Shanghai Express Will the Shanghai–Hong Kong Stock Connect Program Be a Transformational Breakthrough?

Nov/Dec 2014

The Member Magazine for Investment Professionals

Shanghai Express Will the Shanghai–Hong Kong Stock Connect program be a transformational breakthrough?

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28 Go with the Flow Financial crises are caused by 28 cross-border investment flows, not misbehavior, says economist Robert Aliber. By Nathan Jaye, CFA

COVER STORY 32 Shanghai Express Will the Shanghai–Hong Kong Stock Connect program be a transformational breakthrough? 32 By Sherree DeCovny 36 Science, Art, and Investment Management Have recent events, especially 32 the global financial crisis, changed the consensus about the correct relationship between investment theory and practice? And how are “WHEN STOCKS new perspectives changing the way BECOME LESS hiring firms evaluate job candidates? CORRELATED WITH Two researchers share their findings. By Nathan Jaye, CFA THE MARKET, ALPHA WILL POP UP LIKE DANDELIONS IN MAY AND ACTIVE INVESTING WILL BECOME FASHIONABLE AGAIN.” COVER ILLUSTRATION Timothy Cook 47 SMART BETA STOXX LIMITED ADVANCED BETA SMART BETA SMA ADVANCED BETA CLARITYSUPER BETA IS EVERYTHING.

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CFA_Institute_8x10.indd 1 15/10/2014 15:05 Nov/Dec 2014

CFA INSTITUTE NEWS “CFA INSTITUTE WILL 7 EMEA Voice BE UNWAVERING IN ITS Europe’s Changing Financial Regulatory Landscape COMMITMENT TO THE By Rhodri Preece, CFA

PROMOTION OF INVESTOR 9 APAC Focus INTERESTS AND FINANCIAL The Way Forward in China and India MARKET INTEGRITY By Vidhu Shekhar, CFA, and Wendy Guo, CFA THROUGH THE MIFID II 11 The Future of Finance in Latin America REFORMS AND BEYOND.” VIEWPOINT 7 12 Better Credit Metrics for Emerging Markets Integrating corporate governance is key for improving credit analysis in emerging markets By David Smith, CFA 14 Skill or Be Skilled To improve skill, active managers need better data on their own performance By Michael A. Ervolini 17 Using ESG Factors for Equity Valuation How should analysts apply ESG factors? By Jeroen Bos, CFA 18 Marks of Distinction Overlooked skills can help investment professionals distinguish themselves from the crowd By Jason Voss, CFA

PROFESSIONAL PRACTICE

20 Can reforms boost China’s hedge fund sector? 47 22 Accessing multiple platforms via one service 24 Bringing big data to smaller wealth managers 26 Disconnected, overloaded, and reloaded

ETHICS AND STANDARDS

42 Market Integrity and Advocacy • Why policymakers value CFA Institute’s input • How investor redress helps market discipline • Does proxy access benefit shareholders? • Debating forward-looking information

5 In Summary 47 Chapter 10 Nov/Dec 2014 Vol. 25, No. 6 CFA INSTITUTE PRESIDENT & CEO ASSISTANT EDITOR Dwight D. Churchill, CFA Michele Armentrout

CFA Institute Magazine (ISSN 1543-1398, CPM 400314-55) is published bimonthly—in MANAGING EDITOR GRAPHIC DESIGN January, March, May, July, September, and November—by CFA Institute. Periodicals Roger Mitchell Communication Design, Inc. postage paid at Charlottesville, VA, and additional mailing offices. POSTMASTER: Send [email protected] [email protected] address changes to CFA Magazine, 915 East High Street, Charlottesville, VA 22902. Statements of fact and opinion are the responsibility of the authors alone and ONLINE PRODUCTION COORDINATOR CIRCULATION COORDINATOR do not imply an endorsement by CFA Institute. Kara Hite Jennette Townsend [email protected] Copyright 2014 by CFA Institute. All rights reserved. Materials may not be ADVERTISING MANAGER ® reproduced or translated without written permission. CFA , Chartered Financial Tom Sours ® Analyst , and the CFA Institute logo are just a few of the trademarks owned by [email protected] CFA Institute. See www.cfainstitute.org for a complete list. Annual subscription rate for CFA Institute members is US$40, which is included in the membership dues. Annual nonmember subscription rate is US$50. EDITORIAL ADVISORY TEAM Shanta Acharya Kate Lander, CFA THE AMERICAS EUROPE, MIDDLE EAST & AFRICA Bashir Ahmed, CFA Casey Lim, CFA 915 East High Street 131 Finsbury Pavement, 7th Floor Jim Allen, CFA Michael Liu, CFA Charlottesville, VA 22902 London EC2A 1NT Jonathan Boersma, CFA Bob Luck, CFA USA United Kingdom Jarrod Castle, CFA Farhan Mahmood, CFA Phone: (800) 247-8132 or Phone: +44 (20) 7330-9500 Michael Cheung, CFA Dennis McLeavey, CFA +1 (434) 951-5499 Josephine Chu, CFA Sudip Mukherjee ASIA–PACIFIC Franki Chung, CFA Jerry Pinto, CFA 477 Madison Avenue, 21st floor 23/F, Man Yee Building Darrin DeCosta, CFA Linda Rittenhouse New York, NY 10022 68 Des Voeux Road Nick Dinkha, CFA Craig Ruff, CFA USA Central, Hong Kong Jerry Donohue, CFA Christina Haemmerli Schlegel, CFA Phone: +1 (212) 754-8012 Phone: +852 2868-2700 Alison Durkin, CFA David Shen, CFA Kenneth Eisen, CFA Arjuna Sittampalam, ASIP BRUSSELS William Espey, CFA Larry Swartz, CFA NCI LOCARTIS European Parliament Julie Hammond, CFA Jacky Tsang, CFA Square de Meeûs 38/40 Burnett Hansen, CFA Gary Turkel, CFA 1000 Brussels (Belgium) M. Mahboob Hossain, CFA Raymond Wai Pong Yuen, CFA Phone: +32 (02) 401-6828 Vahan Janjigian, CFA James Wesley Ware, CFA Andreas Kohler, CFA Jean Wills Aaron Lai, CFA

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4 CFA Institute Magazine Nov/Dec 2014 IN SUMMARY

Confirmation Bias and Molten Lava

“Being a man of integrity, Suda immersed himself in insight into skill” (“Skill or Be Skilled,” 14). Likewise, in the study of rock reading, lava analysis and seismology.” Volcano, Jinpei Suda has no way of adapting to evolving —Shusaku Endo, Volcano circumstances. To do so would mean abandoning illusions about himself. When a minor eruption occurs and warn- The recent eruption of the Mount Ontake volcano in Japan ing signs appear—visible changes on the mountain, seis- struck a chord. Not only was the mountain a popular des- mic activity (which he tries to conceal), and new analysis tination for hikers, with more than 40 killed in the erup- by a scientist who predicts a violent eruption—Suda con- tion, but a fairly extensive lodge was located near the peak. tinues to reassure others and tells himself, “Akadaké will Both circumstances made the eruption Japan’s worst volca- not play me false.” nic disaster in almost a century. They also resembled the With volcanoes or financial markets, small changes can plot of a novel published more than 50 years ago. signal “a start of something big,” as one observer remarks In Volcano, the Japanese writer Shusaku Endo tells the about gradual reforms toward opening China’s markets (Port- story of Jinpei Suda. In an “unspectacular career” as a sec- folio Performance, 20). Although the Shanghai–Hong Kong tion chief for the weather bureau, Suda makes himself the Stock Connect program could be a “transformational break- resident expert on the local volcano Akadaké. He literally through” (“Shanghai Express,” 32), recent political demon- follows in the footsteps of a dead geologist who believed strations in Hong Kong remind us that even well-designed the volcano was “decrepit and extinct.” Suda makes more policy initiatives must be applied to a dynamic, nonlinear than 80 trips to study the mountain and assembles what he system called “history.” In the words of Sergio Focardi, considers irrefutable evidence that the volcano will never “Finance theory is the theory of the behavior of a human erupt again. artifact” (“Science, Art, and Investment Management,” 36). A local city councilman named Aiba has a scheme to With complex systems, inputs do not drive outputs in develop a hotel on Akadaké and make it a tourist attrac- a direct, mechanical, and thus predictable way. An appar- tion. He recruits Suda as an expert to reassure the devel- ently minor flaw in the system, such as inadequate meth- oper that the mountain is perfectly safe, but Suda has an ods of providing investor redress, can weaken market disci- ulterior motive. At the point of retirement, he wants Aiba’s pline (Market Integrity, 44). Cross-border investment flows patronage to help him publish his study of Akadaké. The can slowly distort economies and markets over a period of weaving together of personalities, purposes, and business years and establish the preconditions for a sudden finan- is always a risk for investors. In particular for credit analy- cial crisis (“Go with the Flow,” 28). sis in emerging markets, writes David Smith, CFA, investors Jinpei Suda’s beliefs about the volcano are not scientific. should carefully consider “character and motivation … piec- They are personal artifacts. Like everyone else in the novel, ing together the informal networks that may connect indi- he conveniently sees in the volcano what he wants to see. In viduals” (“Better Credit Metrics for Emerging Markets,” 12). his case, that means a safe mediocrity untainted by scandal Suda has been diligent in his investigation of the moun- and free from dangerous, combustible passions, including tain, but this expertise is actually “a secret vanity,” infect- love. The city councilman and the developer see a business ing him with a severe case of confirmation bias about the proposition. A fallen old man sees the power of evil, which theoretical model he inherited from the late scientist. He explodes like an unstoppable natural disaster, meaning he is never considers other interpretations. Throughout his career not really to blame for his own moral failures. The idealistic and personal life, he has been blind to his character flaws. pastor of a local church sees only pristine natural beauty, “From fifty years of experience in the art of getting along the perfect site to build a place for spiritual retreats. The in the world,” writes Endo, “he had learned that medioc- story ends with Jinpei Suda dying with the knowledge that rity was the secret of contentment.” A preference for safe he deluded himself about his empty, sterile life and the vol- mediocrity is what some observers perceive in the recent cano’s true potential for spewing destruction. Meanwhile, trend away from active management. “Many of us decided construction crews begin building the hotel project and to become CFA charterholders because we are brilliant, the retreat center on the volcano. From Pompeii to Mount courageous risk takers and swashbuckling top-gun fighter Ontake, people have a long history of living too close to pilots,” writes Ralph Wanger, CFA. “Passive investing is for volcanoes. One thing about the course of human events is airline pilots” (“Captain Alpha’s Flying Circus,” 47). very predictable—there will be eruptions. The threat to active managers is real, according to behav- Roger Mitchell, Managing Editor ([email protected]) ioral expert Michael Ervolini. To survive, they will need to have demonstrable skill at beating the market, but if their mission is to improve skill, these ace fighter pilots are flying blind because traditional portfolio metrics “provide zero

Nov/Dec 2014 CFA Institute Magazine 5 CIPM

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CIPM.indd 7 8/28/14 12:26 PM CFA INSTITUTE NEWS EMEA VOICE

Europe’s Changing Financial Regulatory Landscape

By Rhodri Preece, CFA

This November heralds the beginning order-to-trade ratios, and tick sizes for equity markets), data of the new legislative cycle in the Euro- publication and access, and other reporting issues. pean Union (EU), marked by the com- A central objective of MiFID II is to increase the level mencement of duties for the new Col- of transparency in financial markets. To that end, the pro- lege of Commissioners. The installation visions for pre- and post-trade transparency in non-equity of the new European Commission in markets such as bonds and derivatives have far-reaching Brussels completes the makeover of the implications and perhaps reflect the most ambitious aspects EU’s policy-making apparatus and fol- of ESMA’s work. CFA Institute supports the general prin- lows the resumption of discourse in the ciple of bringing greater transparency to these markets to European Parliament after the summer reduce the informational advantage held by dealer banks recess and the elections that preceded it. The broad policy over investors, which can keep spreads (and thus costs) arti- objectives for the new legislature focus on restoring jobs, ficially high. But because the calibration of these require- growth, competitiveness, and a “capital markets union” in ments in non-equity markets needs to balance transparency Europe to complement the banking union established under with liquidity-provision considerations, a gradual approach the previous Commission. Yet amid these policy aspirations is warranted. To provide sufficient clarity and certainty to and institutional changes, regulators’ immediate attention market participants, the transparency framework should will be focused on an existing piece of legislation—namely, avoid undue complexity. the Markets in Financial Instruments Directive (MiFID II). ESMA’s consultation paper focuses on investor-protection Passed into law in June 2014, MiFID II sets new rules for measures related to MiFID II’s conduct-of-business require- the structure of markets and the trading of financial instruments, which address the assessment of the suitability and ments and prescribes conduct-of-business standards for the appropriateness of investment products by financial advis- provision of investment products and services. Since this ers and strengthen the rules on inducements. CFA Institute past summer, the European Securities and Markets Author- has voiced strong support for investor-protection measures, ity (ESMA), alongside the European Commission, has been calling for more transparency and consistency in invest- engaged in the ongoing process of developing technical ment product disclosures and product governance. To bol- standards to implement the legislation. CFA Institute, in ster this debate, CFA Institute is actively promoting investor its commitment to promoting financial market integrity, is protection through its Future of Finance initiative and high- providing input via two key channels. lighting the importance of investors’ rights to information, First, Josina Kamerling, head of regulatory outreach fair and honest advice, and accurate assessment of risk and in EMEA at CFA Institute, has been appointed to ESMA’s reward. We believe that a commitment to uphold the highest secondary markets consultative working group (see page standards of investment practice and to serve investors and 42 for more information). A key part of this committee’s the global economy can effect a positive change in finance. remit is to advise ESMA on the structure, transparency, and The next step in the policy-making process will be another efficiency of secondary markets for financial instruments, consultation round in which ESMA must set out its draft tech- including regulated trading venues and OTC markets. nical standards. By the end of 2015, the European Commis- Because these issues are central to the MiFID II reforms, sion must adopt these standards through legislation, paving our presence on the committee makes us well positioned the way for the implementation of MiFID II in January 2017. to deepen and expand our regulatory engagement with With such a broad and lofty policy agenda for the incom- MiFID II and to provide the investor’s perspective in the ing Commission, the regulatory landscape for financial mar- policy debate. kets and financial services is likely to change significantly Second, CFA Institute has been engaged in the regulatory between now and 2017. Throughout this period of change, consultation process that began with the June publication of CFA Institute will be unwavering in its commitment to the both a discussion paper and a consultation paper by ESMA promotion of investor interests and financial market integ- (you can view our responses at http://bit.ly/commentletters). rity through the MiFID II reforms and beyond. The discussion paper sets out ESMA’s initial thinking on the Rhodri Preece, CFA, is head, capital markets policy EMEA, at CFA Institute. development of rules for a wide swathe of topics: investor protection (including increased disclosures relating to best execution), transparency in equity and non-equity markets, microstructural issues (including organizational requirements for algorithmic trading, market-making obligations,

Nov/Dec 2014 CFA Institute Magazine 7 209,5x276,2 AAA 2014.indd 1 Seminar “ State-of-the-art riskmanagementandassetallocationprocesses forproduct innovation Past participant Past participant Senior Associate, CPPInvestmentBoard,Canada James Kwon,CFA I havealreadyrecommendedthisseminartomycolleagues! quantitative financeintoaveryintuitiveandinteractivedialogue. Lionel Martelliniisawizardintranslatingtechnicalaspectsof Past participant SNS Asset ManagementHeadofAllocation,Netherlands Rene Groteboer portfolio) tothegoal-basedoptimaldynamicallocationbetweenthem. harvesting riskpremia(returnportfolio)andliabilityhedging(matching Excellent three-daytourthroughlatestadvancesinassetallocation,from President, Vice Paul Fahey,CFA recommend toanyassetmanagerwithliabilitymatchingresponsibilities. risk managementprocesses.ItwasaninvaluableexperiencethatIwould great dealthatIcanapplyinmyresponsibilitiestosignificantlyimproveour presenting complexconceptsinanunderstandablefashion.Ialsolearneda The coursewasnothingshortofexcellent.LionelMartellinididagreatjob Pension Investments, NAVCANADA,Canada core-satellite allocationtorefine investmentmanagementand risk Allocation Seminar Bridge thegapbetweenmodernportfoliotheoryandpractical management processes anddesignnewinvestmentsolutions Use dynamicbetamanagement,riskbudgeting,and Advances in Asset Advances inAsset Understand optimalbenchmarkconstructionstrategies www.cfainstitute.org and theirapplicationtosmartindexconstruction portfolio constructiontobuildstablemodels Understand state-of-the-artALMandLDI “ CFA Institute—EDHEC-Risk Institute www.regonline.co.uk/AAA_July_2015 (NewYork) www.regonline.co.uk/AAA_February_2015 (London) [email protected] Mélanie Ruiz:+33493187819 Information andregistration: New York City, 7-9July2015 London, 3-5February2015 EDHEC-Risk Institute Scientific Director, Lionel Martellini,PhD www.edhec-risk.com Institute 15/10/2014 12:20 CFA INSTITUTE NEWS APAC FOCUS

The Way Forward in China and India

By Vidhu Shekhar, CFA, and Wendy Guo, CFA

“We must create cultures where business and finance can example, in the context of Safeguarding the System, the lack work together to create high-performing companies and earn of highly developed fixed-income markets and the exces- returns for savers on a sustainable basis.” sive dependence on bank credit by companies in China and —John Kay, chairman of the Future of Finance Advisory Council, India may create a fragile financial system that is vulnera- quoted from the Kay Review of UK Equity Markets and Long-Term ble to corporate defaults. With risk heavily concentrated in Decision Making (July 2012) one sector of the financial system, defaults can cause banking sector distress and, in turn, put pressure on the govern- In the coming year, CFA Institute will open offices in India ment to bail out troubled banks in order to maintain finan- and China as part of our initiative to better support our cial stability. In contrast, in the United States and Europe, mission in these two countries. In addition to serving our a significant portion of debt is securitized and held by non- members, a significant part of our activities in China and bank financial institutions. India will involve working with industry participants, regulators, and policymakers in such areas as ethics, gover- IT IS IMPORTANT TO RECOGNIZE THAT nance, financial market integrity, and transparency. Our work in China and India is also important for the Future THE FUTURE OF FINANCE INITIATIVE AND of Finance initiative at CFA Institute, a long-term global proj- ITS SIX FOCUS AREAS MAY LOOK VERY ect to shape a trustworthy and forward-looking finance industry that serves society. Developments in China and India in DIFFERENT IN INDIA AND CHINA COMPARED the next few years will have a significant global impact not WITH THE DEVELOPED WORLD. only because of the size of their markets but also because of the unfinished task of developing their financial markets. There is currently a great deal of speculation as to when China will become the world’s dominant economic power. For In the area of Retirement Security, the demand for pen- example, the Economist has asked its readers when China will sion assets is growing very quickly in both countries. China’s surpass the United States in terms of gross domestic prod- population is aging rapidly, and structural reform is neces- uct (the consensus, at the time of this writing, was 2021). sary to address the ballooning deficit. Capital market devel- Yet despite its impressive and unprecedented achievements, opment and the availability of diverse investment instru- China remains a developing country. It has the second-largest ments are both equally important in successfully meet- number of poor people after India, and its per capita income ing the challenge. In India, as the fiscal deficit is brought is still far below the levels of developed countries. Moreover, under control and the growth rate of government borrow- China is entering a delicate period of economic rebalancing ing comes down, pension funds will look for longer-term as it tries to rely less on real estate, infrastructure invest- corporate assets. The development of this market requires ments, and exports (all of which have driven growth over the fixing problems in the legal system, creating strong inter- years) and attempts to stimulate more domestic consumption. mediaries, and improving regulation and enforcement. India may lack the economic muscle of China, but it too Financial Knowledge will also become very important for has made significant progress in the past 20 years within a both countries as they experience rapid expansion of access somewhat unpredictable democratic process. India’s economic to financial products and services in the coming years. Thus, reforms began in earnest after the balance-of-payments crisis significant outreach is needed for educating investors and in 1991. Since then, financial markets and institutions have advisers and for creating the proper foundations for liquid steadily replaced the government in handling the task of cap- and vibrant markets. This need places an important respon- ital allocation. But large banks, insurance companies, and sibility on investment professionals, a responsibility that pension funds remain state controlled. Significant reforms CFA charterholders are well positioned to bear. are needed before market institutions can become capable We have our work cut out for us in China and India. Under- of fully supporting economic growth and financial inclusion. standing the specific long-term challenges faced by these Against this backdrop, it is important to recognize that countries will allow CFA Institute and our members to con- the Future of Finance initiative and its six focus areas (Put- tribute more effectively to the development of these markets ting Investors First, Financial Knowledge, Transparency and and to realize the vision of the Future of Finance initiative. Fairness, Retirement Security, Regulation and Enforcement, Vidhu Shekhar, CFA, is country head for India at CFA Institute. Wendy Guo, and Safeguarding the System) may look very different in CFA, is the China plan general manager at CFA Institute. India and China compared with the developed world. For

Nov/Dec 2014 CFA Institute Magazine 9 CFA INSTITUTE NEWS

IN MEMORIAM

Thomas L. Hansberger, CFA, passed Considered a pioneer in the field of away on 1 October in Red Lodge, Montana. global investing by his peers, he was Paul A. Delaney, CFA His wife, Patty, said that even though Tom honored with a leadership award in his Toronto had a small family of his own, he always name in 1998—the Thomas L. Hansberger considered CFA Leadership in Global Investing Award. Morton Langer Institute to be his Past AIMR chair John Maginn, CFA, New York City extended family. recalls how Hansberger’s experience Nicholas A. Valtz, CFA His deep provided contacts and perspective for New York City commitment to the staff and board that proved invalu- the organization able. “Tom was really a prime mover and is evident in his motivator of the organization’s shift from In 1979, Hansberger joined the Temple- history of global a largely North American-focused organi- ton organization, becoming its first outreach. He was zation to a truly global organization.” analyst, and within a few years became a founder and the T.K. Yap, CFA, a former CFA Institute president and CEO of Templeton World- first president of the International Society Board member, remembers Hansberger wide. Sir John Templeton, CFA, personally of Financial Analysts (ISFA), our first soci- as being a “beacon for many of the early requested that Hansberger work for him ety outside North America. He later served charterholders and society leaders” in at Templeton, one of the first companies as chair of both the Financial Analysts Asia: “Tom will be remembered for his to venture into international investing. Federation (FAF) and the Association for vision to start the ball rolling in this region.” A service is scheduled for 22 Novem- Investment Management and Research Hansberger helped found and was ber in Ft. Lauderdale, Florida. Friends (AIMR). A recipient of the Alfred C. Morley president of CFA Society Tampa Bay and can contact Patty Hansberger at Distinguished Service Award, Hansberger CFA Society The Bahamas. He also was [email protected], or at 860 S. Davis was characterized frequently as “modest.” president of CFA Society South Florida. Blvd., Tampa, FL, 33606.

