In times of chaos, choose to innovate INVESTMENT INSIGHTS | JANUARY 2020 Uncovering innovation on the right side of change Driving positive change with municipal bonds Watching China’s quest for technology independence Building a new playing field with smaller issuers Embracing machine learning for value discovery Challenging assumptions in portfolio construction Plus, real stories of conversations with clients and colleagues that shape our leaders’ views on driving innovation.
Transcript
In times of chaos, choose to innovate
INVESTMENT INSIGHTS | JANUARY 2020
Uncovering innovation on the right side
of change
Driving positive change with
municipal bonds
Watching China’s quest
for technology independence
Building a new playing field with smaller
issuers
Embracing machine
learning for value discovery
Challenging assumptions in portfolio
construction
Plus, real stories of conversations with clients and colleagues that shape our leaders’ views on driving innovation.
We’re at a pivotal stage for the economy and the markets. There are many questions, but no clear answers.
It would be easy for me to rattle off many words of predictions or platitudes. I prefer a more direct approach. On some days, the world of investing, and the world itself, can feel incredibly uncertain and borderline chaotic.
So why not pause from asking questions about events we can’t control and instead ask ourselves: In times like these, what can we do about it? We think there is a one-word answer: innovate. This approach can work for businesses and, in our view, it can work for investors as well.
Bring the chaos, we’ll bring the ideasWhen there is uncertainty and change, many businesses choose to adapt and bring together people they trust and develop an innovative new vision aimed at long-term success. Innovation involves new perspectives, new thinking, and new action to creatively build new ways of tackling problems.
That’s what we’re doing. Our culture—the ethos that drives how we serve our clients—runs on innovation. We feel the uncertainty you do. We feel the urgency of your financial challenges. We know, on any given day, a seismic event could shake the markets. Therefore, we’re focusing on big ideas instead of uncontrollable events—and we recommend you do the same.
This 2020 outlook might be a bit different from others you’ve seen. We take you inside the walls of Wells Fargo Asset Management where our portfolio managers, strategists, and leaders are creating and using totally new ideas to manage assets. The markets may feel chaotic, but our people are challenging old ways of doing things and, in turn, pursuing a path to success.
We believe our innovations can help our clients achieve their desired outcomes, no matter what chaos this world delivers.
Bring the chaos. We’ll bring the ideas.
Where are we in the economic and market cycles?
With Phase One done, what’s next with global trade relations?
What will the Federal Reserve do next and when?
What’s going to happen in the Middle East and with North Korea?
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MESSAGE FROM Kirk HartmanChief Investment OfficerWells Fargo Asset Management
Asking the tough questionsHave you ever felt concerned, even during good financial times? (As CIO, it’s my job to worry.)
When markets perform well, investors can become complacent. They stop asking important questions. But in your heart, you know some issues have been bubbling under the surface. The challenge is: How do you react to that?
As I look back on 2019, I cannot help but notice the phenomenal performance of both equity and fixed-income markets, even as times of chaos permeated the news—all amid a backdrop of global central banks supporting the markets at unprecedented levels through low borrowing rates and a growing balance sheet. It seemed the world was awash with liquidity. Both consumers and businesses were borrowing and spending. Many would think: Good times, right?
As we look forward, it’s 2020 and these conditions have helped generate a rather large amount of debt in our global financial system. This has been on my mind, and I believe it’s time to ask: What happens to all that leverage when a credit crunch hits the markets?
Investment capital would become harder to secure. Lenders would become wary about loaning to consumers and businesses. And those accommodative central banks? Historically, they would lower rates in this environment. Instead, they have limited room to do that since rates are already near historical lows and their balance sheets are massive. There will undoubtedly be economic ripple effects.
However, we’ve seen this before. Recall 2008. A credit crunch hit the world as part of the Global Financial Crisis. I had some very candid, emotional conversations with clients. A common question they’d ask me: “When will this end?”
Naturally, clients sought a forecast for when market conditions would change. When chaos is outside of your control—and it threatens to affect your financial goals—it is unnerving. But I couldn’t lead with that type of outlook. Instead, we dug deeper and asked questions such as this: “What are we doing about it?”
The answer then was innovation, just as I believe it is now. While the issues leading up to the 2008 credit crunch bubbled under the surface, our money market team had been studying credit risk and structure. Our competitors had been turning to credit agency ratings for direction. So, we asked ourselves: “Is there a smarter approach?” That’s when our team decided to build an in-house credit scoring system.
To this day, I believe that system helped us avoid the money market bailouts that many others in the industry were forced to undergo. The reason: We understood structured investments and we focused on the quality of the collateral underlying the debt obligations. This allowed us to avoid many credit problems.
Here’s the takeaway I’d apply to 2020:
Say market conditions do end up shifting due to events we can’t control. I’d want to look back and know that I acknowledged the concerns, asked tough questions, and tackled issues head-on through innovative thinking.
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INVESTMENT DISCOVERIES
Uncovering innovation onthe right side of change
Michael Smith, CFASenior Portfolio Manager, Fundamental Growth Equity Team
Ozo Jaculewicz, CFAAssociate Portfolio Manager and Senior Portfolio Specialist, Fundamental Growth Equity Team
What does it mean for a company to be on the right side of change in 2020?Put yourself in the shoes of a respected entertainment brand that’s given the magical gift of flight to cars, caretakers, and elephants. You’re known for innovation, but to make your next act work—creating a wearable technology to enhance the guest experience at your theme parks—you need the gift of top-flight software talent.
But that type of talent can be as elusive as the rightful owner of a glass slipper.
This story is emblematic of a digital transformation happening on a massive scale across corporate America. As companies embrace new technologies and strive to meet evolving consumer demands, they must find the talent to manage an array of new digital complexities. Increasingly and across industries, these firms are struggling to do so due to a scarcity of skilled software developers. Two forces are at play:
1. Digital transformation is of strategic importance to many global companies.
2. Trillions of dollars in market cap are resting on the shoulders of the search for software developer talent.
This is leading companies to turn to external service providers to meet their needs. And they are hunting in all corners of the globe to find this talent.
While conducting bottom-up research, we on the Fundamental Growth Equity team identified a compelling theme around this growing supply-and-demand imbalance for software developers. Our research analysts met with multiple management teams from companies of all sizes that noted over and over again how hard it was to find talent. Following our process to “surround the company,” the search for a solution to the developer shortage led our analysts to companies that recruited and developed skilled labor pools outside the U.S.
