Shanghai Express - CFA Institute

TRUE OR FALSE: SKILL = PERFORMANCE?

HARNESSING BIG DATA FOR SMALLER FIRMS

HOW CROSS-BORDER FLOWS CAUSE CRISES

The Member Magazine for Investment Professionals

Nov/Dec 2014

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

An investor should consider investment objectives, risks, charges and expenses carefully before investing. To obtain a prospectus, which contains this and other information, call 1-866-SECTOR-ETF or visit www.sectorspdrs.com. Read the prospectus carefully before investing.The S&P 500, SPDRs, and Select Sector SPDRs are trademarks of The McGraw-Hill Companies, Inc. and have been licensed for use. The stocks included in each Select Sector Index were selected by the compilation agent. Their composition and weighting can be expected to differ to that in any similar indexes that are published by S&P. The S&P 500 Index is an unmanaged index of 500 common stocks that is generally considered representative of the U.S. stock market. The index is heavily weighted toward stocks with large market capitalizations and represents approximately two-thirds of the total market value of all domestic common stocks. Investors cannot invest directly in an index. The S&P 500 Index figures do not reflect any fees, expenses or taxes. Ordinary brokerage commissions apply. ETFs are considered transparent because their portfolio holdings are disclosed daily. Liquidity is characterized by a high level of trading activity.Select Sector SPDRs are subject to risks similar to those of stocks, including those regarding short-selling and margin account maintenance. All ETFs are subject to risk, including possible loss of principal. Funds focusing on a single sector generally experience greater volatility. Diversification does not eliminate the risk of experiencing investment losses. ALPS Portfolio Solutions Distributor, Inc., a registered broker-dealer, is distributor for the Select Sector SPDR Trust.

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Nov/Dec 2014

28 Go with the FlowFinancial crises are caused by

cross-border investment flows,

not misbehavior, says economist

Robert Aliber.

By Nathan Jaye, CFA

COVER STORY

32 Shanghai ExpressWill the Shanghai–Hong Kong

Stock Connect program be a

transformational breakthrough?

By Sherree DeCovny

36 Science, Art, and Investment ManagementHave recent events, especially

the global financial crisis, changed

the consensus about the correct

relationship between investment

theory and practice? And how are

new perspectives changing the way

hiring firms evaluate job candidates?

Two researchers share their findings.

By Nathan Jaye, CFA

“WHEN STOCKS BECOME LESS CORRELATED WITH THE MARKET, ALPHA WILL POP UP LIKE DANDELIONS IN MAY AND ACTIVE INVESTING WILL BECOME FASHIONABLE AGAIN.”

47COVER ILLUSTRATION

Timothy Cook

32

28

32

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

CFA INSTITUTE NEWS

7 EMEA VoiceEurope’s Changing Financial Regulatory LandscapeBy Rhodri Preece, CFA

9 APAC FocusThe Way Forward in China and IndiaBy Vidhu Shekhar, CFA, and Wendy Guo, CFA

11 The Future of Finance in Latin America

VIEWPOINT

12 Better Credit Metrics for Emerging MarketsIntegrating corporate governance is key for improving credit analysis in emerging marketsBy David Smith, CFA

14 Skill or Be SkilledTo improve skill, active managers need better data on their own performanceBy Michael A. Ervolini

17 Using ESG Factors for Equity ValuationHow should analysts apply ESG factors?By Jeroen Bos, CFA

18 Marks of DistinctionOverlooked skills can help investment profes-sionals distinguish themselves from the crowdBy Jason Voss, CFA

PROFESSIONAL PRACTICE

20 Can reforms boost China’s hedge fund sector?

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

47

“CFA INSTITUTE WILL BE UNWAVERING IN ITS COMMITMENT TO THE PROMOTION OF INVESTOR INTERESTS AND FINANCIAL MARKET INTEGRITY THROUGH THE MIFID II REFORMS AND BEYOND.”7

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CFA Institute, 915 East High Street, Charlottesville, VA 22902Editor (Name and complete mailing address)

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Nov/Dec 2014 Vol. 25, No. 6

EDITORIAL ADVISORY TEAMShanta AcharyaBashir Ahmed, CFAJim Allen, CFAJonathan Boersma, CFAJarrod Castle, CFAMichael Cheung, CFAJosephine Chu, CFAFranki Chung, CFADarrin DeCosta, CFANick Dinkha, CFAJerry Donohue, CFAAlison Durkin, CFAKenneth Eisen, CFAWilliam Espey, CFAJulie Hammond, CFABurnett Hansen, CFAM. Mahboob Hossain, CFAVahan Janjigian, CFAAndreas Kohler, CFAAaron Lai, CFA

Kate Lander, CFACasey Lim, CFAMichael Liu, CFABob Luck, CFAFarhan Mahmood, CFADennis McLeavey, CFASudip MukherjeeJerry Pinto, CFALinda RittenhouseCraig Ruff, CFAChristina Haemmerli Schlegel, CFADavid Shen, CFAArjuna Sittampalam, ASIPLarry Swartz, CFAJacky Tsang, CFAGary Turkel, CFARaymond Wai Pong Yuen, CFAJames Wesley Ware, CFAJean Wills

CFA INSTITUTE PRESIDENT & CEODwight D. Churchill, CFA

MANAGING EDITORRoger [email protected]

ONLINE PRODUCTION COORDINATORKara Hite

ADVERTISING MANAGERTom [email protected]

ASSISTANT EDITORMichele Armentrout

GRAPHIC DESIGNCommunication Design, [email protected]

CIRCULATION COORDINATORJennette [email protected]

4 CFA Institute Magazine Nov/Dec 2014

Nov/Dec 2014 CFA Institute Magazine 5

Confirmation Bias and Molten Lava“Being a man of integrity, Suda immersed himself in the study of rock reading, lava analysis and seismology.” —Shusaku Endo, Volcano

The recent eruption of the Mount Ontake volcano in Japan struck a chord. Not only was the mountain a popular des-tination for hikers, with more than 40 killed in the erup-tion, but a fairly extensive lodge was located near the peak. Both circumstances made the eruption Japan’s worst volca-nic disaster in almost a century. They also resembled the plot of a novel published more than 50 years ago.

In Volcano, the Japanese writer Shusaku Endo tells the story of Jinpei Suda. In an “unspectacular career” as a sec-tion chief for the weather bureau, Suda makes himself the resident expert on the local volcano Akadaké. He literally follows in the footsteps of a dead geologist who believed the volcano was “decrepit and extinct.” Suda makes more than 80 trips to study the mountain and assembles what he considers irrefutable evidence that the volcano will never erupt again.

A local city councilman named Aiba has a scheme to develop a hotel on Akadaké and make it a tourist attrac-tion. He recruits Suda as an expert to reassure the devel-oper that the mountain is perfectly safe, but Suda has an ulterior motive. At the point of retirement, he wants Aiba’s patronage to help him publish his study of Akadaké. The weaving together of personalities, purposes, and business is always a risk for investors. In particular for credit analy-sis in emerging markets, writes David Smith, CFA, investors should carefully consider “character and motivation … piec-ing together the informal networks that may connect indi-viduals” (“Better Credit Metrics for Emerging Markets,” 12).

Suda has been diligent in his investigation of the moun-tain, but this expertise is actually “a secret vanity,” infect-ing him with a severe case of confirmation bias about the theoretical model he inherited from the late scientist. He never considers other interpretations. Throughout his career and personal life, he has been blind to his character flaws. “From fifty years of experience in the art of getting along in the world,” writes Endo, “he had learned that medioc-rity was the secret of contentment.” A preference for safe mediocrity is what some observers perceive in the recent trend away from active management. “Many of us decided to become CFA charterholders because we are brilliant, courageous risk takers and swashbuckling top-gun fighter pilots,” writes Ralph Wanger, CFA. “Passive investing is for airline pilots” (“Captain Alpha’s Flying Circus,” 47).

The threat to active managers is real, according to behav-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

insight into skill” (“Skill or Be Skilled,” 14). Likewise, in Volcano, Jinpei Suda has no way of adapting to evolving circumstances. To do so would mean abandoning illusions about himself. When a minor eruption occurs and warn-ing signs appear—visible changes on the mountain, seis-mic activity (which he tries to conceal), and new analysis by a scientist who predicts a violent eruption—Suda con-tinues to reassure others and tells himself, “Akadaké will not play me false.”

With volcanoes or financial markets, small changes can signal “a start of something big,” as one observer remarks about gradual reforms toward opening China’s markets (Port-folio Performance, 20). Although the Shanghai–Hong Kong Stock Connect program could be a “transformational break-through” (“Shanghai Express,” 32), recent political demon-strations in Hong Kong remind us that even well-designed policy initiatives must be applied to a dynamic, nonlinear system called “history.” In the words of Sergio Focardi, “Finance theory is the theory of the behavior of a human artifact” (“Science, Art, and Investment Management,” 36).

With complex systems, inputs do not drive outputs in a direct, mechanical, and thus predictable way. An appar-ently minor flaw in the system, such as inadequate meth-ods of providing investor redress, can weaken market disci-pline (Market Integrity, 44). Cross-border investment flows can slowly distort economies and markets over a period of years and establish the preconditions for a sudden finan-cial crisis (“Go with the Flow,” 28).

Jinpei Suda’s beliefs about the volcano are not scientific. They are personal artifacts. Like everyone else in the novel, he conveniently sees in the volcano what he wants to see. In his case, that means a safe mediocrity untainted by scandal and free from dangerous, combustible passions, including love. The city councilman and the developer see a business proposition. A fallen old man sees the power of evil, which explodes like an unstoppable natural disaster, meaning he is not really to blame for his own moral failures. The idealistic pastor of a local church sees only pristine natural beauty, the perfect site to build a place for spiritual retreats. The story ends with Jinpei Suda dying with the knowledge that he deluded himself about his empty, sterile life and the vol-cano’s true potential for spewing destruction. Meanwhile, construction crews begin building the hotel project and the retreat center on the volcano. From Pompeii to Mount Ontake, people have a long history of living too close to volcanoes. One thing about the course of human events is very predictable—there will be eruptions.

