. The CCT brought a local focus to the investing to assure that funds were invested where the investors intended them to be.  MacArthur brought its institutional funds and Calvert added funds raised from their individual investors interested in the strategy. 

The Q&A session that followed the discussion lasted for half an hour, indicating the high level of interest from the audience. The first question asked the panelists to identify some impact investments that had not worked out as expected. Chung listed emerging market infrastructure, solar power following the removal of government subsidies, and wind farms in the North Sea. Coustan added for-profit education as an example. Lee noted that sometimes an underperforming investment needs to be reassessed to see if the investor can help the organization improve. The panel was in agreement that impact investing was more difficult to apply to fixed income. Chung advised that fixed income managers should borrow the scoring methodologies used on the equity side.  Lee added that UBS has substituted bonds from supranational financial companies such as the World Bank and UN-sponsored development banks in place of sovereign debt in the high-quality portion of fixed income portfolios. Coustan said MacArthur primarily utilizes private debt vehicles for impact investing because of the flexibility in structure and use of the funds. In these cases, however, their return objective is only to preserve capital.

Big Data, Machine Learning & AI

Cathy O’Neil: Founder of ORCAA and
Author of Weapons of Math Destruction: How Big Data Increases Inequality and Threatens Democracy

Big Data, artificial intelligence (AI) and machine learning are becoming some of the hottest topics in finance. A packed room of CFA charterholders gathered to hear a presentation by Weapons of Math Destruction author Cathy O’Neil and a panel discussion on that topic in early May.

O’Neil began her discussion with Google’s autocomplete predictive search that can occasionally feature unreliable or conspiracy-laden results. She said that Google shouldn’t be able to have it both ways, making money off users’ trust yet saying that bogus search results aren’t their fault.

According to O’Neil, AI is not a model for truth. Artificial intelligence technology could be characterized as a series of opinions fed into an algorithm. The authors behind the algorithm will tell you to “trust the math”, but should we be that trusting when companies are incentivized not by truth but by profit?

AI amounts to making a prediction. There are two parts to an artificial intelligence prediction: the historical data, which contains a possible pattern, and the algorithm’s definition of success (such as a quant generating profit at a certain volatility level). Even mundane things such as determining what to cook for dinner could be characterized as an algorithm.

Our lives are increasingly touched by algorithms, in areas such as banking and credit, policing, jobs and even matchmaking. Sometimes the algorithms are incredibly helpful, but sometimes they can cause a great deal of harm. When a company runs an algorithm on you, you should trust that it will optimize the result to the company’s definition of success, not necessarily what is best for you. O’Neil said that many of today’s algorithms can be characterized as WMDs (Widespread, Mysterious and Destructive). And algorithms do make mistakes, but those mistakes aren’t typically publicized because the algorithms are usually secret intellectual property.

O’Neil told a story about a teacher who was fired because her students received poor test scores. This happened even though the administration didn’t have access to the actual score which was generated in a black box that no one outside of the firm had access to. Finally, access to the scores was provided. Upon reviewing them, the teacher scores looked essentially like completely random numbers with little predictive power from year to year. Some teachers have sued for wrongful termination and have won their cases.

Another example O’Neil gave of an algorithm causing harm was the case of Kyle Beam, who didn’t get a Kroger job because of a personality test result. The test resulted in a “red light” outcome where Kyle was not offered an interview. He complained to his father about the process, who is an attorney, and his father determined that the test violated the Americans With Disabilities act, as it is unlawful for a company to require a health exam as part of a job screening.

One of the main problems with algorithms today is that they tend to look for an initial condition that led to success in the past. Amazon developed a hiring algorithm (that wasn’t ultimately used) that aimed to determine which characteristics of certain hires led to success in the job. The algorithm proxied job success with metrics such as salary raises, promotions and workers who stayed more than four years. Upon scanning the data, the algorithm found that initial conditions such as being named “Jared” and using the word “execute” more frequently on resumes tended to lead to success. Unfortunately, it was also determined that male candidates tended to use the word “execute” more frequently than women, so some of the characteristics the algorithm was searching for were proxies for gender.

Couldn’t there be a market-based solution to all the defects inherent in algorithmic decision-making? According to O’Neil, expecting companies to self-police their own algorithms might be somewhat unlikely. This is because algorithms that maximize profits without any constraint on fairness are more profitable than algorithms with fairness constraints. This dilemma can be seen with Facebook. Facebook has a higher level of engagement and a more lucrative advertising business when its users are arguing about fake news and conspiracies.  Most companies facing demanding shareholders would be reluctant to agree to lower profitability in order to ensure fair algorithms. Because of this issue and others outlined above, O’Neil believes that regulation is needed.

Currently the legality and ethics around employers sourcing alternative data such as health information in order to make hiring decisions is murky. “What’s stopping Walmart from buying data to see who is sick or healthy [in order to make decisions on employment],” O’Neil asked.

O’Neil laid out three principles for responsible algorithm usage:

1) First do no harm

2) Give users the ability to understand scores and decisions

3) Create an FDA-like organization that is tasked with assessing and approving algorithms with a high level of importance

L to R:
Metin Akyol, Ph.D., CFA (Zacks Investment Management) Kevin Franklin (BlackRock),
Sam Shapiro (Goldman Sachs Asset Management), Cathy O’Neil (ORCAA)

During the panel discussion, speakers talked about how machine learning and AI are used in their portfolio management process, particularly parsing through large data sets. They talked about how it is more challenging to hold risk models to the same standard as trading models because risk cannot be directly measured, and the success of a trading model can easily be evaluated by the P&L generated. Are machine learning and Big Data a flash in the pan, or are they here to stay? The CFA Institute believes that it’s the latter, and have added the topics to the 2019 CFA curriculum.

The Equity Risk Premium: Applications for Investment Decision-Making

Professor Aswath Damodaran’s opening remarks at CFA Society Chicago’s Equity Risk Premium event on April 2, 2019 at the W Chicago City Center.

Aswath Damodaran, Kerschner Family Chair in Finance Education and a Professor of Finance at New York University Stern School of Business, is well known for his books and articles in the fields of valuation, corporate finance, and investment management, philosophies, and strategies. On April 2, he treated the CFA Society Chicago to a tour de force through the foundations of risk premia, the macroeconomic determinants of equity risk, and how the risk premium can me misused.