INVESTMENT PROFESSIONALS AND FIDUCIARY DUTIES

Marianne M. Jennings

“Find out why the investment industry is at a crossroads in terms of the roles investment professionals play and the standards to which they are held.”

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10 CFAlit_ad_jennings.indd Institute Magazine 1 Nov/Dec 2014 9/19/14 2:27 PM The Future of Finance in Latin America

Members of the CFA Institute Ameri- cas and Future of Finance teams vis- ONE WAY TO RESTORE BALANCE TO THE GLOBAL ited Latin America over the summer to ECONOMY IS THROUGH PROMOTION OF FUTURE OF engage with local candidates and members; to promote our programs to regula- FINANCE OUTPUT AND ACTIVITIES, INCLUDING SUPPORT tors, employers, and university students; OF THE STATEMENT OF INVESTOR RIGHTS AND and to encourage our members there to help shape the future of the finance PUTTING INVESTORS FIRST MONTH. industry. Tom Robinson, CFA, managing director, Americas; Rafael Matallana, manager, Latin America relations; and Team members also met with José in building trust and a stronger finan- Ashvin P. Vibhakar, CFA, senior adviser, Luis Ramirez Pérrigo, Jorge Mogrovejo cial ecosystem. “The most important led the trips to Bogotá, Colombia; Lima, Gonzalez, and Augusto Vidal at Super- thing is you always put your clients’ Peru; and Santiago, Chile. intendencia de Banca y Seguros y AFP interests first, before yours or before While in Peru, the team had an (SBS, the local banking and pension fund your firm,” Robinson said. [His Diario opportunity to participate in the Peru regulator) to discuss SBS staff participa- Gestión interview is available online at Capital Markets Day (CMD) Seminar tion in CFA Institute programs and other http://gestion.pe/mercados/nuestro- hosted by El Dorado Investments and long-term partnership opportunities. objetivo-ir-hacia-ecosistema-financiero- Universidad del Pacífico. The CMD sem- In addition, the team met with Alejan- sano-2106207.] inar is a one-day event involving about dro Angulo at AFP Integra, the pension Ashvin Vibhakar was interviewed 400 local professionals in the financial fund system in Peru, and presented an by El Comercio regarding the Future of services industry. CFA Institute speak- overview of the CFA Program, the CIPM Finance initiative and the need to restore ers discussed how to improve the cap- Program, and the Claritas Program, as trust in the industry. “According to the ital market ecosystem through ethics, well as the Future of Finance Initiative, Edelman Trust Barometer, the finan- education, CFA Institute programs, and to enthusiastic AFP Integra staff. cial services industry is the least trusted the Future of Finance initiative. About A highlight of the Lima trip included industry globally,” he pointed out. Vib- 600 people in Peru take the CFA exam media interviews with Diario Gestión hakar added that one way to restore bal- every year, and today, there are 80 CFA and El Comercio. Tom Robinson stressed ance to the global economy is through charterholders in the country. the importance of ethics and education promotion of Future of Finance output and activities, including support of the Statement of Investor Rights and Put- DISCIPLINARY NOTICES ting Investors First Month.

SUMMARY SUSPENSION member. Ho was found to have violated Stan- On 2 June 2014, CFA Institute imposed a Sum- dards I(A)—Knowledge of the Law, I(C)—Misrep- mary Suspension on Mingchao Zhao (Canada), resentation, and VI(A)—Disclosure of Conflicts of Programs Now a lapsed affiliate member, automatically the CFA Institute Code of Ethics and Standards of suspending his membership. Because he did Professional Conduct (2005). Eligible for GI Bill in not request a review, the Summary Suspension On 12 March 2013, the Securities and Futures the United States became a Revocation on 3 July 2014. Commission of Hong Kong (SFC) prohibited Ho from re-entering the securities industry for 14 Zhao admitted to engaging in illegal insider CFA Institute’s suite of educational trading between June 2010 and December 2011. months. The SFC found that Ho breached General On 17 May 2013, the Ontario Securities Commis- Principles 6 and 7 and Paragraphs 12.2, 16.3, and programs—the CFA Program, CIPM sion (OSC) approved a settlement agreement 16.4 of the Code of Conduct for Persons Licensed Program, and Claritas Program— by or Registered with the SFC. Specifically, the under which Zhao was permanently prohibited are eligible for reimbursement from trading securities; permanently prohib- SFC found that, on four separate occasions, ited from becoming or acting as a director or Ho filed mandatory account declarations with under the GI Bill. These benefits, officer of an investment fund manager; and his employer that did not disclose his family available through the US Depart- members’ securities accounts at another institu- permanently prohibited from becoming or acting ment of Veterans Affairs, provide as a registrant, investment fund manager, or tion. Additionally, between February 2010 and promoter. In addition to the permanent prohibi- June 2010, Ho was involved in the preparation assistance with costs associated tions, Zhao was ordered to pay OSC a C$750,000 of research reports for three stocks that were with education and training and also traded in his family members’ undisclosed administrative penalty, disgorge C$416,719 in are earned by members of the US profits, and pay C$30,000 in costs. accounts during that time. The trading occurred either one day before or on the same day as Armed Forces. If you’d like to refer TIMED SUSPENSION research reports issued by Ho’s research team. a US veteran to one of our educa- Lastly, the SFC found that Ho failed to disclose Effective 15 July 2014, CFA Institute imposed a tional programs, please visit One-Year Suspension of membership and the to his employer his personal interest in certain right to use the CFA designation upon Ho Kei securities held in one of the related accounts. www.cfainstitute.org/service for Him Calvin (Hong Kong), a lapsed charterholder details and specific instructions.

Nov/Dec 2014 CFA Institute Magazine 11 VIEWPOINT

Better Credit Metrics for Emerging Markets INTEGRATING CORPORATE GOVERNANCE IS KEY FOR IMPROVING CREDIT ANALYSIS

By David Smith, CFA

Emerging markets present investors even greater—importance in emerg- companies are family-controlled con- with an exciting opportunity to tap ing markets. In my view, investors who cerns, it pays to know about reputations. into macroeconomic themes of eco- ignore such information are taking Although the 1997–98 Asian crisis was nomic growth, rising affluence, and uninformed and unrewarded risks. supposed to have lanced “crony capital- emergent consumerism. For the diligent What should investors do to guard ism” in the region, the fact that some investor, the returns can be reward- against these risks? A good way to start groups have managed not only to sur- ing, but poor corporate governance is to look at the people behind the paper. vive but to thrive in the years since can lead to an erosion of these returns. What have they done in the past, and should stand as a warning. Indeed, emerging markets are fraught how have they treated providers of Commercial success is often closely with such governance risk. Cash-rich finance to the companies they previ- tied to political connections, and in companies may be attractive, but will ously owned? At the margin, this eval- many economies, wealth has been investors ever get a slice of the cash? uation involves value judgments, such linked to the granting of preferential Strong cash flows are alluring, but will as deciding whether the promoters are licenses and rent-seeking behavior. The they be reinvested in the company or likely to honor their debts. Trust is vital more powerful vested interests have squandered on vanity projects? Good in regions where legal recourse to debt become adroit at promoting private corporate governance is vital in pro- recovery is very often complicated and gain as a national good. tecting the interests of providers of the impartiality of the courts is at times In the past, bank financing dominated finance, and nowhere is this principle questionable. lending to companies. Well-placed com- truer than in emerging markets. Traditional credit analysis focuses on panies could use their influence to get For these reasons, the integration cash flow and the assets used to gener- access to loans, and indeed, many con- of corporate governance analysis into ate this cash flow. Although covenants glomerates were built with the help of equity investment approaches has been can restrict the ways in which the assets banks they controlled. Banks were part- gaining ground around the world. Less and the cash can be used, covenants ners first and were expected to have a common, however, is the integration of may give a false sense of security. No forgiving attitude when loans could not corporate governance within the credit matter how well covenants are drafted or would not be repaid. Not surprisingly, analysis process. to mitigate corporate governance, artful some companies view the alternative promoters can find ways around them. of financing via the bond markets with QUALITATIVE FACTORS Things to watch for include creative suspicion. They perceive foreign bond- In emerging markets, the global search use of unidentified third-party vendors, holders as opportunists—a convenient for yield introduces investors to new transfer pricing agreements, and asset- stereotype that may hide an ambivalent opportunities and challenges. Emerg- value inflation. view of their obligations as a borrower. ing debt markets are younger, corpo- Covenants are only as strong as the rates there have shorter histories, and institutions charged with enforcing METHODOLOGY information is scarce. These shortcom- behavior. Accordingly, investors would In my experience, any credit examina- ings have impelled us to make corpo- be wise to look at the character and moti- tion must begin by assessing the qual- rate governance a key component of vation of the company’s advisers, audi- ity of cash flow metrics. The level of credit analysis. One must scrutinize not tors, bankers, directors, and so on. Piec- related-party transactions is a good only the traditional credit metrics of the ing together the informal networks that indicator of whether a company exists entity issuing the paper but also the may connect individuals across these to enrich management and promoters or corporate governance of the entity to firms requires time. If a firm chooses an not. A dependence on related parties for be financed, including the background auditor with few clients and an unusual assets, intellectual property, or finan- and track record of the shareholders or record of association with corporate fail- cial assistance will clearly weaken such promoters of the entity. ures, the move should prompt questions. a company as a stand-alone concern. Although the traditional credit anal- Character is a qualitative assess- The issue of intellectual property is ysis process considers the track record ment—one that is tempting to mea- a growing one for investors. Compa- of the entity issuing the paper and the sure using quantitative overlays, such nies frequently lease intellectual prop- incumbent management team, we see as credit standing or bond rating. But erty (such as know-how or trademarks) the pedigree of the promoter and pro- that kind of substitution is dangerous from controlling shareholders at what moter group as being of similar—or and inadequate. Particularly where may appear to be nominal rent. But these

12 CFA Institute Magazine Nov/Dec 2014 agreements often contain clauses that on these individuals. Investment man- Alas, capital markets have a short punish corporates in certain circum- agers should press management hard, memory. After a crash or crisis, irratio- stances, such as a change of control. Dis- particularly where there has been nal exuberance can quickly replace cyn- covering these clauses is laborious yet behavior of questionable motivation icism when good times return, and with vital. An important part of due diligence in the past. If a company cites circum- such exuberance comes a willingness to requires spending hours poring over stances beyond its control as reason for forgive past sins in return for (scarce) debt and equity prospectuses looking a past cash crunch or corporate catas- yield and an indulgent approach to for a single clause in these agreements. trophe, it must show evidence that it due diligence. A related question concerns a com- has learned from the experience. Investing in emerging markets should pany’s ownership of its factors of pro- Before putting our clients’ money never rely on overly quantitative analysis duction. These may be leased from a at risk, it is important that investment characterized by box ticking and false controlling shareholder directly or indi- managers understand the history of quantification. That way lies a kind of rectly (for example, through a variable- the promoter, his or her interests (and willful blindness. Investors can avoid interest entity structure). If the company alignment with the interests of provid- the corporate time bombs that inevita- exists at the pleasure of a controlling ers of finance), linkages between group bly come to market by sticking to a focus shareholder, with the risk that land or companies, and the commitment to on quality and by overlaying qualitative labor may not be supplied so willingly good corporate governance. Only by factors onto traditional credit metrics. in the future, the risk to an investment making this effort will investors gain David Smith, CFA, is head of corporate governance manager’s clients will be substantial. a true picture of credit quality. at Aberdeen Asset Management Asia Limited. All of these issues are important, but investors’ key interest is in management teams and promoters. In some markets, institutional memory and the research INDIA INVESTMENT CONFERENCE network give an investor a good sense of 9 January 2015, Mumbai, India the promoter (including past conduct). This degree of familiarity is especially the case if an investor has direct equity investment experience. The comfort level is naturally higher with those who REBOOTING have built a company through hard work than with those who have been gifted privileges because of their connections. INDIA TO This comfort level tends to go up with companies that have a track record of growing profits, ideally under inde- REALISE ITS pendent management. To return to the theme of family-controlled enterprises, one of the biggest problems is how the POTENTIAL patriarch deals with second- or third- generation members. Do the sons and EARLY-BIRD OFFER daughters automatically get top jobs, or closes after 9 December 2014 do they work their way up through the business while being groomed by out- www.cfa.is/india2015 siders who may retain key positions? We like to see outsiders involved both at the managerial and the board level because of the increased transparency in decision making this involvement implies. Families can be skilled managers, and outside help is not always superior. Further, a promoter who is concerned about his legacy can ensure that the balance sheet is managed conservatively and with an eye to the long term. With any company, investors are trying to form a view of the management team, their credibility, and whether clients’ money should be risked

Nov/Dec 2014 CFA Institute Magazine 13

CFA Mag_1/4 page.indd 1 7/10/14 4:43 PM VIEWPOINT

Skill or Be Skilled TO SURVIVE, ACTIVE MANAGERS MUST LEARN HOW TO IMPROVE SKILL

By Michael A. Ervolini

If you are an active equity manager, it’s to the job. Traditional portfolio metrics thousands of managers and research time for a deep look in the mirror. Your (such as return, relative return, infor- analysts around the globe. But this sit- industry, your business, and your live- mation ratios, alpha, tracking error, uation is changing. A growing number lihood are in jeopardy. The reason is turnover, hit rates, win/loss ratios, of professional investors are learning obvious: Investors are no longer will- and attribution analysis) all have one to improve deliberately, supported by ing to pay more for active management, thing in common: They are scorecards, rigorous and granular feedback that only to receive passive performance or measuring outcomes, but they provide only recently became available to pro- less. You know this already, but are you zero insight into skill. Armed with only fessional investors. really thinking about how to solve it? this type of information, it is virtually The fact is that the worse the indus- impossible to improve. A NEW FRAMEWORK FOR try does, the worse you do. It’s that Compare your situation with that IMPROVEMENT simple. This article provides a critical of a professional golfer. If the golfer A new framework uses the comparison look at the state of active management, were provided only the score after each of adjusted portfolio histories to isolate explains why most managers lack suf- round and nothing more, how would and measure skills. The basic idea of ficient skill to beat their benchmarks, and offers renewed hope by introducing a new framework for improving TRADITIONAL PORTFOLIO METRICS ARE SCORECARDS, deliberately. MEASURING OUTCOMES, BUT THEY PROVIDE ZERO THE CHALLENGE INSIGHT INTO SKILL. Active equity management is under siege, with active managers facing three harsh realities. First, more than 80% of portfolios underperform each year, she know what part of her game is this method, as developed by Cabot and it has been this way for decades. strongest? Is it her drives off the tee, Research, is to begin with the actual his- Second, trillions of dollars are being her irons in the fairway, or her putts on tory of a portfolio and then modify one reallocated out of active management the green? Our golfer would be clue- or more elements in order to construct directly into passive products, with less about her skills, and even more adjusted portfolios. The comparison of no end in sight to this trend. Third, critically, she would have no idea what adjusted portfolios with the actual port- active management fees—your fees— to do today to become a better golfer folio and with each other supports the are dropping like a rock. tomorrow. Golfers do, of course, have precise investigation of skills. The future of active equity manage- much more information than just out- Consider a simple example. A man- ment is problematic and characterized comes. They know everything about ager wants to understand how well his as one of intense competition for scarce their skills and sub-skills based on rig- sizing of positions works. The new ana- assets. The challenges you face as an orous and granular feedback. It is the lytic framework makes it possible to active manager are sufficiently severe quality of their feedback that enables quantify this skill. It involves construct- that the notion of “business as usual” elite athletes to improve throughout ing an adjusted portfolio history that, will translate for many into “soon out of their careers, even as they reach the on every day, owns the same positions business.” But you do have an option— pinnacle of mastery. It is equally true as the manager’s actual portfolio. The one that will offer you the chance at a for other high-performance profession- difference is that the adjusted portfolio future that is brighter and more prof- als, such as surgeons, musicians, and will ignore the manager’s actual sizing itable than the industry at large. The jet pilots. Excellent feedback underlies decisions and will instead size all posi- option sounds simple: learning how to improvement and strong outcomes in tions based on a passive rule. Thus, the improve. But exercising this option is every high-performance arena but one: adjusted portfolio will have the same not easy; it takes guts and hard work. active portfolio management. composition as the actual portfolio but You probably think you already know Because investment skill is not mea- will reflect position sizing that will be how to improve. Wrong. You don’t. sured, money managers’ lack of prog- both passive and independent from the How could you? The feedback you ress at improving is no surprise. Poor active decisions made by the manager. have ready access to is simply not up feedback is holding back hundreds of From this basis, it is simple to compute