Roger Mitchell, Managing Editor ([email protected])

IN SUMMARY

CFA Institute © 2014.

CIPM

Learn more at www.cfainstitute.org/cipm

COMPLETE THE PICTURE.

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Find out how the CIPM® designation can complement what you learned in the CFA® Program and help you build a deeper, more complete evaluation of your investment decisions.

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© 2014 CFA Institute


CFA INSTITUTE NEWSEMEA VOICE

Europe’s Changing Financial Regulatory LandscapeBy Rhodri Preece, CFA

This November heralds the beginning of the new legislative cycle in the Euro-pean Union (EU), marked by the com-mencement of duties for the new Col-lege of Commissioners. The installation of the new European Commission in Brussels completes the makeover of the EU’s policy-making apparatus and fol-lows the resumption of discourse in the European Parliament after the summer

recess and the elections that preceded it. The broad policy objectives for the new legislature focus on restoring jobs, growth, competitiveness, and a “capital markets union” in Europe to complement the banking union established under the previous Commission. Yet amid these policy aspirations and institutional changes, regulators’ immediate attention will be focused on an existing piece of legislation—namely, the Markets in Financial Instruments Directive (MiFID II).

Passed into law in June 2014, MiFID II sets new rules for the structure of markets and the trading of financial instru-ments and prescribes conduct-of-business standards for the provision of investment products and services. Since this past summer, the European Securities and Markets Author-ity (ESMA), alongside the European Commission, has been engaged in the ongoing process of developing technical standards to implement the legislation. CFA Institute, in its commitment to promoting financial market integrity, is providing input via two key channels.

First, Josina Kamerling, head of regulatory outreach in EMEA at CFA Institute, has been appointed to ESMA’s secondary markets consultative working group (see page 42 for more information). A key part of this committee’s remit is to advise ESMA on the structure, transparency, and efficiency of secondary markets for financial instruments, including regulated trading venues and OTC markets. Because these issues are central to the MiFID II reforms, our presence on the committee makes us well positioned to deepen and expand our regulatory engagement with MiFID II and to provide the investor’s perspective in the policy debate.

Second, CFA Institute has been engaged in the regulatory consultation process that began with the June publication of both a discussion paper and a consultation paper by ESMA (you can view our responses at http://bit.ly/commentletters). The discussion paper sets out ESMA’s initial thinking on the 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,

order-to-trade ratios, and tick sizes for equity markets), data publication and access, and other reporting issues.

A central objective of MiFID II is to increase the level of transparency in financial markets. To that end, the pro-visions for pre- and post-trade transparency in non-equity markets such as bonds and derivatives have far-reaching implications and perhaps reflect the most ambitious aspects of ESMA’s work. CFA Institute supports the general prin-ciple of bringing greater transparency to these markets to reduce the informational advantage held by dealer banks over investors, which can keep spreads (and thus costs) arti-ficially high. But because the calibration of these require-ments in non-equity markets needs to balance transparency with liquidity-provision considerations, a gradual approach is warranted. To provide sufficient clarity and certainty to market participants, the transparency framework should avoid undue complexity.

ESMA’s consultation paper focuses on investor-protection measures related to MiFID II’s conduct-of-business require-ments, which address the assessment of the suitability and appropriateness of investment products by financial advis-ers and strengthen the rules on inducements. CFA Institute has voiced strong support for investor-protection measures, calling for more transparency and consistency in invest-ment product disclosures and product governance. To bol-ster this debate, CFA Institute is actively promoting investor protection through its Future of Finance initiative and high-lighting the importance of investors’ rights to information, fair and honest advice, and accurate assessment of risk and reward. We believe that a commitment to uphold the highest standards of investment practice and to serve investors and the global economy can effect a positive change in finance.

The next step in the policy-making process will be another consultation round in which ESMA must set out its draft tech-nical standards. By the end of 2015, the European Commis-sion must adopt these standards through legislation, paving the way for the implementation of MiFID II in January 2017.

With such a broad and lofty policy agenda for the incom-ing Commission, the regulatory landscape for financial mar-kets and financial services is likely to change significantly between now and 2017. Throughout this period of change, CFA Institute will be unwavering in its commitment to the promotion of investor interests and financial market integ-rity through the MiFID II reforms and beyond.

Rhodri Preece, CFA, is head, capital markets policy EMEA, at CFA Institute.

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The Way Forward in China and IndiaBy Vidhu Shekhar, CFA, and Wendy Guo, CFA

“We must create cultures where business and finance can work together to create high-performing companies and earn returns for savers on a sustainable basis.” —John Kay, chairman of the Future of Finance Advisory Council, quoted from the Kay Review of UK Equity Markets and Long-Term Decision Making (July 2012)

In the coming year, CFA Institute will open offices in India and China as part of our initiative to better support our mission in these two countries. In addition to serving our members, a significant part of our activities in China and India will involve working with industry participants, reg-ulators, and policymakers in such areas as ethics, gover-nance, financial market integrity, and transparency.

Our work in China and India is also important for the Future of Finance initiative at CFA Institute, a long-term global proj-ect to shape a trustworthy and forward-looking finance indus-try that serves society. Developments in China and India in the next few years will have a significant global impact not 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 example, the Economist has asked its readers when China will surpass the United States in terms of gross domestic prod-uct (the consensus, at the time of this writing, was 2021). Yet despite its impressive and unprecedented achievements, China remains a developing country. It has the second-largest number of poor people after India, and its per capita income is still far below the levels of developed countries. Moreover, China is entering a delicate period of economic rebalancing as it tries to rely less on real estate, infrastructure invest-ments, and exports (all of which have driven growth over the years) and attempts to stimulate more domestic consumption.

India may lack the economic muscle of China, but it too has made significant progress in the past 20 years within a somewhat unpredictable democratic process. India’s economic reforms began in earnest after the balance-of-payments crisis in 1991. Since then, financial markets and institutions have steadily replaced the government in handling the task of cap-ital allocation. But large banks, insurance companies, and pension funds remain state controlled. Significant reforms are needed before market institutions can become capable of fully supporting economic growth and financial inclusion.

Against this backdrop, it is important to recognize that the Future of Finance initiative and its six focus areas (Put-ting Investors First, Financial Knowledge, Transparency and Fairness, Retirement Security, Regulation and Enforcement, and Safeguarding the System) may look very different in India and China compared with the developed world. For

example, in the context of Safeguarding the System, the lack of highly developed fixed-income markets and the exces-sive dependence on bank credit by companies in China and India may create a fragile financial system that is vulnera-ble to corporate defaults. With risk heavily concentrated in one sector of the financial system, defaults can cause bank-ing sector distress and, in turn, put pressure on the govern-ment to bail out troubled banks in order to maintain finan-cial stability. In contrast, in the United States and Europe, a significant portion of debt is securitized and held by non-bank financial institutions.

In the area of Retirement Security, the demand for pen-sion assets is growing very quickly in both countries. China’s population is aging rapidly, and structural reform is neces-sary to address the ballooning deficit. Capital market devel-opment and the availability of diverse investment instru-ments are both equally important in successfully meet-ing the challenge. In India, as the fiscal deficit is brought under control and the growth rate of government borrow-ing comes down, pension funds will look for longer-term corporate assets. The development of this market requires fixing problems in the legal system, creating strong inter-mediaries, and improving regulation and enforcement.

Financial Knowledge will also become very important for both countries as they experience rapid expansion of access to financial products and services in the coming years. Thus, significant outreach is needed for educating investors and advisers and for creating the proper foundations for liquid and vibrant markets. This need places an important respon-sibility on investment professionals, a responsibility that CFA charterholders are well positioned to bear.

We have our work cut out for us in China and India. Under-standing the specific long-term challenges faced by these countries will allow CFA Institute and our members to con-tribute more effectively to the development of these markets and to realize the vision of the Future of Finance initiative.

Vidhu Shekhar, CFA, is country head for India at CFA Institute. Wendy Guo, CFA, is the China plan general manager at CFA Institute.

CFA INSTITUTE NEWSAPAC FOCUS


IT IS IMPORTANT TO RECOGNIZE THAT THE FUTURE OF FINANCE INITIATIVE AND ITS SIX FOCUS AREAS MAY LOOK VERY DIFFERENT IN INDIA AND CHINA COMPARED WITH THE DEVELOPED WORLD.


CFA INSTITUTE NEWS

IN MEMORIAM

Thomas L. Hansberger, CFA, passed away on 1 October in Red Lodge, Montana. His wife, Patty, said that even though Tom had a small family of his own, he always

considered CFA Institute to be his extended family.

His deep commitment to the organization is evident in his history of global outreach. He was a founder and the

first president of the International Society of Financial Analysts (ISFA), our first soci-ety outside North America. He later served as chair of both the Financial Analysts Federation (FAF) and the Association for Investment Management and Research (AIMR). A recipient of the Alfred C. Morley Distinguished Service Award, Hansberger was characterized frequently as “modest.”

Considered a pioneer in the field of global investing by his peers, he was honored with a leadership award in his name in 1998—the Thomas L. Hansberger Leadership in Global Investing Award.

Past AIMR chair John Maginn, CFA, recalls how Hansberger’s experience provided contacts and perspective for the staff and board that proved invalu-able. “Tom was really a prime mover and motivator of the organization’s shift from a largely North American-focused organi-zation to a truly global organization.”

T.K. Yap, CFA, a former CFA Institute Board member, remembers Hansberger as being a “beacon for many of the early charterholders and society leaders” in Asia: “Tom will be remembered for his vision to start the ball rolling in this region.”

Hansberger helped found and was president of CFA Society Tampa Bay and CFA Society The Bahamas. He also was president of CFA Society South Florida.

