Tag: Education

Preserving Alpha through Successful Execution

Alpha is the ability to generate superior risk-adjusted returns compared to the return of an appropriate index. The purpose of most equity trades for managed portfolios is to hopefully create alpha for that portfolio. The hidden costs of not obtaining the best execution can destroy that alpha.

How does the trader know his trade is being treated fairly with respect to other trades being placed at the same time? Is the trade being shown to the right people? The SEC website lists 20 exchanges approved for securities trading. What drives the decision by a trader to use one exchange over another?

CFA Society Chicago’s Education Advisory Group hosted a panel discussion on insights on market structure in the equity market and how this structure affects equity trading today. The moderator was Michael Thompson, CFA. The panelists were Haim Bodek, Nanette Buziak and Larry Harris, CFA. Their backgrounds are as follows:

Michael Thompson, CFA – Mr. Thompson is a Partner and Head of Domestic Equity and Derivatives Trading for William Blair Investment Management. Mr. Thompson began his career in the late 1980s as a securities trader associate with Principal Financial.

dsc_3238Haim Bodek – Mr. Bodek is a Managing Principal of Decimus Capital Markets, LLC a tactical co nsulting and strategic advisory firm focused on high frequency trading (“HFT”) and U.S. equities market structure. Mr. Bodek is the author of two books on market structure and is known as a whistleblower that brought attention to the questionable practices of HFT.

Nanette Buziak – Ms. Buziak is Head of Equity Trading at Voya Investment Management. Ms. Buziak manages a team of equity traders and is responsible for all facets of equity trading and related operations at Voya.

Larry Harris, Ph.D., CFA – Dr. Harris holds the Fred V. Keenan Chair in Finance at the USC Marshall School of Business.  Dr. Harris addresses regulatory and practitioner issues in trading and investment management in his research and consulting.

Mr. Thompson began the panel discussion by briefly speaking about his background and introducing each panelist. Mr. Thompson provided a brief history of the changes in equity trading since the late 1980s. When Mr. Thompson began his career, there were only two exchanges and orders were brought to brokers who announced the bid or offer on the floor of the exchange. There were only two recognized equity markets, the NASDAQ and the New York Stock Exchange. By his estimate there are now 13 well known exchanges and 40 dark pools that can trade, with all trades done electronically. Each panelist made a brief presentation which is summarized below:

Dr. Larry Harris

  • The need for speed critical, you need to be the first in line for execution or the first to cancel if you don’t want to get hit.
  • A buyer grants a “put” option to the market and the market will move away from a buyer over time.
  • Brokers can hide orders or search for hidden orders. Dark pools will not show orders.
  • Limit trades often come with price discretion. Someone with a limit order of 23 might accept a price of 21; however this fact is not shared with everyone.
  • “Maker-taker” fee structures have become more common. The broker will typically extract a fee from the taker and rebate part of that fee in the form a liquidity rebate to the maker.

Haim Bodek

  • There are basically two worlds in equity trading, HFT and non-HFT. Firms that specialize in HFT exploit the structure of the market to take advantage.
  • HFT is not really a quant strategy.
  • The two biggest HFT firms paid substantial fines to the SEC in 2012 due to the work of Mr. Bodek in exposing the unfair advantage of firms using HFT when competing with traders not using HFT.
  • HFT comprises around 40% of equity volume and is still legal to use as long as those firms use proper disclosure.

Nanette Buziak.

  • Her team is composed of traders, analysts and portfolio managers who are all cognizant of trading costs. The team strives to limit the implicit costs of trading.
  • The average print size of an equity trade is around 217 shares; her typical trades at Voya are in the millions of shares.
  • Need to assess what venue is appropriate for what trade. Does the name trade in dark pools?
  • HFT is not an issue as long as she feels her positions are not compromised. Some venues can be more toxic than others.
  • Liquidity appears to be coming out of the market at this time since the dwindling amount of IPO’s are not able to replace firms lost to M&A.

There was a brief Q&A session following the panel’s presentations that touched on the following topics:

  • There was some frustration expressed on how slowly the SEC responds to complaints. Since the SEC must follow due process, it is up to institutions to do their own due diligences on these venues and brokers.
  • Firms that do large equity buybacks in many cases use minority brokers.
  • In assessing what algorithm to use when trading it’s important not to use those that are repeatable and can be used against you.
  • Voya’s portfolio managers know what names are not liquid and they will not build a large position in a thinly traded stock.

In response to where they see the market in 5 years, most participants felt there would be little change in that time. With the new administration, Dodd-Frank might be in jeopardy

Investing in Innovation

 

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From L to R: John Pletz; Bruno Bertocci CFA; Tricia Rothschild, CFA; Matt Litfin, CFA; Daniel Nielsen

If you compare the list of Fortune 1000 companies from ten years ago to today, over 70% of its members have been replaced due to disruptive market forces and mergers and acquisitions. In the next ten years another large batch of less-innovative firms will likely be erased from the index as groundbreaking technology continue to affect long-running corporations, causing a frenzy of movement for companies to stay relevant against an incredibly competitive global landscape. Innovation isn’t just a buzzword for corporations these days, but a means toward survival.