1 millionNumber of IT jobs unfilled in the U.S.
80% of about 2,800 Tech-hiring decision-makers at U.S. firms who identified lack of IT talent as a key challengeSources: IT trade group CompTIA and Robert Half
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A chance conversation we had with a software management team at an industry conference added to our conviction, as the executive sang the praises of some select outsourced developers. Through the execution of our investment process, the team developed an investment thesis that Globant—an information technology (IT) services company in Latin America with 6,000+ IT professionals—has the potential to be a key beneficiary of the demand for software talent.
The company’s highly skilled software engineers have done work for a wide variety of businesses, such as American Express, Southwest Airlines, Zynga, and Google. Globant’s share price at the time did not reflect the growth opportunity we expected to see from owning it when we purchased the stock. This is where our example of a storied entertainment brand comes back into the picture.
Globant also helped gaming brand Electronic Arts develop its FIFA soccer game franchise and partnered with London’s Metropolitan Police to develop a digital platform for accessing police services digitally.
In conclusion, we believe 2020 will be a year where the pace of change continues to accelerate. Technological disruption will become even more pervasive. In order to thrive, companies will require a far greater amount of digital capabilities than they have in the past. We believe businesses on the right side of change that can meet the changing demands of consumers—such as the acute shortage of software developer talent—can be poised to produce strong excess returns. Just as major entertainment brands can revolutionize the consumer experience by bringing the right minds together, our team is using a uniquely designed process to capture these opportunities.
Can you recall a time in your family history of taking young children to a theme park? Amid the joyful memories, you may remember a certain amount of chaos. The hours of waiting in line for rides. The constant juggling of food, balloons, and at least one child while you fumbled for your wallet to pay for it all. And finally, after a long day, near the point of collapse from exhaustion, you’ve arrived at your hotel room door only to realize you have lost your key.
Globant—as reported on its website1—helped Disney create a next-generation online experience for its parks and resorts.
Perhaps you’ve heard of the MagicBand, a sensor-enabled wristband that—as reported by Wired2—allows wearers to avoid lines, pay for meals, and even unlock their hotel room doors. In our conversations with Globant, we learned it provided talent to help the entertainment brand achieve its innovative vision.
1. As reported on Investors.Globant.com: “Globant—We Are Ready”
2. As reported on Wired.com: “Disney’s $1 Billion Bet on a Magical Wristband”
Jeffrey Weaver, CFASenior Portfolio Manager, Head of Municipal and Short Duration Fixed Income, WFAM Global Fixed Income
Terry GoodeSenior Portfolio Manager, WFAM Global Fixed Income—Municipal
Thomas StoeckmannHead of Municipal Research, Municipal Credit, WFAM Global Fixed Income
A story by Thomas Stoeckmann.
At the intersection of a long school hallway filled with the buzz of youthful activity, I stood as a silent observer of what I had witnessed numerous times before. A young first-grade boy approached the principal, wrapping his arms around her legs and fighting back tears that had noticeably been flowing for some time that morning.
Followed by another staff member, I observed as two school leaders’ eyes met, silently communicating that this student’s morning was different. It wasn’t about the all-too-common mornings that began without food or the stressful experience of a bus ride gone bad. There was something more. The principal excused herself for a few moments from our tour together to usher the boy and a staff member into the nearby counseling room for some solace.
Minutes later, as the children settled into their classrooms and the hallways became quiet, my host returned and we continued our conversation about the school’s academic progress. It was apparent from the student work neatly posted in the hallways that their methods were working. Witnessing the students’ engagement and positive academic performance confirmed a primary reason I had recommended the public charter school’s municipal bond to my colleagues on the Municipal Fixed Income team for portfolio investment several years earlier.
This K-12 grade school of choice serving 1,064 students within the local community was rated as “Exceeds Expectations” according to state standards. The vast majority of other local district and school choice options were a woeful 20 to 60 percentage points behind our school’s state accountability rating. Our investment was not in some suburban school. Instead, 92% of the school’s population is economically disadvantaged, 99% of its students are minority, and 10% of its students live with disabilities.
Located near Milwaukee’s north side and just 3.5 miles from where I was born, this school site visit was different from the dozens of others I had made. As the principal and I wrapped up our meeting in her office, she revealed that the young boy I had witnessed earlier in the hallway was mourning with his mother, who had lost her boyfriend to gunshot wounds the evening before.
Two things resonated loud and clear that morning: the staff’s support for their student who was enduring the unimaginable, and the staff’s hope of a successful academic future for their community. What was my team’s role in this story? Our investment gave us the opportunity to make a positive impact.
For readers thinking about environment, social, and governance (ESG) in 2020 and beyond, there’s a takeaway here.
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Municipal fixed-income markets are an ideal space for identifying securities with impact. The asset class at its core is designed for public good and is ripe with inefficiency creating opportunity. We’ve made these kinds of investments in our portfolios over the years. However, we’re now seeing investors’ interest growing to the extent that they want to experience the impact associated with these investments. And, our team’s own longstanding interest in ESG has led us to a few realizations:
1. The ESG investing space for municipal securities is still in the earlylife cycle phase, and we believe our extensive research expertisecan help move the debate forward.
2. The extent to which an investor wants to focus on sustainabilityas a dimension of their investing can vary—and we need to helpfacilitate that.
3. There is not yet an obvious recognized benchmark or standardizedways to report sustainability considerations for municipal debtsecurities. We expect the industry to evolve to meet some ofthese emerging demands.
In order to proactively contribute in this area, over the past year we’ve researched and constructed a framework to help assess whether positive environmental and/or social impacts exist in each municipal security and, if so, to what extent (low positive, medium positive, or high positive).
A four-pillar approach to identifying impact with municipal fixed-income investments
WFAM ESG impact framework
1
Use of proceeds analysis
2
Issuer ESG impact analysis
3
Underserved population
analysis
4
Vended data
analysis
Why do we believe in this approach? It can allow us to:
• Select securities offering the highest potential positive impact
• Understand the dynamic between potential returns, credit risk, and impact levels
• Customize around impact interests, meaning we can hone our participationacross sectors that we feel align with green or social bond principles; in themuni space, this includes sectors such as water/sewer, health care, public power,education, and project finance with environmental and social impacts
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Municipal fixed income, at its core, is geared toward improving essential services around the U.S. It offers investors a way to build communities by raising the education level, helping enable access to quality resources, and reducing the negative effects that result when these services aren’t provided. Sustainability of this sort does not need to be an afterthought. Rather, it can be a key building block in how investors build wealth and effect change in local communities and beyond.