In 1979, Hansberger joined the Temple-ton organization, becoming its first analyst, and within a few years became president and CEO of Templeton World-wide. Sir John Templeton, CFA, personally requested that Hansberger work for him at Templeton, one of the first companies to venture into international investing.

A service is scheduled for 22 Novem-ber in Ft. Lauderdale, Florida. Friends can contact Patty Hansberger at [email protected], or at 860 S. Davis 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.”

For more information or to download a free copy, visit www.cfainstitute.org/duties.


lit_ad_jennings.indd 1 9/19/14 2:27 PM

Paul A. Delaney, CFA Toronto

Morton Langer New York City

Nicholas A. Valtz, CFA New York City


The Future of Finance in Latin AmericaMembers of the CFA Institute Ameri-cas and Future of Finance teams vis-ited Latin America over the summer to engage with local candidates and mem-bers; to promote our programs to regula-tors, employers, and university students; and to encourage our members there to help shape the future of the finance industry. Tom Robinson, CFA, managing director, Americas; Rafael Matallana, manager, Latin America relations; and Ashvin P. Vibhakar, CFA, senior adviser, led the trips to Bogotá, Colombia; Lima, Peru; and Santiago, Chile.

While in Peru, the team had an opportunity to participate in the Peru Capital Markets Day (CMD) Seminar hosted by El Dorado Investments and Universidad del Pacífico. The CMD sem-inar is a one-day event involving about 400 local professionals in the financial services industry. CFA Institute speak-ers discussed how to improve the cap-ital market ecosystem through ethics, education, CFA Institute programs, and the Future of Finance initiative. About 600 people in Peru take the CFA exam every year, and today, there are 80 CFA charterholders in the country.

Team members also met with José Luis Ramirez Pérrigo, Jorge Mogrovejo Gonzalez, and Augusto Vidal at Super-intendencia de Banca y Seguros y AFP (SBS, the local banking and pension fund regulator) to discuss SBS staff participa-tion in CFA Institute programs and other long-term partnership opportunities. In addition, the team met with Alejan-dro Angulo at AFP Integra, the pension fund system in Peru, and presented an overview of the CFA Program, the CIPM Program, and the Claritas Program, as well as the Future of Finance Initiative, to enthusiastic AFP Integra staff.

A highlight of the Lima trip included media interviews with Diario Gestión and El Comercio. Tom Robinson stressed the importance of ethics and education

in building trust and a stronger finan-cial ecosystem. “The most important thing is you always put your clients’ interests first, before yours or before your firm,” Robinson said. [His Diario Gestión interview is available online at http://gestion.pe/mercados/nuestro-objetivo-ir-hacia-ecosistema-financiero-sano-2106207.]

Ashvin Vibhakar was interviewed by El Comercio regarding the Future of Finance initiative and the need to restore trust in the industry. “According to the Edelman Trust Barometer, the finan-cial services industry is the least trusted industry globally,” he pointed out. Vib-hakar added that one way to restore bal-ance to the global economy is through promotion of Future of Finance output and activities, including support of the Statement of Investor Rights and Put-ting Investors First Month.

Programs Now Eligible for GI Bill in the United StatesCFA Institute’s suite of educational programs—the CFA Program, CIPM Program, and Claritas Program— are eligible for reimbursement under the GI Bill. These benefits, available through the US Depart-ment of Veterans Affairs, provide assistance with costs associated with education and training and are earned by members of the US Armed Forces. If you’d like to refer a US veteran to one of our educa-tional programs, please visit www.cfainstitute.org/service for details and specific instructions.

DISCIPLINARY NOTICES

SUMMARY SUSPENSIONOn 2 June 2014, CFA Institute imposed a Sum-mary Suspension on Mingchao Zhao (Canada), a lapsed affiliate member, automatically suspending his membership. Because he did not request a review, the Summary Suspension became a Revocation on 3 July 2014.

Zhao admitted to engaging in illegal insider trading between June 2010 and December 2011. On 17 May 2013, the Ontario Securities Commis-sion (OSC) approved a settlement agreement under which Zhao was permanently prohibited from trading securities; permanently prohib-ited from becoming or acting as a director or officer of an investment fund manager; and permanently prohibited from becoming or acting as a registrant, investment fund manager, or promoter. In addition to the permanent prohibi-tions, Zhao was ordered to pay OSC a C$750,000 administrative penalty, disgorge C$416,719 in profits, and pay C$30,000 in costs.

TIMED SUSPENSIONEffective 15 July 2014, CFA Institute imposed a One-Year Suspension of membership and the right to use the CFA designation upon Ho Kei Him Calvin (Hong Kong), a lapsed charterholder

member. Ho was found to have violated Stan-dards I(A)—Knowledge of the Law, I(C)—Misrep-resentation, and VI(A)—Disclosure of Conflicts of the CFA Institute Code of Ethics and Standards of Professional Conduct (2005).

On 12 March 2013, the Securities and Futures Commission of Hong Kong (SFC) prohibited Ho from re-entering the securities industry for 14 months. The SFC found that Ho breached General Principles 6 and 7 and Paragraphs 12.2, 16.3, and 16.4 of the Code of Conduct for Persons Licensed by or Registered with the SFC. Specifically, the SFC found that, on four separate occasions, Ho filed mandatory account declarations with his employer that did not disclose his family members’ securities accounts at another institu-tion. Additionally, between February 2010 and June 2010, Ho was involved in the preparation of research reports for three stocks that were also traded in his family members’ undisclosed accounts during that time. The trading occurred either one day before or on the same day as research reports issued by Ho’s research team. Lastly, the SFC found that Ho failed to disclose to his employer his personal interest in certain securities held in one of the related accounts.

ONE WAY TO RESTORE BALANCE TO THE GLOBAL ECONOMY IS THROUGH PROMOTION OF FUTURE OF FINANCE OUTPUT AND ACTIVITIES, INCLUDING SUPPORT OF THE STATEMENT OF INVESTOR RIGHTS AND PUTTING INVESTORS FIRST MONTH.


VIEWPOINT

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

By David Smith, CFA

Emerging markets present investors with an exciting opportunity to tap into macroeconomic themes of eco-nomic growth, rising affluence, and emergent consumerism. For the diligent investor, the returns can be reward-ing, but poor corporate governance can lead to an erosion of these returns. Indeed, emerging markets are fraught with such governance risk. Cash-rich companies may be attractive, but will investors ever get a slice of the cash? Strong cash flows are alluring, but will they be reinvested in the company or squandered on vanity projects? Good corporate governance is vital in pro-tecting the interests of providers of finance, and nowhere is this principle truer than in emerging markets.

For these reasons, the integration of corporate governance analysis into equity investment approaches has been gaining ground around the world. Less common, however, is the integration of corporate governance within the credit analysis process.

QUALITATIVE FACTORSIn emerging markets, the global search for yield introduces investors to new opportunities and challenges. Emerg-ing debt markets are younger, corpo-rates there have shorter histories, and information is scarce. These shortcom-ings have impelled us to make corpo-rate governance a key component of credit analysis. One must scrutinize not only the traditional credit metrics of the entity issuing the paper but also the corporate governance of the entity to be financed, including the background and track record of the shareholders or promoters of the entity.

Although the traditional credit anal-ysis process considers the track record of the entity issuing the paper and the incumbent management team, we see the pedigree of the promoter and pro-moter group as being of similar—or

even greater—importance in emerg-ing markets. In my view, investors who ignore such information are taking uninformed and unrewarded risks.

What should investors do to guard against these risks? A good way to start is to look at the people behind the paper. What have they done in the past, and how have they treated providers of finance to the companies they previ-ously owned? At the margin, this eval-uation involves value judgments, such as deciding whether the promoters are likely to honor their debts. Trust is vital in regions where legal recourse to debt recovery is very often complicated and the impartiality of the courts is at times questionable.

Traditional credit analysis focuses on cash flow and the assets used to gener-ate this cash flow. Although covenants can restrict the ways in which the assets and the cash can be used, covenants may give a false sense of security. No matter how well covenants are drafted to mitigate corporate governance, artful promoters can find ways around them. Things to watch for include creative use of unidentified third-party vendors, transfer pricing agreements, and asset-value inflation.

Covenants are only as strong as the institutions charged with enforcing behavior. Accordingly, investors would be wise to look at the character and moti-vation of the company’s advisers, audi-tors, bankers, directors, and so on. Piec-ing together the informal networks that may connect individuals across these firms requires time. If a firm chooses an auditor with few clients and an unusual record of association with corporate fail-ures, the move should prompt questions.

Character is a qualitative assess-ment—one that is tempting to mea-sure using quantitative overlays, such as credit standing or bond rating. But that kind of substitution is dangerous and inadequate. Particularly where

companies are family-controlled con-cerns, it pays to know about reputations. Although the 1997–98 Asian crisis was supposed to have lanced “crony capital-ism” in the region, the fact that some groups have managed not only to sur-vive but to thrive in the years since should stand as a warning.

Commercial success is often closely tied to political connections, and in many economies, wealth has been linked to the granting of preferential licenses and rent-seeking behavior. The more powerful vested interests have become adroit at promoting private gain as a national good.

In the past, bank financing dominated lending to companies. Well-placed com-panies could use their influence to get access to loans, and indeed, many con-glomerates were built with the help of banks they controlled. Banks were part-ners first and were expected to have a forgiving attitude when loans could not or would not be repaid. Not surprisingly, some companies view the alternative of financing via the bond markets with suspicion. They perceive foreign bond-holders as opportunists—a convenient stereotype that may hide an ambivalent view of their obligations as a borrower.

METHODOLOGYIn my experience, any credit examina-tion must begin by assessing the qual-ity of cash flow metrics. The level of related-party transactions is a good indicator of whether a company exists to enrich management and promoters or not. A dependence on related parties for assets, intellectual property, or finan-cial assistance will clearly weaken such a company as a stand-alone concern.