14 CFA Institute Magazine Nov/Dec 2014 the daily returns for both portfolios, cal- REAL-WORLD EXPERIENCES costs their portfolio in excess of 100 bps culate a measure of aggregate perfor- With the ability to look deeper and annually. The framework of deliberate mance (e.g., annualized return, relative more clearly into the decisions manag- improvement is able to assist manag- return, alpha, etc.), and then compare ers make, the new framework is uncov- ers in identifying more effective sizing the results. If the actual portfolio out- ering previously hidden insights about regimes that improve performance and performs the adjusted portfolio, then skill, process, and behaviors. Based simplify their process. the manager’s judgments regarding on my firm’s experience working with SELLING HURTS. A number of emo- position sizing added value, meaning managers of portfolios totaling more tions drive managers toward ineffec- the manager has sizing skill. Alterna- than US$800 billion in assets, here tive sell practices. Common behav- tively, if the actual portfolio underper- are a few of the lessons learned about ioral biases seen within sell disciplines forms the adjusted portfolio, it suggests what’s really going on in actively man- are selling winners prematurely (risk that sizing skill is weak or at least insuf- aged portfolios. aversion), capitulating with losers and ficient to beat the passive rule. SKILL EXISTS. The majority of under- selling them prior to rebound (avoid- This form of analysis also can be performance is attributable to large skill ance of pain), holding winners too long used to understand more granular skills asymmetries and not the total lack of (endowment effect), and sometimes and to identify behavioral tendencies. skill, as is commonly thought. Manag- holding losers far too long (loss aver- Suppose a manager is interested in ers often generate 100 bps or more of sion, which is observed in less than 5% seeing if she engages in regret aver- excess return with one skill (i.e., buys, of portfolios). sion (the tendency to keep “younger” sells, sizing) only to give that much SELLING SUCCESS. Despite industry winners undersized). This behav- and more back with one or two weak folklore to the contrary, you don’t have ioral tendency will also show up as skills. These managers can start moving to be a great buyer to outperform. With a weak sizing skill. The new frame- toward their benchmarks by building rigorous analysis, managers realize work starts with the manager’s actual on their positive skills and retooling that, although their buying is simply portfolio and constructs an adjusted skills that need help. fair or even subpar, their brilliance at portfolio wherein only certain posi- NOBODY’S PERFECT. Even highly suc- selling (and sizing) is what allows them tions are adjusted, specifically those cessful managers (those above their to beat their benchmark regularly. Self- that are relatively new in the portfo- benchmark regularly) typically have awareness of this kind, which is fact lio and that have an unrealized gain. one skill that is negative and dragging based and correct, allows managers to Once identified, these younger win- down performance. Traditional ana- do more of what is working and retool ners are increased to a target weight lytics obscure such weaknesses, keep- other skills as appropriate. that reflects the manager’s typical full ing managers in the dark about what position size. No adjustment is made if is working and what is not. Reversing THE CHOICE: LUCK OR SKILL? such a younger winner is already at or these hidden shortcomings is among Active equity management is under above this target weight. Once again, the surest sources of incremental alpha siege. Profitable survival is going to the daily returns and overall perfor- for any portfolio. require that you become a manager mance of the actual and adjusted port- with demonstrable skill, that you have folios are computed and compared. If BEHAVIORS ABOUND. Evidence shows a process that is clear and reliable, and the adjusted portfolio outperforms the that 85% of portfolios exhibit at least one that you work regularly at becoming actual portfolio, younger winners are behavioral tendency that is persistent better and better at your job. If you pos- probably being undersized. Further over long periods of time, costing the sess these traits, you will be the kind investigation is required to identify how portfolio in excess of 100 bps annually. of manager whom search consultants persistent this behavior is and whether TROUBLING WINNERS. Although hold- and capital sources are longing to meet. corrective action is warranted. ing on to losers (loss aversion) plagues Your ticket to success is learning to Portfolio managers who use this retail investors, professional investors improve deliberately by using exact- framework are becoming more self- are more likely to be tripped up by win- ing measurement like that provided aware, learning about their real ners. The endowment effect (holding through the new framework I have strengths and shortcomings, and (most winners far past their alpha-generat- described. The choice is yours: You can importantly) implementing improve- ing ability) is seen in one out of every begin to improve deliberately starting ment efforts that are delivering stron- four professionally managed portfolios. right now with rigorous and granular ger and more consistent results. A Regret aversion (the inadequate build- investigations into your skills, or you more complete description of the new ing up of winners) is found in one out can hope that luck will offset whatever framework and how it can be used to of six portfolios. skill you lack. help you start improving deliberately THE WRONG SIZE. Sizing is often the today is provided in my book Man- Michael A. Ervolini is the CEO of Cabot Research least rigorously developed skill, com- LLC based in Boston and the author of Manag- aging Equity Portfolios: A Behavioral monly reflecting hunches or rules-of- ing Equity Portfolios: A Behavioral Approach to Approach to Improving Skills and Invest- thumb learned from early mentors. Improving Skills and Investment Processes (forth- coming from MIT Press in November). ment Processes. More than half of studied managers possess a negative sizing skill, and it

Nov/Dec 2014 CFA Institute Magazine 15 VIEWPOINT LETTERS

A WARNING ABOUT CAP AND TRADE? “None of the carbon markets are If you cut off our hind legs, we will crawl Richard Sandor whistles a familiar tune generating much abatement in the short on our stumps and bite you. You will have (“The Rise of Environmental Markets,” term and it is currently questionable to drag us along, with our jaws clasped September/October 2014). He would have if they send the right signal for long- firmly around your ankles.” us believe the fiction that cap-and-trade term investments,” says senior analyst We’ve been warned. programs are reducing greenhouse gas Hege Fjellheim at Thomson Reuters Point William D’Alessandro emissions significantly. Carbon (“Strong Paris deal needed to Editor, Crosslands Bulletin Sandor’s Chicago Climate Exchange make carbon pricing work—analysts,” (CCX) closed its trading desk in 2010. The Responding to Climate Change blog AN OUT-OF-THE-BOX THINKER private club of blue-chip companies was [www.rtcc.org], 24 September 2014). The interview with Thomas Howard (“The forced to accept the facts. Their lobbying Lack of ambition also marked the US Next Paradigm,” September/October) was efforts on Capitol Hill would not pay off in acid rain cap-and-trade program, which one of the more interesting and thought- valuable emission allowances. The body Sandor touts. Sulfur dioxide emission provoking articles I’ve read in quite a while. politic was in no mood to legally sanction levels were set so low no coal-fired power Howard is truly an out-of-the-box thinker. a scheme where those who make the plant had to install scrubbers. Cheaper I found especially interesting his assertion rules win the game. low-sulfur coal was already en route to the that the Prudent Man Rule is “a legalizing So Sandor is betting on regional cap- trouble spots by rail from western mines. of the cult of emotion.” I didn’t agree with and-trade programs. Independent market Alas, cap-and-traders never quit. everything he said, but I certainly enjoyed analysts are skeptical. Existing carbon According to his own book Good Deriva- reading about his unusual viewpoint. pricing initiatives are too modest in their tives, Sandor described CCX to the mul- Jay A. Yoder, CFA current climate reduction targets to drive tinationals he was wooing as being “like Richmond, Virginia a meaningful transition to low-carbon a Doberman Pinscher. If you cut off our technologies. front legs, we will walk on our hind legs.

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16 CFABus_dev_CFAmag_halfpg.indd Institute Magazine Nov/Dec 1 2014 10/1/14 3:45 PM Using ESG Factors for Equity Valuation

By Jeroen Bos, CFA

In the article “Integrating ESG Factors in could be seen as double counting, lead- earnings or price/book multiples, one the Investment Process” (January/Feb- ing to an unrealistically low fair value can integrate ESG factors by adjusting ruary 2014), I discussed the key drivers for the company. Integrating ESG fac- the target multiple. Simply add a pre- of the growing importance of integrat- tors by adjusting the discount rate only mium to the target multiple for coming environmental, social, and gover- works properly if ESG factors are dif- panies that do well on ESG and apply a nance (ESG) factors in your investment ficult to translate into financials, such discount to the target multiple for com- process. This trend is likely to continue as some governance factors, and have panies that score poorly on this front. in the coming years because ESG inte- not yet been reflected through more or These methods have the same issues gration in the mainstream investment less volatile stock prices. as the adjustment of the discount rate process provides a clear opportunity to A better way of integrating ESG fac- (arbitrary level of adjustment and risk optimize the risk–return characteris- tors in the DCF is by adjusting the future of double counting). With this way of tics of your portfolio. From a practitio- cash flows of a company. For exam- integration, however, at least an attempt ner’s perspective, one of the key chal- ple, think about the BP oil spill in the is made to integrate ESG factors so lenges is how to integrate these factors Gulf of Mexico in 2010. Not only did they are not completely absent from in a company’s valuation, an interest- the spill result in fines for the compa- the company’s valuation and investing area that is still in development. nies involved, but it also led to disrup- ment conclusion. Today, investors are still using several tion of production and operations and Often, trying to translate ESG fac- different ways of applying ESG factors stricter (hence more expensive) safety tors into future cash flows with a high in company valuations. measures in the years thereafter. All of degree of conviction is difficult. For Let’s begin by focusing on one of these impacts have an effect on future this reason, analysts also need to look the traditional valuation methods, the cash flows that can and should be inte- at the sensitivities of the ESG factors to discounted cash flow (DCF). One of grated in the DCF. The same could be the overall valuation and consider dif- the ways to include ESG is by adjust- argued when it comes to the apparel ferent scenarios. These steps will help ing the discount rate. Thus, compa- factory collapse in Bangladesh in 2013, the investor gain better insights into nies that score poorly on ESG metrics which will likely drive costs higher the materiality and potential impact will have a higher risk profile on aver- for some of the consumer companies of ESG factors on the overall valuation. age, and for such companies, one could going forward (increasing supply chain For example, for companies that have argue for using a higher discount rate costs through better safety standards a more binary ESG risk, one could look (resulting in a lower valuation) in the and potentially higher wages). Another at a “business as usual” scenario and a DCF. The reverse holds true for com- clear example of how ESG factors can scenario in which the ESG issues mate- panies that score well when it comes drive future cash flows is the potential rialize. Both scenarios could be proba- to ESG metrics. impact of future water shortages on the bility weighted to come to a fair value Although this method of ESG inte- operations and profitability of mining for the company. gration is being used frequently in the companies in certain regions. The momentum in favor of ESG inte- sector, it does have two challenges. The key advantage of this method gration has increased substantially in The first difficulty is the magnitude is that it forces the investor to trans- recent years, a trend that is likely to of adjustment. Should one adjust the late the company’s ESG factors into continue in the years to come. In prac- discount rate by 25 bps, 50 bps, or future cash flows and thus to focus on tice, ESG factors can be integrated in maybe even 150 bps? Because research the relevant material issues. That said, a company’s valuation in several dif- in this field is still very limited, with it is understandably difficult to esti- ferent ways, with the translation into no clear conclusions yet, the magni- mate cash flow impact on low-proba- future cash flow having the advan- tude of adjustment remains an arbi- bility, high-impact events, such as an tage that it provides the most insights trary decision. The second problem is oil spill, or to try to assign monetary and clarity for investors. The discus- the risk of double counting. If a com- value to ESG factors for which there is sion on this topic is ongoing, and the pany has a higher risk profile as a con- no market, such as governance factors. field is still evolving. Consensus about sequence of relatively poor ESG factors Still, this way of integration provides a the best practice for using ESG factors and this risk is already widely known much better starting point for discus- remains a work in progress. in the market, one could argue that sion because the assumptions used are Jeroen Bos, CFA, is the head of global equity it is already reflected in its discount clearer than those made in the discount research at ING Investment Management and rate (through a higher company beta, rate adjustment. a member of the board of directors of the CFA Society Netherlands. assuming that the capital asset pricing In addition to DCF, a widely used and model holds). In such a case, adjusting popular way to value companies is mul- the discount rate again for ESG factors tiple analysis. When looking at price/

Nov/Dec 2014 CFA Institute Magazine 17 VIEWPOINT

Marks of Distinction OVERLOOKED SKILLS CAN HELP AN INVESTMENT MANAGER STAND OUT FROM THE CROWD

By Jason Voss, CFA

Some of the skills most investment are likely to be out of accord with your share price. Unfortunately, I could not managers look for are obvious, such as innate talents. For example, if you objec- wait to make an imprint on the fund I a love and vast knowledge of econom- tively perform best when your adren- was promoted to co-manage. Engaging ics, business, and finance; high drive; aline is coursing through your veins in meditation ahead of time would have confidence; and persistence. You prob- and critical decisions need to be made prevented the loss of capital endured ably recognize these skills as necessary immediately, then it makes little sense by the fund’s shareholders. because they permeate the mythology for you to deploy tools like deliberate of the investment business. Yet many financial statement analysis and dis- CREATIVITY of the critical skills needed for a suc- counted cash flow analysis. Perhaps One of the questions I used to ask aspir- cessful investment management career the better match for your tool kit is a ing investor candidates was, “What do are not taught in business schools, dis- piece of software that helps you comb you do that is creative?” In all of my cussed in the business press, or under- Twitter for actionable information. It years of asking this question, I only ever stood by most firms doing the hiring. should be obvious that knowing this got two coherent answers. One was so Having hired research analyst about yourself would mean you likely superior that I insisted on hiring the interns, research analysts, a portfolio want to work on a trading desk rather candidate on the spot. manager, and even my own successor than a value investment shop. Why is the answer to this question when I retired from investment man- REMEDY. Take up practicing medita- so important? There are two reasons. agement in 2005, I have gained a fair tion or mindfulness. When you start First, it measures whether or not you amount of knowledge about which skills practicing meditation, you are gain- know how your mind works, and two, separate you as an investment man- ing a skill set that humanity has found it reveals whether or not you are con- ager. Distinctive skills include such useful for more than 3,000 years to get scious about using your entire mind to attributes as introspection, creativ- to know yourself. think and to solve problems. ity, intuition, decisiveness, absolute APPLICATION. My very first purchase as In reality, every time we cross the versus relative decision making, and a portfolio manager was International street we are taking in lots of data discernment. If you would like to sep- Rectifier (IRF). As a research analyst, I about the situation and inventing an arate yourself from the crowd of highly spent months trying to understand and on-the-spot solution to the various fac- motivated and highly intelligent candi- model this company, and I bought its tors at play: icy road, fast-moving traffic, dates, try adding these to your arsenal shares shortly after my promotion to number of lanes to cross, your health, of skills. In the first part of this series, the role of portfolio manager from ana- your footwear, and so forth. The solu- I will focus on the first three: introspec- lyst. My model suggested fair value for tion is a creative solution. People are tion, creativity, and intuition. the company was $45 conservatively. using their creativity all the time to The market price at the time was right solve problems, but most have zero INTROSPECTION around $45. International Rectifier pro- awareness of how they think. If you do not have self-knowledge about ceeded to trade far down from my esti- Many people who are conscious yourself, you cannot know which of mate of fair value. of creativity as a part of their mental your weaknesses need to be addressed Not until I engaged in careful intro- framework still get it wrong because with personal forgiveness, thoughtful- spection did I realize that I had ignored they have made an archetype of creativ- ness, a well-crafted plan, and discipline. my preferred rule of buying only a stock ity, meaning that they define creative Consequently, you are doomed to repeat in which there was a margin of safety things as drawing, painting, sculpting, your mistakes over and over. Few fund (i.e., a current price at least 15% below or playing music. But a true creative management firms have patience for my fair value estimate) in a company’s practice is just being aware that you damaging mistakes being repeated. In are creative and doing things to culti- fact, my personal goal during my career This article is adapted from an ongoing series of vate that part of your mental apparatus. was never to repeat the same mistake posts being published on the Enterprising Investor REMEDY. Gaining creativity has two blog. To date, installments of the “Skills That twice. Although I made many mistakes Separate You as an Investment Manager” series major accelerants. First, constantly be in my investment career, I only repeated have addressed such topics as introspection (April), aware of your boundaries and your one of my mistakes. creativity (May), intuition (June), decisiveness firm’s boundaries. Creativity is about (July), and absolute versus relative decision making Furthermore, if you do not know (August). All posts in the series are available at pushing past boundaries into new terri- yourself, then your intellectual tools blogs.cfainstitute.org/investor. tory—doing what no one else is doing.

18 CFA Institute Magazine Nov/Dec 2014 If you do what you have always done, INTUITION Maurice Dirac as scientists who expe- then you will get what you have always I think Daniel Kahneman sets intu- rienced immediate apprehensions and gotten. Second, creativity is about ition up as a straw man for his behav- flashes of noninferential knowledge that awareness. The remedy has two parts: ioral economics theories. In his well- advanced science in meaningful ways. meditating and challenging orthodoxy received book Thinking, Fast and Slow, These flashes of brilliance stand in stark by taking mental leaps of faith. of which I am a fan, he associates intu- contrast to both System 1 and System APPLICATION. Creativity is such a gen- ition with “System 1” thinking, which 2 thinking as depicted by Kahneman. eralized skill that it can be deployed in he calls “fast thinking,” characterized My book The Intuitive Investor almost any situation. The most obvious by snap assessments of situations, sub- describes intuition as tuning into the application, however, is in generating conscious thinking, and thoughts pro- cosmic radio station. Using similar lan- new investment ideas. After all, to out- cessed in the brain’s amygdala. Kahn- guage, Derman says of intuition, “The perform your investment management eman holds up “System 2” thinking observer becomes so close to the object competition, you must be doing some- as the opposite. It is “slow thinking,” (or person) observed that he begins thing that they are not doing. Creativ- characterized by deep analysis and pro- to experience their existence from ity is the skill that helps you to iden- cessed in the prefrontal cortex. both outside and inside them. Intu- tify what no one else is doing. I submit, however, that he associ- ition is a merging of the observer with In my investment management ates the wrong word with System 1 the observed.” In both cases, intuition career, I developed an important thesis thinking. It should not be intuition but requires deliberation, despite the ultimate “eureka moment.” But why is any of this important to investment management? One of the conditions of intuitive TO OUTPERFORM YOUR INVESTMENT MANAGEMENT insight is an unbiased, unattached mind—one free from the preferences, COMPETITION, YOU MUST BE DOING SOMETHING THAT prejudices, and emotional constraints associated with the amygdala. It turns THEY ARE NOT DOING. CREATIVITY IS THE SKILL THAT out that the ability to apprehend, com- prehend, and resonate with the truth HELPS YOU TO IDENTIFY WHAT NO ONE ELSE IS DOING. of the universe as closely as possible is exactly the discounting process that every analyst is charged with fulfilling. REMEDY. The key to developing intuition is stripping away autonomic emotional responses and attuning oneself early on: a sneaky way to inexpensively instinct that is Kahneman’s descrip- to a state of no-mind. Again, these are own the technology boom. Via my cre- tor for System 1 thinking. In fact, the the very fruits of healthy introspection ativity practice, I recognized technol- Oxford English Dictionary (OED) defines and mindfulness/meditation practice. ogy as both a breadth and a depth story. intuition as “direct perception of truth, APPLICATION. Intuition is a skill with That is, more and more people globally fact, etc., independent of any reason- endless applications. It was my intu- would be buying technological gadgets ing process; immediate apprehension.” ition that led me to publicly call the 9 and more and more gadgets would ben- An alternative definition, also from March 2009 S&P 500 market low on efit from new technology (such as refrig- the OED, is “pure, untaught, nonin- 12 March 2009. Using meditation, I felt erators, toothbrushes, and so forth). ferential knowledge.” Note the terms that most market participants were no Unfortunately, it was almost impos- “apprehension” and “noninferential longer anxious to the point of nausea sible to buy the technology leaders at knowledge,” which suggest a flash of and instead were exhausted and spent. discounted prices. But through cre- brilliance, not a gut-level response. This was at a time of high emotional ativity I recognized that all of these Dictionaries are not the only author- paranoia and forecasts of the end times. devices required electricity and that ities that view intuition differently from But using the power of intuition, I was electricity was also therefore a depth the way Kahneman views it. In a 2013 able to strip away the autonomic emo- and breadth story. This insight led me presentation at the Battle of the Quants, tional responses of the amygdala and to look for a global power company so Emanuel Derman, widely considered see the world differently, enabling me I could capture the upside benefits of the grandfather of quantitative finance, to make a very different call from many technological growth but experience pointed out that the foundations of other market participants. the growth through a very stable, estab- science itself are the result of intui- Jason Voss, CFA, a former mutual fund manager, lished business. As a result of creativity, tive processes. He specifically pointed is a content director at CFA Institute. I purchased shares in AES Corporation to Johannes Kepler, Sir Isaac Newton, (AES)—a decision that was among the André-Marie Ampère, James Clerk Max- best I made as an investment manager. well, Albert Einstein, and Paul Adrien

Nov/Dec 2014 CFA Institute Magazine 19 PROFESSIONAL PRACTICE PORTFOLIO PERFORMANCE

“A Start of Something Big”? NEW REFORMS AIM TO BOOST CHINA’S HEDGE FUND SECTOR

By Leonora Walet

China’s move to deregulate its alternative asset manage- This performance came in a year when the Shanghai stock ment industry is paying off—both for fund managers court- market contracted nearly 7% in value and was among the ing the country’s wealthy potential clients and for investors worst-performing markets in the world. seeking to diversify their holdings. Even with such recent success among hedge funds, the In the year since the opening of the industry, the Asset reforms have a long way to go in transforming China into a Management Association of China (AMAC) has registered major asset management hub. “There are still many uncer- about 3,563 private fund managers. Collectively, these tainties in the onshore management sector in China. We need managers run 5,232 funds much more clarification from the CSRC [China Securities with assets totaling RMB1.98 Regulatory Commission] and the tax authority about what New initiatives are generat- trillion (US$322.3 billion). hedge funds are allowed to do,” says David Walter, the Sin- ing optimism about China’s Thousands more licensing gapore-based director of US-based fund-of-funds manager evolving hedge fund sector. applications are in the works, Pacific Alternative Asset Management Company (PAAMCO). according to AMAC, which “The currency capital account [situation in China] isn’t In 2013, some hedge funds is the self-regulatory body helping,” adds Walter, who predicts the asset management KEY POINTS in China achieved supe- established to oversee the business in China will evolve in tandem with the opening rior returns, despite a major alternative asset industry on up of China’s broader capital markets. downturn in the Shanghai the mainland. Global institutions and international fund managers, stock market. China’s liberalization of however, are keeping tabs on the developments in the Such developments are its asset management market industry. They see these funds as a potential way to gain attracting foreign investors enables it to breed one of access to more than 2,500 companies listed on the main- and international funds, the world’s most vibrant pri- land. Traditional hedge funds that run Chinese strategies with hedge fund assets vate fund management busi- outside China are sometimes limited to trading only 160 projected to grow rapidly nesses, which could eventu- or so Chinese firms listed in Hong Kong, the United States, in China. ally account for a large chunk or the European Union. of the US$70 trillion global fund management indus- STEPPING UP THE PACE try. Since the passage of the In a sign that domestic hedge funds are preparing for change, Securities Investment Fund Law in June 2013, more man- China is stepping up the pace of reforms in the sector. agers are opening their own securities trading accounts and In August 2014, the CSRC released new regulations running their own hedge fund platforms, abandoning the for private funds, marking a continuation of the regula- traditional structure of managing assets through govern- tor’s efforts to shape the legislation for the asset management-backed trust funds. ment sector. High-net-worth individuals are defined to be “The regulation is geared for Chinese local managers that owners of assets of at least RMB3 million, earning half a want to do business locally or go overseas. The registration million yuan a year, according to CSRC guidelines. Institu- lends more credibility for these fund managers, especially tional investors, except social security funds or company when they do business with international investors,” says pension funds, are expected to have net assets of at least Joseph Zeng, CFA, partner at Greenwoods Asset Manage- RMB10 million. The minimum investment they can make ment, which manages more than US$4 billion in assets. in a single fund is a million yuan. Given the pace of wealth creation in China, the development was good news for the country’s high-net-worth inves- A FLURRY OF INITIATIVES TO OPEN tors and family offices. The lack of investment options has long been a challenge in the development of China’s capital UP THE INDUSTRY IS ATTRACTING THE markets, with choices for Chinese investors limited to bank ATTENTION OF A NUMBER OF FOREIGN savings, stocks, bonds, and property. Regulated hedge funds will give these investors easier access to new products and INVESTORS AND INTERNATIONAL FUNDS, instruments and a chance to further diversify their portfolios. EVEN AS MANY OF THEM REMAIN In 2013, hedge funds in China achieved some of the best returns in the world, with the average hedge fund gaining SKEPTICAL ABOUT THE CHANGES. more than 19%, according to research firm Eurekahedge.