Dr. James Conley teaches a course at Northwestern on intellectual property and made for a perfect moderator to lead a discussion on investing in innovation. To begin, he used the same video he plays for his students as an introduction to the panel discussion. The five minute video introduced concepts around the value and management of intangibles by corporations. There has been a marked shift in the asset composition of corporate assets from tangible (factories, buildings, equipment) to intangible (patents, ideas, processes, code). Now over 80% of companies’ market value stems from intangible resources. The video explained how patents protect IP owners and the difference between utility patents (20 year life) and design patents (14 year life). It also laid out the rules for what can be patented and why the patent system matters. Copyright protection was also discussed, and this can give authors and creators 100+ years of protection. Trade secrets, such as the recipe for Coca Cola, receive the highest level of protection and can last indefinitely. The benefits of intellectual property regimes include providing incentives to inventors to create and advance collective knowledge. They also help consumers avoid confusion from competing products. Intellectual property has been receiving a lot of attention lately from many sources, not just in the startup and corporate world. Conley said that Christine Lagarde of the IMF mentioned the phrase six times during a recent address to Kellogg students.

Terry Howerton focuses on tech investing and has built a technology community in Chicago called TechNexus. He said that he believes that innovation will drive industry performance and most innovation will come from an entrepreneurial community, not from incumbent corporations. His firm became an accidental incubator for startups as he found himself acting as a conduit between major corporations looking to be linked up with startups in order to drive innovation.

Conley said that the shift in corporate assets from things like factories and machines to intellectual property and ideas is as significant as the Industrial Revolution. In his investment process he identified 300 companies with the most valuable patent portfolios. This was based upon his own research that indicated companies with stronger intellectual property outperformed companies with weaker intellectual property. The question he often hears is “How can a single factor model (in this case, IP) outperform the market (often to the tune of 200-300 bps a year)?” He says it is due to most investors’ lack of knowledge on which companies actually own good intellectual property assets, and as a result, those firms go undervalued.

dsc_3136On the financial reporting side, Janine Guillot of the Sustainability Accounting Standards Board (SASB) said her group’s goal is to provide reliable valuation measures to intangible assets, which is often hard to do. She discussed how financial reporting needs to evolve as the percent of a company’s overall market value coming from intangible assets continues to increase. This goal will be accomplished by creating a common accounting language across IP and intangibles that is industry-based. The board has created a set of material, non-financial factors that are grouped into five themes:

  • Human Capital
  • Social Capital
  • Environmental Capital
  • Business Innovation
  • Leadership and Governance

The panel noted that corporate ventures are difficult. Not too many Alphabets (parent of Google), with its strong investing capabilities, exist in the corporate world. Time horizons often pose a challenge, as corporate earnings are measured by the quarter while success in the VC world can take many years. The primary goal of a corporate venture also needs to be due to strategic reasons, not to drive short-term returns.

Howerton told a story about an insurance firm that was bragging about undertaking an IT project that would be the biggest of all time, taking over 36 million man hours. Successfully completing the project, with its immense cost, would be seen by many as incredibly risky. Yet that same corporation would view sending four people off to an idea lab to try to come up with innovative solutions as “too risky”. Companies need to recalibrate to the new realities of risk and failure as the pace of the economic landscape moves increasingly rapidly and longstanding businesses find themselves irrelevant in the new economy.

Best Practices in Risk Management

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What is risk?

Many metrics and measures fall into the overall category of investment risk, including operational risk, market risk and credit risk. Investment risk is generally defined as “loss arising from changes in interest rates, credit spreads, equity prices, foreign exchange or commodity prices.”  Liquidity risk, at the forefront of many investors’ minds these days, could also be added to this list as a standalone item or included as part of price risk.

While a definition of market and credit risk may be fairly understood, the concept of “operational risk” is sometimes more nebulous. Operational risk could be described as “losses due to anything else, aside from market and credit risk”. But there are other ways to lose money that shouldn’t necessarily be categorized as true risks, such as not having the right strategy or the right timing on an investment, which could be considered outside the scope of what a risk management function can do.

Michelle McCarthy, Managing Director at Nuveen Investments, stated that each type of risk has its own type of P&L distribution. Credit, with its main reward being coupon payment and repayment of principle, has much lower upside and a bigger left tail, or possibility of large losses, than market risk, which follows a more normal distribution. Operational risk also displays a larger loss potential. Combining the three main types of risk into a single cohesive measurement becomes difficult given their differences in distribution.

There are also two primary styles of risk, binary risks and risks of degree. Binary risks are purely unwanted and offer no upside potential, and include things like fraud, theft and legal violations. Companies can use controls and processes to manage these risks to as close to nil as possible. Risks of degree offer upside potential, and are the result of an investment decision. These types of risks are market or credit-related, and need to be managed and monitored. As a risk manager, McCarthy looks out for hidden risks that may not show up in a risk report, risks that are disproportionate to the amount of the potential gain, and risks that have a potentially unexpected return distribution.

What types of risk metrics are important to a hedge fund manager? Jennifer Stack said that at Grosvenor they often look at many different measures instead of relying upon a single number, and utilize Value-at-Risk (VaR), contribution to VaR, stress testing and factor models the company has built. While VaR is helpful for a total portfolio view risk that can integrate exposures across asset classes, different asset classes often require different risk measures.  For instance, looking at the Value-at-Risk (particularly historic Value-at-Risk) of real estate is often misleading as returns look smooth and volatility appears artificially low as a result. Regarding how best to protect a portfolio, Jennifer said that as a hedge fund investor, “sometimes the best hedge is to sell.”