The issue of intellectual property is a growing one for investors. Compa-nies frequently lease intellectual prop-erty (such as know-how or trademarks) from controlling shareholders at what may appear to be nominal rent. But these


agreements often contain clauses that punish corporates in certain circum-stances, such as a change of control. Dis-covering these clauses is laborious yet vital. An important part of due diligence requires spending hours poring over debt and equity prospectuses looking for a single clause in these agreements.

A related question concerns a com-pany’s ownership of its factors of pro-duction. These may be leased from a controlling shareholder directly or indi-rectly (for example, through a variable-interest entity structure). If the company exists at the pleasure of a controlling shareholder, with the risk that land or labor may not be supplied so willingly in the future, the risk to an investment manager’s clients will be substantial.

All of these issues are important, but investors’ key interest is in management teams and promoters. In some markets, institutional memory and the research network give an investor a good sense of 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 have built a company through hard work than with those who have been gifted privileges because of their connections.

This comfort level tends to go up with companies that have a track record of growing profits, ideally under inde-pendent management. To return to the theme of family-controlled enterprises, one of the biggest problems is how the patriarch deals with second- or third-generation members. Do the sons and daughters automatically get top jobs, or do they work their way up through the business while being groomed by out-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 deci-sion making this involvement implies.

Families can be skilled managers, and outside help is not always supe-rior. Further, a promoter who is con-cerned about his legacy can ensure that the balance sheet is managed conserva-tively and with an eye to the long term.

With any company, investors are trying to form a view of the man-agement team, their credibility, and whether clients’ money should be risked

on these individuals. Investment man-agers should press management hard, particularly where there has been behavior of questionable motivation in the past. If a company cites circum-stances beyond its control as reason for a past cash crunch or corporate catas-trophe, it must show evidence that it has learned from the experience.

Before putting our clients’ money at risk, it is important that investment managers understand the history of the promoter, his or her interests (and alignment with the interests of provid-ers of finance), linkages between group companies, and the commitment to good corporate governance. Only by making this effort will investors gain a true picture of credit quality.

Alas, capital markets have a short memory. After a crash or crisis, irratio-nal exuberance can quickly replace cyn-icism when good times return, and with such exuberance comes a willingness to forgive past sins in return for (scarce) yield and an indulgent approach to due diligence.

Investing in emerging markets should never rely on overly quantitative analysis characterized by box ticking and false quantification. That way lies a kind of willful blindness. Investors can avoid the corporate time bombs that inevita-bly come to market by sticking to a focus on quality and by overlaying qualitative factors onto traditional credit metrics.

David Smith, CFA, is head of corporate governance at Aberdeen Asset Management Asia Limited.

REBOOTING INDIA TO REALISE ITS POTENTIALEARLY-BIRD OFFER closes after 9 December 2014 www.cfa.is/india2015

INDIA INVESTMENT CONFERENCE 9 January 2015, Mumbai, India

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

By Michael A. Ervolini

If you are an active equity manager, it’s time for a deep look in the mirror. Your industry, your business, and your live-lihood are in jeopardy. The reason is obvious: Investors are no longer will-ing to pay more for active management, only to receive passive performance or less. You know this already, but are you really thinking about how to solve it? The fact is that the worse the indus-try does, the worse you do. It’s that simple. This article provides a critical look at the state of active management, explains why most managers lack suf-ficient skill to beat their benchmarks, and offers renewed hope by introduc-ing a new framework for improving deliberately.

THE CHALLENGEActive equity management is under siege, with active managers facing three harsh realities. First, more than 80% of portfolios underperform each year, and it has been this way for decades. Second, trillions of dollars are being reallocated out of active management directly into passive products, with no end in sight to this trend. Third, active management fees—your fees—are dropping like a rock.

The future of active equity manage-ment is problematic and characterized as one of intense competition for scarce assets. The challenges you face as an active manager are sufficiently severe that the notion of “business as usual” will translate for many into “soon out of business.” But you do have an option—one that will offer you the chance at a future that is brighter and more prof-itable than the industry at large. The option sounds simple: learning how to improve. But exercising this option is not easy; it takes guts and hard work.

You probably think you already know how to improve. Wrong. You don’t. How could you? The feedback you have ready access to is simply not up

to the job. Traditional portfolio metrics (such as return, relative return, infor-mation ratios, alpha, tracking error, turnover, hit rates, win/loss ratios, and attribution analysis) all have one thing in common: They are scorecards, measuring outcomes, but they provide zero insight into skill. Armed with only this type of information, it is virtually impossible to improve.

Compare your situation with that of a professional golfer. If the golfer were provided only the score after each round and nothing more, how would

she know what part of her game is strongest? Is it her drives off the tee, her irons in the fairway, or her putts on the green? Our golfer would be clue-less about her skills, and even more critically, she would have no idea what to do today to become a better golfer tomorrow. Golfers do, of course, have much more information than just out-comes. They know everything about their skills and sub-skills based on rig-orous and granular feedback. It is the quality of their feedback that enables elite athletes to improve throughout their careers, even as they reach the pinnacle of mastery. It is equally true for other high-performance profession-als, such as surgeons, musicians, and jet pilots. Excellent feedback underlies improvement and strong outcomes in every high-performance arena but one: active portfolio management.

Because investment skill is not mea-sured, money managers’ lack of prog-ress at improving is no surprise. Poor feedback is holding back hundreds of

thousands of managers and research analysts around the globe. But this sit-uation is changing. A growing number of professional investors are learning to improve deliberately, supported by rigorous and granular feedback that only recently became available to pro-fessional investors.

A NEW FRAMEWORK FOR IMPROVEMENTA new framework uses the comparison of adjusted portfolio histories to isolate and measure skills. The basic idea of

this method, as developed by Cabot Research, is to begin with the actual his-tory of a portfolio and then modify one or more elements in order to construct adjusted portfolios. The comparison of adjusted portfolios with the actual port-folio and with each other supports the precise investigation of skills.

Consider a simple example. A man-ager wants to understand how well his sizing of positions works. The new ana-lytic framework makes it possible to quantify this skill. It involves construct-ing an adjusted portfolio history that, on every day, owns the same positions as the manager’s actual portfolio. The difference is that the adjusted portfolio will ignore the manager’s actual sizing decisions and will instead size all posi-tions based on a passive rule. Thus, the adjusted portfolio will have the same composition as the actual portfolio but will reflect position sizing that will be both passive and independent from the active decisions made by the manager. From this basis, it is simple to compute

VIEWPOINT

TRADITIONAL PORTFOLIO METRICS ARE SCORECARDS, MEASURING OUTCOMES, BUT THEY PROVIDE ZERO INSIGHT INTO SKILL.


the daily returns for both portfolios, cal-culate a measure of aggregate perfor-mance (e.g., annualized return, relative return, alpha, etc.), and then compare the results. If the actual portfolio out-performs the adjusted portfolio, then the manager’s judgments regarding position sizing added value, meaning the manager has sizing skill. Alterna-tively, if the actual portfolio underper-forms the adjusted portfolio, it suggests that sizing skill is weak or at least insuf-ficient to beat the passive rule.

This form of analysis also can be used to understand more granular skills and to identify behavioral tendencies. Suppose a manager is interested in seeing if she engages in regret aver-sion (the tendency to keep “younger” winners undersized). This behav-ioral tendency will also show up as a weak sizing skill. The new frame-work starts with the manager’s actual portfolio and constructs an adjusted portfolio wherein only certain posi-tions are adjusted, specifically those that are relatively new in the portfo-lio and that have an unrealized gain. Once identified, these younger win-ners are increased to a target weight that reflects the manager’s typical full position size. No adjustment is made if such a younger winner is already at or above this target weight. Once again, the daily returns and overall perfor-mance of the actual and adjusted port-folios are computed and compared. If the adjusted portfolio outperforms the actual portfolio, younger winners are probably being undersized. Further investigation is required to identify how persistent this behavior is and whether corrective action is warranted.

Portfolio managers who use this framework are becoming more self-aware, learning about their real strengths and shortcomings, and (most importantly) implementing improve-ment efforts that are delivering stron-ger and more consistent results. A more complete description of the new framework and how it can be used to help you start improving deliberately today is provided in my book Man-aging Equity Portfolios: A Behavioral Approach to Improving Skills and Invest-ment Processes.

REAL-WORLD EXPERIENCESWith the ability to look deeper and more clearly into the decisions manag-ers make, the new framework is uncov-ering previously hidden insights about skill, process, and behaviors. Based on my firm’s experience working with managers of portfolios totaling more than US$800 billion in assets, here are a few of the lessons learned about what’s really going on in actively man-aged portfolios.

SKILL EXISTS. The majority of under-performance is attributable to large skill asymmetries and not the total lack of skill, as is commonly thought. Manag-ers often generate 100 bps or more of excess return with one skill (i.e., buys, sells, sizing) only to give that much and more back with one or two weak skills. These managers can start moving toward their benchmarks by building on their positive skills and retooling skills that need help.

NOBODY’S PERFECT. Even highly suc-cessful managers (those above their benchmark regularly) typically have one skill that is negative and dragging down performance. Traditional ana-lytics obscure such weaknesses, keep-ing managers in the dark about what is working and what is not. Reversing these hidden shortcomings is among the surest sources of incremental alpha for any portfolio.

BEHAVIORS ABOUND. Evidence shows that 85% of portfolios exhibit at least one behavioral tendency that is persistent over long periods of time, costing the portfolio in excess of 100 bps annually.

TROUBLING WINNERS. Although hold-ing on to losers (loss aversion) plagues retail investors, professional investors are more likely to be tripped up by win-ners. The endowment effect (holding winners far past their alpha-generat-ing ability) is seen in one out of every four professionally managed portfolios. Regret aversion (the inadequate build-ing up of winners) is found in one out of six portfolios.

THE WRONG SIZE. Sizing is often the least rigorously developed skill, com-monly reflecting hunches or rules-of-thumb learned from early mentors. More than half of studied managers possess a negative sizing skill, and it

costs their portfolio in excess of 100 bps annually. The framework of deliberate improvement is able to assist manag-ers in identifying more effective sizing regimes that improve performance and simplify their process.