Damodaran’s talk was followed by a panel which included himself, Michele Gambera, co-head of Strategic Asset Allocation Modeling at UBS Asset Management, and Bryant Matthews, global director research at HOLT. The panel discussion was moderated by Patricia Halper, CFA, co-chief investment officer at Chicago Equity Partners.

Damodaran pointed out that while the risk-premium is referred to as one number, it contains several various risk factors, such as political and economic risks, information opacity, and liquidity risks. Despite the underlying complexity, a common way to derive the risk premium is from the average volatility of some historical period. This, Damodaran warns, is a dangerous approach. By using historical data you can derive any risk premium you want by using the time horizon of your choosing. When you look at historical averages, you are also searching for a number that nobody has ever experienced. And even if they did, you should not believe that history will simply repeat itself. And even if history did repeat itself, you are still estimating a number with large error margins. In the end, the exercise is just not useful.

Damodaran has done a lot of work determining equity risk premia for different countries and makes his data available on his homepage. His approach is to derive an implied risk premium based on consensus forecasts of earnings and adding country risk premia for different countries. He cautions that there is no pure national premium thanks to our integrated world. Much of S&P earnings, for instance, are derived from abroad, and this must be taken into account.

For a person who has devoted so much time to estimating risk premia, it may come as a surprise that Damodaran thinks people should spend less time on it. His approach is that once you observe the market-implied risk premium, you should use this in your valuation model and devote your attention to estimating cash-flows. Right now, too many people are wasting too much time on valuing companies through finding the perfect risk-premia when cash-flows are ultimately going to determine whether they will get valuations right. Academic finance is another culprit here, which spends too much research time on discount rates.

Ask yourself this, are you working on your model’s risk premia because that is where you have superior knowledge, or because it is your comfort zone?

Damodaran is also critical of the use of the price-to-earnings ratio to assess valuation, since it looks at earnings only for the current period. In the US market the ratio may look high, but the pictures very different for current implied risk premia. Since 2008, risk-free rates have come down while expected stock returns have remained roughly the same. This actually implies a higher risk premium.

 Michele Gambera shares Damodaran’s criticism of historically derived risk premia. He also pointed out that while the risk premium fluctuates a lot, we pretend in our models that it is constant. In effect, Gambera stressed, we are estimating a random-walk variable. A better approach for your valuations is to use a forward-looking covariance matrix with various factor loadings.

Should we therefore throw the historical data out the window? When asked the question, Bryant Matthews of HOLT pointed out that historical data are not all useless in a world where variables tend to mean-revert. But you may need to wait a long time for it to happen.

Is there a small-cap premium? Damodaran pointed out that if you estimate the historical premium since 1981, it is negative, which is clearly fictional. However, Matthews estimated a small cap premium of 0.6%, albeit with a standard error that makes it statistically zero. By slicing the equity market in other ways, he estimates that value stocks tend to have a 3.5% equity premium over growth stocks, while Fama and French’s quality stocks-factor enjoys a 2.1% premium over non-quality stocks.

Matthews has also calculated market implied risk premia for over 70 countries, and found it rising in the US from 0% in 2000 to 4% today. Such estimates, he pointed out, are often counterintuitive for clients. Surely, equities were riskier in 2000 when valuations were high. But precisely because valuations were so high, the implied risk premium, which was part of the discount rate, was low.

Can we make money by investing in high-risk premium stocks? After all, theory tells us returns are the reward for taking risk. Yet as Gambera pointed out, high-volatility stocks tend to be favored by investors in part as a way to leverage up according to the CAPM-models, as is done for instance in risk-parity models. At the same time, pointed out Matthews, low-volatility stocks are generally also high-quality stocks and therefore tend to have high return, despite their historically low risk.

Matthews argued that while profits are high for the US market as a whole, this really applies to only 100 companies. This concentration, he suggested, is due to lax regulations. Damodaran, however, suggested that antitrust measures cannot be relied on to change this fact. They may have been politically attractive in the time of Standard Oil, when that company’s dominated position allowed it to raise prices. The dominant firms of today are offering consumers very low prices. Break them apart and any politician will be met with discontent from voters.

Let us end with some historical perspective from Michele Gambera. Much of the early work on risk premia was made at a time of a very different market structure of industrialized countries. Steel and railroads ruled the day and many of today’s giants were not listed. The likes of Alphabet and Facebook pose new challenges in estimating risk premia. This suggests that now more than ever historical data will be misleading in estimating the risk premium, a modest number that means so much.

Portfolio Construction and Allocation in this ever changing market

On Feb 20th at the UBS Tower, CFA Society Chicago’s Education Advisory Group offered a panel discussion highlighting the issues and opportunities of allocating assets for various types of portfolios. A full room of about 100 financial professionals were privileged to hear from an experienced, diverse group of fund managers and advisors.

Opening speaker Tim Barron, CAIA, CIO of Segal Marco Consulting, prepped the feature event with his entertaining yet practical list of eight things to be aware of and thinking about when structuring portfolios. His list consisted of relating several quips from the likes of Yogi Berra, Mike Tyson, Harvey Pinnick, Wayne Gretzky and Bobby Unser into practical guidance for professional investment of assets. Lessons learned included; understanding the purpose for the portfolio, having a plan in place in the event of market turmoil, not having a false sense of security in making predictions while understanding one’s skillsets, and not being afraid to stand apart from the herd while putting in the hard work necessary for being in a position to win.

A brief Q&A ensued before giving way to moderator Chris Caparelli, CFA, at Marquette Associates and the panel of (1) Patricia Halper, CFA, CIO at Chicago Equity Partners, (2) Josh Lohmeier, CFA, Head of Investment Grade Credit and AIA Investment Officer, Aviva Investors, (3) Ellen Ellison, CFA, Chief Investment Officer, University of Illinois Foundation, and (4) Kevin Zagortz, FSA, US Head of Portfolio Management (OCIO) at Aon.

Caparelli’s first question for the panel was to provide a high-level description of their approach to asset allocation. Kevin spoke first from his background with qualified corporate defined benefit and 401(k) plans. His first objective is to be mindful of mitigating risk before evaluating a multitude of asset classes in priming the portfolio for growth was a common theme across the panel.