 

Organizational Structure

Mike Edleson of University of Chicago kicked off the panel with some background on his institution’s endowment. He described their organization as “very enterprise risk focused” and said that they employ a total of 28 investment professionals, with 3 devoted to risk management.

Noreen Jones of NYSTRS said that her pension sees its primary goal as funding liquidity. Every month, NYSTRS delivers benefit payments to 150,000 retirees, and these payments total $600 million a month. The pension’s risk management group is only two years old and was created in response to a regulatory analysis of a gap on calculating and reporting risk at the total plan level. In response, NYSTRS built their risk group from scratch and currently employs four risk professionals tasked with measuring and monitoring the risk of a $100 billion asset pool. Initially, the risk group found it difficult to get a buy-in on a formal risk management approach across portfolio management groups. While the public market groups were used to routine risk measurement and monitoring, the attitude of the private market teams was often “My portfolio didn’t lose money, so where’s the risk?”

Grosvenor Capital has $45 billion in AUM and approximately 400 employees, mainly in Chicago. Its primary business is a hedge fund-of-funds, where it invests money on behalf of institutional and individual clients into various external hedge fund portfolios. Jennifer Stack, the firm’s head of risk, said that their primary goal is to “achieve not only great returns, but to achieve great returns on a risk-adjusted basis.” Grosvenor operates under a system of checks and balances between its risk function and investing functions to achieve that goal.

The panel discussed how risk ought to fit in with the broader investment function. According to David Kuenzi of Aurora Investment Management, risk management can’t be merely a policing function focused on divesting “too risky” securities; it needs to be a collaborative exercise with the portfolio management team.

Sometimes being a risk manager can be a very lonely place. During the Dotcom boom of the late 1990s, McCarthy had to have difficult conversations with star portfolio managers making piles of money on internet stocks about their sector concentration risk. To Jennifer Stack, risk “is not so much about policing, but having a second set of eyes.” And often the best portfolio managers will welcome a conversation about risk, added McCarthy.

 

Risk Budgeting

“We’re a little different than other endowments,” Mike Edleson said of his employer, the University of Chicago endowment fund.  Instead of a traditional investment policy statement that would dictate targets for asset class allocations, University of Chicago follows a risk budgeting approach. “There are 12 or 13 things that we’ve found to be our primary risk and return drivers,” Edleson said.

As University of Chicago researched risk budgeting and a potential shift away from a policy statement to guide investment allocation decisions, they determined that equity market performance was the most important factor for overall risk and return. This led them to the formalization of their risk budget, which is comprised of four pillars:

  • An overall portfolio beta of between .75 and .80
  • A liquidity constraint that caps private investments at 35%
  • The ability to maintain a beta of between .75 and .80 even during a financial crisis (betas typically rise during large market drawdowns)
  • An absence of leverage (which takes into account the use of implied leverage often embedded in derivatives)

University of Chicago is not the only investor looking at employing a risk budgeting framework. Jones said NYSTRS is also working on one, and the Employees’ Retirement System of the State of Hawaii is also building an allocation strategy around risk factor groups instead of asset classes. Edleson said that staying right on their risk budget forces a discussion around trade-offs into each allocation discussion, putting risk at the forefront of every decision made.

 

Liquidity Risk

Buying illiquid assets may look good on the way in, as each subsequent purchase by a portfolio manager tends to raise the price, but could pose a problem on the way down if there is a dearth of buying interest.

For Jones at NYSTRS, coming up with the $600 million due to beneficiaries each month is a huge challenge that is at the forefront of the fund’s investment officers’ minds. In addition to the benefit payments they must pay, they also must deal with flows from rebalancing activities and undrawn commitments that need to be paid. They do a cash flow projection to help guide their allocations and measure their liquidity in months of payroll. Given their high liquidity needs, NYSTRS has a large chunk of its portfolio in Treasury securities, one of the world’s most liquid markets.

In a hedge fund context, measuring and managing liquidity can be a bit different. Jennifer Stack of Grosvenor looks at liquidity in two ways: the degree of mismatch between a manager’s long term investment and short-term financing, and the underlying asset liquidity.

While investors usually want as much liquidity as possible, there is a potential for too much liquidity. University of Chicago actually rejected two hedge fund managers’ proposals as they found the redemption terms to be overly generous given the liquidity of the underlying securities. The endowment didn’t want to find itself last to redeem if there was a stampede out the door, which could result in the endowment holding the most illiquid portions of the manager’s positions.

 

Managing Risk in a Crisis

Another risk management puzzle arises because “Humans are stupid, and we love to buy high and sell low,” said Edleson, “Especially those in the investment community”. As with any shrewd investor, the University of Chicago endowment wishes to be countercyclical with their private market allocations, but this is “horrendously hard to do in practice”. So University of Chicago always does the same thing, and keeps their beta consistent across normal and distressed market conditions.

