Vault Series: Aegon Asset Management

On Demographics, Growth, and Investing: When the structural collides with the cyclical

Francis Rybinski CFA, treated CFA Society Chicago to his analysis of the current global demographic situation and its implications at the latest Vault Series lecture on March 12.  Rybinski is the chief macro strategist at Aegon Asset Management, responsible for guiding the firm’s global macroeconomic view pertaining to tactical and strategic asset allocation. His presentation included a wealth of statistics that highlighted the weak rates of growth of both population and productivity in developed economies around the world and how that situation limits investment managers.

Rybinski began with some observations on the trend in GDP growth in the U.S.:

  • Actual GDP growth has declined erratically from about 4% in the early post-World War II period, to 3% late in the last century, to just 2% since the last financial crisis. Growth above 2% in very recent quarters has not persisted long enough to define a change in trend.  (Slide 4)
  • Accompanying this change has been a decline in the volatility of the growth rate, both absolutely and relative to potential growth.
  • While growth has been slowing, the business cycle has been lengthening. The economy seems to be stretching out expansions by pacing itself at a slower rate of growth.

The two driving factors behind GDP growth are the rates of growth in the labor force, and in productivity. Both have been anemic with little expectation of a move to the upside. The Congressional Budget Office projects near term potential GDP growth at less than 2%, incorporating 0.5% growth of the labor force and 1.4% productivity growth. Rybinski argued that even if the labor force were to grow at 1.4% (the average since 1950) potential GDP would not reach 3%, and would trend downward after 2020.  Even boosting productivity to 2% gets GDP growth only to 2.5%. While President Trump claims his policies will increase productivity well beyond its recent trend, Rybinski is skeptical. He listed several forces most likely to boost productivity significantly including autonomous vehicles, robotics, 3D printing, genomics, and generally the internet of things. He doubted any of these could be as transformative as the forces that drove productivity higher in the 20th century such as the expansion of the electric power grid, telecommunications, and the development of computers. Maintaining a persistent 3% growth in GDP would take 2% productivity growth—a level last experienced in the 1990’s tech boom–and 1% labor force growth–which would be dependent on increased immigration.

Rybinski applied the term “demographic drag” to the situation he had described. Noting that it exists throughout developed economies, he concluded that “It’s a small(er) world after all”. (Or at least a slower growing world.) This situation, he thought, was at the root of many current global movements such as the new nationalism, anti-immigration stands, and the Brexit vote. The demographic situation also has implications for retirement investing and the social safety net. Lower prospective investment returns will require even higher amounts of savings to fund retirement, and/or an increased burden on government retirement plans.

Rybinski went on to present more demographic data to support his premise.

  • In the 1970’s, a demographic tailwind driven by the maturing of the baby-boom generation and the flood of women entering the work force, provided a big boost to GDP growth in the U.S. This has now become a tailwind as the baby-boomers reach retirement age and the increase in women in the work force has leveled off. This leaves only productivity to boost GDP growth.
  • The fertility rate in the U.S. declined by about 50% from 1960-75 and has been under the replacement rate of 2.1 births per woman for a decade. Similar trends appear around the world in countries across the income spectrum.
  • The share of the U.S. population over age 55 is about 27% and continues to rise.  The share in the prime working years has been trending down for over twenty years and is now under 50%.  The share ages 16-24 is not growing, but is stagnant at about 15%.
  • The old age dependency ratio (ratio of people ages 20-64 vs. those older) has received a lot of attention because of its dramatic down trend. Rybinski showed that, when adjusted for the increase in the labor force participation rate since 1948, the decline is not as significant, but the trend is still negative. This is a common feature across developed economies.
  • Currently, immigration accounts for just over 40% of U.S. population growth and it is rising. Native births account for the other 60%, but the share is declining. Within ten years, these factors will be about equal and by 2045, immigration could provide more than 70% of population growth.
  • Average life expectancy continues to increase and has reached 72 years globally (80 years in high income countries).
  • Increasing life expectancies and earlier retirements mean more time is spent in retirement. In 2010 it reached 13 years in the U.S. and 18 years in Germany.  Even China has advanced to eight years from just two in 1990. This adds stress to retirement plans—an inauspicious factor in the U.S. where over 95% of public pension plans were underfunded to a cumulative total of $1.1 trillion by 2017.

Rybinski had one positive observation regarding inflation, based on the correlation between inflation and the dependency ratio. His data shows that countries with a worsening ratio (primarily the U.S., the E.U. and Japan) have experienced low rates of inflation (under 2%) for the past five years. Countries with higher inflation (such as India, Brazil, Turkey, and South Africa) have improving dependency ratios. Not only has inflation been low in developed economies, but it has also been less volatile. These two trends have put downward pressure on the term premia of sovereign debt. In fact, the term premium on the 10-year U.S. Treasury note is negative, and Aegon expects it to remain so, with the extremely low yields on German Bunds an important reason. 

With the Federal Reserve taking a less aggressive position on raising interest rates and inflation expectations anchored, Aegon expects rates on treasury debt to remain at their historically low levels. 