Ellison’s perspective is of a large foundation with a very long-term investing horizon, minimal concern for liquidity and growth sourced from a global rolling portfolio approach. The foundation’s clients consist of a large base of living alumni, trustees and committees, with a strong focus on governance and fiduciary risk. The only thing worse than not having a plan is changing the plan over the course so being mindful of the human element is important.

In contrast, Lohmeier has a relatively narrow focus of investment grade credit and is most concerned about target benchmarks and how to manage to against that performance. Common issues to be aware of include behavioral biases, herd mentality, tail risk and downside protection especially in environments of severe stress.

Halper stressed the importance of knowing your place. If your client is relying on investment exposure to a specific asset class then it is imperative to not stray from that mandate. In other words, only perform asset allocation within the bounds that you engaged for.

The remainder of the discussion involved the panelists providing perspective on a variety of topics such as their use of alternatives, adaptation to the market environment, and being tactical  via factor investing. Context is important once again as each strategy depends on the purpose and objective for that client. 

After taking formal questions, the panelists generously made themselves available after for further inquiries.

In summary, this was a fast paced and informative exposure to the topic of portfolio construction. Caparelli was effective in moderating the discussion and the diversity of viewpoints represented on the panel was of tremendous value.

Economic Outlook and Policies

On January 16, 2019, a profound reflection on economic policy, politics’ influence on it, and the US economic outlook took place at the Standard Club in Chicago. The discussion was moderated by CFA Society Chicago’s very own Lotta Moberg, CFA,—with William Blair’s Dynamic Allocation Strategies team—and featured David Lafferty, senior vice president and chief market strategist at Natixis Investment Managers; Nicholas Sargen, chief investment officer for the Western & Southern Financial Group and chief economist of its affiliate, Fort Washington Investment Advisors Inc.; and Jas Thandi, associate partner of Aon Hewitt’s Global Asset Allocation Team. The discussion began with setting up the big picture of the world economy with the US as the focus and then progressed to cover the panelists’ outlook on how central bank policies and deregulation will play out in the US. Finally, the panelists shared their perspectives on the future of globalization before offering some concluding remarks. After the panel discussion was completed, Moberg opened the panel to Q&A.

Sargen kicked off the discussion by encouraging the attendees to “not focus on the tweets”—referring to the President’s activity on Twitter—or even the Federal Reserve. Instead, he encouraged people to focus on economic policy. He walked through the story of Trump’s economic policy since he took office citing the corporate tax cuts and deregulation in 2017. Sargen explained his view that these policies carried the markets through 2017 and by 2018 most of this positive news was already priced in to the market. The realization that these policies were already priced in combined with the new developments in the China Trade War led to 2018 falling flat by the end of the year. He closed his opening remarks citing political gridlock in America and a global economic slowdown as the continuing risks for markets. Lafferty continued the conversation agreeing with Sargen on all counts and expanding with his views on the global economic slowdown. He laid out a view of global deceleration across all major asset classes stating that some of the pessimism is already priced in. Lafferty even conjectured that he believed most broad asset classes were not far from fair value. However, none of these broad asset classes are currently priced for recession. Thandi rounded out the opening remarks by emphasizing politics’ growing role in markets and bringing focus back to the U.S.-China trade war and its implications on global assets—especially in Europe. He expounded on his European focus by pointing to the ECB and the need for investors to be wary of their policy actions as well. He wrapped up the opening remarks by touching on the increase in supply of treasuries due to the runoff of the Federal reserve balance sheet and the impact we should expect to be seen in the credit markets. This final point set up Moberg’s next point of discussion: how will the U.S. markets react to recent U.S. government and FED policies?

Thandi picked up by stating his belief that the U.S. economy would experience a soft landing due to some growth from the tax stimulus. However, he has been surprised by the way capital expenditures by corporations has “fallen off a cliff.” Lafferty followed Thandi’s comments regarding low capital expenditures by explaining that the execution of economic policy can have an outsized impact. Lafferty explained to attendees that the corporate tax cuts should have incentivized companies to spend more on capital expenditures, however, due to recent protectionist rhetoric from the President many companies became cautious to make capital expenditures due to political uncertainty. Lafferty also stated that the current political gridlock in the U.S. government could be dangerous for markets should any major problems arise. Despite these warnings, Lafferty too expressed some optimism stating his belief that we are merely experiencing a slowdown. However, he cautioned that Federal Reserve adjustments could have already killed the expansion. Sargen agreed with Lafferty regarding Fed policy and shared his view that the Fed’s communication regarding policy has been poor. He also revisited Thandi’s point of the tax cut stating his belief that the resulting stimulus would run its course by mid-2019. However, Sargen also supported the view of a soft landing stating that the U.S. would not experience a recession this year—but a recession beyond that short horizon is likely.

The next topic for the panel was deregulation in the US. Before this topic was kicked off Lafferty offered thoughts by first stating that there has been a surprising focus on regulating new forms of systemic risk and investor protection. He cited the growth of the ETF market as a point of concern for regulators. After making this point he explained that deregulation has been positive for smaller shops as it has eased their regulatory burden. Sargen expounded on this point by saying that executives overwhelmingly prefer less regulation—no matter the size of the company. He pointed to the current political landscape saying it is no longer as supportive of deregulation due to the democratic party’s representation in the House of Representatives. Thandi offered the final thoughts on this topic by stating that deregulation has only had a small impact. He explained that there were short term gains from deregulation but they were muted due to tariffs resulting from the U.S.-China trade war.

After the deep dive into recent developments in the US the panel transitioned to discuss the future of globalization, both in the US and across the globe. Thandi started off by discussing the recent protectionist rhetoric not only in the U.S. but across the globe citing Brexit as a major example. He explained that such policies will lead to consolidation in equities as large companies seek growth through acquisition instead of organically. Ultimately, Thandi believes these policies will lead to a lower growth environment. Lafferty agreed that protectionist policies appear to be growing in developed markets and will lead to a lower growth environment. Further, this lower growth environment will lead to stunted performance in passive investment strategies. He also expects these protectionist policies to cause more volatility in markets. Lafferty’s final point on the matter was that with the combination of low growth and higher volatility investors will allocate more capital to active investment strategies.

Finally, the panelists concluded the evening with their final thoughts:

Lafferty:

  • The trade war is not about prices but about national policy, specifically the U.S. is targeting the “Made in China 2025” effort.
  • Regarding monetary policy, backtracking on Quantitative Tightening is actually bad for equities because it signals the Federal Reserve doesn’t have faith in markets’ strength.
  • The dollar will be stable or bearish in 2019.