“How does one account for betas changing in a crisis event?” McCarthy posed to the panel. At Aurora, David Kuenzi likes to run his portfolios through a stress test focused on the Lehman Brothers bankruptcy in 2008, which he said was “a gift, in a sense” to risk managers as it provided a recent event to use to see how portfolios might perform in a crisis condition. While many securities of today’s portfolios weren’t around in 1987, one of the most common stress test scenarios risk managers like to use, many of the securities in today’s portfolios were around in 2008.

Another facet of risk that University of Chicago focuses on is the potential for regime change, particularly how correlations between securities tends to change over time. As risk-on, risk-off has been the flavor du jour for the macroeconomic environment for nearly a decade, this isn’t always the case. Edleson said that over time, stock and bond correlation is positive about 50% of the time and negative 50% of the time, making it difficult to discern any general relationship outside the context of each particular regime. In addition to stress testing prices, it’s worthwhile to stress test the correlations between market variables and model the effect of potential regime changes on the portfolio.

As risk evolves from measures like duration to Value-at-Risk to modeling macroeconomic shocks, there are a dizzying amount of metrics investors can look at and use to manage their portfolios. As risk practitioners, “We don’t know the future, but we can know our exposures,” said McCarthy. We can determine how our portfolios might break down in an extreme event, and we can instill a culture of risk awareness in our organization in order to avoid huge losses, with hope of buying during a crisis as opposed to selling.

 

Panelists:

Mike Edleson, CFA – Chief Risk Officer, The University of Chicago Endowment Fund
Noreen Jones, CPA, CFA, CAIA, FRM – Director of Risk Management, New York State Teachers’ Retirement System
David Kuenzi, CFA – Partner and Managing Director, Aurora Investment Management
Jennifer N. Stack, Ph.D. – Head of Risk Management, Managing Director, Grosvenor Capital Management

Moderator: Michelle McCarthy – Managing Director, Nuveen Investments

Putting Investors First

DSC_2831Each May, CFA Institute and local societies join together to create awareness around placing investors interest first. This event reminds us of why we work in this industry – to best serve our clients.  Moderator Darin Goodwiler guided panelists Jonathan Boersma, CFA, David Hershey, CFA, and Brian Thompson through a discussion on the current regulatory and ethical environment investment professionals are navigating. The panelists provided insights from CFA Institute, the SEC and consulting and investment management disciplines.

Most of the discussion covered the Department of Labor (DOL) rule and its impacts. Given the goal of DOL is to provide objective advise to investors, 93% of 1400 surveyed want the law and 51% think the law is already set up to meet this objective. Broker dealers will be impacted the greatest and it is likely that security sales will be a differentiated title from what we have known as advisors. As the DOL regulation progresses, we can expect to hear a unified message from the SEC and FINRA via social media and other communication channels.  All who give advice to clients are be held to the same standards and it was noted that CFA charterholders, candidates and members have long been held to a very high standard of loyalty, prudence and care. Due to this, no change is expected for this group.

One thing DOL won’t help with is people behaving badly. Culture and management play a role. Ethics training and regulation can help but regulation backward looking is implemented because we learn from our mistakes and play “catch-up” from innovation. Thompson commented that ethical decision making plays into awareness like yoga does into moods and breathing. Panelists felt that best practices are using GIPS and having a strong and visible Chief Compliance Officer.

This event was part of CFA Institute’s annual ethics initiative. For those wanting to practice ethics by role play in an interactive environment, please see http://cfa.is/1WTtG0G to access on-line programs offered by the CFA Institute.

 

Smart Beta: Smoke and Mirrors or the Next Generation of Investing?

DSC_2604Smart Beta – is it a bad fad or here to stay?

On February 23, two panels set out to discuss that question at the University Club.

Moderator Ben Johnson, CFA, Director of Morningstar’s global ETF research kicked off the discussion with a brief introduction into Smart Beta.

Ben said that the strategies of smart beta don’t necessarily feel smart over the full cycle. Right now there are 539 Exchange Traded Products (ETPs) doing smart beta, with $424 billion in assets and ETPs represent just one wrapper of the strategy. 21% of all ETPs are in the US, and 20% of all total new asset flows are going into smart beta products. The size of smart beta means that it’s too big of a market to ignore. Similarly, in the increasingly crowded ETP space, over a quarter of new launches involves smart beta funds. “This has been an organic growth story,” Ben said. Ben introduced the first panel and asked them to level set the conversation by defining what smart beta means to them.

DSC_2601Craig Lazzara of S&P Dow Jones said he prefers the term “Factor Indices” over smart beta. He quoted Voltaire and said that the saying “The Holy Roman Empire is neither Holy, nor Roman, nor an Empire” applies to smart beta. He encouraged the audience to read William Sharpe’s The Arithmetic of Active Management, which concluded that the average active manager’s return will be less than the average passively managed dollar, a conclusion that helps support the smart beta premise. Craig’s definition of smart beta is simple: Indices that try to deliver returns (or a pattern of returns such as low beta, high volatility, etc) of a factor, not of a benchmark.

Craig went on to say that smart beta factor indices allow a user to “indicize” returns of an active management strategy. “Twenty or thirty years ago, you’d have to pay an active manager to get these kinds of returns,” Craig said. And now with smart beta products, you don’t.