20 CFA Institute Magazine Nov/Dec 2014 and yuan convertibility within the zone, which is expected CHINA’S MOVE TO REFORM ITS STATE- to make headway in market innovations, including commodi- OWNED ENTERPRISES COULD ALSO LEAD ties trading, another area in which hedge funds could thrive. China’s move to reform its state-owned enterprises could TO A MORE ROBUST ASSET MANAGEMENT also lead to a more robust asset management industry as more INDUSTRY AS MORE STATE-OWNED state-owned firms privatize their assets, fueling increased activity in markets, according to Zeng. FIRMS PRIVATIZE THEIR ASSETS. Another potential catalyst is the cross-market stock investment scheme called Shanghai–Hong Kong Stock Con- nect—a program (also called “the through train”) that is The new rules also clarified the roles and activities of predicted to supersede a policy granting foreign investors participants in the hedge fund market and allowed individ- quotas under the QFII (Qualified Foreign Institutional Inves- uals to register with AMAC as private fund managers. Nota- tor) program. QFII allows foreign-registered funds access bly, China’s guidelines for the industry do not impose any to stocks in Shanghai and Shenzhen. restriction on the foreign shareholding of a private fund, The cross-market investment scheme was set for imple- whether structured as a company or a partnership. mentation beginning in October 2014. “Right now, it’s not “This may further pave the way for foreign fund man- easy to get a QFII quota,” says Zeng. “The through train, agers’ entry into the China market through private fund- however, will give all international investors access to the raising,” says Natasha Xie, a partner at Beijing-based Jun A-share market, which means if they have the A-share invest- He Law Offices. ment skills and track record, they can launch a fund in an “We believe this development [the new CSRC regulation] offshore jurisdiction like Cayman or Hong Kong, raise cap- is the start of a clearer and more streamlined regulatory ital in US dollars, and invest in the A-share market.” (For framework for private fund managers in China.” more details on the Shanghai–Hong Kong Stock Connect A flurry of initiatives to open up the industry is attracting program, see the feature article “Shanghai Express” on the attention of a number of foreign investors and interna- page 32 in this issue.) tional funds, even as many of them remain skeptical about the changes. “The importance of having a business pres- ONGOING EVOLUTION ence in China at this time of change can’t be overstated, Domestic hedge funds themselves are evolving. The indus- given the huge potential of its markets,” says Xie. Hedge try has seen more fund launches employing a diverse set of fund assets could hit more than US$100 billion in less than strategies over the past 12 months. Until recently, China’s a decade, according to industry veterans. hedge funds have predominantly used equity-focused and A trend in the space for international funds seeking a long-only strategies. Shorting tools are limited in the main- presence in the mainland is to enter the market as advis- land, and most portfolio managers who came from long- ers to local funds. only public equity funds have limited exposure to manag- “They can’t advise Chinese investors directly,” says Xie, ing other strategies. “but they can become advisers to local managers, employ Recent hedge fund launches have offered more variety their own strategies, and test if they work.” of strategies, including quantitative, arbitrage, and multi- strategy approaches. Technological innovation that allowed NEW CATALYSTS automation and made high-frequency trading possible in Several other initiatives are being implemented to further China has led to the proliferation of these strategies, accord- engage foreign and local hedge fund managers. ing to industry experts. Under the Shanghai Pilot Free-Trade Zone, which is For now, many local managers are doing well, and institu- broadly seen as a template for future capital reforms in tional investors are taking notice of returns, giving a boost to China, registered funds are allowed the overall local hedge fund indus- to raise up to $300 million in invest- KEEP GOING try. The increased pace of reforms ment capital by setting up ven- is adding to the optimism over the tures in the zone covering 28 square “Shanghai Express,” CFA Institute Magazine sector’s growth. kilometers. (November/December 2014) [see page 32 in “The new regulations and some this issue] Hedge funds are also allowed to of the fresh catalysts, including the raise funds in yuan on the main- “Asia or the West: Who Will Dominate the 21st Hong Kong–Shanghai through train Century?” CFA Institute Take 15 series (17 April land for investment overseas. Inter- 2014) [www.cfawebcasts.org] and the state-owned enterprises national companies, such as the reforms, will have a huge impact on “China and Its Financial System: What Could Go Man Group, Winton Capital Man- Wrong?” CFA Institute Conference Proceedings the industry and on China’s A-share agement, and Och-Ziff Capital Man- Quarterly (September 2013) [www.cfapubs.org] market,” says Zeng. “This can be a agement, have established their “The Case for Financial Sector Liberalization in start of something big.” presence there. China,” CFA Institute Magazine (November/Decem- Leonora Walet is a financial writer based On a broader scale, Shanghai ber 2013) [www.cfapubs.org] in Hong Kong. will test interest rate liberalization

Nov/Dec 2014 CFA Institute Magazine 21 PROFESSIONAL PRACTICE TRADING TACTICS

Pipe Dream ACCESS TO MULTIPLE PLATFORMS VIA ONE INTEGRATED PIPE COMES WITH TRADEOFFS

By Sherree DeCovny

So far, 21 swap execution facilities (SEFs) have registered Boston Consulting Group. “When you’re trying to make a with the US Commodity Futures Trading Commission (CFTC). decision between a broad variety of players and you’re over- Among them are multi-dealer platforms, inter-dealer bro- whelmed with compliance and operational burdens as a result kers, exchanges, and new entrants. Each one specializes in of the Dodd–Frank Act, you tend to go for what you know.” one or more specific asset classes. They have different rule Over time, firms will likely want to connect to other books and user agreements, and the technology for con- SEFs. If they go through an aggregation service, all they necting to them varies. Market participants are still adjust- will need to do is select the platforms on which they want ing to the new market struc- to participate, find the best price, and execute orders. They ture, but many believe aggre- must abide by the core principles of the SEF, but the aggre- Connecting to a swap gation services could be a gator handles the requirements associated with being a execution facility (SEF) cost-effective way to navi- direct member, including trade reporting and other com- independently could cost gate the complexity. pliance obligations. up to US$1 million per asset Connecting to a SEF is SEF aggregation has some clear benefits. It allows firms to class in development, expensive, explains Sonia take advantage of one integrated pipe, including the front-end KEY POINTS maintenance, and integra- Goklani, CEO of Cleartrack. application and the application programming interface, which tion costs. It takes four or five develop- reduces infrastructure, connectivity, and operational costs. ers six months to complete It also facilitates trading in nonstandard products and voice With aggregation, firms can the project, and each devel- trades even if they are not mandated for SEF transmission. select the platforms, find oper costs from US$1,200 to “Regulations require swap participants to get at least three the best price, and execute US$1,300 per day. There are quotes, so they have to connect to three or four SEFs, and orders, thereby allowing the additional maintenance costs for a smaller buy-side firm, it’s not profitable,” says Goklani. aggregator to handle the because an upgrade comes “In addition, the FCMs aren’t giving these firms a credit line. other requirements. out every three to six months. They have to go to somebody who can help them build the It is still unclear how aggre- In addition, the maintenance pipes and also be an introducing broker.” gation can be used to team must do integration compress and compact work when the SEF adds new THE RELATIONSHIP-BASED TRADING portfolios. products to the platform. Ulti- mately, trading connectivity WORKFLOW IS IN JEOPARDY AFTER to each SEF could cost nearly THE DODD–FRANK ACT. US$1 million per asset class. Mapping issues often arise. A buy-side firm might call a “fund” an “account,” but a bank might call an “account” Aggregation makes the most sense in circumstances a “fund” and a SEF might call it a “sub account.” Each SEF where a common instrument is supported by multiple mar- has a different reporting framework, with some reporting ketplaces that have resident liquidity available at all times. directly to the swaps data repositories (SDRs), some report- For example, the five-year plain-vanilla interest rate swap ing to the futures commission merchants (FCMs, which in is supported by multiple SEFs, and those liquidity pools can turn report to the SDRs), and others reporting through the be aggregated into a common stack so traders can visual- central counterparty clearinghouse (CCP) or derivatives ize the competitive rate for that instrument. clearing organization (DCO). For less-liquid, more-customized instruments, aggrega- To date, many participants have chosen to connect to tion does not necessarily reveal which SEF has the best rate the existing multi-dealer platforms, such as Bloomberg, for the transaction. Even so, it provides an opportunity to Tradeweb, and MarketAxess. If they are going to invest in do quantitative analysis to determine whether a rate that connectivity, they need to know that a platform displays is being shown is good or not. sufficient liquidity. Moreover, firms’ compliance units are “Aggregation at that point becomes more of a price-dis- more likely to approve institutions where a user agreement covery tool and a way to visualize requests that you might is already in place. be sending out to multiple venues,” says Tom Zikas, an inde- “All of these types of firms have different value proposi- pendent consultant and former CEO of SwapEx. “You need tions, and they all have different liquidity prospects,” says a place where you can easily see and analyze the responses Will Rhode, global head of capital markets research at the that you’re getting.”

22 CFA Institute Magazine Nov/Dec 2014 But it is not clear how aggregation can be leveraged to compress and compact portfolios. If an interest rate swap THE FORCIBLE ELECTRONIFICATION is traded and then the position is offset at a different rate, those two positions do not net off. Instead, they become OF THE COMPRESSION PROCESS ADDS individual contracts that live on the trader’s books and COMPLEXITY FOR INSTITUTIONAL records. Positions are held with an FCM at a specific clearinghouse, so a perfect reversal can be achieved only if the TRADERS AND HEDGE FUNDS. THEY WILL offsetting position is with the same FCM and clearinghouse. If the trader exits the transaction with another FCM or at HAVE TO FIND AN EFFICIENT PROCESS another clearinghouse, the position could still remain on its books and records. Currently, there is no legal frame- TO EXIT TRANSACTIONS AND COMPRESS work for give-ups in cleared over-the-counter swaps (unlike THEIR PORTFOLIOS. futures, which have an established precedent). Buy-side firms and dealers alike compress their portfolios periodically to avoid line-item proliferation. This exer- cise reduces operational risk because fewer line items need AGGREGATORS AND ALTERNATIVES to be monitored and there is less potential for error. More- A few banks that are implementing an agency model or over, it is an efficient mechanism for managing the initial that have single-dealer portals that offer one entry point margin and variation margin posted with the clearinghouse into multiple trading platforms are providing aggregation because there is one net position and one margin call. services. For example, UBS and Credit Suisse have offer- Traditionally, firms maintained relationships with several ings. How many others will jump on the bandwagon is dif- bulge-bracket banks. When the time came to clean up their ficult to determine. books and records, they would pay a fee to a bank to replace Previously, dealers traded as principals with their bilat- a risk-neutral collection of swaps with an equivalent. The eral counterparties, and they made money on the bid–offer bank would extract as much net present value from the deal spread. For some dealers, continuing this practice makes as possible without taking the risk of losing the customer. sense. Alternatively, a dealer can act as an agent and exe- The relationship-based trading workflow is in jeopardy cute an order on the client’s behalf in exchange for a fee. after the Dodd–Frank Act. As the remainder of the swaps Banks are trying to understand the value proposition of the curve becomes mandated as “Made Available for Trading” agency model and determine whether it would be profitable. in accordance with CFTC regulation, traders must effect “It’s not that banks have a view around whether they compression transactions electronically on a SEF. should offer aggregation or not offer aggregation,” says “There is logically not going to be resident liquidity for Rhode. “It’s really that they’re saying, ‘Why would I want to?’” that kind of proprietary bundle of swaps,” says Zikas. “You’re Some observers believe that smart order routers (SORs) going to have to go through a process of getting requests may be an alternative to aggregation. Participants in the equi- or leverage the innovation of SEFs that are creating mech- ties markets use this technology to whiz messages through anisms by which these portfolios can be uploaded and the pipes to find the best fill and hit the top of book. SORs shopped around to potential liquidity providers.” work well because the equities market is extremely frag- The forcible electronification of the compression process mented, the securities are highly liquid, and small orders adds complexity for institutional traders and hedge funds. are executed within milliseconds. They will have to find an efficient process to exit transac- But the SEFs are less fragmented, and they have different tions and compress their portfolios. Further, FCMs will likely trade protocols depending on the asset class. Some of the charge a fee for managing and maintaining swap positions instruments are bespoke and infrequently traded. Rhode that are mandated for clearing and held to maturity, so says it would have to be a pretty “smart” smart order router there will be a cost to not cleaning up books and records. to be effective, and he does not envision them being used Traders need to be mindful of that potential cost and com- in the short term. pare the carrying cost with the cost of exiting transactions. The swaps market may evolve slower than participants Traders can potentially leverage transaction cost analy- expected, but new opportunities will emerge once the new sis (TCA) tools to help them decide where to unwind their workflow is familiar and standardization increases. For portfolio. The cost inputs reflect the layers of explicit charges aggregators, that could mean adding functionality, such (including the cost of margin) from the SEF, CCP/DCO, FCM, as analytics on futures versus OTC contracts, TCA, margin or others, such as independent software vendors. simulation, and rules-based mechanisms to ensure individ- “Unless the trader is equipped with some way of assess- uals can trade only certain products on specific SEFs. For ing and applying those layers of now, the market is in an absorb- costs on a price or a rate that they’re KEEP GOING ing phase, making sure nothing receiving for a particular transac- goes wrong. tion, they could be at risk of making “SEF Awareness,” CFA Institute Magazine Sherree DeCovny is a freelance journal- the wrong decision,” warns Zikas. (January/February 2014) [www.cfapubs.org] ist specializing in finance and technology.

Nov/Dec 2014 CFA Institute Magazine 23 PROFESSIONAL PRACTICE PRIVATE CLIENT CORNER

Little Big Data CAN BIG DATA BENEFIT SMALLER PRIVATE WEALTH MANAGERS?

By Ed McCarthy

The potential business value of big data continues to grow. and maintained that the RIA was a satisfied customer. Two Advocates claim that many industries and businesses, includ- weeks later, the client called and implied that he was consid- ing wealth management, are just starting to tap into the ering leaving. “[The analysis] took an enormous amount of wealth of “actionable intelligence” that is available as the information that a human could not put together and ana- amount of data keeps growing. lyze quickly or efficiently and produced an output that was The usual definition ofbig data (BD) cites three common predicting what could happen,” McCarthy says. criteria known as the “three Vs.” In a May 2013 report, “Big Data in Wealth Management: The Search for Customer TOO MUCH TO HANDLE? Insight,” the consulting firm Large wealth management firms are the obvious beneficia- Celent “defines big data on ries of BD. For example, according to the Bank of America Big data-based analytics three dimensions (volume, Merrill Lynch website, the combined entity is the “largest continue to make inroads velocity, and variety), and brokerage in the world with more than 15,000 Financial among wealth managers. the process includes captur- Advisors and approximately $2.2 trillion in client assets.” ing and gathering data, ana- Add in the tens of millions of banking relationships, trans- Most independent advisory lytics, and visualization.” In actions, and points of customer contact, and the company KEY POINTS firms lack the resources addition, data can be struc- has an enormous amount of data available. to develop their own big tured (securities market data, Even larger RIA firms, with assets over $1 billion, proba- data projects and are turn- for instance) or unstructured, bly do not meet all three BD criteria. And the cost of devel- ing instead to third-party such as email content. oping BD analytics internally can be prohibitive. The Wall vendors. Street Journal recently reported that starting annual sala- Focusing on client relation- POTENTIAL BENEFITS ries for data scientists with just two years’ experience are ship management (CRM) Celent sees BD’s potential often in the $200,000 to $300,000 range. That figure does data is another option for benefits in the front, middle, not include ongoing data acquisition, storage, and platform gaining actionable insights. and back offices. Priority management expenses. areas include client relation- It isn’t that RIAs are not interested in BD but, rather, that ship management and trad- BD involves more than most independent wealth managing in the front office, with compliance, monitoring, and ers can take on, says William Trout, a senior analyst with risk management in the middle and back offices. The ben- Celent in Houston. Most of the smaller RIAs he speaks with efits also extend to the investment process, according to are focused on operations, compliance, and meeting client Celent: “Relationship managers, advisers, and traders are reporting needs. “And so, smaller firms haven’t really had using big data and analytics to help them discover, develop, the bandwidth to address the big data challenge, or—and, and test investment ideas and strategies. Increasingly, firms in part, related to that, I’d say—the inclination,” he says. want to capture more information from looking for corre- McCarthy agrees with that assessment. “Very few, if any, lations and investment opportunities across multiple asset RIAs are able to do that themselves,” he says. “They just classes and over longer time horizons. Big data helps firms don’t have the infrastructure or the technical sophistica- establish larger datasets, which enable users to run experi- tion. Even on the broker/dealer side, the core skill is more ments more quickly to uncover actionable investment ideas.” operational processing and light technology development. Tom McCarthy, senior vice president of IT product man- When you get into the data space, it gets into very large- agement at Fidelity Institutional in Smithfield, Rhode Island, scale database storage, sourcing of data. And most impor- cites an internal project as evidence of BD’s value. Each tantly, what are the intellectual algorithms you put on top registered investment adviser (RIA) affiliate works with a of that data to extract what you’re looking for?” client relationship manager at Fidelity. Client relationship managers were asked to rate the health of the 20 RIA rela- A SMALLER FOCUS tionships for which each manager was responsible. McCar- Some independent RIAs recognize these hurdles to imple- thy’s department then ran BD analytics on the unstruc- menting BD and are responding in two ways. The first is tured data these RIAs had provided in their contacts with to scale back and work on organizing and analyzing data Fidelity: phone calls, emails, service messages, and so on. that the firm generates as part of its business. Neesha Hathi, The analysis indicated that one of the RIAs was at risk for senior vice president of advisor services technology solu- leaving Fidelity. The client relationship manager disagreed tions at Charles Schwab in San Francisco, calls this the