SELLING HURTS. A number of emo-tions drive managers toward ineffec-tive sell practices. Common behav-ioral biases seen within sell disciplines are selling winners prematurely (risk aversion), capitulating with losers and selling them prior to rebound (avoid-ance of pain), holding winners too long (endowment effect), and sometimes holding losers far too long (loss aver-sion, which is observed in less than 5% of portfolios).

SELLING SUCCESS. Despite industry folklore to the contrary, you don’t have to be a great buyer to outperform. With rigorous analysis, managers realize that, although their buying is simply fair or even subpar, their brilliance at selling (and sizing) is what allows them to beat their benchmark regularly. Self-awareness of this kind, which is fact based and correct, allows managers to do more of what is working and retool other skills as appropriate.

THE CHOICE: LUCK OR SKILL?Active equity management is under siege. Profitable survival is going to require that you become a manager with demonstrable skill, that you have a process that is clear and reliable, and that you work regularly at becoming better and better at your job. If you pos-sess these traits, you will be the kind of manager whom search consultants and capital sources are longing to meet.

Your ticket to success is learning to improve deliberately by using exact-ing measurement like that provided through the new framework I have described. The choice is yours: You can begin to improve deliberately starting right now with rigorous and granular investigations into your skills, or you can hope that luck will offset whatever skill you lack.

Michael A. Ervolini is the CEO of Cabot Research LLC based in Boston and the author of Manag-ing Equity Portfolios: A Behavioral Approach to Improving Skills and Investment Processes (forth-coming from MIT Press in November).



ANNOUNCING NEW BUSINESS DEVELOPMENT OPPORTUNITIES WITH CFA INSTITUTE Discover how CFA Institute can help introduce your products to our global membership community.

To inquire, contact Andy Jenkins, Exhibit and Sponsorship Manager, at [email protected].

Bus_dev_CFAmag_halfpg.indd 1 10/1/14 3:45 PM

VIEWPOINT LETTERS

A WARNING ABOUT CAP AND TRADE?Richard Sandor whistles a familiar tune (“The Rise of Environmental Markets,” September/October 2014). He would have us believe the fiction that cap-and-trade programs are reducing greenhouse gas emissions significantly.

Sandor’s Chicago Climate Exchange (CCX) closed its trading desk in 2010. The private club of blue-chip companies was forced to accept the facts. Their lobbying efforts on Capitol Hill would not pay off in valuable emission allowances. The body politic was in no mood to legally sanction a scheme where those who make the rules win the game.

So Sandor is betting on regional cap-and-trade programs. Independent market analysts are skeptical. Existing carbon pricing initiatives are too modest in their current climate reduction targets to drive a meaningful transition to low-carbon technologies.

“None of the carbon markets are generating much abatement in the short term and it is currently questionable if they send the right signal for long-term investments,” says senior analyst Hege Fjellheim at Thomson Reuters Point Carbon (“Strong Paris deal needed to make carbon pricing work—analysts,” Responding to Climate Change blog [www.rtcc.org], 24 September 2014).

Lack of ambition also marked the US acid rain cap-and-trade program, which Sandor touts. Sulfur dioxide emission levels were set so low no coal-fired power plant had to install scrubbers. Cheaper low-sulfur coal was already en route to the trouble spots by rail from western mines.

Alas, cap-and-traders never quit. According to his own book Good Deriva-tives, Sandor described CCX to the mul-tinationals he was wooing as being “like a Doberman Pinscher. If you cut off our front legs, we will walk on our hind legs.

If you cut off our hind legs, we will crawl on our stumps and bite you. You will have to drag us along, with our jaws clasped firmly around your ankles.”

We’ve been warned.

William D’Alessandro Editor, Crosslands Bulletin

AN OUT-OF-THE-BOX THINKERThe interview with Thomas Howard (“The Next Paradigm,” September/October) was one of the more interesting and thought-provoking articles I’ve read in quite a while. Howard is truly an out-of-the-box thinker. I found especially interesting his assertion that the Prudent Man Rule is “a legalizing of the cult of emotion.” I didn’t agree with everything he said, but I certainly enjoyed reading about his unusual viewpoint.

Jay A. Yoder, CFARichmond, Virginia


Using ESG Factors for Equity ValuationBy Jeroen Bos, CFA

In the article “Integrating ESG Factors in the Investment Process” (January/Feb-ruary 2014), I discussed the key drivers of the growing importance of integrat-ing environmental, social, and gover-nance (ESG) factors in your investment process. This trend is likely to continue in the coming years because ESG inte-gration in the mainstream investment process provides a clear opportunity to optimize the risk–return characteris-tics of your portfolio. From a practitio-ner’s perspective, one of the key chal-lenges is how to integrate these factors in a company’s valuation, an interest-ing area that is still in development. Today, investors are still using several different ways of applying ESG factors in company valuations.

Let’s begin by focusing on one of the traditional valuation methods, the discounted cash flow (DCF). One of the ways to include ESG is by adjust-ing the discount rate. Thus, compa-nies that score poorly on ESG metrics will have a higher risk profile on aver-age, and for such companies, one could argue for using a higher discount rate (resulting in a lower valuation) in the DCF. The reverse holds true for com-panies that score well when it comes to ESG metrics.

Although this method of ESG inte-gration is being used frequently in the sector, it does have two challenges. The first difficulty is the magnitude of adjustment. Should one adjust the discount rate by 25 bps, 50 bps, or maybe even 150 bps? Because research in this field is still very limited, with no clear conclusions yet, the magni-tude of adjustment remains an arbi-trary decision. The second problem is the risk of double counting. If a com-pany has a higher risk profile as a con-sequence of relatively poor ESG factors and this risk is already widely known in the market, one could argue that it is already reflected in its discount rate (through a higher company beta, assuming that the capital asset pricing model holds). In such a case, adjusting the discount rate again for ESG factors

could be seen as double counting, lead-ing to an unrealistically low fair value for the company. Integrating ESG fac-tors by adjusting the discount rate only works properly if ESG factors are dif-ficult to translate into financials, such as some governance factors, and have not yet been reflected through more or less volatile stock prices.

A better way of integrating ESG fac-tors in the DCF is by adjusting the future cash flows of a company. For exam-ple, think about the BP oil spill in the Gulf of Mexico in 2010. Not only did the spill result in fines for the compa-nies involved, but it also led to disrup-tion of production and operations and stricter (hence more expensive) safety measures in the years thereafter. All of these impacts have an effect on future cash flows that can and should be inte-grated in the DCF. The same could be argued when it comes to the apparel factory collapse in Bangladesh in 2013, which will likely drive costs higher for some of the consumer companies going forward (increasing supply chain costs through better safety standards and potentially higher wages). Another clear example of how ESG factors can drive future cash flows is the potential impact of future water shortages on the operations and profitability of mining companies in certain regions.

The key advantage of this method is that it forces the investor to trans-late the company’s ESG factors into future cash flows and thus to focus on the relevant material issues. That said, it is understandably difficult to esti-mate cash flow impact on low-proba-bility, high-impact events, such as an oil spill, or to try to assign monetary value to ESG factors for which there is no market, such as governance factors. Still, this way of integration provides a much better starting point for discus-sion because the assumptions used are clearer than those made in the discount rate adjustment.

In addition to DCF, a widely used and popular way to value companies is mul-tiple analysis. When looking at price/

earnings or price/book multiples, one can integrate ESG factors by adjusting the target multiple. Simply add a pre-mium to the target multiple for com-panies that do well on ESG and apply a discount to the target multiple for com-panies that score poorly on this front. These methods have the same issues as the adjustment of the discount rate (arbitrary level of adjustment and risk of double counting). With this way of integration, however, at least an attempt is made to integrate ESG factors so they are not completely absent from the company’s valuation and invest-ment conclusion.

Often, trying to translate ESG fac-tors into future cash flows with a high degree of conviction is difficult. For this reason, analysts also need to look at the sensitivities of the ESG factors to the overall valuation and consider dif-ferent scenarios. These steps will help the investor gain better insights into the materiality and potential impact of ESG factors on the overall valuation. For example, for companies that have a more binary ESG risk, one could look at a “business as usual” scenario and a scenario in which the ESG issues mate-rialize. Both scenarios could be proba-bility weighted to come to a fair value for the company.

The momentum in favor of ESG inte-gration has increased substantially in recent years, a trend that is likely to continue in the years to come. In prac-tice, ESG factors can be integrated in a company’s valuation in several dif-ferent ways, with the translation into future cash flow having the advan-tage that it provides the most insights and clarity for investors. The discus-sion on this topic is ongoing, and the field is still evolving. Consensus about the best practice for using ESG factors remains a work in progress.

Jeroen Bos, CFA, is the head of global equity research at ING Investment Management and a member of the board of directors of the CFA Society Netherlands.


VIEWPOINT

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

By Jason Voss, CFA

Some of the skills most investment managers look for are obvious, such as a love and vast knowledge of econom-ics, business, and finance; high drive; confidence; and persistence. You prob-ably recognize these skills as necessary because they permeate the mythology of the investment business. Yet many of the critical skills needed for a suc-cessful investment management career are not taught in business schools, dis-cussed in the business press, or under-stood by most firms doing the hiring.

Having hired research analyst interns, research analysts, a portfolio manager, and even my own successor when I retired from investment man-agement in 2005, I have gained a fair amount of knowledge about which skills separate you as an investment man-ager. Distinctive skills include such attributes as introspection, creativ-ity, intuition, decisiveness, absolute versus relative decision making, and discernment. If you would like to sep-arate yourself from the crowd of highly motivated and highly intelligent candi-dates, try adding these to your arsenal of skills. In the first part of this series, I will focus on the first three: introspec-tion, creativity, and intuition.