Eugene Podkaminer of Callan Associates began his remarks by saying that he was skeptical about smart beta and thinks that the name smart beta is “stupid”. He said that there is a lot of confusion around smart beta, how strategies are packaged and sold and what is under the hood. Smart beta has been driven largely by retail investors, who are susceptible to return-chasing behavior and clever marketing, while institutional investors with longer time horizons haven’t been as involved. “When you open the hood of a smart beta investment, it’s a different story,” said Eugene, who said he is interested in smart beta from a risk factor allocation perspective.

One important question that needs to be asked of smart beta, according to Eugene is “are you confident that the returns from these factors will continue?”

Trey Heiskell of Blackrock said that smart beta is both old and new. Like Eugene, he also hates the term smart beta and prefers ‘factor-based investing’, which he believes to be a more accurate name. “There is a shift from alpha to smart beta happening right now,” Trey said. And much of its growth is due to the context of the market we are in, with retail investors dissatisfied with the recent underperformance of active managers and growing adoption of ETFs. These are some of the main factors driving the growth in smart beta.

Craig agreed with Trey about smart beta being both old and new, saying that “these strategies have been around for years, packaged differently”.

Once, Craig was asked “What is it that ETFs allow large institutional investors to do that they can’t already do?”

DSC_2612“Absolutely nothing,” he answered. But as a retail investor, now you can get the benefits of factor exposure you want cheaply and easily without dealing with an active manager.

Eugene gave an update on how Callan’s process has evolved and said that now they are very risk and diversification-focused, and when evaluating a potential investment, more interested in its covariance with other investments than its forecasted returns. You need to have a robust set of tools to determine what your factor exposures are, such as a risk model. Some advantages of smart beta ETFs are that they are liquid, transparent and cheap. He said that the question “Why am I paying so much for hedge funds,” will continue as risk factor-based investing grows in popularity. “Indexing and smart beta have chipped away at what we call alpha,” Eugene said.

Craig said that investors need to think about their investments not as a portfolio of stocks, but as a portfolio of attributes. He thinks investors need to consider how they might use smart beta to avoid or minimize paying active management fees.

Eugene stated that smart beta does have some problems. Just because the portfolio appears to perform well in the past, the returns won’t necessarily continue. “Backtests by definition look good,” Eugene said. Smart beta needs to be forward looking, it has to be ex-ante, he said. Investors are trying to build portfolios that work well in the future, and you need to forward-looking economic rationale for any investment you make, which also must apply to smart beta products. Smart beta puts the onus of complex portfolio management tasks on the individual, who now must answer “Why did I make that tilt” instead of asking that same question to a manager.

Trey responded that while an economic rationale is important, it is dangerous to be hyper-focused on short term performance of smart beta.

Craig noted that it is important to watch out for spurious correlation, giving an example of extensive data mining leading to a researcher to conclude that butter production in Bangladesh is a strong leading indicator of the S&P 500.

Trey said that just because it is smart beta, it doesn’t mean you’re excluded from doing your own due diligence.

Eugene posed a philosophical question and asked “Can all market participants do the same thing at the same time? And can everyone be in smart beta at the same time?” This isn’t possible. There has to be someone on the other end. We can’t all be in low volatility products. Why ought to these risk factors continue to deliver these kinds of returns? And how many factors truly exist? At Callan, they don’t believe that there are hundreds of investible factors, they look at about 10.

DSC_2605Trey said that better product definitions on smart beta from index providers are coming up. “Smart beta is the gateway drug to explicit risk factor investing,” said Trey.

Eugene said that smart beta is interesting like a bicycle is interesting, while risk factor investing is more like a race car. “Everyone hates fixed income benchmarks,” Eugene said, saying that that may lend itself well to a smart beta product.

Michael Hunstad said that Northern Trust has been doing factor based investing for 20 years and smart beta is definitely not new. “The hard part with smart beta is making a lot of decisions that were formerly made by your portfolio manager”, Michael said. Some of these decisions are “what factors do I choose?” There are many smart beta providers also, and there are some big considerations involved that clients need help and guidance with.

“Where does smart beta go in my portfolio,” is a very good question. It’s not exactly active, yet not totally passive either. The old way of deciding a manager allocation was by making a list, and allocating to the manager who performed best. This doesn’t work with smart beta, and the selection of products is tough. According to Michael, smart beta is two things:

1) A source of excess return
2) A risk paradigm

If smart beta risk factors are independent sources of return, then they are also independent sources of risk.

Mehmet Beyraktar counted himself among the many in the panel who dislikes the term smart beta, and said investors need to question how the products complement their existing portfolios, and the challenge of smart beta is how to integrate. He said that a big part of the investment process is obtaining the right tools to get transparency into smart beta investments and a means of calculating exposure to risk factors, such as a factor-based risk model. Not that much research is available into how risk factors and smart beta will perform is available just yet, he said.

Ben offered an exchange he heard between a Middle East-based client and an advisor, where the advisor asked how long the client’s time horizon was, and he responded “We measure in generations.” The client then asked “How often do you look at performance?” and the client said “quarterly”, a huge mismatch between the evaluation period and the investment horizon.