Thandi:

  • Reforms and policy decisions in Europe will be more influential than the media is portraying.
  • Assuming a soft landing for the U.S., emerging markets already had their correction and are due for a rebound.

Sargen:

  • Alternatives such as private equity are an attractive investment.
  • Passive investment strategies generally outperform hedge funds in the long run.

After the discussion was concluded Moberg opened the panel to Q&A:

Does it matter who Trump’s Economic Advisor is?

  • Sargen: No.
  • Lafferty: No.
  • Thandi: No.

Is international diversification out of date?

  • Thandi: No, however correlations have lowered with globalization. Currency risk still plays a big role.
  • Lafferty: No, however Emerging Markets are no longer as attractive in the long run because growth has slowed. Low correlations have become much rarer due to an interconnected global economy.
  • Sargen: No, but benefits of international diversification are not as attractive. Additionally, investors should be wary of diversification into bonds as the Federal Deficit continues to grow.

What is the big thing the general consensus is missing?

  • Lafferty: Bubbles in the capital markets.
  • Sargen: Global leaders are running out of policy ammunition to deal with crises.

What will volatility be in the next 6 months?

  • Sargen: Choppy.
  • Lafferty: Low 20s as opposed to low teens (referring to the VIX Index level).
  • Thandi: Choppy.

Private Equity: Should You Invest and How?

The challenges of investing in private equity were addressed at a recent event held at 300 N. Wacker and hosted by CFA Society Chicago’s Education Advisory Group. There are numerous issues that arise when making the decision to invest in the asset class. One of the biggest is regarding transparency. Investors typically do not have information on which companies they will be investing in but rather must put their faith in a fund that follows a certain strategy.

The basic characteristics of an investment in private equity are certainly more complex than an investment in the public market. The typical investor becomes a limited partner in an investment fund with a fixed term. A private equity firm will usually manage a series of distinct funds and will solicit new money as previous funds become fully invested. Funds can be capitalized by equity or debt; highly leveraged funds are LBO funds. Liquidity is limited compared to the public markets and investors that unexpectedly need cash may need to search for a buyer of their investment.

The event was organized into two panels on which six (6) investment professionals participated.  The panelists were divided between asset managers, intermediaries and asset owners.

Panelists for Fund Managers and Intermediaries:

Tobias True, CFA – True is a partner on the Investment Strategy and Risk Management team at Adams Street Partners. He is responsible for portfolio construction and risk management as it applies to portfolios including commingled and separately managed accounts.

Josh Westerholm – Westerholm is partner in the Investment Funds Group of Kirk & Ellis. He is an attorney involved in forming and structuring private funds and advises clients with respect to regulatory exams and inquiries.

Panelists for Asset Owners:     

Brad Beatty, CFA – Beatty is the chief investment officer at Sirius Partners LP. He is responsible for developing and implementing the firm’s investment strategy and oversees the firm’s investment in private equity.

Michael Belsley –Belsley is one of the country’s leading attorneys in the field of secondaries. His practice includes formation and governance of private equity funds (including primary interests in and secondary markets sales of private equity fund interests). He counsels buyers and sellers in their secondary market activities.

Harisha Koneru Haigh, CFA – Haigh manages the Private Investments and Real Asset portfolios for Northwestern University’s $11 billion endowment. Prior to joining Northwestern, she was a private equity manager at PPM America Capital Partners, LLC.

Moderator:

Bill Obenshain – Obenshain is chairman of the Advisory Board of the Center for Financial Services at DePaul University. Before joining DePaul, Obenshain spent 38 years in the financial services industry with Continental Bank and Bank of America.  He is a member of the Economic Club of Chicago and the Chairman’s Circle of the Chicago Council on Global Affairs.

Each panelist gave a brief presentation and then answered questions from the moderator and the audience. The first panel featured fund managers and intermediaries and covered the following points:

What type of due diligence is performed on fund managers?

  • Knowledge of historical performance is critical, as there is evidence that top quartile performance may be a good predictor of future performance.
  • What were the drivers of past performance, what type of risks were taken?
  • What were the sources of return?
  • New investors need to know what type of valuation methods the fund uses. Most funds use a multiple of EBITDA to value potential investments.

What qualitative methods are used to evaluate funds?

  • Does the fund have the infrastructure and back-office personnel to sustain itself across any cycle?
  • What is the quality of the investment professionals making decisions for the fund and how are they compensated?

What are the challenges of creating a portfolio?

  • A portfolio of funds can be diversified by geography, sector and fund size. Over time, different sectors fall in and out of favor. Investment dollars that are paid out over different time periods will aid in the diversification of return.
  • Each investor will have a certain number of funds that they are comfortable investing in.

What is the risk of private equity with respect to other asset classes?

  • Public equity influences private equity; however there is a much different risk profile. Limited liquidity, blind pool risk and higher fees demand that private equity returns be superior to public equity.
  • Investments are made at intervals throughout the life of the fund; the timing will affect the IRR realized by the fund.

In the early days of PE, 25% to 30% returns were common; returns have dropped to the high teens.  How does this change the risk assessment?

  • Over the past 20-25 years there has been 10% annual growth in new dollars committed, this has compressed returns.
  • There is a wide range of returns among funds and access to funds and managers who outperform can be constrained.
  • Private equity funds must show performance at 300-500 bps better than public markets, LBO funds must demonstrate the highest performance premium.

What is a forever fund?

  • A typical private equity fund may have a 10-year life, at which time capital is returned to the investor.
  • There is very high interest from certain types of investors for longer terms from private equity funds. This is a better fit for institutional endowments and family offices needing investments for future generations.

What has been the trend in regulation?

  • With the passage of Dodd-Frank in 2012, private equity is no longer the “Wild West”.
  • Mandated registration has led to more oversight and enforcement actions are climbing.
  • PE firms face more questions from regulators; there is a focus on marketing materials being truthful.
  • More compliance personnel have been added, this is a positive for investors.

In the audience Q&A, the issue of risk was again addressed by the panel. True argued that risk can be defined by 1. Volatility (will it be lower?), 2. Fund Outcome (will return realized in 10-years be adequate?) and 3. Liquidity/cash flow (institutions have cash flow constraints that must be balanced with fund liabilities).