Municipal fixed-income markets are an ideal space for identifying
securities with impact.
LEADER INSIGHTS
A definitive YES
Hannah SkeatesHead of Global ESG
I met with a large pension fund client that was in the process of reviewing its investment managers. It was a Tuesday morning in Manchester, and I was the third manager scheduled topresent. Being third in line isnot a great spot, especially
when your presentation is the last one prior to a much-anticipated lunch break. As I prepared to present, the head of the fund’s board asked me a direct question:
Shouldn’t everyone be incorporating ESG information into their investment decisions?
You see, he noticed that some managers in the room talked about ESG, but not all. I put aside my notes and explained why my answer is a definitive “Yes.”
This client’s desire to see ESG data considered in regular investment management is not a one-off conversation. I’ve seen a groundswell building,
focused in part on ensuring investment managers account for the increasingly obvious ESG risks we see around us. To me, this is good risk management. And as we navigate this new normal, WFAM has been formalizing the process by which our analysts assess ESG issues that could be material concerns for investment choices.
But part of the groundswell is something else: a different type of intention.
A growing number of investors are looking at the effects of our current global economy and way of life and are becoming concerned. Negative environmental consequences and social pressures such as widening inequality may undermine the stability of the world in which we live and invest. Things we took for granted in eras when much of our economic and finance theories were written now seem fragile.
Continued on page 27
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INVESTMENT DISCOVERIES
Watching China’s quest for technology independenceA story by Connie Ou.
This past October, I visited a popular technology conference in Beijing: the 2019 PT EXPO China. In contrast to the chilly weather outside, the expo floor was warm with enthusiasm from the nearly 400 companies showcasing their latest products. The expo had an interesting theme: integrating 5G for a smart and connected world. However, by being on location in Beijing, I obtained a deeper level of insight.
In a new era of technological and industrial revolution, China is evolving continuously—with an eye toward achieving transformative economic goals.
Connie Ou, CFAAssociate Portfolio Manager/Senior Analyst, SF Global Emerging Markets Equity Team
Under the Beijing government’s supportive industrial policies and “Made in China 2025” initiatives, some success is starting to emerge. Local semiconductor production has been growing at a 20% compound annual growth rate in recent years, according to Credit Suisse. In part, this is because the domestic suppliers offer lower cost compared with foreign companies while also providing better service.
The Chinese government is focusing on two key agenda items:
1. Mastering core technology such asadvanced semiconductors
2. Establishing a complete domestic supply chain
The economic drivers:
• Technology remains the largest part of China’s overall imports, measured at 21%.1
• In particular, semiconductors constitute 70% of China’s technology imports.2
• More than $300 billion in semiconductors were shipped to China in 2018, reflecting about 60% of global semiconductor value.3
China’s motivation:
• Supply stability
• National security
• Moving up the value chain through economic transformation
Sources: 1 and 2: Credit Suisse; 3: World Semiconductor Trade Statistics and China’s General Administration of Customs
Alison ShimadaSenior Portfolio Manager, Head of SF Global Emerging Markets Equity Team
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Chinese foundries that fabricate semiconductor wafers and companies that design integrated circuits have been focusing on developing a mature generation of chips and specialty applications. For example, SMIC, China’s largest and most advanced foundry, can provide integrated circuit foundry and technology services on process technology from 0.35 microns to 14 nanometers (one nanometer is one-millionth of a millimeter).
In the semiconductor industry, smaller chip size enables a more advanced level of technology.
A technology gap still exists behind market leaders Intel and TSMC. However, SMIC’s first generation of 14-nanometer “fin-field effect” transistors will be used in a broad set of applications, including high-end consumer products and artificial intelligence capabilities. SMIC plans to accelerate its production capacity by 25% in 2020, given the rising demand for import substitution. Nevertheless, China is still early in its supply chain development and is working to solve for barriers to technology, manufacturing, and high capital expenditure requirements.
Where 5G comes into play
Cloud services Internet of things
Smart manufacturing
After speaking with local company representatives at the PT EXPO, it became clear that China’s effort to gain technology independence would greatly benefit from a new wave of innovation. Most notably, 5G technology is expected to cover over 300 Chinese cities by 2020.
The direct benefits for Chinese semiconductor producers are vast, including demand from network build-out and handset upgrades. Given the faster speed (10 to 20 times faster than 4G) and low latency (short response time over the networks), we believe that 5G will lead to increasing connectivity and will trigger rising demand for three areas that can boost
Chinese semiconductors’ content and volume: cloud services, internet of things, and smart manufacturing.
In our team’s view, on-the-ground insights like these can place us in a strong position to identify companies that will play an integral role in China’s path to gaining technology independence. It also helps that we’re armed with rich local knowledge, a true understanding of Chinese policymaking and geopolitical issues, and a diligent bottom-up approach to research.
While there is still a long path to silicon independence, Chinese companies are rapidly increasing production capacity, narrowing technology gaps, and equipping themselves with a sizable engineering talent pool. With those pieces in place, China’s desire to establish a world-class integrated circuit industry value chain by 2030 is a dream that could eventually come true.
We’ll be watching this story as it unfolds in 2020.
Transformation in the 5G era
I saw something impressive as I spoke with a leading local network equipment-maker at the PT EXPO. A worker was sitting atop a machine from which he controlled a mining operation located far away from Beijing. Imagine: A job that used to be dangerous and costly can now be transformed through human remote control in the 5G era.
As the company showcased its latest 5G-integrated products, I learned that its 5G patent share exceeded 20% globally. The firm has been working with telecom operators to provide solutions for manufacturers and local governments, focusing on smart manufacturing, smart cities, and other areas.
—Connie Ou
2020
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INVESTMENT DISCOVERIES
Building a new playing field with smaller issuers
Janet Rilling, CFASenior Portfolio Manager, Head of Multi Sector – Plus, Global Fixed Income
To find better opportunities, sometimes you have to think bigger than the playing field you’ve been given.