Michael told a story about an investor who thought he could use PMI to make a tactical call on the market. There certainly are leading indicators, but the hard part is determining when they will play out. He said that he doesn’t have much confidence in anyone’s ability to time cycles and market behavior. But multifactor products are the wave of the future in dealing with cyclicality. With smart beta, there is a concentration risk on one end of the allocation spectrum and a dilution risk on the other end. If you simply allocate equally among all the risk factors, you probably will end up with an investment that looks very similar to a cap-weighted benchmark.DSC_2610

 

 

Corporate Tax Evasion or Avoidance?

On December 16th, CFA Society Chicago hosted a timely panel discussion focused on US corporate tax policy and how it compared to the tax policies of other nations.  The current policy motivates US companies to move profits to overseas subsidiaries where corporate taxes are much lower.  Corporate tax inversions may become more common; these will become an important political issue as the election year unfolds.

Mr. Graziano began the event with a presentation entitled “Corporate Tax Risk, The Thin Gray Line”.  He makes the case that US Corporate Tax Policy is not competitive on a global basis.  The US has not cut its corporate tax rate in over 25 years and has the highest tax rate (35%) of any developed country. This antiquated tax policy has motivated US corporations to take action to avoid paying tax in their home country.

The method whereby US companies are able to enjoy the lower tax rates of foreign countries has led to the storing of corporate cash in the country where the lower tax is paid.  Many multi-national US companies now have large cash holdings in countries other than the United States.  The ramifications of these large cash holdings being held abroad by US corporations was discussed at length in the presentation and during the panel discussion.  To repatriate the cash, US corporations would have to pay the 35% federal tax along with any state tax.

Panel Discussion:

Mr. Graziano began the panel discussion by asking if it thinks that US corporations have an economic (or moral) obligation to pay a repatriation tax.  The panelists were unanimous in their opinion that there is not an obligation.  The US has created its own problem in this regard due to its inability to reform these policies.

There was a brief discussion as to how a US value added tax (VAT) might help to replace lost tax revenue if the corporate tax rate was lowered.  The possibility of repeating another “one-time” tax repatriation holiday as was done in 2004 was also discussed.  The panelists were convinced that another “one-time” tax holiday would not solve the problem.  There was very little evidence that the US economy benefitted from the 2004 tax holiday.

Panelists were unanimous in their belief that the antiquated US corporate tax rate puts US corporations in a difficult predicament. Under the current laws, corporations are incented to move cash and business overseas to the detriment of the US economy.  In this environment, tax inversion transactions that make American companies subsidiaries of a parent company in another country can be expected to increase.

Unfortunately, there is no easy solution without bipartisan support for reform.


Ron GrazianoModerator: Ron Graziano, CPA

Mr. Graziano is a Director at Credit Suisse and serves as the Global Accounting & Tax Strategist with the HOLT advisory service of Credit Suisse.

 

Barry Jay EpsteinPanelist: Barry Jay Epstein, Ph.D., CPA, CFF
Dr. Epstein is a Chicago based financial reporting expert, author, and litigation consultant. In his work with Epstein & Nach LLC, he has consulted and/or testified in over 120 cases.

 

Anna GreenPanelist: Anna Green, CPA
Ms. Green is a Tax Partner with PwC Chicago’s Industry Tax Practice. She is responsible for managing a team of professionals providing tax accounting advice to large corporate clients.

 

Robert M. WilsonPanelist: Robert M. Wilson
Mr. Wilson is an investment officer and research analyst at MFS Investment Management. He is responsible for working with portfolio managers to integrate ESG (environmental, social and governance issues) into the investment decision making process

New Risks for Municipal Bond Investors

New Risks for Municipal Bond Investors

Hey! Mom-and-pop retail investors still own about 75% of the municipal bond market (directly or indirectly). They want a stable asset class with relatively few defaults, high credit ratings and interest income that’s tax free at the federal, state and local levels, if possible. In short, they want their father’s Oldsmobile.

Yet, today we’re seeing more stressed municipal credits than ever. Detroit, Michigan, filed for Chapter 9 bankruptcy protection in 2013 and is now the largest municipal bankruptcy filing in U.S. history at $18 billion. In this environment, there are new risks for municipal bond investors to evaluate. So investors should think again and remember the old advertising slogan: This is notyour father’s Oldsmobile—or his municipal bond either!

Public Finance: Key Issues and Red Flags 

To address this timely topic, the CFA Society of Chicago brought a panel of experts together for a program entitled: Uncovering Value and Risks in Stressed Municipal Credits. The panel was moderated by Arlene Bohner, Senior Director U.S. Public Finance, at Fitch Ratings and provided forward-looking insights on how to navigate these uncharted waters.

Bohner opened with a big picture overview of key state credit issues. She noted that U.S. states have broad economies and tax bases with substantial control over spending and raising revenue and this, in turn, generally supports their higher credit ratings. However, most governments made heavy cuts during the ’08-’09 recession and are still challenged by higher labor costs, pension funding deficits and huge infrastructure needs.

Longer-term, Bohner feels states remain significantly exposed to the possibility of federal funding cuts (e.g. Medicaid), although Bohner says, “Fitch believes states would have time to adjust to any significant federal actions.” Even still, Fitch has Connecticut, Illinois, Mississippi, and New Jersey currently on a negative outlook yet feels most state ratings will remain stable. In addition, she notes that steep cuts to vulnerable discretionary programs and/or federal tax code changes could have significant effects on state budgets and economies over time.