24 CFA Institute Magazine Nov/Dec 2014 “little data” approach. It starts with a focus on customer have a net worth of $1 million plus, and we’re getting the relationship management (CRM) software. This CRM-cen- data from about 75 different disparate sources,” he says. tric data strategy results from the recognition that client “We’re pulling in all of this mass amount of information and relationships are a key value proposition for RIAs, says our technology allows us to map it in a sophisticated way.” Hathi. That understanding leads to using the CRM system WealthEngine’s analyses estimate wealth and income, as a centralized data repository. Once data are in the CRM but that’s just the first layer, Dean says. The reports can system, it becomes easier to preserve and share knowledge provide details on family information, marital status, eth- about clients as the firm grows and to extract intelligence nicity, employment, business ownership interests, and life- from the analyses. style, among other attributes. Mapping technology cross- That approach has been taken a step further by United references database entries so advisers can see the con- Capital Financial Advisers LLC in Newport Beach, Califor- nections among individuals and use that information for nia. Mike Capelle, senior vice president of platform tech- business development. He shares the hypothetical example nology, says that the firm has almost 50 offices nationwide, of an adviser who has a 6 handicap in golf, conducts busi- with slightly more than $10 billion in managed assets. The ness frequently on the golf course, and works with older firm centralizes its data in Salesforce.com’s CRM system, but lawyers looking to transition out of their practices. The the data collection goes beyond clients’ contact details to company’s FindWealth 8 service helps the adviser iden- include asset information and other client records. Although tify members of that cohort who also play golf. Armed United Capital is in the early stages of using its CRM system with that information, the adviser can attempt to connect for analytics, Capelle believes that consolidating it at Sales- with the prospects through a shared connection or market force.com is an essential first step. “We view Salesforce as directly to them. our integration layer, if you will, and that’s where we con- Analyzing economic and investment market data is solidate as much information as we can,” he says. another use for BD. Raj Udeshi, co-founder of HiddenLevers Such third-party vendors can work with a company’s in New York City, says the firm collects over 100 economic data. Hathi cites the example of a Schwab RIA affiliate who indicators—the “levers”—and prices for multiple securi- emailed clients a newsletter and started using a third-party ties, including stocks, exchange-traded funds, American application that linked to his Salesforce.com data. The appli- Depositary Receipts, mutual funds, currencies, fixed-income cation tracked each client’s interaction with the newsletter— instruments, and options. The firm’s website describes the how frequently the client opened an article, click-throughs analytic approach: “The HiddenLevers model is currently for more information, and so on—and fed the results back composed of two levels: a regression model that calculates to the adviser’s Salesforce.com platform. Those interactions the relationships between every economic lever and every alerted the adviser to topics that potentially concerned or asset, and an intelligent filtering process that separates interested the client. out correlation from causation within this large universe of regression data.” OUTSOURCING The analytics allow users to measure how different Third-party vendors, including custodians, are moving to macroeconomic scenarios—the Iran conflict, hyperinfla- fill RIAs’ BD needs. McCarthy cites as an example Fideli- tion, and so on—affect the different levers and how those ty’s internal efforts that will probably be offered eventually changes flow through to industries and specific securities. to institutional clients. A Fidelity retail adviser might work HiddenLevers integrates with numerous partners—includ- with several hundred clients, making it difficult to contin- ing Advent, Envestnet, Fidelity, and Pershing—so advisers uously monitor each client’s details. Predictive BD analysis can stress-test clients’ portfolios under different scenarios can help identify which clients are most likely to establish to identify risk exposures. retirement accounts, college savings plans, and so on. “There are control groups of reps who are actually using this pre- LOOKING AHEAD dictive analytic,” he says. “The closure rates and the new- Several sources noted that in their experience, using more product sales on the predictive analytics were much higher data has proven better than using less. But from a practi- [than for advisers not in the control group].” cal perspective, how will the new analytics fit into firms’ Several companies offer specialized analytics, cover- workflows? For instance, will advisers be forced to hire ing a range of business functions, on a subscription basis. additional specialized staff to review, distribute, and imple- Bethesda, Maryland–based Weal- ment an influx of analytic results? thEngine uses BD to identify pro- KEEP GOING As BD becomes more prevalent, spective wealth management cli- perhaps the next wave of hiring in ents. According to James Dean, “The Signal and the Noise: Making Sense of private wealth management will be senior vice president and head of Big Data,” CFA Institute Take 15 Series for data managers instead of addi- [www.cfawebcasts.org] the firm’s financial services prac- tional wealth managers. tice, the firm aggregates an enor- “The Devil’s in the Data,” CFA Institute Confer- ence Proceedings Quarterly (19 June 2014) Ed McCarthy is a financial writer in Pas- mous amount of data. “We have [www.cfapubs.org] coag, Rhode Island. over 230 million individuals in our database, about 15 million of them

Nov/Dec 2014 CFA Institute Magazine 25 PROFESSIONAL PRACTICE CAREER CONNECTION

The Disconnected, the Overloaded, and Beyond

By Lori Pizzani

Noteworthy findings about career and employment during 2014 came from a variety of sources and involved a wide ORGANIZATIONS WITH A HIGH range of topics. This article rounds up some of the stray LEVEL OF EMPLOYEE ENGAGEMENT items that might be of interest to investment professionals. Also, looking to 2015 and beyond, three experts were SAW A 22% HIGHER LEVEL asked to share their predictions for emerging trends that OF PRODUCTIVITY. will affect people working in the investment management industry over the next one to three years.

THE DISCONNECTED • Establish a social media policy and ensure that employees Higher employee engage- In February, the HR firm understand the guidelines. Social media, such as Facebook, ment (a less disconnected Randstad US released the can often absorb an hour or more of employees’ time each workforce) is associated results of its “Engagement day, so be sure they understand the rules and use their with significantly higher Study,” which found a discon- time productively. productivity, according to nect between what employees KEY POINTS • Provide employees with a defined career path. It’s important one recent study. want and what employers are for employees to know they are valued and are part of actually providing in terms of Multi-tasking is actually the company’s long-term business plan. promotions and bonuses, flex- counterproductive and ible work arrangements, com- reduces individual produc- THE OVERLOADED fortable but stimulating work tivity, and simple behavioral A January 2014 workplace trends report from Sodexo in environments, encouraging mistakes can damage pros- Gaithersburg, Maryland, based on a study of 488 employ- employees to share ideas pects for career success. ees (10% from the financial services industry), suggested and opinions, and investing ways to combat the technology and communication overload Within the next few years, in employee training, pro- that plagues many of today’s always-connected employees: according to one expert, fessional development, and • Stop multi-tasking. Successful multi-tasking doesn’t really demand for “breadth of continuing education. Rand- exist. Multi-tasking is actually a “shifting of attention” skills” will cause “a shift in stad’s chief HR officer, Jim between tasks that fosters mistakes and reduces produc- hiring demands and promo- Link, pointed out that orga- tivity. The better way is to eliminate tech distractions tion opportunities at invest- nizations with a high level of and focus on one task. ment management firms.” employee engagement saw a 22% higher level of produc- • Take short breaks. Energize your work by taking a one-min- tivity and that employers that ute break between tasks and a 10- or 15-minute break “get it right” will find they have a workforce committed to every few hours to recharge. both personal achievements and the overall mission. • Set boundaries. Reduce work–life conflict by establishing Randstad’s handful of recommendations to employers rules, such as turning off your cell phone during family for better employee engagement still apply: meals. • Foster a culture in which employees’ time away from the office • Manage expectations. Alert superiors and co-workers that is truly their time. The blurring of lines between work and you will not immediately respond to emails/texts after home—constant connectivity—does not necessarily equate a certain hour. to increased productivity. • Turn off and tune in. Train yourself by putting away your • Cultivate a more dynamic work force and determine the right cell phone and focusing on a single task, such as when cultural fit by asking less conventional questions during can- having a meal. didate interviews. Employers ranked a good cultural fit as • Break bad habits. Technology habits are formed through the most important factor after work ethic. repetition and become automatic. To break habits, try • Satisfy employees’ hunger to continue learning and enhancing simple steps, such as turning off your smartphone and skill sets through workweek training/development programs. minimizing open windows on your laptop. At least 40% of employees said that training and devel- • Recharge. Switch off work-related tasks and thoughts by opment are among the most important skills for grow- engaging in hobbies, community and sporting events, or ing careers. fitness activities and by focusing on important relationships.

26 CFA Institute Magazine Nov/Dec 2014 THE MISGUIDED Coming Soon: A Preview of Future Everyone makes mistakes, but according to Wall Street vet- Career and Industry Trends eran Ben Carpenter, 10 big mistakes in particular can sab- otage careers, as outlined in his book The Bigs: The Secrets “Within the next one to three years, investment managers Nobody Tells Students and Young Professionals About How will have no choice but to engage in increased risk taking to Find a Great Job, Do a Great Job, Start a Business, and while demonstrating a commitment to protecting inves- Live a Happy Life. These mistakes, and Carpenter’s advice, tors, as clients will expect outsized performance over an include the following: extended period. Analysts and portfolio managers will need to wear multiple hats and commit to risk management and • Succumbing to distractions. Don’t allow personal or pro- compliance as well as continuing education.” — Roy Cohen, fessional outside activities or responsibilities to get in the New York City career coach and author of The Wall Street Pro- way of doing your best work at your full-time job. fessional’s Survival Guide • Being too patient. If you work hard but feel invisible and your present employer cannot/will not give you the oppor- “A breadth of skills will be at a premium in a world driven by tunities you need to advance, find a new job. clients demanding more complex investment solutions that encompass a sophisticated set of asset/liability tools, not • Faking it. Don’t try to fake it till you make it if you don’t under- just specialized asset class relative performance. This trend stand something. Speak up and ask questions as needed. is already strong in the institutional separate account world • Being unresponsive. Always respond within 24 hours to and is moving into the retail universe. This will lead to a shift bosses, co-workers, and clients, even if it is only to say in hiring demands and promotion opportunities at invest- that you are working on the issue. ment management firms toward rewarding professionals • Not owning your mistakes. Always own up to your inevitable with a breadth of skills.” — George Wilbanks, founding partner mistakes and see them as chances to learn and improve. at Wilbanks Partners, an executive recruiting firm in Stam- • Griping about the job. Complaining to sympathetic co-work- ford, Connecticut ers is a no-no. If you must complain, do so to family and “Just as there is ‘price discovery,’ which allows firms to friends and raise tangible issues with your boss. determine a market price for an asset, the future will see • Getting embroiled in office drama. Don’t participate in and ‘value discovery,’ which will allow firms to determine a cus- don’t instigate office drama. Doing such things can lead tomized investor profile based upon individual investors’ to your downfall. attitudes, time horizons, wealth level, risk tolerance, knowl- • Badmouthing co-workers. Stay away from gossip. Nega- edge about investing, and what each wants to do with their tive comments about co-workers have a way of coming money. This will become as individualized as fingerprints or back to bite. the iris of your eye.” — Charles D. Ellis, CFA, chair of the White- head Institute board of directors, author of more than 17 • Putting your interests ahead of those of your company and books (including most recently, What It Takes: Seven Secrets boss. If you’re a rookie, prove you’re the team’s most valu- of Success from the World’s Greatest Professional Firms), and able player by putting your needs last. former managing partner of Greenwich Associates • Neglecting to network. Remember to keep networking (with higher-ups, bosses, people in other departments, and those outside the company) even after you have landed a job. Also in June, a report from CIBC World Markets in Toronto revealed that job stability in Canada is stronger than THE ROUTE TOO MUCH TRAVELED ever—despite earlier projections that in the “new economy,” The results of the “Emerging Work- employers would increasingly see force Study” (also conducted by the KEEP GOING employees as disposable and turn- Harris Poll for Spherion), released over would ratchet up. CIBC found in June 2014, showed that 61% “The Career Paths of Mutual Fund Managers: a 60% chance that Canadians will of the workers polled agreed that The Role of Merit,” Financial Analysts Journal stay with an employer after com- (July/August 2014) [www.cfapubs.org] “changing jobs every few years is pleting their first year, with a reten- usually damaging to a person’s long- “The Importance of Effective Leadership,” tion rate of nearly 95% for those CFA Institute webcast (22 May 2014) term career advancement,” up from [www.cfawebcasts.org] working five or more years at a 47% in a similar 2002 poll. A full company. Why the change? CIBC “Career Intentionality and Using Data to 70% of respondents agreed that Make Career Decisions,” CFA Institute webcast pointed to several factors, includ- their level of commitment to their (20 March 2014) [www.cfawebcasts.org] ing changing employer needs, rising employer depends on the likelihood “Networking and Relationship Building Skills job vacancy rates, and a sustained of long-term job security. Moreover, for Your Career,” CFA Institute webcast unemployment rate. (20 February 2014) [www.cfawebcasts.org] 83% of workers agreed that “loy- Lori Pizzani is an independent financial alty is being willing to stay with an “The Inefficient Frontier: Work–Life Balance,” and business journalist based in Brews- employer for the long haul,” a 12% CFA Institute Magazine (January/February 2014) ter, New York. [www.cfapubs.org] increase since 2002.

Nov/Dec 2014 CFA Institute Magazine 27 Financial crises are caused by cross-border investment flows, not misbehavior, says economist Robert Aliber

WITT H GO H FLE OW By Nathan Jaye, CFA

Financial crises are widely believed to be caused by greed, What’s the main storyline of your research? corruption, or lack of regulation. But what if the cause is We’ve seen four waves of banking crises in simply the variability of cross-border investment inflows? the past 30 years, all very similar. The first wave was in Mexico, Brazil, Argentina, and 10 That’s the model developed by Robert Aliber, professor other developing countries in the early 1980s. emeritus of international economics and finance at the Japan and several of the Nordic countries were University of Chicago Booth School of Business. Aliber, involved in the second wave in the early 1990s. editor and co-author with Charles P. Kindleberger of the The third wave was the Asian financial crisis in July 1997, and the fourth is what I call the 1978 classic Manias, Panics, and Crashes: A History of “Anglo-Saxon real estate crisis,” which became Financial Crises, predicted the Icelandic banking crisis apparent in September 2008. 18 months before it happened. In an interview with CFA Each country that experienced a banking Institute Magazine, Aliber offers a different view on the crisis previously had an economic boom and an increase in cross-border investment inflows, cause of financial crises, discusses why banking crises which led to increases in the prices of its secu- almost always coincide with currency crises, and explains rities and to an increase in the price of its cur- why cross-border investment flows should be moderated. rency—unless the increase was forestalled by central bank intervention. These cross-border investment inflows are too rapid to be sustained. Eventually, one or several of the lenders recognize that borrowers’ indebtedness is increasing too rapidly or that the borrowers’ indebtedness is too large relative to their incomes. When that happens, lenders become more cautious. Borrowers will not have enough cash to pay the interest. They become distress sellers of real estate and securities. The prices of real estate and securities decline, loan losses surge, and the country experiences a banking crisis. It’s also a currency crisis in that many of the borrowers default on their liabilities denominated in the foreign currency.

28 CFA Institute Magazine Nov/Dec 2014 How did you become aware of this pattern? calculated that the spreads between the interest rates they Gradually, over more than 10 years. I was visiting a class- could earn when they bought mortgages and the interest room at London Business School in April 2006. A young rates they had to pay when they sold their own IOUs were man from Iceland was there—he spoke about his coun- sufficiently large so that the loans would be very profitable. try’s economy and the soaring stock prices—and I had a In my model, these firms are channels for the distribution bizarre experience. I could complete all of his sentences, of credit. They compete fiercely for market share, but they even though I knew nothing about Iceland. He had a set of do not determine the supply of credit. facts, and I had a model. The two fit together quite nicely. The Washington policy establishment interpretation I went to Iceland in June 2007 and spoke with 10 or 12 cannot explain why the US banking crisis occurred in 2008 economists at the central bank, in the private banks, at the rather than in 1988 or in 1998. The character of Lehman University of Iceland. I was convinced there was a massive et al. did not change between 1988 and 2005; instead, the asset price problem. A few months later, I wrote a paper change was in the credit market conditions. The Washing- on Iceland, and I gave a lecture in Reykjavik in May 2008. ton policy establishment is unwilling to connect the dots I said they were sitting on a volcano of credit and it would that link their own policies with the subsequent banking soon implode. The price of the currency would fall, and the crisis. They want to ignore the relationship between the price of securities would fall sharply. Four months later, in monetary policy in 2003 and 2004, the surge in property September 2008, Iceland imploded. prices, and the subsequent bust. And they ignore the sim- ilarity of events in the United States with those in many How does your model explain the 2008 crisis other countries. in the United States? The monetary instability of the Beginning in 2003, cross-border investment flows to the last 30 years is unprecedented. The United States increased sharply. Foreigners were buying title of Chairman Greenspan’s book more US dollar-denominated securities; the Chinese trade is The Age of Turbulence. The book FLOW surplus had surged. China’s reserve managers bought sev- is in its second edition, but Green- eral hundred billion dollars of IOUs in Fannie Mae and Fred- span still has not been able to iden- die Mac, which enabled these institutions to buy more mort- tify the source of turbulence. gages and more mortgage-backed securities. At the same time, Fed Chairman [Alan] Greenspan fol- What are the sources lowed an extremely expansive monetary policy. Thus, the of credit flows? rapid increase in the domestic supply of credit complemented If we look at the 1982 crises, the the increase in the supply of credit to American borrowers credit inflows came from the major from the investment inflows. The United States had a mas- international banks that bought the Robert Aliber sive housing boom. If Chairman Greenspan had been less US dollar–denominated loans of expansive, the United States still would have had a housing the governments and government-owned firms in Mexico, boom and a subsequent crisis, but it would have occurred Brazil, and Argentina. The investment inflows that pre- later and might not have been as severe. ceded the banking crises in Norway, Sweden, and Finland Iceland, Ireland, Britain, and Spain had banking crises involved the sale of IOUs of the Nordic banks to banks in at the same time as the United States. Every banking crisis London and other foreign centers; the Nordic banks repa- is preceded by an excess supply of credit; the crisis occurs triated the money that they lent to commercial borrowers when credit market conditions suddenly tighten. and real estate developers, who acquired the currency risk.

How does your model differ from the dominant What factors determine supply of credit? interpretation of the 2008 crisis? Often, the increase in the cross-border investment inflows The dominant interpretation (the Washington-policy-estab- is stimulated by a boom in the economy of the country lishment consensus, including nearly everyone connected that experiences the investment inflow. At other times, the with the Federal Reserve) is that the US banking crisis was increase is a response to a relaxation of regulations that pre- the fault of lenders, such as Countrywide Financial, Lehman viously had limited cross-border investment flows, which Brothers, Bear Stearns, Washington Mutual, and several was the Nordic experience. hundred others, because they acquired too many “risky In the 1990s, Mexico was being prepared for adherence loans.” The public officials have been successful in creat- to the North American Free Trade Agreement, and the lib- ing the impression that the crisis would not have occurred eralization of economic regulations in Mexico was exten- if the private lenders had behaved responsibly. sive. Moreover, macroeconomic initiatives to reduce infla- But these crises are not caused by the misbehavior of tion (after several years when inflation was higher than the private sector lenders. If the credit is there, it has to 100%) led to extraordinarily high real interest rates on go someplace. Why does subprime become important? peso-denominated securities, which attracted money market Because there aren’t enough prime borrowers. The only mutual funds. American, Japanese, and European firms reason Countrywide and Washington Mutual went scroung- were investing in Mexico as a low-cost source of supply for ing for borrowers was because the credit was there. They the American market.

Nov/Dec 2014 CFA Institute Magazine 29 Does the boom cause the credit inflow, or vice versa? to its GDP, both domestically and externally. It was predict- Cross-border investment inflows contribute to the booms by able that when the lender stopped providing money in the elevating securities prices in the countries experiencing the form of the loans to the borrowers, some of the borrowers inflows; as household wealth increases, consumption spend- would default and the currency would collapse. ing increases. Higher levels of spending lead to increases When the krona collapsed, many of the IOUs of the Ice- in GDP growth rates and higher anticipated returns on the landic borrowers were denominated in foreign currencies. securities available in these countries, which attracts even For example, the Icelandic banks were helpful in enabling larger investment inflows. Some countries have had booms Icelandic households to borrow, to finance the purchase without increases in investment inflows, but investment of cars and homes with loans denominated in the Japa- inflows have almost always led to booms when currencies nese yen, the Swiss franc, the euro. When the price of Ice- have not been anchored to parities. landic krona fell very sharply, the krona equivalent of the liabilities denominated in the foreign currency increased in How do you distinguish between structural proportion to the decline in the price of the krona and many and monetary causes of shocks? of these borrowers were then bankrupt. In this way, the cur- One of the major arguments advanced in support of a move rency crisis intensifies the banking crisis. toward a floating exchange rate system in the 1950s and If the borrowers’ expenditures (exclusive of interest pay- 1960s was that economies would be better able to adjust ments) are larger than revenues, then it must follow that the to structural shocks. Structural shocks are oil price shocks, increase of indebtedness is larger than interest payments. bad harvest shocks, new discoveries of North Sea gas, etc. That’s an explosive relationship; it cannot continue. This Monetary shocks are largely (not exclusively) changes logic can be applied to a family, to a firm, and to a govern- in investor demand for securities dominated in the foreign ment. Indebtedness cannot grow more rapidly than interest currency, which immediately leads to a change in the price payments. It may for one, two, or several years, but indebt- of the country’s currency. The shocks in my narrative are edness cannot grow more rapidly than interest payments virtually all monetary shocks. for an extended period of time.