My team was working on several fixed-income projects, including one to improve a passive retirement plan strategy and another to help pension clients improve the diversification in their long-duration credit mandates. Despite a variety of cases, we noticed a pattern—a linked set of challenges due to the very nature of the bond markets. In a nutshell, existing fixed-income indices exhibit a degree of concentration. For a pension plan that is striving to match its assets to its liabilities, such concentration introduces undesirable idiosyncratic risk.
As we dug deeper, we identified three common obstacles that U.S. pension plans face:
1Credit indices are concentrated in “mega” issuers. In fact, the top 10% of the issuers make up about 50% of the Bloomberg Barclays U.S. Long Credit Index (Long Credit Index).
2 Large issuers may seem like a safer bet because of their size and liquidity, but size does not necessarily equal safety.
3Many large asset managers tend to focus their portfolios on these largest issuers, compounding the concentration.
So like an R&D lab, we did a series of tests. We looked for ways to improve both the benchmark and the portfolio. We focused our efforts on a part of the market where we have historically found good investment ideas—companies that issue smaller amounts of debt and are generally under-followed.
We also drew on our niche as a credit-focused, bottom-up investment manager. Our research team helps us identify attractive investment candidates. Our modest asset size allows us to source enough of these small issuers’ bonds to make a difference in our portfolios. For a larger manager, finding enough of these types of bonds to be impactful can be a challenge. Further, if enough are found, a large manager’s share of the company’s outstanding debt may be too large, a condition often precluded by client guidelines.
With these ideas in mind, we built a new index—the Wells Fargo Small Issuer Long Credit (SILC) Index. We started with the constituents of the standard benchmark for pension funds—the Long Credit Index. Our innovation:
10%Remove the largest 10% of issuers from the Long Credit Index
90%
Create an index with the remaining 90% of issuers
Despite this change, the characteristics of our SILC Index still closely resembled the Long Credit Index across all relevant factors: duration, credit quality, yield, and industry type. But, importantly, the enhancement removed exposure to the largest issuers that pension plans already tend to have a lot of exposure to.
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As we look to 2020, two developments are driving increased interest in an active strategy that uses a benchmark like the SILC Index.
First, as the economic cycle progresses and the risks of downgrades and defaults increase, clients are more focused on reducing idiosyncratic risks.
Second, as the Pension Benefit Guaranty Corporation premiums continue to rise, pension plans are looking to make contributions and de-risk their plans. And plans that already have a sizable allocation to fixed income want to add something different, rather than more of the same. In both cases, the addition of a SILC strategy to a pension plan’s asset portfolio is a simple way to make an incremental credit allocation without adding to the large issuer concentration that may already exist.
Further, a SILC strategy offers diversification in a part of the market that is less efficient and offers a different alpha source.
A comparison of concentration levels
The SILC Index is less concentrated in a review of its top 25 constituents versus those of the Long Credit Index
SILC Index
Long Credit Index
Top 25 as % of index 18.45% 30.09%
Largest issuer weight 0.88% 2.57%
Difference in weight between 1st and 25th largest constituent
0.26% 1.81%
Sources: WFAM and Bloomberg Barclays as of December 31, 2019
Reimagining the conventional
“One of our innovations in helping institutional clients with their fixed-income portfolios has been understanding the limits and potential improvements to traditional fixed-income benchmarks, as discussed by Janet Rilling. Starting from the point of what an investor wants and needs, it becomes clear that improvements can be achieved.
I remember one particular client meeting back in 2016. The client was a corporate pension plan interested in investing in a liability-aware manner, with a view toward establishing a new liability-driven investment portfolio. Their liabilities—like most every pension plan—are long term, and the measurement framework that is important to them is based on high-quality corporate yields. As such, they were interested in a well-constructed long-duration investment-grade portfolio.
We started breaking apart the fixed-income world using subsets of traditional bond indices and made good progress, but ultimately we realized we could do more. In my mind, I was impressed by how this client sought to balance liability-like characteristics with the tenets of good investing and was willing to challenge some conventional norms.
That client meeting and our idea exchange set in motion a quest to design a widely usable yet complementary portfolio that enabled more diversification where it mattered most—in security-specific risk and in alpha. As illustrated above, we built this idea into an entirely new index: the Small Issuer Long Credit Index. We’ve talked with other institutional clients and consultants about this concept, and it’s resonating well with them.
Andy Hunt, CFA, FIA Senior Fixed Income Business Initiatives Leader
2020
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INVESTMENT DISCOVERIES
Embracing machine learning for value discovery
Craig Pieringer, CFAPortfolio Manager, Stageline Value Equity Team
Gustaf LittleAssociate Portfolio Manager, Stageline Value Equity Team
While the prospect of machine learning might frighten some fundamental analysts, we want to embrace it.
We’ve learned firsthand that machine learning doesn’t replace any portion of our investment process—and that, in our view, it can make us even better investors. As 2020 takes shape, we’re thinking about how we can use this technology to supplement our existing process during the new year.
Ever since 1988, our team has focused on finding value stocks that are away from the crowd. In other words, we look for public companies that are typically underfollowed by the investment community and have current stock prices that we believe inaccurately reflect the companies’ true market values.
Over the years, we’ve remained open to considering new and innovative quantitative tools that could prove helpful as we screen companies and analyze potential candidates for the portfolios we manage. In 2018, WFAM’s Investment Analytics team introduced us to new technology it’s been developing—a computer-aided stock selection process called CASPRTM. In collaboration with the team, we began experimenting with CASPR, using it to sort through a universe of roughly 12,000 stocks in search of companies consistent with our process for making investment decisions.
Given that we enjoy discovering value where few investors are found and limit investments in top benchmark names, we’re sometimes drawn to stocks that don’t screen well initially. Usually, that’s because their value may not be immediately obvious. At first blush, the idea appealed to us that a machine might be able to uncover value because this approach would remove human bias from the investment process.
Early in our work with CASPR, some stocks it suggested seemed expensive to us. But when several of them kept reappearing in subsequent months, they piqued our interest.
Using CASPR as a resource in identifying stocks
CASPR supports a portfolio manager (PM) team’s stock selection capabilities by simulating previous decisions that have been made in the portfolio through consideration of over 40 fundamental and quantitative factors.
CASPR doesn’t replace any portion of a PM team’s investment process—its recommendations supplement their existing process.