At the municipal level, Bohner looks for a number of red flags including:

  • Declining revenue base
  • Declining population and/or school enrollment
  • Increasing unemployment rate, coupled with a declining labor force
  • Relatively high tax burden
  • High and rising fixed cost burden
  • Declining assessed property valuations
  • Large debt issuances for controversial / non-essential projects
  • High levels of variable rate debt or swap obligations (> 15% of total debt)
  • Unusually contentious relationships among officials and/or with the State (including poor relationships between management, labor and taxpayers)
  • Inability to resolve labor disputes
  • Long-term labor contracts with inflexible terms
  • Low pension funding ratios with payments below actuarial required contributions (ARC)
  • Agressive budgeting and/or economic assumptions
  • Weak disclosure practices

Bohner now expects to see increased debt issuance at the municipal level to address deferred maintenance and capital needs. She notes that “pay-go” capital spending, which uses savings or current cash flow to finance projects, was reduced or eliminated by most governments well into the recovery. She also cautions investors about the increasing use of direct bank loans (private placements) for municipal financing due to their lack of transparency.

Forward-looking Municipal Metrics

Richard Ciccarone, President and CEO, Merritt Research Services LLC, reported that most cities experienced net general fund deficits from 2008 through 2010 and this was a reflection of the economic downturn. During this period, as many as 62% of big cities (over 500,000 population) and 58% of all cities reported deficits. But Ciccarone points out that Meredith Whitney’s prediction of billions being lost in the muni bond market didn’t come true and that general fund deficits returned to the 23% to 41% range between 2011 through 2014 (see graph below).

Percent of Cities with a Net General Fund Deficit                                    

 All Cities vs. Biggest Cities (Over 500,000 Population) FY 2006-2014

Source: Merritt Research Services, LLC

But that’s ex post information and investors need effective ex ante tools to guide future investment decisions. Ciccarone says, “in almost all distressed situations the unrestricted net asset ratio is negative.” Ciccarone started using this ratio around 2000 and says it has key predictive capability. As shown below, the ratio compares unrestricted net assets, which are resources considered usable for any purpose (numerator), to governmental activities expenditures, which are outflows of resources recorded on the government-wide financial statements per GASB Statement No. 34 (denominator).

Source: Merritt Research Services, LLC

Like a coverage ratio, this metric illustrates the availability of funds relative to expenditures—so the higher the ratio the better. As shown below, the largest cities (a with population over 500,000) have fallen into negative territory since 2009. Meanwhile, for all of the 2,000 cities in Ciccarone’s study, unrestricted net assets were between 20% to 23% of governmental activities expenditures from 2011 to 2014.

Importantly, we need to look at the government-wide balance sheet rather than the fund accounting statements that ignore long-term liabilities. Remember that governmental fund accounting focuses on the short run. But the government-wide balance sheet will reveal pension obligations, OPEB, debt and contra assets with deficit financing and no assets or revenue supporting them.

In regards to significantly underfunded pension obligations, Ciccarone’s big concern is that they may restrict a municipality’s ability to provide essential services (police, fire, garbage, etc.). He emphasized that Chicago’s actuarially required pension contribution (ARC) was as high as 55% of its general fund expenditures in 2014. That’s more than three times the level of other big cities (with a population over 500,000) as shown below. However, like many big cities, Chicago actually paid in far less to its pension plans than its actuarially required contribution levels.

Pension Requirements for Chicago and Big Cities:                          

Annual (Actuarial) Pension Cost as a % of General Fund                                                             Single Employer Plans only (2007-2014)

 Source: Merritt Research Services, LLC

Watch the Early to Mid-Career Numbers

Ciccarone’s final piece of forward-looking advice is to watch the early (25-29 years) to mid-career (30-34 years, 35-39 years) population numbers. These numbers tend to fall in distressed areas and Ciccarone says we need to watch them closely for Chicago. The charts below illustrate the decline for fallen angelslike Detroit and Puerto Rico. Fortunately, Chicago appears to be holding its own on these metrics and/or increasing in some areas.

Detroit Early to Mid-Career Population Groups                                      

(25-29 Years, 30-34 Years and 35-39 Years)

Source: Merritt Research Services, LLC & Government Census Data

Puerto Rico Early to Mid-Career Population Groups                            

(25-29 Years, 30-34 Years and 35-39 Years)

Source: Merritt Research Services, Inc. & Government Census Data

Chicago Early to Mid-Career Population Groups                                      

(25-29 Years, 30-34 Years and 35-39 Years)

Source: Merritt Research Services, Inc. & Government Census Data

Bankruptcy – Is the stigma is gone?

 Shawn O’Leary, Senior Vice President, Senior Research Analyst at Nuveen Investments is concerned that the stigma associated with default is gone. O’Leary noted that historically there’s been a significant fear of losing access to credit markets during bankruptcy. Yet he points out that  Detroit, Michigan, Jefferson County, Alabama and Stockton, California all refinanced and gained market access after bankruptcy. These cities are among the top five municipal bankruptcies in US history (below).