There was some audience Q&A with respect to the loosening of debt covenants and fee structure.  Higher leveraged funds will be riskier and require a higher return. Historically, the fee structure has been 1%-2% of assets managed and a 20% share of profits at the back-end. The limited partnership agreement must be specific when enumerating fees (list it or lose it).

After a short break the second panel was convened. This panel was comprised of asset owners who were able to provide some additional perspective on the issues.

What kind of due diligence is done before investing?

  • Haigh stated that 22% of Northwestern’s portfolio is in private equity. These are in co-investment’s with manager with which they have the highest conviction.
  • Investors are under pressure to commit money to managers within a relatively tight-time frame as funds are closed to new investors quickly
  • Staff resources are dedicated to getting to know the managers, those with a history of success are favored.

Now that all sectors are fair game for PE, how has the risk profile changed?

  • The benefit has been the ability to diversify within this asset class. Different managers may specialize in different sectors.
  • The challenge becomes “Which managers have the expertise for which sector?”
  • PE firms with specialty funds in out of favor sectors still have to do deals; given the time-frame can they attract investment dollars?
  • This trend reflects the maturation of the sector.

Given that the current part of this cycle has led to high valuations, what defensive measures do you take?

  • Patience is needed, however when top quartile funds are raising cash, you need to invest if you have dollars to put to work.
  • Investing consistently is important; timing the market is a mistake.
  • Take advantage of secondary sales if possible.

In the audience Q&A there were several questions concerning currently inflated valuations among private companies and the paucity of investment opportunities because of over-valuation. Investors take comfort in PE firms who have followed companies for 3-4 years and use consistent valuation methods. The computation for EBITDA can vary among managers, the biggest error can be overpaying for an asset.

QE Postmortem

A review of the Quantitative Easing (QE) programs conducted by central banks around the world since the financial crisis of 2008-09 was the topic of a panel discussion before a full house at the Hotel Allegro on September 13th. Dr. Dejanir Silva, professor of Business at the Gies School of Business at the University of Illinois served as moderator. Dr. Dejanir focuses his research on unconventional monetary policy, financial regulation, and entrepreneurial risk-taking. His panelists included:

  • Roberto Perli, from Cornerstone Macro in Washington, D.C. where he heads global monetary policy research. Prior to moving to the private sector in 2010, Dr. Perli worked at the Federal Reserve Board, assisting with the formulation of monetary policy.
  • Nomi Prins, journalist and author with experience in international investment banking.
  • Brett Ryan, senior economist at Deutsche Bank responsible for high-frequency data forecasting for North America.

Dr. Dejanir kicked-off the event with preliminary comments starting with a quote from the former President of the Federal Reserve Board, Ben Bernanke:

“The problem with quantitative easing is it works in practice, but it doesn’t work in theory.”

More specifically, Dr. Dejanir explained that although empirical tests have shown positive effects of QE, we don’t have a clear understanding of the channel by which it works: the how and why of QE. This condition makes QE programs difficult to plan, execute, and, most importantly, evaluate after the fact.

The panelists then gave their general observations on QE as conducted by the Federal Reserve (Fed), European Central Bank (ECB), and the Bank of Japan (BOJ). Prins pointed out the huge size of the programs—the equivalent of $22 trillion. Even though the Fed has begun (slowly) to unwind its QE program, the ECB and BOJ are still accumulating securities. Prins called this an “artificial subsidy” which has encouraged investors of all types to take more risk than they otherwise would (or should) have. Perversely, this could end up having a destabilizing impact.

Ryan complimented the central banks for conducting QE claiming it helped avoid a long, global depression, and he added, they had learned a lot about how to use the tool in the future. He admitted surprise that the term premium in financial markets hadn’t returned to pre-crisis levels, and wondered what this might imply for the performance of risk assets in the future.

Perli, pointed out that, because the QE programs at the ECB and BOJ are still underway, conducting a postmortem is premature. Indeed, the ensuing discussion failed to reach many insightful conclusions about QE.

Dr. Dejanir then asked the panelists if central banks should conduct QE at all, in light of the risks it poses for them (by investing in asset classes beyond sovereign debt) and for investors (by reaching out on the risk spectrum further than usual). Ryan thought the risks were lower for the U.S. than for other countries because the dollar is the world’s reserve currency. That effectively removes a limit on QE for the Fed. He added that the increases in required bank capital enacted during the crisis counteracted the QE programs by requiring banks to operate at lower leverage ratios. This has led to the idea of flexible capital regulations allowing for their application counter-cyclically. The Fed is conducting research into this concept.

Perli, said that in a time of extreme crisis, central banks must take actions that go beyond standard policy, and the recent experience fits the bill. However, he questioned the separate nature of the various QE programs, and suggested a coordinated effort could be more effective in the future.

Prins, acknowledged the inherent riskiness of QE. She contended that a lot of the liquidity has found its way into equity markets, either from end investors, or corporate buybacks. She feared that future rounds might require further investments into equity markets by the central banks to be effective. She also noted that the lack of a clear exit strategy added to the uncertainty, if not the outright risk, of QE programs.

The next question put to the panelists was whether or not the central banks should (or would) seek to reduce their balance sheets to pre-crisis levels. All three were skeptical that they would. With specific regard to U.S. MBS, Ryan doubted the Fed could reduce its holdings significantly without a material impact on the market, which it would be reluctant to do. Banks invest heavily in agency MBS because of their low-risk weighting in determining capital requirements. Prins pointed out the Fed would be careful not to upset the MBS market and generate a knock-on negative impact on bank capital. Perli expected all central banks to continue with greatly expanded balance sheets for the foreseeable future. He also expects a slow transition to transactions-based policy rates rather than administered ones. Ryan seconded this opinion and endorsed SOFR (Secured Overnight Financing Rate)–essentially the overnight treasury repo rate–as an alternative to Fed Funds.

The discussion moved on to the topic of the increase in indebtedness since the crisis. Prins presented figures highlighting recent changes. Total household debt has barely budged since 2007, rising just $100 billion to $9.4 trillion. However, this masks a shift of over $1 trillion from mortgage debt to other types of consumer debt. Non-financial corporate debt has nearly doubled to $3 trillion (Ryan noted that ratios of corporate indebtedness have reached levels usually characteristic of recessions). Student loans have risen dramatically, in relative terms, from $500 billion to $1.4 trillion. When sovereigns are included, total global debt has risen from about $97 trillion to $247 trillion, mainly because debt remains very cheap for borrowers almost everywhere in the world. All panelists acknowledged, however, that emerging market countries, having to borrow in developed markets, will struggle to service their debt denominated in foreign currencies.