INTROSPECTIONIf you do not have self-knowledge about yourself, you cannot know which of your weaknesses need to be addressed with personal forgiveness, thoughtful-ness, a well-crafted plan, and discipline. Consequently, you are doomed to repeat your mistakes over and over. Few fund management firms have patience for damaging mistakes being repeated. In fact, my personal goal during my career was never to repeat the same mistake twice. Although I made many mistakes in my investment career, I only repeated one of my mistakes.

Furthermore, if you do not know yourself, then your intellectual tools

are likely to be out of accord with your innate talents. For example, if you objec-tively perform best when your adren-aline is coursing through your veins and critical decisions need to be made immediately, then it makes little sense for you to deploy tools like deliberate financial statement analysis and dis-counted cash flow analysis. Perhaps the better match for your tool kit is a piece of software that helps you comb Twitter for actionable information. It should be obvious that knowing this about yourself would mean you likely want to work on a trading desk rather than a value investment shop.

REMEDY. Take up practicing medita-tion or mindfulness. When you start practicing meditation, you are gain-ing a skill set that humanity has found useful for more than 3,000 years to get to know yourself.

APPLICATION. My very first purchase as a portfolio manager was International Rectifier (IRF). As a research analyst, I spent months trying to understand and model this company, and I bought its shares shortly after my promotion to the role of portfolio manager from ana-lyst. My model suggested fair value for the company was $45 conservatively. The market price at the time was right around $45. International Rectifier pro-ceeded to trade far down from my esti-mate of fair value.

Not until I engaged in careful intro-spection did I realize that I had ignored my preferred rule of buying only a stock in which there was a margin of safety (i.e., a current price at least 15% below my fair value estimate) in a company’s

share price. Unfortunately, I could not wait to make an imprint on the fund I was promoted to co-manage. Engaging in meditation ahead of time would have prevented the loss of capital endured by the fund’s shareholders.

CREATIVITYOne of the questions I used to ask aspir-ing investor candidates was, “What do you do that is creative?” In all of my years of asking this question, I only ever got two coherent answers. One was so superior that I insisted on hiring the candidate on the spot.

Why is the answer to this question so important? There are two reasons. First, it measures whether or not you know how your mind works, and two, it reveals whether or not you are con-scious about using your entire mind to think and to solve problems.

In reality, every time we cross the street we are taking in lots of data about the situation and inventing an on-the-spot solution to the various fac-tors at play: icy road, fast-moving traffic, number of lanes to cross, your health, your footwear, and so forth. The solu-tion is a creative solution. People are using their creativity all the time to solve problems, but most have zero awareness of how they think.

Many people who are conscious of creativity as a part of their mental framework still get it wrong because they have made an archetype of creativ-ity, meaning that they define creative things as drawing, painting, sculpting, or playing music. But a true creative practice is just being aware that you are creative and doing things to culti-vate that part of your mental apparatus.

REMEDY. Gaining creativity has two major accelerants. First, constantly be aware of your boundaries and your firm’s boundaries. Creativity is about pushing past boundaries into new terri-tory—doing what no one else is doing.

This article is adapted from an ongoing series of posts being published on the Enterprising Investor blog. To date, installments of the “Skills That Separate You as an Investment Manager” series have addressed such topics as introspection (April), creativity (May), intuition (June), decisiveness (July), and absolute versus relative decision making (August). All posts in the series are available at blogs.cfainstitute.org/investor.


If you do what you have always done, then you will get what you have always gotten. Second, creativity is about awareness. The remedy has two parts: meditating and challenging orthodoxy by taking mental leaps of faith.

APPLICATION. Creativity is such a gen-eralized skill that it can be deployed in almost any situation. The most obvious application, however, is in generating new investment ideas. After all, to out-perform your investment management competition, you must be doing some-thing that they are not doing. Creativ-ity is the skill that helps you to iden-tify what no one else is doing.

In my investment management career, I developed an important thesis

early on: a sneaky way to inexpensively own the technology boom. Via my cre-ativity practice, I recognized technol-ogy as both a breadth and a depth story. That is, more and more people globally would be buying technological gadgets and more and more gadgets would ben-efit from new technology (such as refrig-erators, toothbrushes, and so forth).

Unfortunately, it was almost impos-sible to buy the technology leaders at discounted prices. But through cre-ativity I recognized that all of these devices required electricity and that electricity was also therefore a depth and breadth story. This insight led me to look for a global power company so I could capture the upside benefits of technological growth but experience the growth through a very stable, estab-lished business. As a result of creativity, I purchased shares in AES Corporation (AES)—a decision that was among the best I made as an investment manager.

INTUITIONI think Daniel Kahneman sets intu-ition up as a straw man for his behav-ioral economics theories. In his well-received book Thinking, Fast and Slow, of which I am a fan, he associates intu-ition with “System 1” thinking, which he calls “fast thinking,” characterized by snap assessments of situations, sub-conscious thinking, and thoughts pro-cessed in the brain’s amygdala. Kahn-eman holds up “System 2” thinking as the opposite. It is “slow thinking,” characterized by deep analysis and pro-cessed in the prefrontal cortex.

I submit, however, that he associ-ates the wrong word with System 1 thinking. It should not be intuition but

instinct that is Kahneman’s descrip-tor for System 1 thinking. In fact, the Oxford English Dictionary (OED) defines intuition as “direct perception of truth, fact, etc., independent of any reason-ing process; immediate apprehension.”

An alternative definition, also from the OED, is “pure, untaught, nonin-ferential knowledge.” Note the terms “apprehension” and “noninferential knowledge,” which suggest a flash of brilliance, not a gut-level response.

Dictionaries are not the only author-ities that view intuition differently from the way Kahneman views it. In a 2013 presentation at the Battle of the Quants, Emanuel Derman, widely considered the grandfather of quantitative finance, pointed out that the foundations of science itself are the result of intui-tive processes. He specifically pointed to Johannes Kepler, Sir Isaac Newton, André-Marie Ampère, James Clerk Max-well, Albert Einstein, and Paul Adrien

Maurice Dirac as scientists who expe-rienced immediate apprehensions and flashes of noninferential knowledge that advanced science in meaningful ways. These flashes of brilliance stand in stark contrast to both System 1 and System 2 thinking as depicted by Kahneman.

My book The Intuitive Investor describes intuition as tuning into the cosmic radio station. Using similar lan-guage, Derman says of intuition, “The observer becomes so close to the object (or person) observed that he begins to experience their existence from both outside and inside them. Intu-ition is a merging of the observer with the observed.” In both cases, intuition requires deliberation, despite the ulti-mate “eureka moment.”

But why is any of this important to investment management?

One of the conditions of intuitive insight is an unbiased, unattached mind—one free from the preferences, prejudices, and emotional constraints associated with the amygdala. It turns out that the ability to apprehend, com-prehend, and resonate with the truth of the universe as closely as possible is exactly the discounting process that every analyst is charged with fulfilling.

REMEDY. The key to developing intu-ition is stripping away autonomic emo-tional responses and attuning oneself to a state of no-mind. Again, these are the very fruits of healthy introspection and mindfulness/meditation practice.

APPLICATION. Intuition is a skill with endless applications. It was my intu-ition that led me to publicly call the 9 March 2009 S&P 500 market low on 12 March 2009. Using meditation, I felt that most market participants were no longer anxious to the point of nausea and instead were exhausted and spent. This was at a time of high emotional paranoia and forecasts of the end times. But using the power of intuition, I was able to strip away the autonomic emo-tional responses of the amygdala and see the world differently, enabling me to make a very different call from many other market participants.

Jason Voss, CFA, a former mutual fund manager, is a content director at CFA Institute.

TO OUTPERFORM YOUR INVESTMENT MANAGEMENT

COMPETITION, YOU MUST BE DOING SOMETHING THAT

THEY ARE NOT DOING. CREATIVITY IS THE SKILL THAT

HELPS YOU TO IDENTIFY WHAT NO ONE ELSE IS DOING.


PROFESSIONAL PRACTICEPORTFOLIO 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-ment industry is paying off—both for fund managers court-ing the country’s wealthy potential clients and for investors seeking to diversify their holdings.

In the year since the opening of the industry, the Asset Management Association of China (AMAC) has registered about 3,563 private fund managers. Collectively, these

managers run 5,232 funds with assets totaling RMB1.98 trillion (US$322.3 billion). Thousands more licensing applications are in the works, according to AMAC, which is the self-regulatory body established to oversee the alternative asset industry on the mainland.

China’s liberalization of its asset management market enables it to breed one of the world’s most vibrant pri-vate fund management busi-nesses, which could eventu-ally account for a large chunk of the US$70 trillion global fund management indus-try. Since the passage of the

Securities Investment Fund Law in June 2013, more man-agers are opening their own securities trading accounts and running their own hedge fund platforms, abandoning the traditional structure of managing assets through govern-ment-backed trust funds.

“The regulation is geared for Chinese local managers that want to do business locally or go overseas. The registration lends more credibility for these fund managers, especially when they do business with international investors,” says Joseph Zeng, CFA, partner at Greenwoods Asset Manage-ment, which manages more than US$4 billion in assets.

Given the pace of wealth creation in China, the develop-ment was good news for the country’s high-net-worth inves-tors and family offices. The lack of investment options has long been a challenge in the development of China’s capital markets, with choices for Chinese investors limited to bank savings, stocks, bonds, and property. Regulated hedge funds will give these investors easier access to new products and instruments and a chance to further diversify their portfolios.

In 2013, hedge funds in China achieved some of the best returns in the world, with the average hedge fund gaining more than 19%, according to research firm Eurekahedge.

This performance came in a year when the Shanghai stock market contracted nearly 7% in value and was among the worst-performing markets in the world.

Even with such recent success among hedge funds, the reforms have a long way to go in transforming China into a major asset management hub. “There are still many uncer-tainties in the onshore management sector in China. We need much more clarification from the CSRC [China Securities Regulatory Commission] and the tax authority about what hedge funds are allowed to do,” says David Walter, the Sin-gapore-based director of US-based fund-of-funds manager Pacific Alternative Asset Management Company (PAAMCO).