Are banking crises always associated Do you use an actual model? with currency crises? I count the cranes [for construction] in the urban landscape When I started looking at this, what struck me was that and whether they are moving or stationary. I look at the rela- banking crises and currency crises were twinned. There tion between rental rates of return and mortgage interest was a very strong overlap. I began to wonder, what was the rates. If rental rates are less than mortgage interest rates, relationship between them? Did one cause the other? Did a property prices are in bubble territory. Moreover, I look at banking crisis cause the currency crisis? the pattern of cash flows and the relationship between the Ninety percent of banking crises have been associated increase in the indebtedness of the borrowers and their with a currency crisis, and every currency crisis has been incomes and also the increase in the borrowers’ indebted- associated with a banking crisis. But I now realize these ness and the interest rates on their indebtedness. If some are not different crises. These are different manifestations of the borrowers have primary deficits and are dependent in different markets of reductions in investment inflows. on the increase in their indebtedness for some of the cash to pay interest on their loans, then I know that the borrow- Are you saying a banking crisis is predictable? ers are on a non-sustainable trajectory and that they will Yes. Banking crises are predictable—with uncertain dates. be obliged to reduce their consumption when the lenders Are earthquakes predictable? If you live along the San become more cautious. Andreas Fault or the Hayward Fault, earthquakes are pre- One question is when the lenders will realize that the dictable, but you can’t really predict the exact date when borrowers are on a non-sustainable trajectory. Another ques- one will occur. But I’ve predicted some of these crises, tion is whether the borrowers can adjust to the decline in including those in Iceland, Mexico in 1994, Thailand and their ability to increase their indebtedness and adhere to Malaysia in 1997, and Argentina in 2001. their debt-servicing commitments.

Is there a tipping point when a banking crisis What are the implications of your research? is inevitable? One set of implications is for investors: when to buy for- I fly small airplanes, and in one of my Walter Mitty moments, eign stocks and bonds and when to sell domestic stocks and I imagine that I’m at Roosevelt Field in 1927 advising Charles bonds. Investment practitioners should follow the money Lindbergh. I say, “Charlie, when you cross the 19th merid- and momentum strategies; increases in prices of securities ian, you can’t turn back. The winds will be against you, are correlated with increases in the prices of currencies. and you won’t have enough fuel.” That’s the concept of “the And they should always ask, “How long can the borrowers point of no return,” which can be modified to “the date of no continue to have a primary deficit?” return.” What is the date after which a crisis is inevitable? The second set of implications is for domestic financial In the Icelandic case, Iceland had a massive capital account regulations: whether bank capital requirements should be surplus after 2005. It had a very high level of debt relative high or low, whether banks need living wills, and whether

30 CFA Institute Magazine Nov/Dec 2014 large banks are too big to fail. The current stance of bank WHY DO WE HAVE SO MANY regulation increases the costs that banks (and hence both borrowers and depositors) incur. BANKING CRISES? THE The third set of implications is for central banks and INTERNATIONAL MONETARY the management of monetary policy. Many central banks, including the Federal Reserve, operate as if they were in FUND (IMF) PRESIDES a windowless silo. They ignore the impacts of changes in OVER A DYSFUNCTIONAL cross-border investment inflows on the prices of securities, household wealth, and consumption spending. FINANCIAL ARRANGEMENT. The fourth set of implications involves the design of the international financial arrangement for resolving imbal- ances in payments among countries. Why do we have so many banking crises? The International Monetary Fund to my account at LaSalle Bank in Chicago.” I had to pay a (IMF) presides over a dysfunctional financial arrangement; $75 fee. I sold my 1998 Cessna and went to the factory and the IMF is like the three monkeys—deaf, dumb, and blind. bought a new Cessna. Every banking crisis has resulted from highly variable cross- MBNA essentially was going to make me a zero inter- border investment flows, and investment flows are much est rate loan because the supply of credit available through more accelerated when currencies are floating than when MBNA was extremely large and very cheap. And MBNA had they are pegged. When money begins to flow into a country, calculated for every 100 people who take advantage of this whether it’s to Iceland or to the United States, the coun- offer, 95 would be on the hook at the end of the first year try has a boom, rates of return increase, and the inflow of and would then pay an annual interest rate of 15% or 20%. money brings even more money. This anecdote demonstrates that the supply of cheap credit was super-abundant. Should credit flows be moderated or regulated? At the minimum, we need to do something to moder- Why does credit funnel into consumption whereas in ate cross-border investment flows. We could go back to a the past it financed infrastructure? modified Bretton Woods arrangement with a much larger I don’t have a good answer. But if there is a large flow of range of movement of currencies around a central parity. money, it’s going to go into the housing market and to con- We could rely on exchange controls—or on some combi- sumers; housing loans offer the lenders the security of nation of the two. collateral. One difference is that in the 19th century, the cross-border investment flows were long term. More recently, What are the chances of this happening? these investment inflows are short term or term loans with Every now and then, the IMF makes a noise as if it will interest rates that change when a base interest rate changes. allow some sort of margin control or prudential require- In the 19th century, infrastructure investments were financed ment—that’s the term they use; it sounds less offensive than in the private sector, but now, they’re in the public sector “control”—some form of ad hoc control. But I want to min- for a variety of reasons. The public sector is reluctant to imize the ad hoc controls. I want to return to a system. We increase borrowing to finance infrastructure investments. don’t have a system now. We now live in a world in which anything is feasible and many of the measures adopted How does your model contradict monetarist by foreign countries have had very high cost to the United economic theories? States, to the US export industry. Asian countries in partic- The “constitution” for the international financial arrange- ular have kept the prices of their currencies extraordinarily ment that we have today is founded on a set of articles by low. That’s cost millions of manufacturing jobs in the United my colleagues at Chicago (Milton Friedman and Harry John- States. That’s because we do not have a rule-based system. son) and by other scholars, such as Fritz Machlup at Prince- ton and Gottfried Haberler at Harvard. Their description of Haven’t we always had changes in credit flows? the adjustment process when currencies are floating is the In the 19th century, cross-border investments often financed counterpart of the “rules of the game” of the gold standard. large infrastructure investments. The United States bene- The proponents said that if currencies were allowed to fited greatly from the investment inflows from Britain and float, the changes in the prices of currencies would be grad- a few other countries that financed much of the US rail- ual and that the deviations of the market prices of curren- road system. In the last few decades, investment inflows cies from long-run equilibrium prices would be much smaller have stimulated consumption booms and real estate booms. than when currencies were pegged. They told us that there I’ll give you a personal anecdote. In August 2004, I would be fewer currency crises and that the demand for received an announcement from my credit card company international reserves would be smaller. They claimed that MBNA, and the announcement was that I had been preap- countries would be better insulated from foreign shocks. proved for a balance transfer for one year at zero interest Every one of their claims is now challenged by the data. rate. When I called MBNA, I asked, “What is my credit line?” Nathan Jaye, CFA, is a member of CFA Society San Francisco. They said US$100,000. I said, “Fine, please wire $100,000

Nov/Dec 2014 CFA Institute Magazine 31 32 CFA Institute Magazine Nov/Dec 2014 SHANGHAI EXPRESSEXPRESSEXPRESSEXPRESS Will the Shanghai–Hong Kong Stock Connect program be a transformational breakthrough?

By Sherree DeCovny

When China’s government unveiled a bold set of reforms MidCap Index. Also eligible are all H-shares in November 2013, linking up the stock markets of its two that are not included in these indexes but that major financial centers (Hong Kong and Shanghai) was have corresponding A-shares listed in Shang- hai. Eligible shares listed in Shanghai are the a key goal. Set to launch in October 2014, the Shanghai– constituent stocks of the SSE 180 Index and SSE Hong Kong Stock Connect program (also called the “through 380 Index. All SSE-listed shares not included in train”) is essential to the government’s master plan to these indexes but that have corresponding shares further open its capital market to the world and could listed and traded in Hong Kong are also eligible. China is still a closed market, and the gov- represent a transformational breakthrough. ernment is sensitive to foreign currency fluctu- ations. To this end, the program has a quota to Until the Stock Connect program, foreign control the flow of capital in and out of China. investors seeking to trade in China had to be The quota is considered generous for a pilot licensed as a Qualified Foreign Institutional scheme, being close in size to the total quota Investor (QFII) or a Renminbi Qualified For- approved under the existing QFII or RQFII eign Institutional Investor (RQFII) by the China schemes. The advantage of the Stock Connect Securities Regulatory Commission. To open program is that the aggregate quota is net of all an account, foreign investors also needed to buys and sells. In addition, the program applies be approved by China’s central bank. In the only to long positions, which means that inves- case of a QFII, capital had to be fully injected tors can sell at any time. in US dollars onshore in China and converted In the traditional QFII/RQFII channel, when to RMB, and then investments were subject to investors sell and repatriate their capital from a lock-up period. the principal, they lose their quota and they Now, via the northbound trading link of Stock have to go back into the queue to reapply. They Connect, individuals and institutions worldwide also have to obtain regulatory approval to repa- can invest in eligible shares listed on the Shang- triate funds, and the QFII/RQFII is subject to hai Stock Exchange (SSE) through a broker China’s capital gains tax. With Stock Connect, licensed to trade on the Hong Kong Exchange. when foreign investors want to sell mainland Individual investors on the southbound trad- China shares, they place an order with their ing link must hold a minimum aggregate bal- Hong Kong broker. Once the shares are sold, ance of RMB500,000 in their securities and they are paid cash in RMB in the Hong Kong cash accounts to qualify as an investor in eligi- market the following day. ble shares listed on the Hong Kong Exchange. Stock Connect is a critical path to RMB inter- Eligible shares listed in Hong Kong are the nationalization because all transactions are set- constituent stocks in the Hang Seng Compos- tled in offshore RMB. Previously, RMB was only

Illustration by Timothy Cook Timothy by Illustration ite LargeCap Index and Hang Seng Composite allowed to flow cross-border freely for purpose

Nov/Dec 2014 CFA Institute Magazine 33 of trade settlement. With Stock Connect, RMB is States. Thus, with the US and Hong Kong sys- allowed to flow cross-border freely from main- tems, the security and cash are transferred land China to Hong Kong for settling invest- simultaneously to minimize counterparty risk. ment transactions. The program will increase This kind of cycle is known as receipt versus liquidity in the offshore RMB market and enable payment/delivery versus payment (RVP/DVP). individuals and institutions to potentially earn Mainland China’s “free of payment” arrange- a higher yield by investing their offshore RMB ment is risky because the securities and cash deposits in the stock market. are exchanged at different times, creating counterparty exposure. OPERATIONAL ISSUES Short sales of A-shares are not permitted, The two exchanges worked on the program in so investors who want to sell must move their secrecy for about 18 months prior to announc- shares from the custodian to the broker the day ing it to the market in April 2014. The tech- before or on the trade date before 7:45 a.m. nical operating details were released in May, Because of the time difference, US investors and since then, market participants have been must pre-deliver two days before the shares are scrambling to fine-tune the model before the sold. The exchange checks all brokers’ positions launch. There is a huge political push to get at 8:00 a.m. daily to confirm how many shares “IT’S A STEP Stock Connect off the ground. Most financial they are entitled to sell. AHEAD, BUT institutions have a project underway to ensure The initial plan for Stock Connect was to have that the compliance, operations, risk, IT, and the transfer occur between 6:30 p.m. and 7:30 IT DOESN’T fund management teams have the capabilities p.m. on the day prior. Because US mutual funds NECESSARILY to access the program. are required to hold their shares with a qualified “It’s intense in Hong Kong,” says Nick Ron- custodian, they would not be able to transfer SOLVE ALL THE alds, managing director and head of equities them to the Hong Kong broker and leave them PROBLEMS.” at the Asia Securities Industry and Financial there overnight. To fix this problem, a morn- Markets Association. “A project of this scale ing window was added to allow shares to be requires significant systems and programing moved between 7:15 changes. Everything is affected.” a.m. and 7:45 a.m. on Although the rehearsals have gone smoothly, the trade date. market participants will have to live with some “It’s a step ahead, inconveniences, imperfections, and uncertain- but it doesn’t necessar- ties. For example, China has a 10% capital gains ily solve all the prob- tax for foreign investors, including QFIIs. The lems,” notes Cindy government has not clarified who needs to col- Chen, Hong Kong head lect the tax and how it has to be collected. Until of securities and fund now, registered QFIIs have been making a tax services at Citi. provision so they can pay when China is ready to Investors are only collect it. With Stock Connect, brokers are con- Cindy Chen allowed to submit mar- cerned that if they do not collect the tax from ket-limit orders, and if their customers and their customers close their the market price moves away, they may not sell accounts, then they could be liable for paying their shares on that day. This restriction means the tax. The current view is that there will be they have to move the shares back from the an exemption for at least three years. broker to the custodian, which is burdensome Significant operational issues need to be for investors outside of Hong Kong. resolved. Stock Connect shares cannot be mingled Citi has partnered with the Hong Kong with onshore shares. A particular share bought Exchange to address these issues. Banks cannot via Stock Connect may be the same equity as one lend RMB to foreign investors onshore, but they bought via a QFII, but they must be treated as can lend in the offshore market in Hong Kong. separate and have different symbols. New sym- Although Chen is not offering to sell or solicit bols must be developed and incorporated into an offer to enter into a transaction with Citi, brokers’ systems, and staff need to be trained. she notes that the bank could help facilitate The mainland settlement cycle is different RVP/DVP settlement for securities and cash to from the settlement cycle of developed markets. settle on T. That arrangement could help over- The mainland settles securities on T (investors come the concerns about counterparty risk. For buy and receive the share today), but cash is example, Hong Kong brokers could borrow the settled T + 1, whereas the settlement cycle is RMB and pay the investors on T instead of on T + 2 in Hong Kong and T + 3 in the United T + 1 when the investor sells the shares. For

34 CFA Institute Magazine Nov/Dec 2014 example, if an investor uses Citi for execution, be shy about participating. A fund that today custody, and clearing, the shares already will has zero allocation in Asia, maybe in a year’s be in the bank’s records, which means it will be time will have a 10% or 15% allocation. I don’t unnecessary to pre-deliver the shares. think it will be 50%.” A third group of participants—long-only insti- MARKET REACTION tutions with stringent due diligence require- Market participants will differ in how they ments—will likely wait until all of their issues respond to the Stock Connect initiative, with are resolved. Some fund managers’ mandates do reactions fitting in three broad categories. not recognize Shang- One group of participants is excited and hai as a stock exchange eager to enter the Chinese equity markets. For for investment. They them, Stock Connect provides an opportunity are concerned about to develop cross-border RMB businesses. Hedge the beneficial owner- funds, fund managers, and Chinese brokers ship structure and set- with a strong presence in Hong Kong and the tlement process, both mainland fall into this category. of which may require “The scheme will help open up the enor- changes to prospec- mous mainland China market for Hong Kong tuses. And if institu- investors in the long run,” says James Su, direc- tional investors have tor of investment at Hai Tong Asset Manage- Nick Ronalds to pre-deliver shares, ment (HK) and Haitong International Asset they will not be able Management. “Our existing and potential cli- to react to immediate developments (such as ents will be exposed to more diversified invest- economic, political, or share-specific news) the ment opportunities to optimize their portfolio.” way they would normally. Over time, the RMB will become more impor- “Those operational issues are not at all triv- tant and investors will increase their allocation ial for a lot of institutional investors because to the currency via an array of assets, includ- they require practices in their trading and port- “YOU CAN’T JUST ing stocks, bonds, and exchange-traded funds. folio management approaches that are differ- CHANGE YOUR The second group of potential participants ent from their customary practices,” says Ron- is interested in the program but likely will wait alds. “You can’t just change your investment INVESTMENT to see if the legal and operational issues are approach at the snap of a finger.” APPROACH resolved before the launch. Moreover, passive funds must be able to enter Leon Goldfeld, director of investment at and exit stocks in the appropriate proportions AT THE SNAP Amundi in Hong Kong, notes that the value of so they can adhere to their benchmark index. OF A FINGER.” mainland China’s market has declined but there The Stock Connect quota introduces execution are still some bargains. Ultimately, Shanghai is uncertainty. Passive funds that are already par- a large, liquid market—albeit one dominated by ticipating in China will likely continue to par- mainland China investors—with a long history ticipate via their QFIIs, but generally, they will of price setting. He believes Hong Kong insti- wait until the restrictions are lifted and their tutions will look for opportunities unavailable questions are resolved. in their own local market. Further, both Hong Stock Connect may open China’s markets Kong–centric and mainland China–centric port- faster than people expect. If the pilot is suc- folios will start to increase their allocation to cessful, it could be extended to a Shenzhen– A-shares rapidly. Hong Kong Stock Connect program and might Hong Kong–based fund managers are famil- include other asset classes. The quota could be iar with the stocks that are dual listed in Hong increased soon and be eliminated altogether. Kong and on the mainland, but building research Meanwhile, mainland China investors can learn on mainland China companies will take time. about the dynamics of the Hong Kong market, Although large-cap- and mid-cap-listed com- supporting the government’s goals of reforming panies are accustomed to meeting analysts, the financial and securities industry. In turn, the small-cap companies are still on a learning Hong Kong market will benefit from increased curve. In addition, language may be a barrier liquidity and a more diversified investor base. for global investors. Sherree DeCovny is a freelance journalist specializing in “There are practical challenges across a finance and technology. breadth of areas, but this also creates opportunities,” says Goldfeld. “I don’t think Hong Kong institutions and other foreign institutions will

Nov/Dec 2014 CFA Institute Magazine 35 AAARRRTTT AND INVESTMENT MANAGEMENT

By Nathan Jaye, CFA Is investment management a science or an art? And how have recent events, especially the global financial crisis, Are changing opinions changed the consensus about the correct relationship about investment between theory and practice? To answer such questions, three authors teamed up to investigate the state of invest- theory and practice ment management’s body of knowledge, how it should be taught by business schools, and what attributes investment altering the way hiring firms are seeking in job candidates. Their analysis and con- firms look at candidates? clusions are reported in the recent book Investment Man- agement: A Science to Teach or an Art to Learn? published Two researchers by the CFA Institute Research Foundation. share their findings. In this CFA Institute Magazine interview, two of the authors—Sergio Focardi (visiting professor of finance at Stony Brook University) and Caroline Jonas (managing partner with The Intertek Group in Paris)—discuss the implications for the investment profession. Because each addressed different facets of the topic, the interview is presented in two parts.