The debt question eventually led into the final topic of the event: inequality. Ryan noted that inequality has been rising since 1980 but has only become an issue more recently. Dr. Dejanir asked if central banks should take inequality into consideration in conducting QE in the future.  Ryan responded that central banks lacked tools to address the issue. Perli agreed, saying that in times of crisis, central banks had to act to help economies quickly, without consideration of side issues like inequality. In any case, inequality is a macro policy issue, not a monetary policy one. Prins thought inequality should be addressed with regulations all the time, not just during crises.

In the end the panel had no concrete conclusions on QE, but agreed on some broader points:

  • Despite uncertainty over the size, timing, and ending of their programs, the central banks in the largest global economies needed to act beyond monetary policy, to help their economies recover from the great recession.
  • Experience has shown that these programs entail risks that could prove to be larger problems in the future.
  • Central banks should learn from their experience with recent QE programs, share that knowledge, and plan now for more coordinated programs when they are needed next.

China Opens Its Doors to Foreign Investors

On May 17th, 2018, CFA Society Chicago hosted a program to address challenges and opportunities for the US and China. Patrick Chovanec, managing director and chief strategist, of Silvercrest Asset Management, presented his thoughts about the relationship between China and the US. His comments focused on the trade deficit and the effect of General Secretary Xi Jinping and President Donald Trump.

Chovanec noted that trade imbalances are not inherently good or bad. He stated that competitive advantages only address part of the reason for these imbalances.  Trade deficits and surpluses also result from differences in savings rates. In the 19th Century, the US borrowed from the UK to invest in plant and equipment, which resulted in a win for both parties. In contrast, Germany used its trade imbalance and relatively high savings rates to lend money to Greece, which used the funds for consumption, hurting both entities.

The trade imbalance between China and the US represents a significant challenge for both parties. The genesis for the trade deficit began with China’s desire to support capital investments with foreign demand for the goods it produced. This strategy can work for small and emerging economies. However, this plan does not work as well for the world’s second-largest economy.

The US supplied demand for goods produced in China until the 2008 financial crisis. China reacted to the decline in US demand with an investment boom to continue economic growth. China recognizes that it cannot rely on foreign demand and domestic investments. Growth in domestic consumption represents the long term path to sustainable growth.

Chovanec believes that higher trade barriers do not represent the solution for the US trade deficit. President Trump has focused on an unfair playing field, which presents a profound problem for the US. China should be open to a fairer system and continue its efforts to increase domestic consumption. However, lower trade barriers and increased consumption in China would cause the US to consume less and/or produce more. The biggest US problem is over consumption. The Federal budget deficit supports entitlement payments, which crowds out borrowing for investment. Borrowing for consumption versus investment underlies the US challenge.

In 2013, the third plenum of China’s Central Committee established a goal of opening capital markets. Xi has committed to this goal. The challenge for foreign investors has been a lack of economic reform and assessing valuation levels for assets. The Chinese stock market collapse in 2016 slowed foreign interest. The Chinese government heavily intervened to establish a floor of 3,000 for the Shanghai Composite by essentially ordering domestic owners not to sell.

China accounts for about 15% of global GDP, but just over 3% of global equity market capitalization. The world’s second-largest economy has long kept most foreign investors out of its capital markets. But as the country’s economic model undergoes a transition from export and investment-led growth, to one powered by consumer spending it is simultaneously opening its doors to foreign capital.

Nick Ronalds, CFA, founder and president of RhoFinancial, LLC, led a panel discussion about the opportunity for foreign capital investments in China. The panel included Christopher Balding, professor of economics at Peking University, Craig Feldman, global head of index management research at MSCI, and Sandy Li, senior vice president at Loop Capital Market, who discussed some of the more promising areas for investing in China’s future.

Fintech Part 2: Rise of Robo-Advisors

David Koenig, CFA

CFA Society Chicago hosted Rise of Robo-Advisors, the second fintech event of a three-part series. The event was held at The Standard Club on April 19, 2018, commanding a crowd of over 120 people. The event started with a keynote address and was followed by a panel discussion with thought leaders in “Robo-Advisory.” Those in attendance were able to participate in a Q&A session at the end of the event.

David Koenig, CFA, the keynote speaker, is chief investment strategist for Charles Schwab’s digital advice solutions. He helps oversee Schwab Intelligent Portfolios and provides research and analysis about automated investment advisor services. He opened with an introduction to what “Robo-Advisory” really means and provided some background on the topic as well as the agenda for the evening:

  • How technology is changing investment advice
  • Robo-Advice Landscape
  • The rise of technology in investing
  • Where the industry is going
  • Panel Discussion
  • Q&A session

Koenig continued to give a breakdown of how today’s clients interact with technology and how technology is developing in business. He explained that clients are using a variety of devices throughout the day for a variety of tasks from utilizing GPS to ordering lunch online. This attachment to technology has also become pervasive in the business environment from digitizing paperwork and payment systems to hosting virtual meetings. After highlighting the breadth of technology in our lives, he continued to discuss the types of technology we use today—such as social media, mobile processing, and automated payment processing—and what kind of technology we can expect to see in the future through machine learning algorithms and artificial intelligence.

Once the audience had an understanding of the current and prospective technology landscape, Koenig proceeded to discuss the current client experience in financial services. He brought attention to how little time the average investor spends contemplating investment decisions. For reference, he highlighted that, on average, people will spend more time deciding whether or not to take a vacation than make an investment decision. This appears to be due to customer’s lack of satisfaction with the advisory process. Customers tend to classify investment advisory as tedious, intimidating, and inconvenient. However, robo-advisory is shifting that mindset.

Koenig opened the discussion of the current robo-advice landscape by emphasizing that current models typically do not work directly with customers of investment advice. Instead, they work through traditional advisors to empower their decision making and automate redundant technical tasks. This technology has led to more sophisticated advice and asset management being delivered at a significantly lower cost. He went on highlight that this business model was developed by corporate fintech innovators such as Betterment and Covestor and validated by advisory incumbents such as Charles Schwab and Vanguard.