“The currency capital account [situation in China] isn’t helping,” adds Walter, who predicts the asset management business in China will evolve in tandem with the opening up of China’s broader capital markets.

Global institutions and international fund managers, however, are keeping tabs on the developments in the industry. They see these funds as a potential way to gain access to more than 2,500 companies listed on the main-land. Traditional hedge funds that run Chinese strategies outside China are sometimes limited to trading only 160 or so Chinese firms listed in Hong Kong, the United States, or the European Union.

STEPPING UP THE PACEIn a sign that domestic hedge funds are preparing for change, China is stepping up the pace of reforms in the sector.

In August 2014, the CSRC released new regulations for private funds, marking a continuation of the regula-tor’s efforts to shape the legislation for the asset manage-ment sector. High-net-worth individuals are defined to be owners of assets of at least RMB3 million, earning half a million yuan a year, according to CSRC guidelines. Institu-tional investors, except social security funds or company pension funds, are expected to have net assets of at least RMB10 million. The minimum investment they can make in a single fund is a million yuan.

New initiatives are generat-ing optimism about China’s evolving hedge fund sector.

In 2013, some hedge funds in China achieved supe-rior returns, despite a major downturn in the Shanghai stock market.

Such developments are attracting foreign investors and international funds, with hedge fund assets projected to grow rapidly in China.

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A FLURRY OF INITIATIVES TO OPEN UP THE INDUSTRY IS ATTRACTING THE ATTENTION OF A NUMBER OF FOREIGN INVESTORS AND INTERNATIONAL FUNDS, EVEN AS MANY OF THEM REMAIN SKEPTICAL ABOUT THE CHANGES.


The new rules also clarified the roles and activities of participants in the hedge fund market and allowed individ-uals to register with AMAC as private fund managers. Nota-bly, China’s guidelines for the industry do not impose any restriction on the foreign shareholding of a private fund, whether structured as a company or a partnership.

“This may further pave the way for foreign fund man-agers’ entry into the China market through private fund-raising,” says Natasha Xie, a partner at Beijing-based Jun He Law Offices.

“We believe this development [the new CSRC regulation] is the start of a clearer and more streamlined regulatory framework for private fund managers in China.”

A flurry of initiatives to open up the industry is attracting the attention of a number of foreign investors and interna-tional funds, even as many of them remain skeptical about the changes. “The importance of having a business pres-ence in China at this time of change can’t be overstated, given the huge potential of its markets,” says Xie. Hedge fund assets could hit more than US$100 billion in less than a decade, according to industry veterans.

A trend in the space for international funds seeking a presence in the mainland is to enter the market as advis-ers to local funds.

“They can’t advise Chinese investors directly,” says Xie, “but they can become advisers to local managers, employ their own strategies, and test if they work.”

NEW CATALYSTSSeveral other initiatives are being implemented to further engage foreign and local hedge fund managers.

Under the Shanghai Pilot Free-Trade Zone, which is broadly seen as a template for future capital reforms in China, registered funds are allowed to raise up to $300 million in invest-ment capital by setting up ven-tures in the zone covering 28 square kilometers.

Hedge funds are also allowed to raise funds in yuan on the main-land for investment overseas. Inter-national companies, such as the Man Group, Winton Capital Man-agement, and Och-Ziff Capital Man-agement, have established their presence there.

On a broader scale, Shanghai will test interest rate liberalization

and yuan convertibility within the zone, which is expected to make headway in market innovations, including commodi-ties trading, another area in which hedge funds could thrive.

China’s move to reform its state-owned enterprises could also lead to a more robust asset management industry as more state-owned firms privatize their assets, fueling increased activity in markets, according to Zeng.

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 predicted to supersede a policy granting foreign investors quotas under the QFII (Qualified Foreign Institutional Inves-tor) program. QFII allows foreign-registered funds access to stocks in Shanghai and Shenzhen.

The cross-market investment scheme was set for imple-mentation beginning in October 2014. “Right now, it’s not easy to get a QFII quota,” says Zeng. “The through train, however, will give all international investors access to the A-share market, which means if they have the A-share invest-ment skills and track record, they can launch a fund in an offshore jurisdiction like Cayman or Hong Kong, raise cap-ital in US dollars, and invest in the A-share market.” (For more details on the Shanghai–Hong Kong Stock Connect program, see the feature article “Shanghai Express” on page 32 in this issue.)

ONGOING EVOLUTIONDomestic hedge funds themselves are evolving. The indus-try has seen more fund launches employing a diverse set of strategies over the past 12 months. Until recently, China’s hedge funds have predominantly used equity-focused and long-only strategies. Shorting tools are limited in the main-land, and most portfolio managers who came from long-only public equity funds have limited exposure to manag-ing other strategies.

Recent hedge fund launches have offered more variety of strategies, including quantitative, arbitrage, and multi-strategy approaches. Technological innovation that allowed automation and made high-frequency trading possible in China has led to the proliferation of these strategies, accord-ing to industry experts.

For now, many local managers are doing well, and institu-tional investors are taking notice of returns, giving a boost to

the overall local hedge fund indus-try. The increased pace of reforms is adding to the optimism over the sector’s growth.

“The new regulations and some of the fresh catalysts, including the Hong Kong–Shanghai through train and the state-owned enterprises reforms, will have a huge impact on the industry and on China’s A-share market,” says Zeng. “This can be a start of something big.”

Leonora Walet is a financial writer based in Hong Kong.

“Shanghai Express,” CFA Institute Magazine (November/December 2014) [see page 32 in this issue]

“Asia or the West: Who Will Dominate the 21st Century?” CFA Institute Take 15 series (17 April 2014) [www.cfawebcasts.org]

“China and Its Financial System: What Could Go Wrong?” CFA Institute Conference Proceedings Quarterly (September 2013) [www.cfapubs.org]

“The Case for Financial Sector Liberalization in China,” CFA Institute Magazine (November/Decem-ber 2013) [www.cfapubs.org]

KEEP GOING

CHINA’S MOVE TO REFORM ITS STATE-OWNED ENTERPRISES COULD ALSO LEAD TO A MORE ROBUST ASSET MANAGEMENT INDUSTRY AS MORE STATE-OWNED FIRMS PRIVATIZE THEIR ASSETS.


PROFESSIONAL PRACTICETRADING TACTICS

Pipe DreamACCESS TO MULTIPLE PLATFORMS VIA ONE INTEGRATED PIPE COMES WITH TRADEOFFS

By Sherree DeCovny

So far, 21 swap execution facilities (SEFs) have registered with the US Commodity Futures Trading Commission (CFTC). Among them are multi-dealer platforms, inter-dealer bro-kers, exchanges, and new entrants. Each one specializes in one or more specific asset classes. They have different rule books and user agreements, and the technology for con-necting to them varies. Market participants are still adjust-

ing to the new market struc-ture, but many believe aggre-gation services could be a cost-effective way to navi-gate the complexity.

Connecting to a SEF is expensive, explains Sonia Goklani, CEO of Cleartrack. It takes four or five develop-ers six months to complete the project, and each devel-oper costs from US$1,200 to US$1,300 per day. There are additional maintenance costs because an upgrade comes out every three to six months. In addition, the maintenance team must do integration work when the SEF adds new products to the platform. Ulti-mately, trading connectivity to each SEF could cost nearly 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” a “fund” and a SEF might call it a “sub account.” Each SEF has a different reporting framework, with some reporting directly to the swaps data repositories (SDRs), some report-ing to the futures commission merchants (FCMs, which in turn report to the SDRs), and others reporting through the central counterparty clearinghouse (CCP) or derivatives clearing organization (DCO).

To date, many participants have chosen to connect to the existing multi-dealer platforms, such as Bloomberg, Tradeweb, and MarketAxess. If they are going to invest in connectivity, they need to know that a platform displays sufficient liquidity. Moreover, firms’ compliance units are more likely to approve institutions where a user agreement is already in place.

“All of these types of firms have different value proposi-tions, and they all have different liquidity prospects,” says Will Rhode, global head of capital markets research at the

Boston Consulting Group. “When you’re trying to make a decision between a broad variety of players and you’re over-whelmed with compliance and operational burdens as a result of the Dodd–Frank Act, you tend to go for what you know.”

Over time, firms will likely want to connect to other SEFs. If they go through an aggregation service, all they will need to do is select the platforms on which they want to participate, find the best price, and execute orders. They must abide by the core principles of the SEF, but the aggre-gator handles the requirements associated with being a direct member, including trade reporting and other com-pliance obligations.

SEF aggregation has some clear benefits. It allows firms to take advantage of one integrated pipe, including the front-end application and the application programming interface, which reduces infrastructure, connectivity, and operational costs. It also facilitates trading in nonstandard products and voice trades even if they are not mandated for SEF transmission.

“Regulations require swap participants to get at least three quotes, so they have to connect to three or four SEFs, and for a smaller buy-side firm, it’s not profitable,” says Goklani. “In addition, the FCMs aren’t giving these firms a credit line. They have to go to somebody who can help them build the pipes and also be an introducing broker.”

Aggregation makes the most sense in circumstances where a common instrument is supported by multiple mar-ketplaces that have resident liquidity available at all times. For example, the five-year plain-vanilla interest rate swap is supported by multiple SEFs, and those liquidity pools can be aggregated into a common stack so traders can visual-ize the competitive rate for that instrument.

For less-liquid, more-customized instruments, aggrega-tion does not necessarily reveal which SEF has the best rate for the transaction. Even so, it provides an opportunity to do quantitative analysis to determine whether a rate that is being shown is good or not.

“Aggregation at that point becomes more of a price-dis-covery tool and a way to visualize requests that you might be sending out to multiple venues,” says Tom Zikas, an inde-pendent consultant and former CEO of SwapEx. “You need a place where you can easily see and analyze the responses that you’re getting.”