From his analysis Rybinski provided two implications for asset allocation:

  1. As inflation has declined secularly in the past forty years, the correlation of returns on treasuries vs. equities has fallen from strongly positive, to slightly negative. Thus, treasury debt has been a good hedge against equity markets. With Aegon’s forecast for low inflation to hold treasury yields lower for longer, he expects this hedge relationship to continue.
  2. Low growth of global GDP, and the worsening demographic situation, will place a premium on growth investments. Searching these out will be the primary challenge for investment managers in the foreseeable future. This would typically suggest emerging or frontier markets, but they present increased risks. Many are not easy places to conduct business. Managers will need to be highly selective on choosing which countries to invest in, and will also need to search for pockets of growth hidden in selected industries or companies within developed markets.

Supplement: Post-Event Q&A by Brian Gilmartin, CFA

The overall theme of the presentation was that as the US population has aged, from the 1960’s “baby boom” being in full swing to the Generation X, Y and Z’s, of today, US GDP trend growth has slowed, and the aging of the US population is presenting challenges for everything from retired workers outliving their savings to putting pressure on public and private pension fund plans.

In other words, the “demographic tailwind” has become a “demographic headwind” (per two slides within the presentation) for the USA, much like it has become in Japan.

“Trend” growth for the US economy was 6% in the 1960’s, slowing to 4% in the 1980’s and 1990’s and is now just 2.5% today. (My thought on this was that, the US economy – in terms of real GDP was also much lower in the 1960’s, just under $1 trillion in each of the 4 quarters in 1966 per the FRED database, to over $20 trillion by Q4 ’18. The logic being growth looks faster with a smaller denominator.)

Frank Rybinski noted the decline in global fertility as well as the increasing life expectancy and slowing population growth rates has resulted in a “global silver” economy as the number of countries with more 65+ adults than kids under the age of 15 has expanded from 30 in 2015 to a projection of over 60 by 2035.

From an investing perspective, the presentation noted that the older a society becomes, the slower the change in the CPI, and in the Q&A following the presentation, Frank was asked if this changes the role of the Fed as America ages. Frank Rybinski noted that finding the “optimal policy” for the Fed today is more challenging given demographics, since the “old rules” (and Frank Rybinski” specifically cited the Taylor Rule) may have diminished influence in the future.

From an asset allocation perspective, looking strictly at demographics, the Frontier and Emerging Markets are better longer-term equity investments given that GDP growth and productivity improvements are still to be seen by many of these economies while Japan and old world Europe and other mature countries (and even the US to some degree) are at the opposite end of the spectrum and bond market investments and US Treasuries should be held in portfolios, with Aegon calling Treasuries a “viable portfolio hedge” as structurally slower growth and low inflation keep inflation contained.

Sub-Saharan Africa, Frontier Markets and Emerging Markets should be held as equity investments given the longer-term GDP growth potential, while Treasuries and fixed-income should be held for clients in mature countries.

Vault Series: Cambridge Associates

Gender equality in the investment profession has been a hot topic in the industry lately, and it was addressed in detail during a January 10, 2019 Vault Series talk from Dierdre Nectow. Her firm Cambridge Associates, a large institutional investment consultant, is an outlier in the profession with half of its executives being women. Nectow discussed why her firm has much higher female representation than average, and what the state of women in finance is today.

To start, some good news: the number of women in finance is growing, yet as a percent of the workforce, women are still underrepresented. The United States is also a laggard when it comes to gender equality in the workplace, coming in at a dismal 51st place globally. One of the worst places for gender equality in finance can be seen in venture capital, where just 9 of the top 100 VCs are female. In contrast, the hedge fund industry has the best female ownership numbers, with 2% of AUM managed by women-owned firms.

Cambridge has been a bit different than its peers in hiring and promoting far more women than average in large part due to the philosophy of its co-founder Jim Bailey. His mother was a strong woman that had inspired him, and he saw women as an untapped resource. Hiring them could lead to outperformance in the industry. The firm has also spent time training workers on unconscious bias and has sought to make it safe to have those kinds of conversations while fostering more thoughtful attitudes around encouraging women and minorities in the workplace. Additionally, Cambridge has a mentorship program, a CFA women’s group and a new initiative called Prevail, which is designed to bring women at asset management firms as well as Cambridge clients and prospects together to talk about investing and issues.

Gender equality is becoming increasingly important for financial firms because pensions are using women and minority representation as a means to hire managers (or not hire ones with inadequate representation). Many companies have been hiring diversity officers to address this trend.  Cambridge is also scouring the landscape to find female and minority-owned managers due to demand.

Following the introduction, David Baeckelandt, senior investment director at Cambridge Associates, took the stage to give us a brief history of women in financial markets, beginning with ancient firms. While by day Baeckelandt is a salesman at Cambridge, in his free time he is a history buff and has done extensive reading on the subject of women in finance.

Beginning in ancient Egypt, Baeckelandt said that Cleopatra was the first women to coin her own currency and put her image on it, which was an important step in modern finance. Another famous woman in finance milestone came with Queen Isabella funding Columbus’s voyage to the new world. Baeckelandt said that you could argue that Isabella led the most successful venture investment of all time, as the exploration of the Americas led to vast wealth for Spain. Another milestone took place in the coming years, with the Dutch East India Company being perhaps the world’s first IPO, and it had a number of women investors involved.