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One of these is a leading global consumer products company offering creative solutions to consumers through its diverse portfolio of well-recognized and widely trusted housewares, health care and home, and beauty brands. The company’s shares had declined following a tepid earnings report and concerns over the negative impact of potential tariffs on the firm. We knew this company well, as we had owned shares in the past. We weren’t inclined to reinvest in it, though, because even after the sell-off, its shares were priced above its long-term average.
However, CASPR’s repeated suggestions of this stock encouraged us to take another look at the company’s future prospects.
We considered the potential impacts of its possible sale of select personal-care brands and of the second phase of its growth plan, which would
be unveiled at an upcoming analyst meeting. Our conclusion was that we should reestablish a position in the company’s shares. All the elements at the core of Stageline’s investment process—an attractive valuation, evidence of a quality partner, and a contrarian opportunity—were evident to us.
That decision has proven to be a good one: The shares have performed well, and we continue to hold them today.
Our experience with CASPR has been favorable. We’ve used insights gained from CASPR research to uncover value in other stocks—including a restaurant company, an HVAC company, and an electronic components company. For us, machine learning—as demonstrated by CASPR—is an innovative addition to our mosaic of approaches for unearthing value.
Driving innovation with our clients in mind
When it comes to innovation, we embrace the concept of better, simpler, faster. One manifestation of this concept is CASPR, a tool our team is developing to supplement the native idea-generation capabilities of teams that manage fundamental investment strategies across our firm.
CASPR employs machine-learning methods upon a variety of digitized factors to continually improve the quality of its recommendations with experience and repetition. Here, quality means the ability to mimic the nuance and judgment that are employed by human professionals during the often time-consuming and inefficient phase of in-depth fundamental analysis. This part of the process is critical for separating winners from losers among potential portfolio candidates, yet fundamental investment teams have found it notoriously difficult to scale—until now. CASPR pursues more insights and better insights with greater speed than was possible before it and is fully adaptable to the unique success drivers of any fundamentally driven investment process. It is our intention to further develop this capability for the benefit of skilled teams, like Stageline’s, and ultimately for the benefit of our clients.
“
Randy Mangelsen, CFA, CQF, FRM, PRM Co-Head, WFAM Investment Analytics Team
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The shifting (and sometimes unexpected) impact of innovation on today’s financial advisors
More than 400 fintech businesses focused on investing have launched in the past several years¹
l Some are apps that aim to automate key aspects of managing one’s investments.
l O thers channel artificial intelligence in efforts to automate the art of providing financial advice.
How might this wave of tech innovation affect intermediaries such as financial advisors? According to the Wells Fargo/Gallup Investor and Retirement Optimism Index:
84%
84% of investors say human financial advisors will always be needed and will not be replaced by automated investing technology
More than half of investors revealed they would prefer working with an advisor who uses automated investing tools on their behalf
%<25Less than one-fourth of investors want to use automated investing tools for their own investments
These findings might feel like a relief to advisors.
But, in an era when data-driven technologies are constantly improving, it’s important to maintain a mindset of innovation:
1. How can advisors enhance their capabilities to pr ove investors are right to prefer a human advisor?
2. And how can advisors use technology to str engthen their client relationships?
On the latter point, here’s some food for thought—three capabilities that investors rank as important or critical when working with advisors.
69% Keeping them motivated and on track with financial goals
63% Understanding their personal lives and family dynamics
55% Helping clarify broader life values and goals
Remember, innovation isn’t only about reacting to technological advancement.
Sometimes it’s as fundamental as discovering ways to enhance the human skills needed to help investors live the best financial lives possible.
Here at Wells Fargo Asset Management, we offer extensive resources designed to help advisors maximize the value they bring to their clients. This includes innovative practice management tools and timely insights on investing and the markets authored by WFAM portfolio management teams—all available on our website, Twitter, and LinkedIn.
Sources: Deloitte (1), Q1 Wells Fargo/Gallup Investor and Retirement Optimism Index (all other statistics)
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INVESTMENT DISCOVERIES
Challenging assumptions in portfolio construction
Brian Jacobsen, Ph.D., CFA, CFP Senior Investment Strategist
Frank Cooke, CFA Solutions Manager, Multi-Asset Solutions Team
In times of chaos, keeping an open mind to alternative perspectives can help us gain a clearer vision of the path to a better outcome. We believe this mindset applies to portfolio construction techniques.
Traditionally, our industry has relied on capital market assumptions (CMAs) that offer estimates of how asset classes might perform in the future. While CMAs have had a central position in the design of asset allocation strategies, we on the Multi-Asset Solutions team believe it’s time to challenge how CMAs are used.
In large part, this means downplaying the role of longer-term return estimates in day-to-day portfolio management and elevating the role of expected risk.
In our view, a risk-based portfolio construction framework—rather than a traditional asset allocation framework—is crucial for building more resilient portfolios, especially in the face of market chaos. We use this approach for our institutional clients.
In a nutshell, here’s how it works:
1 We identify asset classes that span the investment universe, representing all major decision points.
2 Next, we set a risk target for each asset class informed by empirical evidence and professional judgment.
3 Finally, we apply a risk targeting process to spend risk across the investment universe to achieve the client’s goal.
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Why is this innovative? Because innovation implies improvement, and we think risk-based portfolio construction can do the following:
• Produce a better range of outcomes than traditional asset allocation
• Specifically, lead to portfolios that can more readily withstand uncertain market conditions and that are more relevant to solving real-world problems
• Overall, improve both investment efficiency and efficacy
The specific mix of objectives (protecting wealth, generating income from wealth, or growing wealth) is unique to each client, as are the constraints (regulatory, tax, or others). Let’s assume a hypothetical client’s risk profile is best met from a simplified risk-balanced portfolio that allocates 50% of the total portfolio risk contribution to equities and 50% to bonds (the risk-balanced proxy portfolio shown in Figure 1 below). The risk allocation translates to a capital allocation of roughly 25% to equities and 75% to bonds, generating an expected return of cash plus 3%. But, what if the desired risk allocation produces a return expectation that is insufficient to meet the client’s objectives?
Figure 1: How four approaches to portfolio construction could achieve different levels of target portfolio returnsUsing risk and return targets, we compare how four hypothetical portfolios, based on a hypothetical investor’s willingness and ability to invest in cash or borrow cash to invest in the portfolios, could perform.