36 CFA Institute Magazine Nov/Dec 2014 Broad Vision and Rigorous Analysis

“Recent crises have made employers more skeptical of Is macroeconomic theory (and historical perspectives persons with sophisticated mathematical skills but on it) undervalued by job seekers? How sought after is no economic or business understanding,” says Caroline this knowledge by employers? Jonas, managing partner of The Intertek Group in Paris. It’s not so much a question of macroeconomic theory as of macroeconomic understanding, reasoning. The theory doesn’t What are asset management HR really bring much to the job. What matters is that the future managers looking for in candidates? investment professional have the ability to reason on how It’s difficult to offer a general answer to changes in the geopolitical environment, the economy, trade this question. Much depends on the style patterns, trends in specific industry sectors, and so on might of management—for example, traditional impact a given portfolio. Such an understanding is essen- versus quant. But I think it’s fair to say tial to protecting the client’s investments—and his or her that there is a sort of rebalancing going [the investment professional’s] job and the firm’s business. on. Most persons we talked to at asset Caroline Jonas management firms remarked that they What qualities in job applicants are in shortest supply? are looking for candidates that combine solid economic Persons we talked to said that the skill most difficult to find reasoning, including an understanding of the global macro in a candidate was the ability to combine reasoning on the and the geopolitical, with the ability to work with statistics “big picture,” the global macroeconomic outlook, with the and modeling, understanding that a statistic or a modeling ability to make a rigorous analysis, including the ability to result always requires a critical evaluation. Even for quants, use, or at least understand, model results and their even- firms are looking for people with broad vision, able to formu- tual shortcomings. late judgments on the global macroeconomic environment. Which attributes are overabundant in the industry? How is what they are looking for changing? None! Perhaps what are overabundant are applicants for Again, one big change we noted in doing the study was jobs in the industry. Like finance in general, there are more the emphasis asset managers now put on sound macroeco- applicants than job openings in investment management. nomic reasoning. Together with that, certainly, the amount A job in asset management is attractive—it is intellectually of data now available makes it imperative for anyone want- challenging and financially rewarding. But while schools ing to work in the industry to be able to work with data, to continue to form students for jobs in finance, jobs in asset determine patterns in data and separate signal from noise. management are still not back to their pre-crisis levels. Even fundamental managers now run their data through models and screening and are trying to learn how to read What’s a description of the ideal candidate—if there is one? the data using analytics. It’s difficult to describe an ideal candidate given the variety of jobs, for example, in client relations, marketing and Are engineers, mathematicians, and physicists as sales, fundamental analysis, systemic management, or risk sought after as previously? management. I think it’s fair to say that all would need a I would say yes, with a caveat: Candidates must also show good macro understanding, some statistical and mathemat- economic understanding. Certainly, such areas as multi- ical skills, and the ability to use technology, but the balance asset or systemic fund management, market and credit risk will depend on the specific job, which is great because that measurement, or derivatives pricing will always require leaves the door open to many profiles. persons with a high level of mathematical skills. And note that these areas are those that are growing in the industry. How much added value are top schools and MBA programs However, recent crises have made employers more skepti- delivering to job applicants? cal of persons with sophisticated mathematical skills but That’s a difficult question. I suppose it varies from one coun- no economic or business understanding. try to another, one firm to another, and among jobs. Clearly, in the United States, those holding an MBA are sought after Is there a tradeoff between business school training for jobs in marketing and sales while engineers, mathema- and out-of-the-box thinking? ticians, and physicists are more sought after for the quant- I think it’s fair to say that in an industry dominated by the oriented jobs. In Europe, with perhaps the exception of sub- need to outperform one’s competitors, out-of-the-box think- sidiaries of US asset management firms, the MBA is not so ing is appreciated only if it helps identify profit opportuni- important. The economics and finance departments of uni- ties that others have not found. The teaching in finance pro- versities form students for jobs in finance—typically with grams tries to give students the classical intellectual tools a sound grounding in macroeconomics. to find sources of profit. Certainly, firms do not want to pay for value that is not

Nov/Dec 2014 CFA Institute Magazine 37 delivered, any more than they want to overpay for the assets efficiency is flawed. Let me explain why. According to the they invest in. While we didn’t get much feedback on spe- original definition of efficiency introduced by Eugene Fama, cific evaluation programs, it’s clear that HR tracks the per- markets are efficient if prices reflect all available informa- formance of recent graduates, the schools they come from, tion. Translated into the language of mainstream finance and their pay relative to their performance. One comment theory, market efficiency means that actual prices are equal often heard is that recent hires that come from MBA pro- to theoretical prices. But there is no agreement on theoreti- grams have high expectations in terms of salary and a fast cal prices, so we can’t really teach market efficiency as the career path, which means that to deliver added value, they timeless truth that actual prices equal theoretical prices. It have to outperform candidates without an MBA. Some per- is an idealization. sons we talked to reported that this is not necessarily the More recently, market efficiency has been recast as the case. Another remark with a bearing on the return on invest- unforecastability of returns. Now, if markets were efficient in ment is that MBA candidates tend to be more ideological, the sense that actual prices always equal theoretical prices, arrogant, and unlikely to change their minds when con- then returns would indeed be unforecastable. But the con- fronted with others’ opinions or new information. trary is not true. Returns can be unforecastable without implying that prices reflect a theoretical value. So, if we What are some “untaught” skills that companies are teach that market efficiency means the unforecastability of looking for? returns, we have to be careful not to confuse this concept Certainly, the ability to think out of the box is not a skill with the classical concept of market efficiency. typically taught to students of finance! Finance tends to be The notion of market efficiency as unforecastability of taught dogmatically in terms of theories—often nonvali- returns might create some confusion. The classical argu- dated theories—such as efficient markets and the capital ment in favor of the unforecastability of returns dates back asset pricing model. This does not encourage students to to Paul Samuelson’s 1965 paper “Proof That Properly Antic- be open minded, to examine alternative ways of thinking ipated Prices Fluctuate Randomly [Industrial Management about a problem. Of course, being too open minded might Review, Spring 1965].” Samuelson’s argument does not not always be an advantage in an organization! rely on the notion of theoretical prices but runs like this: If returns were forecastable, then investors would immedi- How impressed are HR managers with the CFA ately try to exploit their forecasts to make a profit or avoid designation? a loss and, in so doing, would invalidate the forecast. This What we heard for this study—and, by the way, for past argument is very general; it applies to any forecast made studies—is that the CFA designation is an important indi- by an intelligent processor of information whose action can cation of a commitment to the profession and the willing- change the course of events. For example, if I can forecast ness to continue to learn. The latter is particularly impor- that tomorrow a car will hit me when crossing a given street, tant in an industry where nothing stands still. Financial I will not cross that street, thereby invalidating my forecast. innovation is high, and the global macro environment and Students of investment management should understand technology are continually changing. the difference between forecasting stock prices, which leads to the unforecastabil- What surprised you about responses from HR managers? ity of returns but does not imply theoret- HR managers—and indeed the whole industry—seem to ical prices, and forecasting future cash put much more emphasis on the need for global macroeco- flows, which leads to theoretical prices and nomic reasoning, while this seems to be the poor stepchild implies the unforecastability of returns. of most academic programs. Forecasting is a fundamental concept in finance. Basically, every task in finance depends on the ability to forecast Sergio Focardi the future. In a broad sense, forecasting Market Noise and is the basic task of science. The objective is to determine what will happen in the future or what is happening in other Complex Reasoning places, having knowledge of events here and now. Students should grasp the central role of forecastability and its lim- “To gain a better understanding of markets, we would need itations, including the fact that any notion of perfect fore- a more robust theory based on a different type of mathemat- castability, even in a probabilistic sense, is subject to poten- ics,” says Sergio Focardi, visiting professor of finance tial contradictions. at Stony Brook University. As with many other concepts in finance, the forecastability of returns is a purely intellectual concept. In prac- Should finance professors teach market efficiency tice, no investor can make perfect forecasts of returns as as a timeless truth, an idea found to be deeply flawed, we cannot make perfect forecasts of future cash flows on or something in between? which returns depend. It really depends on how market pricing efficiency is taught. Market efficiency is an approximate quantitative con- In my opinion, the classical, mainstream concept of market cept that implies that markets are difficult to forecast and

38 CFA Institute Magazine Nov/Dec 2014 that, generally speaking, prices are equal to a valuation on (collateralized debt obligation) and other more complex con- which there is substantial agreement. In some conditions, tracts behind the subprime mortgage crisis that brought on it’s very difficult to make forecasts and markets are said to the recent financial crisis. Thomas Kuhn’s classical analysis be efficient. In other conditions, markets are easier to fore- of scientific revolutions made clear that behind the adoption cast and there are profit opportunities, which is to say that of scientific theories there are political and economic consid- markets are less efficient. But these are pragmatic concepts, erations as well as purely intellectual ones. Physics envy is difficult to formalize. only one, but perhaps not the strongest, motivation behind the adoption of the framework of classical physics in finance. Is finance theory an empirical science or more of a social science? How problematic is it that many economic and financial I think it’s fair to say that it’s a mix of both. Finance theory terms are not observable? is the theory of the behavior of a human artifact—finan- Any empirical science is based on observables. In physics, cial markets—but the laws of financial markets and finan- many terms are not directly observable but are linked to cial markets themselves are subject to change. A number observables through the theory itself. Temperature is one of facts related to financial markets are pretty general and such term. What we observe is not the temperature itself but can be handled with the methods of empirical science. For the readings of an instrument, in this case, of a thermome- example, we can empirically ascertain with some degree of ter. These readings are connected by the theory. Any mean- accuracy the probability distribution of returns and other ingful physical theory must be observationally complete. facts, such as cointegration or regime shifting of financial In finance, there are terms that are neither observable time series. These facts are not the universal laws that we nor able to be linked to observables through the theory have in the hard sciences but can be modeled as empirical itself. Any formulation of a theory based on terms that are regularities, albeit with uncertainty. Tick-by-tick data (fre- intrinsically not observable is intrinsically weak. Consider, quently referred to as ultra-high-frequency data) provide a for example, a notion such as the “infinite stream of future database with strong empirical regularities. We have a rea- cash flows” originated by an asset. Well, as you might imag- sonably good idea of the behavior of high-frequency data, ine, an infinite stream of cash flows is not observable, nor including the distribution of the time between successive are the utility functions of market participants. market orders and many other facts. In practice, “proxies” are used. But a proxy is not a the- But political or social changes with a bearing on finan- oretically well-defined term. To use a proxy would require cial markets are not so easy to model. In many instances, we a theory of the proxy—clearly an oxymoron. Again, we need complex reasoning, which is very difficult to formal- encounter another weakness of our mathematical theory: a ize. It’s in such circumstances that finance becomes more theory that relies on a proxy for key terms is a weak theory. of a social science, requiring broader knowledge (such as the history of economic thought or the history of econom- Is there an overreliance on mathematics in the teaching ics and finance) and, incidentally, more creative thinking. of finance? It’s interesting to note that while most today would agree That’s a difficult question. The problem is not with the teach- that a scientific theory requires empirical validation, there ing of finance but with the theory itself. For example, the is a strain in economic thought going back to the Austrian mathematization based on the representative agent is prob- economist [Ludwig] von Mises (and shared by some contem- lematic because, as demonstrated by a famous theorem of porary mainstream economists) that the study of the econ- Sonnenschein, Debreu, and Mantel, we cannot consistently omy can be done with idealized models and thought experi- aggregate utility functions. Or consider the so-called vola- ments and that our theory does not need empirical validation. tility smile—it’s clearly an indication of the uncertainties in derivatives pricing. Does finance theory have “physics envy”? Despite the lack of true scientific validation of our theory, Well, that has been suggested, hasn’t it? Finance theory has mathematization has created significant profit opportuni- created huge mathematical frameworks, similar to those of ties—at least for some players. The incentive to abandon physics, especially in the realm of derivatives. Macroeco- a scientific paradigm that supports a profitable business is nomics has done the same. But by the standards of modern understandably low. But from the scientific point of view, physics, the validation of our finance theory is very weak. if we want to gain a better understanding of markets, we As remarked by the late Fischer Black in his famous paper would need a more robust theory based on a different type “Noise,” by the very nature of financial markets, little infor- of mathematics, likely more in line with the theory of com- mation is available; noise, which is the term we use for plex systems or even biomathematics. But personally, I don’t unpredictable disturbances, prevails. think we’re anywhere near achieving this. It’s difficult to believe that the motivation for building Also, don’t lose sight of the fact that finance departments this huge conceptual edifice, which has such a weak empir- at business schools and universities prepare students for jobs ical basis, was “physics envy.” Actually, the mathematiza- in the industry, so it’s important for them to ensure that tion of, for example, derivatives pricing, although scientif- their graduates have the skillset the industry requires, even ically weak, has opened the door to a very profitable busi- if the validity of the theory taught and the appropriateness ness for some financial firms. Another example is the CDO of the math are questionable. Certainly, for those students

Nov/Dec 2014 CFA Institute Magazine 39 wanting to go into a job that requires a lot of math, such as How much have closed-end publication policies affected derivatives pricing, systemic or multi-asset fund manage- finance theory? ment, or risk management, one cannot say that there is an Unfortunately, closed-end publication policies have put a over-emphasis on teaching mathematics. damper on what many consider to be the necessary reexam- That being said, professors of finance and investment ination of some of the fundamentals in our finance theory. management should make students aware of the limits of Academic careers depend on publication in a number of methods currently used and perhaps progressively introduce “select” journals. These journals are typically edited by students to a different type of mathematics that might better mainstream economists or finance theorists. Referees are capture the complexity of financial markets and investment chosen from among mainstream theorists. As a result, inno- decision making. vative papers that poke holes in mainstream theory tend to get rejected. Even papers that report empirical facts—if the Are we seeing a sea change in finance theory—or just findings cannot be explained by or are in disagreement with the onset of a newer generation of theorists (because mainstream theory—get rejected. As a result, many research- as physicist Max Planck once said, “Science advances ers have to publish their work in journals such as Physica one funeral at a time”)? A, but these publications have little impact on the domi- Actually, we’re seeing surprisingly little change if you con- nant thinking and are typically not read by the profession. sider that over a period of 20 years, we have had at least The result is that young economists and finance theo- three significant stock market crashes, that of 1987, the rists who want to make a career in these disciplines tend to collapse of the dot-com bubble between 1999 and 2001, research subjects and publish papers that are not controver- and the more recent crisis originating with subprime mort- sial. We see many papers that are technically brilliant but gages. Market crashes are not taken into consideration by that lack the fundamental spirit of research by accepting neoclassical finance theory, which is deeply rooted in the the usual long list of what I would call false assumptions. notions of rational expectations, optimization, and equilibrium. Finance departments are staffed with professors Is diversification still considered universally beneficial? versed in neoclassical finance theory; business schools and Generally speaking, a well-diversified portfolio is better universities are reluctant to make radical changes in their than a poorly diversified one. In this sense, diversification finance programs; and innovative theories and mathemat- certainly is not dead. However, blind reliance on diversifi- ical approaches have difficulty getting published in main- cation is by now an obsolete thing of the past. Perhaps what stream journals. We’ve seen a lot of technical innovation was lacking earlier in the practice of diversification was the with, for example, derivatives pricing, high-frequency trad- notion of changing market conditions. A dynamic view of ing, and CDOs but little innovation as regards the funda- the markets calls for reviewing the allocation of assets as mental theory. For example, despite the most recent finan- market conditions change. The dominant paradigm now is cial crisis, the role of the banking system or liquidity in dynamic asset allocation, which we might simply call dynamic determining asset prices is generally neglected in standard diversification. Of course, dynamic asset allocation does not courses and in research papers. have the simple robust character of naive diversification. It implies dynamic forecasting of returns over different time Are we seeing a reexamination of the “dominant think- scales and complex optimization methods. ing?” What does that mean? I think it’s fair to say that most of the reexamination of the What is trend diversification? How is it implemented? dominant thinking is coming from the domain of econom- Asset prices follow what we call local trends; that is, the ics, where a number of leading academics are questioning average value of returns remains constant or nearly con- the foundation of the prevailing economic theory. Perhaps stant for a while and then changes to a different value, pos- the most radical innovation is to consider any economy as itive or negative. This is what gives the central direction of a complex system made of many interacting agents. Ironi- prices. But generally speaking, all asset classes do not trend cally, this idea is not new. It comes from Adam Smith! Smith in the same direction (that is, up or down). Just like with conceptualized markets as complex systems governed by an classical diversification, where you do not want to put all invisible hand. Later, the liberal Austrian economist Fried- your eggs in one basket, so with trend diversification, you rich Hayek advanced the idea of the economy as a system do not want to put all your assets in classes that trend in made up of independent units. These ideas, however, were the same direction. There might well be extended periods lost in mainstream economics. where most return trends are negative, but there must be In finance theory, some attempts are being made to “com- some asset classes where the return trend is positive. The plete” the theory (for example, adding liquidity and the objective, of course, is to diversify on asset classes that do banking system). But as far as I know, there is little ques- not trend in the same direction. Trend diversification can tioning of the fundamentals. be implemented, for example, by clustering time series of prices around common trends. Nathan Jaye, CFA, is a member of CFA Society San Francisco.

40 CFA Institute Magazine Nov/Dec 2014 CFA INSTITUTE ANCFANU INALSTITUTE ANCONFERENCENUAL CO2INVESTING6–29 NFERENCEApril 2015 WITH | Frankfurt PURPOSE, German y 26–29 April 2015 | Frankfurt, Germany

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68AC_fpAd.indd 1 10/3/14 8:40 AM ETHICS AND STANDARDS MARKET INTEGRITY AND ADVOCACY

A Seat at the Table POLICYMAKERS AROUND THE WORLD SEEK INPUT FROM CFA INSTITUTE

By Kurt N. Schacht, JD, CFA

In a recent article for CFA Institute Mag- to promote its new investor education initiative. The IASB azine, I examined whether regulators had reached out to CFA Institute to explore possible collab- listen to organizations like CFA Insti- oration, given our extensive investor network and exper- tute when issuing new rules impact- tise in communicating with investors. Through our recently ing investment products and services. launched joint webcast series, we’ve updated investors on In a rapidly changing policy landscape, newly released standards that have a bearing on investment one way we know we are registering is analysis, including new rules aimed at plugging loopholes whether regulators seek regular dialog in off-balance-sheet accounting (an issue that came into with us. Not only are they inviting our sharp focus during the financial crisis) as well as updated input on regulatory consultations, but accounting requirements designed to help investors better they cite CFA Institute member surveys assess financial instruments–related risk exposures. This in their policy proposals. They also seek alliance illustrates that CFA Institute is a valued partner in our participation on advisory councils and other initiatives the accounting standard-setting process. that can benefit from our technical expertise and strong investor perspective. Ultimately, we can help these global ULTIMATELY, WE CAN HELP THESE policymakers understand what matters most to investors. It is a voice that is welcomed openly by regulators because GLOBAL POLICYMAKERS UNDERSTAND it is typically under-represented in the regulatory process around the globe. WHAT MATTERS MOST TO INVESTORS. In the European Union, we’re gaining one such important platform via our recent appointment to the Group of Economic Advisers, a key advisory body for the European In the case of the Global Investment Performance Stan- Securities and Markets Authority (ESMA). Members of this dards (GIPSTM), the training of regulators is where we have advisory group, who are considered specialists in financial a direct impact on how the principles of fair representation stability and economic issues related to financial markets, and full disclosure (and the core elements of compliance) will offer guidance on monitoring, assessing, and measur- are addressed in practice. To that end, the GIPS standards ing market developments, systemic risk, and other imped- team is currently providing training to US Securities and iments to financial stability. It is a critical time in the reg- Exchange Commission (SEC) examination staff in all 11 ulation of systemic risk as regulators continue to grapple regional offices, which offers an opportunity for SEC exam- with “too-big-to-fail” issues and emerging risks within the iners to ask questions and have direct access to CFA Insti- shadow banking sector. tute staff responsible for the GIPS standards. We’ve also been named to ESMA’s Secondary Markets Sometimes, the themes of our research and thought leader- Standing Committee consultative group, which will give ship resonate with the policymaker community to the degree CFA Institute increased visibility when providing input on that we’re invited to present our findings to regulatory staff. ESMA regulatory proposals, including the Markets in Finan- One such recent example is an invitation from the Securi- cial Instruments Directive (MiFID II) in particular. As the ties and Futures Commission of Hong Kong for an in-depth cornerstone of EU securities market legislation, MiFID II is discussion of our report on non-preemptive share issues in still evolving as policymakers develop technical standards Asia, in which we advocate for greater transparency among and devise guidelines to implement the legislation, including companies seeking mandates to waive pre-emptive shares rules for the structure and organization of trading venues and recommend that regulators consider tightening rules to and off-exchange markets and measures to increase price better protect the interests of minority shareholders. transparency and investor protection. While we may not always agree with Our work in the EU is just one way KEEP GOING the ultimate policy outcome, having a in which we are directly supporting seat at the table means that our advo- the work of policymakers and work- Follow the Market Integrity Insights cacy voice is not only heard but valued. ing to restore the trust of the invest- blog: http://blogs.cfainstitute.org/ marketintegrity Kurt N. Schacht, JD, CFA, is managing director ing public in financial markets. We’re of Standards and Financial Market Integrity at also partnering with the International Follow us on Twitter: @MarketIntegrity CFA Institute. Accounting Standards Board (IASB)

42 CFA Institute Magazine Nov/Dec 2014 Society Members Go to Congress

By Jim Allen, CFA, and Bob Luck, CFA

The “District Dialog” program, now in its second year, has generated increased interest among societies wishing to aid in US policy-making outreach. By putting House and Senate BY PUTTING U.S. HOUSE AND SENATE members who set financial regulatory policy in touch with CFA Institute society members in their home districts, the MEMBERS WHO SET FINANCIAL program enables member societies to promote the advo- REGULATORY POLICY IN TOUCH WITH cacy message of CFA Institute. The lessons learned from the six events held this year will help us prepare for an even CFA INSTITUTE SOCIETY MEMBERS IN greater effort in 2015. Topics of discussion included a uni- form fiduciary standard, oversight of investment advisers, THEIR HOME DISTRICTS, THE DISTRICT and Dodd–Frank Act reforms. Kicking off the 2014 District Dialog season was CFA Soci- DIALOG PROGRAM ENABLES MEMBER ety West Michigan, which hosted Representative Bill Hui- SOCIETIES TO PROMOTE THE ADVOCACY zenga (who represents Michigan’s second congressional district) as part of the society’s “Putting Investors First” MESSAGE OF CFA INSTITUTE. program. Drawing on his background in real estate, the congressman fielded members’ questions about the role of government and regulations in the economy. CFA Society Orlando was the second society to organize a Dialog event in 2014, hosting Representative Bill Posey. Congressman Posey represents Florida’s eighth congressional “Putting Investors First” advocacy efforts and its “State- district, which is home to a number of society members. ment of Investor Rights.” He showed particular interest in In the House, Rep. Posey serves on the Financial Services the society’s financial literacy initiative and descriptions of Committee and its financial institutions and monetary policy the CFA Program and the Claritas Program, and he invited subcommittees, which have direct jurisdiction over the the Boston society and CFA Institute to maintain a dialog financial services industry. with him on key issues facing the financial services indus- The Orlando meeting contributed to Rep. Posey’s aware- try, stressing that he looked forward to future collaboration. ness and understanding of CFA Institute and the ethical and At the last Dialog of the season, held by CFA Society market-based foundation of its positions on capital market Houston, a delegation of society leaders met with Repre- issues. As a follow-up to the meeting in Orlando, CFA Insti- sentative Al Green at his local office in the ninth congres- tute capital market staff and a member of the Orlando soci- sional district of Texas. Congressman Green specifically rec- ety have already arranged to meet with Congressman Posey ognized the benefits of working with society members when and his staff in Washington. he told member Elizabeth Burdine that he could have used More than 50 CFA Society Philadelphia members attended her knowledge of the real estate market in 2007 to help a luncheon presentation with Senator Tom Carper of Dela- him understand what was happening as the crisis began. ware on 19 July. Senator Carper spent time meeting with The District Dialog program is gaining traction because the board leadership of the Philadelphia society, individual of the work of local society leaders who have arranged the society members, and CFA Institute staff over lunch before meetings (and the venues as well in some cases). Through speaking to the audience about issues facing Delaware and the their efforts, these volunteers have increased the recognition nation, concluding with a lively question-and-answer session. and credibility of CFA Institute’s policy initiatives. We are The event not only provided society members who live and excited to note that several other societies are planning to work in the Philadelphia area with an informative program host similar meetings in the coming months. The net impact but also raised the profile of CFA Institute for the senator and of this collaboration will benefit members directly and will his staff. Given its diverse membership, CFA Society Philadel- enhance our ability to achieve CFA Institute’s primary goal phia plans to host several additional District Dialog events of serving the interests of investors through better regula- for society members in both Pennsylvania and New Jersey. tion of fair and efficient capital markets. On 20 August, the Boston Security Analysts Society Jim Allen, CFA, is head of Americas capital markets policy at CFA Insti- board hosted a District Dialog with Representative Michael tute, and Bob Luck, CFA, is director of society advocacy engagement at Capuano, a member of the House Financial Services Com- CFA Institute. mittee. Notably, Congressman Capuano represents the sev- enth congressional district of Massachusetts, where approximately 80% of Boston society members work. The Boston society board informed the congressman of CFA Institute’s