An interesting story of women in finance came from Abigail Adams, wife of John Adams. She made a small fortune trading bonds, which she turned into a small farm that she used to convince her husband to return to from Europe. Victoria Woodhull was another luminary who spotted an arbitrage opportunity between gold bullion and US dollars and used it to make a substantial profit. She then ran a financial firm with her sister, and her story is the subject of an upcoming TV series. Baeckelandt mentioned Hortense Friedman, a story familiar to many charterholders (there is an award given out annually in her name). A number of other women firsts took place in the late 1800’s, with the first women CPA’s and the first women investment bankers in the US.

There are a number of positive signs with respect to women in finance, yet there is much work to be done, particularly with respect to compensation. Public pensions and other large investors will continue to put pressure on firms to ensure adequate female and minority representation, and the march towards gender equality will likely continue to grow in the investment industry.

Vault Series: John Wightkin, CFA, TradeInformatics

On November 8, 2018, John Wightkin, CFA, a senior trade consultant at TradeInformatics, spoke at the Vault Series of the CFA Society Chicago about how the process of examining trading costs can help preserve portfolio alpha.

According  to John, “trading costs can represent close to half of active returns” and the process of analyzing and examining trading costs can help claw back those costs that preserve alpha. The dispersion of average trading costs can be between 3 and 48 basis points per the presentation. The process John outlined to combat these high costs has three basic steps:

  1.  Alpha profiling, which is the analysis of the firm’s linkage and relationship between the portfolio manager, trader, broker and analyst. The “alpha profile” tries to identify the unique DNA of portfolio ideas and then link the process to return preservation and implementation.
  2. Return preservation, which means looking across different participation rates and liquidity buckets for opportunities which might not be apparent. The participation rate refers to identifying active vs passive relative to market flow and the liquidity buckets are determining what order size is relative to average daily volume.
  3. Implementation is the last step to be considered and ought to be low-cost and transparent. The client firm will learn how to take control of trade execution on a specific platform to prevent information leakage, but also use the platform as a way to receive information about market flow and trade reception.

A case study was provided where TradeInformatics examined a hedge fund with 30 traders but no central trading desk. When the trades were working in the desk’s favor, there was an average of 12 minutes between trades, but when trades were working against the desk, or positions were losing, the average time between trades lengthened to 40 minutes. The conclusion drawn was that actual returns were 5.9% lower than “expected return” based on the actual trading patterns.

Using a healthy lifestyle analogy, TradeInformatics concluded that to reduce trading costs, the trading desks should “lose weight and eat a balanced diet” which translates into slowing their trading down and doing it more consistently over both sides of the market, i.e. whether the trades are winning or losing.

Summary / conclusion: The takeaway from John Wightmkin’s slide presentation was to slow down and be more consistent with a firm’s trading practices. The time differential between winning and losing trades was antithetical to the traditional practice within investing of “cutting your losses and letting your winners run”. Trade Informatics often found that the opposite was the case.

Trade Informatics can provide more discipline around the trading / execution process, for which the goal is to ultimately lower trading costs and preserve portfolio alpha.

Vault Series: James D. Shilling, DePaul Department of Real Estate

The Evolution of Modern Real Estate and its Role in a Multi-Asset Portfolio

CFA Society Chicago gathered in the Vault at 33 North LaSalle to hear Professor James Shilling from the DePaul Department of Real Estate discuss the evolution of commercial real estate and its increasing role in a diversified portfolio. Shilling was the James A. Grasskamp Professor of Real Estate and Urban Land Economics at the University of Wisconsin and currently holds the George L. Ruff Endowed Chair in the Real Estate Center at DePaul University.

Professor Shilling began his presentation by showing that the value of diversification has been recognized since the days of King Solomon (circa 970 BC). He then goes on to discuss how Nobel Laureates Harry M. Markowitz (1952) and Robert C. Merton (1973) quantified the concept of diversification for the portfolio.

Harry M. Markowitz is known as the Father of Modern Portfolio Theory. His work set the stage for the Capital Asset Pricing Model (CAPM) and a two-fund theorem. This theorem holds that for diversification purposes investors should hold a combination of the risk-free asset and a market portfolio of risky assets.

Robert C. Merton extended the Markowitz framework by allowing for multiple sources of uncertainty. In this framework commercial real estate can now assume a critical role as investors require another “hedge” against risk. However, real estate was slow to enter portfolios as there were only a few indices that could track performance. Beginning in the late 1970’s and early 1980’s the development of appraisal-based commercial real estate indices ameliorated this problem.

Professor Shilling pointed out that during prolonged periods of low economic growth and low interest rates the inclusion of commercial real estate is of great benefit to any investment portfolio. He argued that the current US economy continues to reflect this “secular stagnation”. The persistence of low interest rates has incented portfolio managers to leave fixed income and increase their investments in real estate. Current pension portfolios average around a 10% exposure to commercial real estate. If recent trends continue, this exposure will only increase.