The discussion continued to present the different business models that have emerged over the years: the fully automated robo-only model, virtual advice using both robo and a traditional investment advisor, and institutional services. The robo-only model’s greatest advantage is the extremely low or non-existent investment minimums. The virtual advice model takes all the power of robo model and leverages the skills and experience of a financial advisor. These two models make up the current retail landscape of robo-advice. Koenig also briefly discussed institutional robo-advice in the business-to-business landscape. He highlighted the streamlined client communication and onboarding processes, automated risk profiling and account aggregation, intelligent portfolio construction and rebalancing, and the attractive interface of the modern advisor dashboard. All of these advantages have led to significant growth over the past four years alone—145% compounded annual growth to be specific.

After familiarizing the audience with current landscape, Koenig went into detail about what makes digital advice so appealing. He began by introducing many of the common myths associated with robo-advice and proceeded to break each one. First, he introduced the myth that “robo-advisors are only for millennials.” This was followed by a chart showing that, in fact, baby boomers and Gen X clients are actually the biggest consumers of robo-advisory taking up 44% and 34% of the market, respectively. Next he addressed the myths that “robo-advisors are only for less sophisticated investors” and “robo-advisors are only for small accounts.” These myths were met with examples from Koenig’s personal experience in robo-advisory where he has aided with the direction of several high-net worth and sophisticated accounts. Finally, he addressed the myth of “robo-advisors are going to replace humans” where he once again drew on his own experience to once again explain how the technology is actually used. He emphasized once again that robo-advisory is not replacing traditional advisory, but rather empowering it. His discussion of these myths was closed out by a series of metrics that displayed current investor interest in robo-advisory and highlighted opportunities to educate.

To conclude the keynote presentation, Koenig covered where robo-advisory is going. He drew attention to the fact that it is growing rapidly and differentiating across various financial service functions. He discussed how the implementation of newer technology such as artificial intelligence, chatbots, and machine learning algorithms will continue to empower and change the landscape of financial advisory by adding a heightened level of personalization to the technology. Additionally, he emphasized that he expects consumers will demand both digital and human advice; further perpetuating his message that robo-advisory will empower traditional advisory rather than replace it. He closed out his presentation with a quote from a recent Morningstar editor’s letter stating “Maybe [robo-advisory] automation will make the advisory experience more human.”

The second half of the evening featured a panel discussion moderated by Sunitha C. Thomas, CFA, regional portfolio advisor at Northern Trust, and included speakers Joel Dickson, Sylvia Kwan, and Dan Egan. Each of the panelists introduced themselves and discussed how they leverage robo-advisory for their clients.

Joel Dickson is Vanguard’s global head of advice methodology. As one of the first widely-recognized incumbents to enter the robo-advisory space, Dickson and Vanguard have focused on maximizing their advisors’ alpha, managing global portfolios, and maximizing short and long term goals for clients. They accomplish this through lowering incremental costs to attract clients and automating rules-based tasks as well as implementing continuous risk-profiling of their clients. This continuous risk-profiling is starting to replace more traditional portfolio “bucket” assignments. He also emphasized that robo-advisory has allowed Vanguard’s advisors to focus more on the advisory services by catering more to individual client preferences and goal-focused information.

Sylvia Kwan is the chief investment officer at Ellevest, a technology-enabled investment platform redefining investing for women. In her role, she is responsible for developing investment portfolios and proprietary algorithms that drive Ellevest’s investment recommendations. Ellevest is trying to bridge the investment gap between men and women as current data shows that women are substantially under invested when compared to their male counterparts. Kwan explained that portfolios are assigned through the use of a goals-based questionnaire and client engagement is maintained through a variety of communication channels including their “What the Elle” newsletter. They initially engage their clients through social media and their current community of female investors.

Dan Egan is the managing director of behavioral finance and investing at Betterment, one of the first-movers in the robo-advisory space. Betterment’s value proposition is to “connect common investors to quality advice.” They don’t assign portfolios as much as they allow customization coupled with quality education. With their current product they are working to automate as much as possible and allow their advisors to focus more time on the human element of the business. They use social media to engage clients but their primary source of engagement has been word of mouth and they maintain engagement through precise communication catered to individual clients. This communication includes sharing education on investment planning as well as market news. Machine learning is becoming an increasingly integral part of this communication process.

All of the panelists explained that their current business models are built on advisory fees and a focus on goals-based investing. Additionally, as technology continues to develop and automate the more mundane elements of financial advisory, they are increasingly seeking advisors with greater communication and people skills. The event concluded with a Q&A session.

Q&A

As investing tasks become more automated will investment managers continue to be held accountable for performance? Yes, but accountability will be less focused on short-term and investment philosophy performance and more focused on goal achievement and catering to client engagement.

What has been the conversion rate from traditional to robo-advisory? While nobody could provide an exact metric, the general consensus was that it has been high, especially in more recent years.

Can behavioral coaching be coded? With enough time, yes. However, that technology appears to be in the far future and will likely not be a major impact in the next decade.

How satisfied are people with robo-advisory and how is satisfaction gauged? The success of robo-advisory platforms are measured through client surveys and the current data shows satisfaction rates are high. However, each of the events’ presenters were quick to point out that robo-advisors have yet to endure a recession.

Fintech Part 1: Blockchains – Disruptor, Panacea, and Reality

CFA Society Chicago hosted Blockchains – Disruptor, Panacea, and Reality, the first fintech event of a three-part series, focusing on blockchain technology and its applications. The event was held at The Chicago Club on January 17, 2018, attracting a sold-out crowd of over 200 people. The afternoon started with a keynote address and was followed by a panel discussion with industry members working in the crypto space. Those in attendance participated in Q&A session at the end of the event.

Keynote Address

Wulf Kaal, the event’s keynote speaker and moderator, is director of the University Of St. Thomas Private Investment Fund Institute, a tenured associate professor of law at UST School of Law, a leading expert on hedge fund regulation in US and EU, and an industry expert in the cryptocurrency space. He initiated the event by gauging the audience knowledge and involvement within the crypto space, introduced blockchain technology and outlined the following event agenda:

  • Blockchain Technology
  • Smart Contracts
  • ICO Market – Best fundraising for start-ups
  • Case Study – Blockchain in Loan Industry
  • Panel Discussion
  • Q&A session

Kaal then continued to highlight the magnitude of growth possibilities within the crypto space. He displayed past year price data for Ethereum and Bitcoin (two of the most famous cryptocurrencies) and emphasized the fact that what has been seen to date can be thought of as linear growth and that exponental growth is expected by the industry. He also shared four years of ICO related market data showing a total fund raising of $6.4bn to date.