Nov/Dec 2014 CFA Institute Magazine 43 ETHICS AND STANDARDS MARKET INTEGRITY AND ADVOCACY

Investor Redress EFFECTIVE MEANS OF RESOLVING DISPUTES CAN IMPROVE “MARKET DISCIPLINE”

By Lori Pizzani

CFA Institute has released a new report detailing and ana- instigated by the investor to the service provider, with a lyzing the various processes for investors to resolve dis- potential settlement deal between the two as the goal. In putes within the financial services industries in the Amer- this regard, CFA Institute recommends five best practices icas, Europe, and Asia. Titled Redress in Retail Investment for the internal management of investor disputes: Markets: International Perspectives and Best Practices, the • Senior management should take responsibility report also offers recommendations for enhancing current and perform oversight. practices to improve handling of investor complaints and • Firms should handle complaints effectively and fairly. resolution of disputes. The concept of investor redress refers to how the rights • Firms should have transparent procedures for filing of retail investors are enforced within the different regu- a complaint. latory frameworks of the global financial services industry • Firms should identify recurring problems and take when monetary harm is caused by illegal activity or mis- remedial actions. conduct, such as mis-selling. • Supervisors should play an active role in identifying emerging risks so as to reduce instances of external ADR. ALTERNATIVE PROCEDURES Dispute resolution that takes place outside of the court ASSESSING GLOBAL PROGRAMS system can provide an easier, faster, and less expensive In 2011, the High-Level Principles on Financial Consumer way for investors to have financial business disputes equi- Protection were issued and endorsed by the G-20. Accord- tably resolved. These “alternative dispute resolution” (ADR) ing to these principles, consumers, including investors in mechanisms can often adequately and financial products, ought to have access fairly compensate investors for mone- KEEP GOING to ADR complaint-handling and redress tary losses incurred through misconduct mechanisms that are affordable, inde- (but not losses resulting from market The full report Redress in Retail pendent, fair, accountable, timely, and risk or other legitimate risks) without Investment Markets: International efficient. As the CFA Institute report Perspectives and Best Practices is imposing any of the punitive damages available online at www.cfainstitute. outlines, however, these programs are associated with the court system. In org and www.cfapubs.org. For more not always available and not all service contrast, because turning to the court information on investor rights, see providers are required to participate. CFA Institute’s “Statement of Investor system can prove to be costly and less Rights,” which is available at For Europe in particular, CFA Institute flexible and can involve lengthy proce- investorrights.cfainstitute.org. recommends several policy changes, dures, it is often seen as the tool of last including further interpretive guid- resort for investors. It is important to ance on the application of these prin- note, however, that ADR procedures are typically consid- ciples, strengthening the financial dispute resolution net- ered only for cases in which efforts at direct settlement fail. work across European nations, and developing a common The CFA Institute report also explores case studies and supervisory approach. how the process unfolded for each and compares and con- Even with ADR mechanisms in place, the processes can trasts investor-redress frameworks across geographic regions. vary greatly among countries and jurisdictions. For example, the amount of award that can be sought under an ADR WIDER SIGNIFICANCE program differs dramatically. The costs passed on to inves- The importance of investor redress goes beyond the investors also vary, with more complicated and labor-intensive tors directly affected by misconduct or other wrongful cases being more of a costly burden on investors. More- action. “Redress does not merely satisfy an individual inter- over, whereas some countries allow for investors to have est; it also incites market discipline, which benefits other legal representation, which can add to costs, other coun- market participants,” says Mirzha de Manuel Aramendía, tries actively deter legal representation. director of capital markets policy at CFA Institute. Fur- Lori Pizzani is an independent journalist based in Brewster, New York. thermore, having efficient and fair processes in place that allow investors to seek redress when warranted is vital to building trust and promoting retail investor participation in investment markets. In many cases, the first step should be a formal complaint

44 CFA Institute Magazine Nov/Dec 2014 Does Proxy Access Benefit Shareholders?

By Rhea Wessel

CFA Institute recently commissioned a report on a proxy Understanding the cost of proxy contests, especially in access rule developed by the US Securities and Exchange comparison with proxy access, is important, according to Commission (SEC) that was vacated by a court decision. Orsagh. “Proxy access would likely be cheaper,” he said. The study indicates that proxy access can be beneficial to shareholders and markets, but the matter needs a compre- CONTEST OF IDEAS hensive assessment by the SEC. Christian Faitz, CFA, a senior analyst at Macquarie Securi- Proxy access allows major shareholders to make their own ties in Frankfurt, says a key point is board accountability. nominations for board members instead of accepting only “If an activist investor has ownership, like 3%, then why those candidates proposed by a governance or nominating shouldn’t the investor have a say? It’s a good thing to have committee. The practice is commonplace in markets around activist shareholders. Not because they’re always right, but the world for shareholders who hold a minimum number because they tend to have a point from time to time,” said Faitz. of shares. The US is a notable exception, in the sense that In general, a company’s proxy access policy is not some- shareholders do not have the ability to nominate directors thing Faitz or his team of analysts track in their equity cov- to the corporate ballot unless a company’s bylaws allow it. erage, yet he welcomes shareholders having the ability to The SEC tried to make the practice mandatory under nominate directors. Rule 14a-11, but the proposed rule was struck down by the “I think proxy access should be implemented voluntarily, DC Circuit Court in July 2011. not as a rule. Having the voice of more activist investors Supporters of proxy access say shareholders should be on the board would put more control in the shareholders’ able to nominate their own representatives in order to hands, as opposed to the management. And that’s where it ensure board accountability and that a board member’s job should be. They can pressure the board to focus its opera- is, in part, to represent shareholders. Opponents of proxy tions,” said Faitz. access usually point to the chance that activist sharehold- Of course, getting a hand-picked director on the ballot ers might pursue special interests if they gain access to the is different from getting him or her on the board, and once board with a representative. on the board, a director is still subject to a contest of ideas. Matt Orsagh, CFA, director of capital markets policy at “If a shareholder with 4% tries to push through a measure, CFA Institute, worked closely with the research institute that that shareholder still has to convince at least 46% that he or produced the report. “We want to raise the idea of proxy she is right to have the majority. That’s a very high bar,” said access again,” he said. “Our study shows that proxy access Orsagh. “If someone is agitating for no good reason, over can be beneficial to shareholders and the markets at very time, the person will lose their reputation as a fair arbiter.” little cost to the market. We invite the SEC to do its own The proxy access debate could benefit from a focus on study on the matter.” board independence, according to Kathrin Schwesinger, a More companies appear to be deciding to implement lawyer in New York who is an expert on corporate gover- proxy access under “private ordering,” which allows inves- nance. “A good director who is capable of doing the job well tors to put forth a resolution to change a company’s bylaws is best if he or she is independent and safe,” said Schwesinger. to allow proxy access. For example, Hewlett-Packard’s board “You’re not going to get directors who are more indepen- proposed proxy access, and the proposal passed with 68% dent by tying them closer to shareholder interests any more support in 2013. The threshold was set at 3% of shares out- than tying them to management’s interests. This is getting standing, held for three years, with a nomination threshold lost in the proxy access debate.” of up to 20% of board seats. The same year, Verizon Wire- STUDY METHODOLOGY less also passed a proposal having the same thresholds with CFA Institute hired Industrial Economics (IEc) to assess the 53.3% support. The proposal was made by C.W. Jones, the costs and benefits of proxy access on a preliminary basis. head of the Association of BellTel Retirees, and it passed The resulting study included a comprehensive literature despite the board’s recommendation against the proposal. review and analysis of seven event studies related to the perceived wealth effects of proxy access. COSTS OF PROXY ACCESS The authors of the report said that the underlying fun- One concern regarding proxy access is the costs involved. damentals of event studies suggest that proxy access was Proxy contests usually feature shareholders who want to received more positively than negatively by financial markets. install directors to gain control of a board, whereas proxy When the results of the studies are extended for over- access is often used to get a seat at the table so as to influ- all US market capitalization, the estimated positive impact ence the conversation on a board. When contests are held, of proxy access reform ranges from $22.8 billion to $363 both the investor and the company have to spend money on billion, or 0.1% to 1.9% of total US market capitalization. marketing, printing, and contacting investors to persuade Rhea Wessel is a freelance journalist based in Frankfurt. them of their opinion.

Nov/Dec 2014 CFA Institute Magazine 45 ETHICS AND STANDARDS MARKET INTEGRITY AND ADVOCACY

Backward on Forward-Looking Information? DEBATE ABOUT FINANCIAL DISCLOSURES NEEDS TO INCLUDE THE INVESTOR VIEWPOINT

With initiatives under way by standard setters and regula- financial analyses. For example, in 2011, the FASB could not tors around the world to reform financial reporting disclo- issue requirements for enhanced interest rate and liquidity sures, CFA Institute has sought to contribute the investor risk disclosures, even after outreach showed investor sup- viewpoint to the dialog with a new report titled Forward- port for these disclosures. Looking Information: A Necessary Consideration in the SEC’s The CFA Institute report also examines the misconcep- Review on Disclosure Effectiveness. tion that US GAAP does not include forward-looking infor- The US Securities and Exchange Commission (SEC) has mation, demonstrating through the use of examples that launched a review of the effectiveness of disclosures under financial statements currently include substantial degrees Regulation S-K, which sets requirements for public company of forward-looking information. disclosures outside the financial statements, and Regula- The most obvious instance of forward-looking information S-X, which concerns disclosures within the financial tion in the financial statements cited in the report is the case statements. As the SEC conducts its review, CFA Institute of financial instruments measured or reported at fair value. believes that “forward-looking information” is an essential Reporting financial instruments at fair value requires an entity part of the disclosure debate. to project future cash flows, often far out into the future and In 2013, CFA Institute published Financial Reporting Dis- discounted at a rate that market participants would use to closures: Investor Perspectives on Transparency, Trust, and discount them. Even fixed assets—such as property, plant, Volume, which describes investor perspectives on needed and equipment, which is generally carried at historical cost— improvements in financial disclosures. Building on this include and convey forward-looking information/expecta- effort, the new Forward-Looking Information report explores tions. The selection of a depreciation period, although typ- the challenge of drawing a dividing line between forward- ically standard in nature, is nevertheless an indication of looking information that belongs within the financial state- management’s estimate of the future useful life of the asset. ments and forward-looking information that belongs out- “Investors perceive inconsistencies in the argument to side the financial statements. exclude forward-looking disclosures, such as liquidity and The report examines the definition and reviews the his- interest rate risk, in the financial statements yet include for- tory of forward-looking information as defined under US ward-looking measurements, such as the proposed impair- securities laws as well as safe harbors for such information ment model, in the financial statements,” says Peters. under securities laws and SEC rules. However, US gener- CFA Institute believes the lack of a conceptual framework ally accepted accounting principles (GAAP) lack a defini- for measurement is one of the underlying contributors to the tion of forward-looking information, which has contributed contradictions in the debate regarding the nature of forward- to the debate regarding its location, with companies prefer- looking information included in the financial statements. The ring to include such information outside rather than within conceptually inconsistent measurement of assets and liabili- the financial statements. ties currently used in financial statements creates confusion “Investors find forward-looking information to be the most for all stakeholders regarding the characteristics of an asset ‘decision-useful’ in the investment decision-making process,” or liability that define how it should be measured as well as explains Sandy Peters, CPA, CFA, head of financial reporting the degree to which forward-looking information should be policy at CFA Institute. “For example, uncertain fair value incorporated into the measurements. Furthermore, it leads measurements that reflect current conditions and expecta- to a debate regarding the nature of the disclosures neces- tions of future conditions are significantly more useful than sary to make such measurements meaningful for investors. measurements like amortized cost, which, though highly Investors want clarity on the SEC’s perceived dividing certain, only reflect past values and give no indication of line as part of the disclosure effectiveness review. The cur- current market expectations of value. Investors need dis- rent state of the debate delays progress on improving disclosures to understand the inputs to such measurements.” closures that would be useful for investors. CFA Institute Indeed, the financial crisis has highlighted the need for maintains that the pursuit of artificial boundaries regarding further improvements in risk and liquidity disclosures, a where to provide additional forward-looking information type of forward-looking information. But the debate regard- simply ends up significantly constraining needed improve- ing the appropriateness of including forward-looking dis- ments to financial reporting information. closures in financial statements has delayed the Financial Instead, as the CFA Institute report states, “The nature of Accounting Standard Board’s (FASB’s) development of new the improvements, rather than their location in the finan- accounting standards and disclosure requirements that could cial filings, should be of principal concern to policymakers.” provide additional useful information to investors in their

46 CFA Institute Magazine Nov/Dec 2014 CHAPTER 10

Captain Alpha’s Flying Circus WHY DO PORTFOLIO MANAGERS HAVE A RISK-SEEKING BIAS?

By Ralph Wanger, CFA

Professional investors are human beings, and as human And we are biased to believe that the past three years of beings, we have biases. Biases can be bad (for instance, if data describe a permanent structure. there is some class of people we are prejudiced against). The world of investing has always been cyclic. There Biases can be neutral, such as which baseball team you prefer. will be periods, such as the past few years, when active Some biases can be good in the sense that your investment investing trails the S&P 500, but there have been and will strategy is logical and successful, even if it is perceived as be other periods in which active investing will do just fine. a bias by the jerk in the next office. From a quant point of view, we have been through a period One bias that is very important to us is investors’ regard when the correlation of individual stocks with the indexes for active management. In a recent FAJ article, Charles Ellis has increased. Investment returns have been all beta and proclaimed that performance investing was obsolete, so we no alpha. This tight correlation must decrease in the future should spend our time trying to cheer up our clients (“The because no correlation can get higher than 1.0. When stocks Rise and Fall of Performance Investing,” Financial Analysts become less correlated with the market, alpha will pop up Journal, July/August 2014). Ellis is an experienced, thought- like dandelions in May and active investing will become ful investment professional and worth listening to. But fashionable again. many of us decided to become CFA charterholders because Another important bias for portfolio managers is the desire we are brilliant, courageous risk takers and swashbuckling of managers to take on a lot of risk, often more than their top-gun fighter pilots. Passive investing is for airline pilots. clients are comfortable with. Suppose you have just been Why is active investing out of favor? I do not think it is assigned to run a $50 million mutual fund equity portfo- theoretically impossible. I do admit that it hasn’t worked lio. There are 99 other mutual funds in the same Morning- very well for the past seven years. Even the self-anointed star category as you. On 2 January, you start with a port- geniuses in the hedge fund world have had pathetic results. folio of your 50 favorite stocks and are confident that you At this point, the realists, such as Ellis, say that financial will do well. In the mutual fund sales arena, you will earn analysts can be replaced by a $30 piece of software in the a big bonus if you are in the top five for the coming year. If

same way that fighter pilots are being replaced by drones. you end up in the group of the next 45 funds, you will keep Robert Meganck by Illustration

Nov/Dec 2014 CFA Institute Magazine 47 CHAPTER 10

your job but get a small bonus. If you are in the bottom half, end up gaining the lead in your industry and become rich your fund will have net outflows and your job will in jeop- and famous, although this is not the most likely outcome. ardy. You want to win. Think about the fund group of 100 as a whole. The first- Before you know it, 31 January has arrived. Your port- place fund is cruising along cheerfully and is maintaining a folio is doing alright, but your fund is ranked only 11th out sensible portfolio. The other 98 managers are going through of 100. There is no need to worry, really, because markets the same thought process as you. Everybody starts goos- in January are peculiar. Small stocks always do better in ing their portfolios by taking more risk. The real losers are January. You can afford to wait and see what happens. But the mutual fund shareholders, most of whom do not want only four weeks later, it is the end of February. Although to take that much risk, but the risk-seeking bias of portfo- your portfolio is still performing decently, you now own a lio managers acts against their interests. few stocks that are lagging noticeably. Your ranking has This risk-seeking bias is even stronger for hedge fund gone down to 17th. managers. They have the dream of making $100 million You sell the five stocks that are the laggards in your port- annually if they can win the race. The risk-seeking bias folio and reinvest the money in fresher, more promising becomes so strong for these avid competitors that they will ideas. That actually helps a little, but at the end of the first use very high degrees of leverage in their portfolios. Their quarter, your ranking is 21st and you’re fully 2 percentage competitive spirit can become so desperate that they may points behind the leader. violate the law, which can range from insider trading to How are you going to catch up? Minor tinkering in the Madoff-like fraud. portfolio no longer looks like the right strategy to win the So what is an investment professional to do? Three steps race. The only chance you have is to take more risk. You (in increasing level of difficulty) can help. First, be alert to need to concentrate your portfolio in one or two industries the biases of other people. Next, recognize bias in your- and double your weighting in your favorite stocks in those self. Third, if your bias is harmful, change your behavior. industries. Ralph Wanger, CFA, is a trustee of Columbia Acorn Trust. As long as it’s just you taking the risk, the world of finance is indifferent to your results. Sometimes, you will

GET THE INSIDER’S VIEW. Introducing Industry Guides—a new CFA Institute publication series written by and for CFA Institute members.

CFA INSTITUTE CFA INSTITUTE INDUSTRY GUIDES INDUSTRY GUIDES Each guide is focused on providing a brief but THE comprehensive examination of a specific industry, MACHINERY including an overview of its structure, its primary INDUSTRY PHARMACEUTICALTHE economic drivers, and practical guidance for INDUSTRY conducting effective valuation and analysis. Browse

ISBN 978-0-938367-81-9 9 0 0 0 0 and download current titles at www.cfapubs.org 9 780938 367819 or at www.amazon.com.

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ISBN 978-0-938367-79-6

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Want to give back to the profession by sharing your experience as an Industry Guide author? Learn more at www.cfainstitute.org/community/volunteer.

48 CFA Institute Magazine Nov/Dec 2014 WhyWhy become become an an independent independent Advisor Advisor onon Interactive Interactive Brokers’ Brokers’ platform? platform?

• Freedom• Freedom and and flexibility flexibility to to run run your your • Generate• Generate Higher Higher Returns: Returns: ownown business. business. • Lower• Lower commissions, commissions, no no ticket ticket charges; charges; no no minimums;minimums; and and no no technology, technology, software, software, • No• No contract. contract. platform,platform, or or reporting reporting fees. fees. • Better • Better executions. executions. We We do do not not sell sell or or trade trade • Keep• Keep 100% 100% of of your your fees. fees. againstagainst your your orders. orders. • Minimal• Minimal start start up up and and overhead overhead costs. costs. • Low• Low interest interest rates, rates, and and higher higher loan loan values values onon portfolio portfolio margin margin accounts accounts over over $100K. $100K. • Full• Full White White Branding Branding capability capability with with customizedcustomized statements. statements. • Model• Model Portfolios, Portfolios, Option Option Analytics Analytics and and Algos. Algos.

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InteractiveInteractive Brokers Brokers LLC LLC - member- member NYSE, NYSE, FINRA, FINRA, SIPC. SIPC. Supporting Supporting documentation documentation for for any any claims claims and and statistical statistical information information will will be be providedprovided upon upon request. request. * Subject * Subject to registrationto registration requirements requirements (US (US only). only). [1] [1] Includes Includes Interactive Interactive Brokers Brokers Group Group and and its itsaffiliates. affiliates. 09-IB14-80509-IB14-805