The present state of the US commercial real estate market reflects the continuance of a slow growth economy. With portfolio managers searching for yield, the vehicle of choice has in many instances been commercial real estate. Professor Shilling argues that this influx of money has continued to compress cap rates, which for some properties approach 3%.

Professor Shilling pointed out that during prolonged periods of low economic growth and low interest rates the inclusion of commercial real estate is of great benefit to any investment portfolio.

Increasing correlation between asset classes due to lower interest rates and the trend towards a flat yield curve has produced a scenario for portfolio managers where there is “nowhere to hide”.   It is increasingly difficult to achieve diversification using only developed market assets. He argues that more effective diversification can be achieved through investments in emerging markets assets.

Vault Series: Ted Reilly, Chicago Media Angels

CFA Society Chicago hosted its first Vault Series event of the year on July 16th featuring Chicago Media Angels (CMA) Founder and Executive Director Ted Reilly. Chicago Media Angels is an investment group seeking attractive returns through financing content in the media and entertainment industries. Reilly spoke about media as an asset class and shared interesting insights into the group’s sourcing, funding and development of such content in Chicago.

Reilly ended up in the Midwest by way of Notre Dame and began his career with Goldman Sachs Private Wealth Management where he held various positions over seven years. During this time, he discovered that his passion was helping entrepreneurs develop their businesses yet his job was convincing them to sell their companies and invest the proceeds.

Reilly left Goldman in 2011 and over the next three years produced a documentary in Uganda about a young medical student. He truly loved the experience and wanted to continue this work but didn’t know how to make a living doing so. With his interest piqued, he immersed himself in the local start up scene and joined Notre Dame’s Angel Fund, Irish Angels, in 2012 to deepen his knowledge about angel investing.

During this period he was searching for mentors when he read an article in Forbes about Steve Jobs. Following his firing from Apple, he sold his shares for $100 million. After his first $50 million investment in another tech company failed, he took his last $50 million to a small startup named Pixar, where he became a billionaire as a film producer. This proved to Reilly there was definitely money to be made in media.

A few years later he presented the notion of investing in movies to Irish Angels and when they weren’t open to the idea, he created Chicago Media Angels. Reilly shared that the biggest realization of angel investing is that you’re looking for Unicorns: Angel Investor = Unicorn Hunter! He said a lot of angel investors just keep trying to make deals work, when in fact they won’t.

There are a number of reasons movie investing is desirable. One of the biggest is the defined negative costs – once financed there isn’t a reliance on future rounds of financing. Adding to that, once a film is made, it can be monetized into perpetuity through various revenue streams. Reilly used Napoleon Dynamite as an example – it was made for $400,000 in 2004 and brought in 48 million at the box office and continues to bring in residuals to this day. In fact, a Napoleon Dynamite doll is being released this summer, some 15 years later.

Chicago Media Angels has grown to 50+ investors and is targeting 100 total. To join it requires a $2,500 annual fee and a $5,000 minimum investment in a deal(s) of your choice. Since hanging their shingle, they have received 3,500 submissions for financing and presented 30 deals to investors. The group views two times budget as an attractive valuation and invests between $250,000 and $1.2 million per deal in low budget independent films.  With the change in technology from film to digital, production costs have come way down.  They prefer movies that are as ready to produce as possible and don’t provide funding until filming starts and distribute the investment throughout filming.  Equity is split 50/50 between producers and investors, and investors receive their money back first.

The cash flow of a film breaks down as follows:

Negative Costs: 1-6 months

Marketing: 6-8 months

Recoupment: 18 months to perpetuity

  • Blue Ray and DVD
  • Theatrical
  • Foreign Release
  • Television
  • TVOD (transactional video on demand) i.e. Apple, Amazon
  • SVOD (subscription video on demand) i.e. Netflix, Hulu

Current CMA investments comprise nine equity financings including six feature films, one episodic pilot (Public Housing Unit), one web series, and one content/technology company. To date CMA Digital Studios has vetted over 300 submissions and whittled those down to five that they will be producing next year.

Reasons to join CMA include: leveraging your network/experience, participation in guest speaker series, access to 12 well-curated investment opportunities annually, full transparency, ability to allocate your own capital, and syndicated risk. Besides Reilly’s assurances of 100% guaranteed fun, there’s the opportunity to impact society – following Hunger Games, there was a 44% increase in female involvement in archery!

Following the presentation, CFA Society Chicago interviewed Reilly for its first ever podcast which will be posted on the CFA Society Chicago website in the coming weeks!

Vault Series: Philip Bartow, RiverNorth Capital Management

 

The new asset class of marketplace lending (MPL) was the topic of discussion at CFA Society Chicago’s Vault Series presentation on January 11, 2018. Presenting was Philip Bartow, lead portfolio manager for MPL at RiverNorth Capital Management. What was once a peer-to-peer market for consumer and small business loans has blossomed into a new institutional asset class totaling $27 billion as of 2016.  RiverNorth is a Chicago-based investment manager founded in 2000 with $3.8 billion under management. The firm specializes in opportunistic strategies with a focus on niche markets that offer opportunities to exploit valuation inefficiencies. Marketplace lending is the firm’s newest strategy.