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Hypothetical risk-basedproxy portfolio
Hypothetical unconstrainedleverage portfolio
Hypothetical relaxedleverage portfolio
Hypothetical growth proxy
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Risk (targeted level of volatility) (%)
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Gold line: The capital allocation line where an investor invests between cash and the hypothetical risk-based proxy portfolio. To aim for a higher return (up and to the right of the hypothetical risk-based proxy portfolio) assumes borrowing to invest in the hypothetical risk-based proxy portfolio.
Purple line: Trajectory for the portfolio holder who does not add leverage. Here the path to pursuing higher returns entails taking on more risk compared with investing along the gold line. Portfolios along this line may be more concentrated, or less diversified, than portfolios along the gold line.
Source: WFAM Multi-Asset Solutions. For illustrative purposes only, not intended to represent investment in any product managed by Wells Fargo Asset Management. Any target is indicative only and not guaranteed in any way. Target figures do not take into account any fees or charges on investment returns.
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To achieve a higher return target (say, cash plus 5%), we could simply apply leverage to the simplified risk-balanced portfolio (unconstrained portfolio in Figure 1). But many clients may face constraints in their use of leverage. This is where our framework comes into play. We can derive reasonable risk and return assumptions from the risk-balanced portfolio to construct a cash-plus-5% portfolio with no leverage (growth proxy portfolio in Figure 1) or one with modest leverage (relaxed leverage portfolio in Figure 1). In place of leverage, we can concentrate risks in assets with favorable characteristics to simultaneously satisfy the client’s unique mix of objectives and constraints.
Our foundational risk-based portfolio is fully unconstrained, but it can serve as the starting point for building portfolios for institutional clients. For example:
• Clients that need more growth may need more leverage, but if they are leverage-constrained, then we can determine the right amount of portfolio concentration to help achieve the goal.
• If the client is more interested in preserving wealth, then we can ratchet down the leverage or incorporate downside risk management strategies.
• Clients that face risk-based capital rules must have those rules incorporated as constraints in the portfolio construction process.
A variety of measures are used by asset managers, including ourselves, to quantify risk. Ultimately, however, the most important measure of risk to the investor is the probability of not meeting their objectives and by how much.
The innovation behind risk-based portfolio construction is that it puts risk front and center as the driver of capital allocation. This focus makes the resulting portfolio more resilient to market shocks that may come in 2020 and beyond—and more practical to the client’s unique set of circumstances, today and tomorrow.
LEADER INSIGHTS
Less talk, more action
Nate Miles, CFA Head of Retirement
In my role, I have the opportunity to meet often with retirement plan sponsors. During these meetings, I explain what WFAM’s research reveals about retirement, mainly from two equally important perspectives: saving for it and spending during it. We want to equip plan sponsors with our latest learnings so they can help employees achieve the financial independence they need to enjoy the retirement they want.
Just as important, I learn a lot in these meetings.
Plan sponsors use this time to tell me what worries them about their employees’ retirement situations and to ask what they can do about it. One question I’ve been hearing repeatedly lately that we’re taking to heart at WFAM: “What can we do, right now, to solve the retirement income challenges our employees are facing?” They’ve told me there have been numerous ideas and theories published on this topic, but no clear path forward that they can follow.
Plan sponsors have been patient, but they’re worried. From my perspective, they’re ready for less talk and more action.
One step we’re encouraging plan sponsors to take now is to start reemphasizing the significant role Social Security could play in an employee’s retirement income stream.
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INNOVATION VIEWPOINTS
Responding to the need behind the question
Dan Morris, AIAHead of Systematic Investments
A story by Dan Morris.
This was it: my first client where I was the lead strategist! After years of mathematics, actuarial training, and client meetings, I was ready. What could go wrong?
The chair of trustees had given me specific instructions on how to reach the board room at the top of a Canary Wharf skyscraper in London and the topics that they wanted me to address to the trustees of the company’s defined benefit plan. I was anxious yet fully prepared, waiting in the glassed lobby to be summoned in. As I entered, the room was daunting and crowded, but I received a warm and friendly welcome from the group, which calmed my nerves. After introductions, the meeting continued.
The chair began, “We have a change of plans for today. Our sponsor is funding the defined benefit plan’s deficit and is closing it down. The real challenge is helping all of the members in the defined contribution plan achieve something as good. What should we do?”
As abruptly, a spontaneous debate broke out on technical aspects of risks faced by the defined contribution plan’s members, engaging the room and animating many of whom had financial backgrounds. Yet the clamoring discussion was brought to a murmur by one trustee, calling across the room:
“We all understand volatility, but this means very little to many of our members. Tell me what they will retire with?”
We were now onto basic goals, the risks of missing those goals, and the available levers a saver has to pull to get back on track. With nothing specific prepared on the topic, it was time for me to go back to first principles and work out what really was being asked. How could I salvage this meeting? I began to piece together a translation of volatility, discussed earlier, into something more tangible that could get to the root of this trustee’s concern.
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He was right of course. Volatility in this context means very little. You see, the same technical measure of risk for someone 40 years away from a planned retirement at age 65 means something very different to someone only 5 years away. If both investors hold a portfolio of equities, then both would face:
• Volatility of, say, 18% (based on capital market assumptions centered on U.S. large-cap equities)
• A 1-in-20 drawdown risk of about 40% (a 1-in-20 risk reflects a degree of certainty an event could occur 1 in 20 years; 40% represents the size of market movement during that hypothetical event)
This is the risk we might see on our portfolio management screens but it is not the risk that members experience.
The real consequence of this risk occurring is that someone may have to delay their retirement—but by how much? We can think of this risk as the additional years required to receive the same pension. Imagine a risk event that causes a saver to delay retirement by, say, five years. The effect on a member would differ depending upon how many years away their planned retirement is. For example:
• A risk event that occurs a long time prior to a member’s planned retirement could have very little impact on that person delaying retirement, since they would potentially have:
– Many years for investment returns to recover and get them back on track
– Many years to pay more in contributions
– A plan to have less in retirement
• Whereas, for someone very close to their planned retirement date, a loss that causes them to delay retirement by five years would have greater consequences, since they could have:
– Less time to make meaningful contributions to take corrective action
– Fewer years for investment performance to come back
– Less time to adjust their spending needs
Furthermore, there may be other reasons why working for longer than planned is simply not realistic.
This translation of a technical risk expression into a real-world consequence could allow members a better way to understand their personal risk tolerance and their actual risk exposure.