The 5 Biggest Municipal Bankruptcies in US History 

  1. Detroit, Michigan (2013)                                          $18 billion
  2. Jefferson County, Alabama (2011)                           $4 billion
  3. Orange County, California (1994)                            $2 billion
  4. Stockton, California (2012)                                        $1 billion
  5. San Bernardino County, California (2012)       $500 million

 Source: Forbes/Capital Economics

Ciccarone agrees with O’Leary and feels that in this environment the potential for more bankruptcies is definitely there—especially if policymakers approve additional bankruptcy statues like the one Governor Rauner proposed in Illinois. Today, approximately 24 states have been granted bankruptcy rights by their State legislatures but U.S. Territories, like Peurto Rico, cannot.

Lessons from Detroit

Bill Grady, CFA, Senior Portfolio Manager, Allstate Investments says that the problems in Detroit were brewing for decades. Grady says, “if you didn’t see them coming—shame on you.” After all, Detroit lost 50% of its population over the last 11 years. And looking even further back, it had been consistently losing population since the 1950s. Today, Grady hears even more municipalities talking about using bankruptcy as a negotiating tool.

O’Leary quickly added that people assume “special revenue bonds” will always pay principal and interest. In the case of Detroit, O’Leary was stunned by a federal judge who wanted to transfer his investors’ collateral (on water and sewer lines) out for ten years in order to redirect payments to unsecured creditors ahead of him. Even some attorneys suggested that he really wasn’t a secured creditor because Detroit had billions in unfunded capital expenditures. Ultimately, he says it took the ratings agencies to help force a tender offer by insisting that paying less than what’s due is recognized as a default.

Puerto Rico – Neither Fish nor Fowl

According to Bloomberg’s Michelle Kaske and Martin Braun, at $72 billion, The Commonwealth of Puerto Rico has more debt than any U.S. state government except California and New York and had been borrowing to pay its debts when they came due, until it defaulted on its payments in August 2015 (see Puerto Rico’s Slide, Bloomberg Quick Take 10/22/15). Notably, Puerto Rico’s bonds are exempt from local, state and federal taxes everywhere in the US—which made it easy for the US territory to double its debt in ten years.

O’Leary explains, “the problem with Puerto Rico is that it’s neither fish nor fowl.” O’Leary says it’s not a true sovereign nation (so they can’t go to the International Monetary Fund) and, unlike municipalities, it doesn’t have collective action clauses which would enable bondholders to implement a debt restructuring plan as long as the majority agrees. Rather, it’s like U.S. states that can’t file for bankruptcy. Hence, Puerto Rico can only ask for a settlement and that encourages creditors to holdout during negotiations. Ultimately, O’Leary feels the federal government needs to step in and make a deal happen.

To that end, on October 21st the Obama Administration announced its support for legislation that would grant Puerto Rico Chapter 9 bankruptcy protection, and a legal framework for U.S. Territories to conduct debt restructuring. Only time will tell if Congress will approve such a measure.

Bill Grady wraps up by saying, “hedge funds are controlling billions of dollars in bonds in Puerto Rico so it’s nearly impossible to take a position there without exceptional research capabilities.” In the end, Ciccarone thinks bondholders will probably recover between 40% to 70% of their investment—at typical sovereign default rates—while noting that the Puerto Rico’s 8% bonds have recently been trading in that range.

A Crisis in Illinois?

Illinois currently has an underfunded pension system of over $100 billion and the lowest credit rating of any state. Notably, Fitch lowered its rating on Illinois’ general obligation bonds to BBB- (just three steps above junk status) on October 19th and Moody’s downgraded the GO bonds to Baa1 on Oct 28th. And we shouldn’t forget that the state of Illinois has been operating without a budget since July 1, 2015. Bill Grady says, “Illinois and Chicago have been penalized but haven’t hit money yet.” So he wouldn’t handicap either as buying opportunities at this point saying, “you would need a cast iron stomach.”

Finally, Ciccarone thinks there will probably be a crisis at the Chicago Public Schools (CPS) first, then there’s the potential for a happy ending. Chicago has a $20 billion unfunded pension liability and has serious structural budget gaps. On the bright side, Ciccarone points out that Chicago’s school, city and county taxes are still only half that of New York on a per capita basis. And on October 28th, the Chicago City Council passed a $543 million property tax increase to be phased in over four years which will help maintain police, fire and other city services. But he still thinks there will be a lot more paper sold and people losing money before it gets better.

In closing, I’d simply add that these risks do not mean that we should avoid the municipal bond market. Rather, we should consider the relevant factors and metrics described above to carefully select the right municipal bond issues for our portfolios. When given a choice, choose well!

Sustainable Investing: Profit with a Purpose

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

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

ESG for Alpha

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

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

ESG Issues

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

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

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

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

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

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

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

Why do ESG issues matter?

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

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

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

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

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

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

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

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

Creating Shared Value

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

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

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

Principles for Responsible Investment (PRI)

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

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

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

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

ESG Methodologies

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

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

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

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

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

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

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

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

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

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

Sustainable Accounting Standard Board (SASB)

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

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

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

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

The Elephant in the Room – Alpha

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

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

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

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

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

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

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

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

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

Fiduciary Duty

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

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

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

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

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

Constituent Demands – Fossil Fuels

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

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

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

Moving Forward

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

As Howard Marks says,

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

Additional ESG Resources

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Upcoming Book Club Schedule:

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

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

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

Sign up for a future book club event.

Chairman’s Message

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

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

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

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

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

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