The Environment for Marketplace Lending

Bartow began with a review of market and economic conditions that support the case for investing in MPL, starting with the interest rate environment. Although the Federal Reserve’s Open Market Committee forecasts three increases in short term rates in 2018, projections from the Fed Funds futures market are less aggressive. The market is saying “lower for longer” still rules the day. In addition, past increases in the Fed Funds rate have caused the yield curve to flatten, making shorter duration instruments relatively more attractive compared to longer investments.

Consumer financial health has improved greatly since the crisis of 2008-09. After a lengthy down trend, the unemployment rate has reached a level consistent with full employment, consumer sentiment gauges are at high levels and are moving in an upward trend. Growth rates of GDP and average hourly wages are finally showing some acceleration. Loan losses on consumer lending (residential mortgages and credit card loans) have fallen from crisis highs to, or below, long term averages.  In addition, corporate credit metrics are strong. Default rates on high yield bonds and leveraged loans have been running below long term averages for several years, and corporate earnings (based on the S&P 500 Index) are strong and expected to rise higher. The household debt service ratio, at just under 10%, sits at a 30 year low, and household debt/GDP at 80%, is at a level not seen since long before the last crisis. In short, the picture of economic fundamentals for both consumers and corporations is a rosy one. A slight rise in consumer delinquencies in 2016 is attributable to borrowers with low FICO scores, under 660 at origination.

The persistence of low interest rates, and the “risk-on” sentiment in financial markets, has pushed valuations to extreme levels. Credit spreads on high yield bonds sit more than a full standard deviation below average levels, and the VIX index of equity market volatility remains very low.

The Case for Marketplace Lending

At its essence, MPL loans involve the use of online platforms to provide secured lending to consumers and small businesses funded by institutional investors. Between borrower and lender sits an innovative loan originator that relies on technology to gather the data to support extending the original loan, servicing it, and monitoring the credit quality. There are 125-150 originators of loans but Lending Club, dating back to 2007, is the largest and most experienced in the market. Established “brick and mortar” banks are only just beginning to get involved.

Bartow began his case for investing in MPL by pointing out the huge spread between the average credit card loan (almost 21%) and the long term average yield in the bond market (measured by the Barclays Aggregate Bond Index) of 4.52%. MPL offer a potential benefit to both borrowers and investors inside this wide difference. The long term average coupon rate on MPL loans is just over 13%, while investors have earned an average of 8.13%.

Several characteristics of MPL loans are instrumental in providing better risk-adjusted returns going forward than direct consumer lending in the past.

  • In particular, originators focus on the higher end of the credit spectrum, lending only to borrowers with FICO scores of 640 to 850 (with an average of 705). This puts them in the higher end of the “near prime” category or better. Borrowers considered subprime and even prime are excluded.
  • In addition, MPL loans are always amortizing installment loans, in contrast to the typical credit card or consumer loan that comes in the form of a revolving credit line. MPL loans thus exhibit a constant rate of repayment, a predictable cash flow, and a lower duration, all of which reduce credit risk. In contrast, revolving credit loans don’t decline. In fact, they often increase ahead of a default as the borrowers tend to draw on their lines more as their financial health slips (slide 16).

An efficient frontier plot of the Orchard U.S. Consumer MPL Index covering January 2014 through September 2017 shows a superior risk-adjusted return versus a variety of relevant Barclays fixed income indices including the 1-3 Year Treasury Index, ABS Credit Card index, Aggregate Index, and High Yield Index, as well as the S&P 500 Index.

Bartow provided further information on the market for investing in MPL loans in general as well as some standards that RiverNorth follows. Although often compared to credit cards loans, MPL loans come in various types and are made to differing borrowers. The most common are consumer loans which are usually used to pay off or consolidate credit card debt. Originators may use a lower loan rate to induce borrowers to allow the originator to pay the credit card directly with the loan proceeds. Doing so has proved to lead to a better record of payment. Student loans and franchisee loans are other common types.

The secondary market for MPL loans is not a liquid one. Trades occur literally “by appointment” when originators announce dates in advance when they will bring supply to market. RiverNorth’s registered mutual fund that invests in MPL loans is an “interval fund”, meaning that it accepts new investments daily, but distributes withdrawals only quarterly, with a limit on the amount. Although many loans go into securitized products, RiverNorth prefers to invest in whole loans directly to improve gross returns. They also buy the entire balance of loans which gives them more control in the case of deteriorating credits or defaults. Loan originators, however, usually retain servicing rights on loans they sell.

Vault Series: Bob Greer, CoreCommodity Management LLC

The why and how of commodity investing–especially when considered as a core position in a well-balanced portfolio–was the topic of the latest CFA Society Chicago Vault Series event held on November 28th, 2017. The presenter was Bob Greer, Senior Advisor at CoreCommodity Management LLC, and Scholar in Residence at the JP Morgan Center for Commodities at the Denver School of Business of the University of Colorado.