Kaal discussed how some market participants regard the rise of blockchain as a bubble; some audience participants share the same view. He went on to educate the audience with the crypto space, blockchain technology and its application beyond the talk-of-the-town cryptocurrencies like Bitcoin and Ethereum.

He described the core characteristics of people believing in the crypto space. The following key characteristics describe a “Crypto Purist”, such as himself:

  • Believes in crypto space
  • Believes in decentralization
  • Believes in a New Economy – a new way of thinking

Moving on, Kaal educated the audience on blockchain technology stating that it is similar to “having an internet” like event. With “Code being the Law”, blockchain technology is self-executing. It is a decentralized public ledger where each block (or node) in the chain can be thought of as a sheet with the footprint of a previous page along with its information. Blockchain could be referred to as a peer-to-peer (P2P) network based upon “Trust” and “Disintermediation” with a copy of the ledger stored in different computers all over the world. The result would be a transparent decentralized economy. Constant additions to the blocks in the chain would require higher computing power to modify past blocks/nodes making it difficult or next to impossible to cheat/hack this system. Lacking scalability in applications at the moment, Kaal believes that whoever can figure out a way to apply blockchain technology to enterprise facing solutions will be the next “Google” of today.

By not being physical in nature and anonymous over VPNs (Virtual Private Networks), the use of blockchain ledger faces issues concerning lack of legal remedies and/or recourse in contrast to what we have today with internet related solutions. However, legal groundwork is being carried out to deal with such issues.

Continuing the discussion on law and blockchain, Kaal geared the discussion towards Smart Contracts which are self-regulating and self-executing contractual obligations. These contracts are inexpensive, automated by code, take only minutes to execute and have automatic remittance versus 1-3 days for traditional contract execution at a comparatively higher price with manual remittance. This reduces the need for lawyers due to the nature of the contract. When a smart contract is coded, it will end with an execution and cannot be stopped by either party. However, this could lead to some issues where unexpected circumstances occur in normal business transactions requiring flexibility from parties to the transaction. Kaal also briefly touched upon the different use cases of smart contracts with varying level of complexities. The industry expects banks to spend heavily in blockchain based solutions in the coming years. He predicted that settlements may very well happen one day using this technology platform.

Kaal then steered the focus towards the funding landscape within the crypto world. He discussed venture capital interest funding blockchain based start-ups in various industries ranging widely from Finance, Government, Consumer and Media. Next, he touched upon ICOs (Initial Coin Offerings) and how they stack up against traditional Venture Capital and crowdfunding sources in characteristics for start-up funding. Kaal shared market data on how since September 2016, Ethereum was the most popular blockchain for ICOs’ assets globally. The US leads the industry with the highest number of crypto start-ups globally followed by Europe and Asia. Russia on the other hand is leading in government support for the overall technology platform with state funded academy formation and by creating a more favorable regulatory environment than the US.

Proceeding to the next agenda item for the evening, the Kaal discussed a blockchain case study of a Loan Securitization. He compared the blockchain process to the existing loan securitization process and identified the following key benefits of the former:

  • Lower costs
  • Increased Safety
  • Faster Payment Streams
  • Rise in trading volume

Panel Discussion

The second half of the evening featured a panel discussion moderated by Wulf Kaal with speakers Colleen Sullivan, Zabrina Smith and Biju Kulathakal. Each of the panelists introduced themselves and discussed how they engage with the crypto space for their clients.

Colleen Sullivan is co-founder and managing member of Sullivan Wolf Kailus LLC, a boutique law firm based in Chicago that specializes in hedge fund, private equity, venture capital, digital assets and other alternative investment products. She discussed blockchain from a legal standpoint clarifying that ground reality for the regulatory environment is very different than what has been observed in the media. She recalled being present in South Korea when a reported surprise government “crackdown” on the crypto exchanges was merely an examination by Korean tax authorities on the tax implications of the crypto exchanges. She noted that governments are looking to exchanges to self-regulate in these unchartered territories.

Furthermore, Sullivan discussed various cases she has been working on for legal solutions around asset servicing, asset management and wealth management. Her firm has been leveraging blockchain technology for asset safety of their clients, efficient transactional authority and transparency, proof of value assessments, etc.

Next, Zabrina Smith, vice president within Northern Trust’s Market Advocacy & Innovation Research (MA&IP) team, introduced herself and described how she was working on researching ways to incorporate block chain technology to add value for global clients. Her team has been working with use cases around contracts, wealth management and other creative uses within the organization to add value and/or improve existing customer solutions. Northern Trust has been proactive in trying to apply the technology and has been working in the space as a pioneer to bring better solutions to its customers.

Finally the last panelist, Biju Kulathakal, founder of Halo Investing – first independent multi-issuer technology platform, introduced himself and described how his organization utilizes the blockchain technology for structured loans with options contracts. Halo Investing packages products from sellers like JP Morgan, Credit Suisse, and Goldman Sachs, and sells it to advisors like Schwab and others.

He presented an example of a typical transaction based on blockchain to illustrate the potential benefits like less documentation, quicker execution, lower costs and flexible issuance sizes when compared to traditional structured notes.

Q&A Session

The session continued with questions from audience noted below:

Implications/application of blockchain for lending securities?
Blockchain can leverage various functions including the following aspects of securities lending:
• Digital Identity; and/or
• Settlements (similar to implementation by Australian Stock Exchange)

Implications of blockchain for auditors?
Blockchain could be applied to automate life cycle processes reducing overall audit times and increasing efficiency for the whole process.

Benefits of leveraging blockchain technology to CDS contracts?
Blockchain based CDS contracts would be expected to be of a lower cost as no counterparty would be maintaining a ledger.

Implications of blockchain on access to asset classes?
By being able to sell part of assets, blockchain implementation would lead to increased access to assets which would otherwise be known as ‘Exotics’.

Implications for Visa systems?
Viewing Visa as a huge notary, blockchain could result in reduced visa costs.

Where blockchain would not be a viable technology?
Blockchain would not be viable where actual enforcement is required, for example policing etc.