• Do I have other sufficient assets to support my retirement?
• Could I work for longer?
• What are the trade-offs if I reduce that risk?
So, what saved the meeting? Well it turns out the key was listening and responding to the need behind the question. The simplicity and clarity of addressing the underlying concern left a palpable sense of relief on the trustees and a path forward. For me, it was the start of a special journey to outcome-based investing that has shaped my career to this day.
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INNOVATION VIEWPOINTS
The final word: Building a
culture that enables innovation
Ann Miletti Head of Fundamental Equity Teams
Part of my job is to make sure the resources are in place for our equity teams to provide the highest value for our clients’ hard-earned capital. We are constantly evaluating new quantitative tools, data, risk systems, and software to improve our decision-making. Yet the ingredient that is most critical to the ongoing success of our business is ironically the only constant in the formula.
I see it going up and down the stairwells every day.
It’s no secret that building human capital begins with selecting the right people, but a significantly more challenging aspect of this pursuit is protecting a culture that can retain and develop talent to its true potential. Protecting the freedom to ask questions and challenge common assumptions is key to this development, and I think its benefits can be realized at the earliest stages of one’s career, as it did mine.
In a prior life, I was an educator.
I remember vividly my first days of work in our offices in Menomonee Falls, Wisconsin, in the 1990s. I was excited about the change in my career path but nervous about the knowledge of my new teammates seated next to me. Many were newly minted finance graduates and others had some industry experience at respected firms. I recall thinking, how can I compete?
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But, I quickly learned that preconceived notions or self expectations could sometimes trip up even my brightest colleagues, making them unwilling to ask timely questions or hesitant to take on certain projects that could reveal ignorance or a blind spot. In contrast, I felt free to ask questions and was encouraged by the response of my peers and team leaders who appreciated a different perspective. I remember one particular week, after a series of grueling meetings, someone I deeply respected pulled me aside and said:
“I’m glad you’ve been raising your hand, because I’ve been afraid to do that.”
That comment stuck with me, and it continues to drive how I think about this business.
Today, I know that the sheer breadth, specialization, and constant change in capital markets can make the most talented investment professional an expert one day and a new student the next. How well they can learn has a lot to do with the confidence they have in themselves and the trust they have in team members to reveal themselves and take initiative. This self-innovation is something I encourage throughout our organization as I look to the next generation of leaders.
Reflecting on our history, the asset management business has changed a great deal since I began my career. Experiencing its rapid growth, maturity, and now consolidation over a relatively short period, my peers and I have seen our industry follow a life cycle similar in trajectory to the various companies and sectors we have followed across our investment disciplines. As much as our business has changed, it remains our ongoing responsibility to identify and allocate capital to the best available opportunities. Investors continue to seek out the investment firms they trust the most to carry out this task.
As I interact with my colleagues day to day, it becomes all the more clear from my perspective:
In times of change, it’s our people who’ll inspire that trust.
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In times of chaos, we hope you’ll also choose to innovateHere’s a summary of the six investment discovery themes that are on our radar in 2020 and beyond.
1. Uncovering innovation on the right side of change
• In 2020, businesses that can enhance their digital capabilities and meet changing consumer demands can be poised to produce strong excess returns.
• To achieve this, companies must find the right talent—but firms are struggling to do so, due to a scarcity of skilled software developers.
• Conversations between WFAM’s Fundamental Growth Equity team and various companies’ leaders led them to a compelling theme around companies that recruit and develop skilled labor pools outside the U.S.
• Just as c ompanies can revolutionize the consumer experience by bringing the right minds together, the Fundamental Growth Equity team is using a uniquely designed process to pursue these opportunities.
2. Driving positive change with municipal bonds
• Municipal fixed-income markets are an ideal space for identifying securities with impact. At their core, muni bonds are geared toward improving essential services.
• Issuers’ projects can offer ways to raise a community’s education level, enable access to quality resources, and reduce the negative effects resulting from the absence of these services.
• WFAM’s Municipal Fixed Income team has made these kinds of investments in its portfolios over the years. And, we’re now seeing investors’ interest growing to the extent that they want to experience the impact associated with these investments.
• Ov er the past year, the team researched and built an ESG impact framework to assess whether—and to what extent—positive environmental and/or social impacts exist in specific municipal securities.
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3. Watching China’s quest for technology independence
• A trip to China revealed a major initiative with support from the Chinese government, as discovered by WFAM’s SF Global Emerging Markets Equity team. The initiative focuses on mastering advanced semiconductor technologies and establishing a fully integrated domestic technology supply chain.
• There’s still a long path to what we call Silicon Independence, but Chinese companies are increasing production capacity, narrowing technology gaps, and recruiting engineering talent.
• With the advancement of 5G technology as a catalyst, the SF Global Emerging Markets Equity team believes that China’s desire to establish a world-class integrated circuit industry value chain is a dream that could eventually come true.
• To identify companies that will likely play a key role in China’s quest, the SF Global Emerging Markets Equity team applies its rich local knowledge, true grasp of Chinese policymaking, and diligent bottom-up research approach.
4. Building a new playing field with smaller issuers
• Credit indices are concentrated in “mega” issuers, which might seem like a safer bet because of their size and liquidity. However, size does not necessarily equal safety.
• For a pension plan that is striving to match its assets to its liabilities, such concentration introduces undesirable idiosyncratic risk.
• WFAM’s Multi Sector – Plus Fixed Income team built a new index—SILC (Small Issuer Long Credit)—that removes the largest 10% of issuers from a well-known long credit index and keeps the remaining 90%, with an eye on companies that issue smaller amounts of debt.
• Our index and its related institutional strategy draw upon the team’s niche as a credit-focused, bottom-up investment manager—and its modest asset size, which allows it to access enough of the small issuers’ bonds to provide a meaningful weighting in portfolios.
5. Embracing machine learning for the art of discovery
• While the prospect of machine learning innovation might frighten some fundamental analysts in our industry, WFAM’s Stageline Value Equity team embraces it.
• The team has learned firsthand that this technology doesn’t replace any portion of their investment process—they believe it can make them even better investors.
• Stageline has been using a computer-aided stock selection process called CASPRTM to sort through a universe of ~12,000 stocks in search of companies that align with their investment process.