Commodities as a Hedge Against Inflation

Greer began by presenting a ten year chart of the Bloomberg Commodity Spot Index (slide 2) which showed considerable swings from highs to lows, but not an impressive net average annual gain. However, for comparison he pointed to other periods when large cap stocks (measured by the S&P 500 Index) provided similarly bland returns—for example, the decades ending in 1974 and 2008 (slide 3). Rather, it’s when one looks at commodities in a portfolio reaching across asset classes that the benefits show up in diversification and the contribution to risk-adjusted returns. This has been especially true during periods of rising inflation when commodities have provided returns that vastly exceed those of bonds and global equities–and even beat natural resource equities by several hundred basis points (slide 4).  This performance, in turn, stems from the high correlation commodities have to inflation—especially unexpected inflation (slides 5 & 6). Unexpected inflation is the investor’s worst enemy in that it has been a major factor in extremely poor, highly correlated returns for both equities and fixed income. Conversely, periods of high unexpected inflation are precisely when commodities have been at their best. Because inflation has been low for a long time, unexpected inflation may have faded from investors’ memories, but Bob offered a list of reasons why that could change soon:

  • Slow growth in the supply of labor in developed countries, with demographic trends showing no sign of reversal, will eventually lead to wage inflation,
  • The rise of populists governments makes trade restrictions increasingly likely,
  • An infrastructure build-out will increase demand for commodities,
  • Large, and growing, government budget deficits are more likely to lead governments to choose a monetary solution (i.e., inflation).

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Commodities as a Diversifying Element

Besides performing as a good inflation hedge, commodities have also performed well as a diversifying element. Greer presented a chart (slide 8) of three year correlations between commodities, stocks, and bonds that showed, at least until the 2008 financial crisis, that pairing commodities with stocks and bonds, diversified as well as the more common stock/bond pairing. During the crisis, this benefit broke down as the unprecedented need for liquidity among all types of investors, raised correlations for many asset classes far beyond anything measured in the past.

Slide 8

Successful commodity investing calls for active management in Greer’s view.  He compared the returns of the Bloomberg indices of spot and futures commodity prices from 2001-17 (slide 9).  While both were volatile, the spot prices generated a cumulative return of about 150%, but the futures prices ended with a small negative cumulative return.  Because the price curve of most futures contracts exhibits a positive slope, rolling out of an expiring contract and extending into a new, longer contract, usually creates a loss. This “negative roll yield” causes the persistent return lag in commodity futures portfolios, and is a primary reason Bob advocates for an active strategy in commodity investing. Commodity futures are less subject to the forces of “irrational exuberance” because there is no limitation on the number of contracts that may trade, and futures prices must converge with cash market prices eventually. This makes analysis of commodity futures prices more effective than for other asset classes. Among the tools managers use to beat the index are:

  • Timing of the roll into new contracts
  • Curve positioning
  • Mis-weighting the constituents versus the index
  • Management of collateral away from passive T-Bills
  • Selective use of commodity equities in place of futures.

Slide 9

 

One metric managers use in applying these tools is a comparison of commodity prices relative to the underlying cost of production (slides 11-12). Over long periods, prices have averaged 30-35% above the cost of production but with significant variability (and including occasional periods of a discount relationship). This applies not only in the aggregate, but also among the various commodities within the Bloomberg Commodity Index. Recent data for the prices of the index members showed a range from a discount of 29% below the cost of production (for Kansas City Board of Trade Wheat) to a premium of 71% (for London Metals Exchange Zinc).

Slide 11

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Commodities as an Asset Class

After laying out his reasoning for including commodities in a well-diversified asset allocation model, Greer explained why the timing is good now for an initial investment into commodity futures. The basic reason? They are cheap relative to the more common asset classes (slide 13). Of the twenty-two constituents in the Bloomberg index, only zinc currently trades above 50% if its long term value. By comparison, stocks, bonds, and REITs are all currently above the 95% mark. Global demographic and economic developments indicate a long term rising trend in the demand for all manner of commodities.  World population continues to grow (slide 19), with a concentration in developing countries. Economic growth in these countries will engender an increasing demand for commodities broadly. This is already reflected in changing dietary habits in developing countries where the consumption of meat in all forms is increasing (while it declines in the U.S.). This has knock-on effects on the prices of grains needed to produce the meat (slides 20 & 21).  Growth in developing economies also increases demand for energy (mainly oil) and metals and industrial goods (to build out infrastructure). Graphs displaying the consumption of corn, wheat, copper, coffee, and oil all show persistent, long term rising trends (slide 22).

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Greer provided greater detail regarding the supply and demand for oil. The two most populous countries in the world, China and India consume significantly less energy per capita in the form of oil than developed, slow growing, Japan and the United States (slides 24-26). So, as their economies develop and grow faster than the developed world, China and India will drive global oil demand. Meanwhile the spare productive capacity of OPEC countries has been declining since 2009 (slide 27) and shale oil production in the U.S. is still a small contributor to global supply–just 5% (slide 28).  Thus the long term trend in global economic growth, driven by the developing world, argues for an allocation to commodities as a contributor to both returns and diversification in a well-balanced portfolio.

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Slide 28

Vault Series: Gautam Dhingra, CFA, High Pointe Capital Management, LLC

On September 7th, the CFA Society Chicago welcomed Gautam Dhingra, CFA, the CEO and a portfolio manager at High Pointe Capital Management, LLC to discuss incorporating intangible assets and ESG factors into stock selection.

 

According to Mr. Dhingra, there are multiple examples of intangible assets; patents in the case of Qualcomm, brands like Pepsi and Apple, difficult to replicate assets like Union Pacific railroad, or sanctioned oligopolies like Moody’s, to name a few. When looking to use these intangible assets one should look beyond accounting data and focus on ‘what really matters’, or historical financials versus future economic profits. Much of the value derived from intangible assets, like the ones mentioned, cannot be found on a balance sheet, rather derived through future pricing power or lack of competition, for example. In the growing information based economy, traditional accounting won’t be as useful going forward and stock selection models must be adapted to incorporate intangible assets to find an edge and outperform. An increasing proportion of companies’ values are being derived by intangible assets, which poses a question; should one view Procter and Gamble and Qualcomm as peers, both benefiting substantially from intangible assets?  The answer is yes.

 

The speaker discussed another form of intangibles, Environment, Social, and Corporate Governance (ESG), which can be described as putting your money to work into companies that follow good practices, e.g. treat their employees and other stakeholders well. With employee satisfaction having shown a strong correlation to stock performance by one study, some 3.5% per year above its benchmark, adjusted for characteristics, which found that it could be a leading indicator to predicting earnings surprises.

 

High Pointe conducts its research into ESG and other intangible factors and inputs it into its model that combines ‘franchise quality’ and ‘expected growth’ in an effort to find great stocks. The company seeks to find a business’s ‘franchise quality’ by ranking stocks on a variety of factors, including ‘how good is the business’ (using barriers to entry, degree of competition, pricing power vs. customers, pricing power vs. suppliers, and suitability of advantage) and ‘how well is this being managed,’ which includes management, employees, and governance.

 

Vault Series: Doug Ramsey, CFA, CMT, The Leuthold Group, LLC

Playing the Market Melt-Up

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The CFA Society Chicago gathered in the Vault Room at 33 North LaSalle to hear Doug Ramsey, CFA of Leuthold Weeden Capital Management discuss the likely future direction of the equity market. Ramsey is the CIO of The Leuthold Group and co-portfolio manager of the Leuthold Core Investment Fund and Leuthold Global Fund. .

Ramsey is both a CFA charterholder and a Chartered Market Technician (“CMT”). Holders of the CMT have demonstrated expertise in the theory, practice and application of technical analysis. He maintains Leuthold’s proprietary Major Trend Index, a multi-factor model that utilizes mainly technical data. The model contains a long history of market data going back to 1930. The data and subsequent market behavior discussed in the Vault Room included data up to May 12th of this year.

The Major Trend Index is comprised of 130 indicators that roll-up into 5 categories. The categories are comprised of quantitative and qualitative factors that influence the direction of markets. A plus and minus figure is computed for each category and a ratio that includes all the data is computed. The Major Trend Index yielded a ratio of 1.14 as of May 12th,  a ratio over 1.00 is considered bullish.

The age of the current bull equity market has many speculating that the bull market is nearing an end. Ramsey spoke at length as to how his model can be used to forecast a market top. The Major Trend Index concludes that the current bull market has more room to run. He believes that the equity market sell-off in early 2016 has set the stage for another leg-up in the current bull market.

The model used by Ramsey uses seven (7) stock market indices to monitor the health of the equity market.  They are as follows:

  • Dow 65 Composite
  • Dow Transports
  • Dow Utilities
  • Russell 2000
  • S&P 500 Financials
  • S&P 500 Cyclicals
  • NYSE Advance/Decline Line

Negative performance in at least 5 of these 7 categories has foretold a market top. Ramsey characterizes a market top as a “lonely” one. The bull market is propelled at its end by only one or two sectors before a bear market begins.

DSC_3744Ramsey then spoke at some length about the market sell-off that occurred at the beginning of 2016 and its effect on the current bull market. In May of 2015 six (6) of the seven (7) categories were in negative territory which is a strong indication of a market top. The equity market was essentially flat in 2015 and the beginning of 2016 a market correction occurred. A bear market did not occur as the index only fell 14%, by definition a bear market does not begin before a 20% sell-off.

The fact that a bear market did not occur after the 2015 signal does not necessarily negate the usefulness of the model. The year 2015 coincided with a trough in corporate earnings and the market reflected that. Ramsey believes that the 14% pullback that occurred in early 2016 has given new life to the current bull market which in his opinion does not look to have reached its top.

Following his presentation Ramsey spoke with a group of attendees on a number of topics including:

  • Momentum investing works, investing in sectors or companies that have already experienced price appreciation can still yield profit.
  • Tech valuations are not in bubble territory. Several slides in his presentation illustrated the strong earnings that are now being realized by tech companies.
  • You can make an argument that low volatility (higher dividend)  stocks may have reached bubble territory since investors appear to be drawn to these.