• M achine learning has served as a valuable complement to the Stageline team’s approach of finding value stocks that are “away from the crowd” (are typically underfollowed) and have current stock prices the team believes inaccurately reflect the companies’ true market values.
6. Challenging assumptions in portfolio construction
• Capital market assumptions have had a central position in the design of asset allocation strategies. WFAM’s Multi-Asset Solutions (MAS) team believes it’s time to update how they’re used.
• In large part, this means downplaying the role of longer-term return estimates in day-to-day portfolio management and elevating the role of expected risks.
• In the MAS team’s view, a risk-based framework can produce more reasonable capital allocations early in the portfolio construction process—these are crucial for building more resilient portfolios, especially in the face of market chaos.
• MAS uses this risk-based approach for its institutional clients, driven by the belief that the most important measure of risk to the investor is the probability of not meeting their objectives.
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Continued from page 10
Many investors now envision a different picture for our future: a sustainable one, widely framed through a combination of:
• A global transition to a “net-zero” carbon economy (in which carbon dioxide emissions are reduced to as near to zero as possible and netted to zero with other processes)
• Consideration of positive or negative contributions to the United Nations Sustainable Development Goals
We’re seeing this manifest now. A group of the world’s largest pension funds and insurance companies created the “Net-Zero Asset Owner Alliance” in 2019. This group, collectively controlling more than $2.4 trillion in investments, is committing to carbon-neutral portfolios by 2050. Imagine—portfolios that will need net-zero carbon investments!
Here at our firm, the WFAM Climate Change Working Group partners with analysts across the organization to take this top-down thinking and apply it to bottom-up, issuer-level opinions. It also helps us work with clients to address specific climate considerations they have for their investments.
Compared with a decade ago, when a client’s strategy may have focused on excluding certain types of companies or issuers from their investments, today’s clients want our help:
• Putting companies or issuers into context within a shift to a sustainable, low-carbon economy (as asset managers, strong active stewardship plays a role here)
• Providing new investment solutions that allow clients to make conscious choices along this new dimension of investing
I believe that it will become normal for investment managers to show a fund’s or strategy’s ESG characteristics, in the same way that food companies show people the calories on the packages of food they buy. And, to use another food metaphor, many clients want a menu choice that includes an organic version.
—Hannah Skeates
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Continued from page 20
This valuable income source (Social Security) has been slipping out of many retirement income projections—especially for younger workers, even though 66% of Gen Xers and 64% of Millennials who participated in the 2019 Wells Fargo Annual Retirement Study agreed with this statement: “I have no idea what I would do without Social Security in retirement if it weren’t there.”
In our view, even if the Social Security program is modified at some point down the road, its retirement benefits are likely to remain a substantial income component for many future retirees. Educating employees about the projected contribution of Social Security benefits to their future retirement income provides information that’s essential as they work toward a financially independent future.
We’re also asking plan sponsors to promote a “planning mindset” within their organization. We characterize employees with a planning mindset as those who set short- and long-term financial goals and actively work toward achieving them. Wells Fargo’s research shows that participants with a planning mindset are more likely to describe their lives as “thriving,” have less financial stress, and have more assets saved for retirement. To make it easier for employees to adopt a planning mindset, we’ve developed tools—like our retirement planning guide, “New Rules of the Road: A Road Map for Pursuing Retirement Success”—to help simplify their retirement planning process.
Going forward, we’ll continue striving to deliver even more features and tools, like those on the right, designed to help plan sponsors help their employees attain financial independence throughout retirement.
How we’re helping plan sponsors help employees pursue retirement success:
• Developing estimates of a retirement plan’s success ratio: Based on its current plan design, we can project the plan’s potential for helping participants accumulate adequate savings for their retirement income needs.
• Creating retirement income checklists: Among other things, the checklist facilitates understanding a plan’s design to allow for taking various types of distributions during retirement.
• Considering innovative retirement income solutions: These would be intended to pensionize some or all of a person’s retirement savings into a recurring income stream that lasts a lifetime.
• Researching non-guaranteed income options: These would be intended for use by plan sponsors who don’t wish to incorporate a solution that includes annuities.
—Nate Miles
We want to help clients build for successful outcomes, defend portfolios against uncertainty, and create long-term financial well-being. To learn more, investment professionals can contact us:
l To reach our U.S.-based investment professionals, contact your existing client relations director, or contact us at [email protected].
l To reach our U.S.-based intermediary sales professionals, contact your dedicated regional director, or call us at 1-888-877-9275.
l To reach our U.S.-based retirement professionals, contact Nathaniel Miles, head of Retirement at Wells Fargo Asset Management, at [email protected].
l To discuss environmental, social, and governance (ESG) investing solutions, contact Hannah Skeates, global head of ESG at Wells Fargo Asset Management, at [email protected].
CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.
The views expressed and any forward-looking statements are as of January 1, 2020, and are those of the authors and/or Wells Fargo Asset Management. Discussions of individual securities, or the markets generally, or any Wells Fargo Fund are not intended as individual recommendations. Future events or results may vary significantly from those expressed in any forward-looking statements; the views expressed are subject to change at any time in response to changing circumstances in the market. Wells Fargo Asset Management disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.
All investing involves risks, including the possible loss of principal. There can be no assurance that any investment strategy will be successful. Investments fluctuate with changes in market and economic conditions and in different environments due to numerous factors, some of which may be unpredictable. Each asset class has its own risk and return characteristics. Investing in environmental, social, and governance (ESG) carries the risk that, under certain market conditions, the investments may underperform products that invest in a broader array of investments. In addition, some ESG investments may be dependent on government tax incentives and subsidies and on political support for certain environmental technologies and companies. The ESG sector also may have challenges such as a limited number of issuers and liquidity in the market, including a robust secondary market. Investing primarily in responsible investments carries the risk that, under certain market conditions, an investment may underperform funds that do not use a responsible investment strategy.
Wells Fargo Asset Management (WFAM) is the trade name for certain investment advisory/management firms owned by Wells Fargo & Company. These firms include but are not limited to Wells Capital Management Incorporated and Wells Fargo Funds Management, LLC. Certain products managed by WFAM entities are distributed by Wells Fargo Funds Distributor, LLC (a broker-dealer and Member FINRA).
WFAM 408726 1-20
INVESTMENT PRODUCTS: NOT FDIC INSURED n NO BANK GUARANTEE n MAY LOSE VALUE