Vault Series: David Ranson, HCWE & Co.

David Ranson provided an enlightening presentation during the second part of CFA Society Chicago’s new Vault Series held on March 15 in the Vault Room of 33 N. LaSalle. Ranson is President and Director of Research at HCWE & Co., an independent investment research firm that was formerly a division of H.C. Wainright & Co. Ranson presented a simple, but effective model–based on his extensive research into capital market returns and correlations–that his firm uses to advise clients on tactical asset allocation. Their process uses historical market price movements to uncover predictive relationships between leading indicators and, highly-correlated, consistent outcomes.

The model’s simplicity derives from viewing the investment universe as comprising just four primary asset classes (exhibit 1):

  • Domestic bonds
  • Gold
  • Domestic equities
  • Foreign assets and physical assets (commodities, real estate, etc.)

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(It’s important to note that the model considers gold as uniquely different from all other commodities.)

Ranson began by describing the role of capital migration in investment performance (exhibit 2). Capital migrates away from countries or markets characterized by economic stagnation, lower asset returns, declining new investment, and rising unemployment, and will flow to areas where the opposite conditions apply. Causes of the poor performance can be excessive government spending, taxation, and regulation, and “regime uncertainty” stemming from secretive or unpredictable policies.  These are difficult to quantify, but are usually accompanied by two more easily measured indicators: currency weakness, and rising economic anxiety (i.e., market stress).  These two indicators are the primary market signals the model relies on.  The price of gold serves to measure a currency’s value, and credit spreads measure economic anxiety.Ranson 1_Page_03

Ranson described four economic scenarios arrayed in quadrants defined by the change in the rates of economic growth and inflation (exhibit 3). Accelerating growth occupies the two lower quadrants and declining growth the top two, while accelerating inflation resides in the two right-hand quadrants and decelerating inflation on the left side. The scenarios (quadrants) determine the best performing assets.  Haven assets (bonds and gold) do best in the two upper scenarios when economic growth declines.  Risk assets (equities and commodities) stand out in the lower half of the array when economies accelerate.  When viewed laterally, financial assets (Ranson called them “soft” assets) that struggle against inflation reside on the left side of the array and those that do better against rising inflation (“hard” assets) reside on the right side.  Hard assets include gold, other commodities, real estate, and foreign equities.  (All foreign equities fit into this category because the model assumes they would perform comparatively well when an investor’s home currency is weak.) Putting the model together, shows gold as the preferred asset in the upper right quadrant (decelerating growth with rising inflation) and bonds preferred in the upper left quadrant (both growth and inflation decelerating). Domestic equities shine in the lower left quadrant (rising growth and decelerating inflation) while commodities and real estate are best in the lower right quadrant when both growth and inflation rise.Ranson 1_Page_04

Ranson presented statistics to support his model (exhibit 4). Separating the past 45 years of available data for the United States, he showed that when the rate of GDP growth accelerated from the prior year, the returns on equities and commodities always improved, while returns on treasury bonds and gold worsened.  When the rate of GDP growth slowed from the prior year, the reverse relationships held: returns on equities and commodities fell, and those for bonds and gold improved.Ranson 1_Page_05

Looking at inflation rates revealed similarly intuitive results (exhibit 6). When the CPI accelerated in a year, financial assets (both stocks and bonds) exhibited weaker returns, and gold and commodities did better than in the prior year.  When the CPI decelerated, financial assets enjoyed improved returns, while gold and commodities worsened.

Putting it all together (exhibit 11), Ranson presented an Asset-Allocation Compass with north pointing to heightened business risk, increasing investment anxiety, weakening economic growth and widening credit spreads. South points to the exact opposite conditions. East points to a weakening, or unstable, currency (measured by the price of gold) and west to a strengthening currency. He then filled in the best asset classes for eight points around the compass. His four primary asset classes occupied the diagonal compass points, corresponding to their positioning in the quadrant array:

  • Gold in the northeast
  • High quality bonds in the northwest
  • Domestic equities in the southwest
  • Hard assets in the southeast

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Ranson assigned the primary points of the compass to sub-groups of the primary classes. The most intuitive one was Treasury Inflation Protected Securities (TIPS) pointing west (declining inflation, strengthening currency). Pointing south toward strengthening growth were risk assets: B-rated junk bonds, MLPs, and developed market foreign equities. Pointing east (rising inflation and a falling currency) were commercial real estate and C-rated junk bonds, assets exhibiting little influence from changing spreads and more from the price of gold. The distinction between B and C-rated junk bonds may be surprising but Ranson’s research has shown that while they are correlated to each other, C’s are much better correlated to the gold price while B’s correlate more to credit spreads.

The compass had nothing listed for north (weakening growth and heightened risk perceptions). Ranson noted that he was not aware of an asset class that would fit well in this slot but, like a gap in the periodic table of the elements, he could describe the attributes he expected it to exhibit. It would have to respond positively to widening credit spreads, and be little effected by the price of gold (or value of the dollar).

In response to a question following his presentation, Ranson pointed out that the correlations his model depends on often take several years to manifest themselves, so the model works best for patient investors with very long investment horizons.