Connecting to a swap execution facility (SEF) independently could cost up to US$1 million per asset class in development, maintenance, and integra-tion costs.

With aggregation, firms can select the platforms, find the best price, and execute orders, thereby allowing the aggregator to handle the other requirements.

It is still unclear how aggre-gation can be used to compress and compact portfolios.

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THE RELATIONSHIP-BASED TRADING WORKFLOW IS IN JEOPARDY AFTER THE DODD–FRANK ACT.


But it is not clear how aggregation can be leveraged to compress and compact portfolios. If an interest rate swap is traded and then the position is offset at a different rate, those two positions do not net off. Instead, they become individual contracts that live on the trader’s books and records. Positions are held with an FCM at a specific clear-inghouse, so a perfect reversal can be achieved only if the offsetting position is with the same FCM and clearinghouse. If the trader exits the transaction with another FCM or at another clearinghouse, the position could still remain on its books and records. Currently, there is no legal frame-work for give-ups in cleared over-the-counter swaps (unlike futures, which have an established precedent).

Buy-side firms and dealers alike compress their portfo-lios periodically to avoid line-item proliferation. This exer-cise reduces operational risk because fewer line items need to be monitored and there is less potential for error. More-over, it is an efficient mechanism for managing the initial margin and variation margin posted with the clearinghouse because there is one net position and one margin call.

Traditionally, firms maintained relationships with several bulge-bracket banks. When the time came to clean up their books and records, they would pay a fee to a bank to replace a risk-neutral collection of swaps with an equivalent. The bank would extract as much net present value from the deal as possible without taking the risk of losing the customer.

The relationship-based trading workflow is in jeopardy after the Dodd–Frank Act. As the remainder of the swaps curve becomes mandated as “Made Available for Trading” in accordance with CFTC regulation, traders must effect compression transactions electronically on a SEF.

“There is logically not going to be resident liquidity for that kind of proprietary bundle of swaps,” says Zikas. “You’re going to have to go through a process of getting requests or leverage the innovation of SEFs that are creating mech-anisms by which these portfolios can be uploaded and shopped around to potential liquidity providers.”

The forcible electronification of the compression process adds complexity for institutional traders and hedge funds. They will have to find an efficient process to exit transac-tions and compress their portfolios. Further, FCMs will likely charge a fee for managing and maintaining swap positions that are mandated for clearing and held to maturity, so there will be a cost to not cleaning up books and records. Traders need to be mindful of that potential cost and com-pare the carrying cost with the cost of exiting transactions.

Traders can potentially leverage transaction cost analy-sis (TCA) tools to help them decide where to unwind their portfolio. The cost inputs reflect the layers of explicit charges (including the cost of margin) from the SEF, CCP/DCO, FCM, or others, such as independent software vendors.

“Unless the trader is equipped with some way of assess-ing and applying those layers of costs on a price or a rate that they’re receiving for a particular transac-tion, they could be at risk of making the wrong decision,” warns Zikas.

AGGREGATORS AND ALTERNATIVESA few banks that are implementing an agency model or that have single-dealer portals that offer one entry point into multiple trading platforms are providing aggregation services. For example, UBS and Credit Suisse have offer-ings. How many others will jump on the bandwagon is dif-ficult to determine.

Previously, dealers traded as principals with their bilat-eral counterparties, and they made money on the bid–offer spread. For some dealers, continuing this practice makes sense. Alternatively, a dealer can act as an agent and exe-cute an order on the client’s behalf in exchange for a fee. Banks are trying to understand the value proposition of the agency model and determine whether it would be profitable.

“It’s not that banks have a view around whether they should offer aggregation or not offer aggregation,” says Rhode. “It’s really that they’re saying, ‘Why would I want to?’”

Some observers believe that smart order routers (SORs) may be an alternative to aggregation. Participants in the equi-ties markets use this technology to whiz messages through the pipes to find the best fill and hit the top of book. SORs work well because the equities market is extremely frag-mented, the securities are highly liquid, and small orders are executed within milliseconds.

But the SEFs are less fragmented, and they have different trade protocols depending on the asset class. Some of the instruments are bespoke and infrequently traded. Rhode says it would have to be a pretty “smart” smart order router to be effective, and he does not envision them being used in the short term.

The swaps market may evolve slower than participants expected, but new opportunities will emerge once the new workflow is familiar and standardization increases. For aggregators, that could mean adding functionality, such as analytics on futures versus OTC contracts, TCA, margin simulation, and rules-based mechanisms to ensure individ-uals can trade only certain products on specific SEFs. For

now, the market is in an absorb-ing phase, making sure nothing goes wrong.

Sherree DeCovny is a freelance journal-ist specializing in finance and technology.

THE FORCIBLE ELECTRONIFICATION

OF THE COMPRESSION PROCESS ADDS

COMPLEXITY FOR INSTITUTIONAL

TRADERS AND HEDGE FUNDS. THEY WILL

HAVE TO FIND AN EFFICIENT PROCESS

TO EXIT TRANSACTIONS AND COMPRESS

THEIR PORTFOLIOS.

“SEF Awareness,” CFA Institute Magazine (January/February 2014) [www.cfapubs.org]

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PROFESSIONAL PRACTICEPRIVATE CLIENT CORNER

Little Big DataCAN BIG DATA BENEFIT SMALLER PRIVATE WEALTH MANAGERS?

By Ed McCarthy

The potential business value of big data continues to grow. Advocates claim that many industries and businesses, includ-ing wealth management, are just starting to tap into the wealth of “actionable intelligence” that is available as the amount of data keeps growing.

The usual definition of big data (BD) cites three common criteria known as the “three Vs.” In a May 2013 report, “Big Data in Wealth Management: The Search for Customer

Insight,” the consulting firm Celent “defines big data on three dimensions (volume, velocity, and variety), and the process includes captur-ing and gathering data, ana-lytics, and visualization.” In addition, data can be struc-tured (securities market data, for instance) or unstructured, such as email content.

POTENTIAL BENEFITSCelent sees BD’s potential benefits in the front, middle, and back offices. Priority areas include client relation-ship management and trad-

ing in the front office, with compliance, monitoring, and risk management in the middle and back offices. The ben-efits also extend to the investment process, according to Celent: “Relationship managers, advisers, and traders are using big data and analytics to help them discover, develop, and test investment ideas and strategies. Increasingly, firms want to capture more information from looking for corre-lations and investment opportunities across multiple asset classes and over longer time horizons. Big data helps firms establish larger datasets, which enable users to run experi-ments more quickly to uncover actionable investment ideas.”

Tom McCarthy, senior vice president of IT product man-agement at Fidelity Institutional in Smithfield, Rhode Island, cites an internal project as evidence of BD’s value. Each registered investment adviser (RIA) affiliate works with a client relationship manager at Fidelity. Client relationship managers were asked to rate the health of the 20 RIA rela-tionships for which each manager was responsible. McCar-thy’s department then ran BD analytics on the unstruc-tured data these RIAs had provided in their contacts with Fidelity: phone calls, emails, service messages, and so on.

The analysis indicated that one of the RIAs was at risk for leaving Fidelity. The client relationship manager disagreed

and maintained that the RIA was a satisfied customer. Two weeks later, the client called and implied that he was consid-ering leaving. “[The analysis] took an enormous amount of information that a human could not put together and ana-lyze quickly or efficiently and produced an output that was predicting what could happen,” McCarthy says.

TOO MUCH TO HANDLE?Large wealth management firms are the obvious beneficia-ries of BD. For example, according to the Bank of America Merrill Lynch website, the combined entity is the “largest brokerage in the world with more than 15,000 Financial Advisors and approximately $2.2 trillion in client assets.” Add in the tens of millions of banking relationships, trans-actions, and points of customer contact, and the company has an enormous amount of data available.

Even larger RIA firms, with assets over $1 billion, proba-bly do not meet all three BD criteria. And the cost of devel-oping BD analytics internally can be prohibitive. The Wall Street Journal recently reported that starting annual sala-ries for data scientists with just two years’ experience are often in the $200,000 to $300,000 range. That figure does not include ongoing data acquisition, storage, and platform management expenses.

It isn’t that RIAs are not interested in BD but, rather, that BD involves more than most independent wealth manag-ers can take on, says William Trout, a senior analyst with Celent in Houston. Most of the smaller RIAs he speaks with are focused on operations, compliance, and meeting client reporting needs. “And so, smaller firms haven’t really had the bandwidth to address the big data challenge, or—and, in part, related to that, I’d say—the inclination,” he says.

McCarthy agrees with that assessment. “Very few, if any, RIAs are able to do that themselves,” he says. “They just don’t have the infrastructure or the technical sophistica-tion. Even on the broker/dealer side, the core skill is more operational processing and light technology development. When you get into the data space, it gets into very large-scale database storage, sourcing of data. And most impor-tantly, what are the intellectual algorithms you put on top of that data to extract what you’re looking for?”

A SMALLER FOCUSSome independent RIAs recognize these hurdles to imple-menting BD and are responding in two ways. The first is to scale back and work on organizing and analyzing data that the firm generates as part of its business. Neesha Hathi, senior vice president of advisor services technology solu-tions at Charles Schwab in San Francisco, calls this the

Big data-based analytics continue to make inroads among wealth managers.

Most independent advisory firms lack the resources to develop their own big data projects and are turn-ing instead to third-party vendors.

Focusing on client relation-ship management (CRM) data is another option for gaining actionable insights.

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“little data” approach. It starts with a focus on customer relationship management (CRM) software. This CRM-cen-tric data strategy results from the recognition that client relationships are a key value proposition for RIAs, says Hathi. That understanding leads to using the CRM system as a centralized data repository. Once data are in the CRM system, it becomes easier to preserve and share knowledge about clients as the firm grows and to extract intelligence from the analyses.

That approach has been taken a step further by United Capital Financial Advisers LLC in Newport Beach, Califor-nia. Mike Capelle, senior vice president of platform tech-nology, says that the firm has almost 50 offices nationwide, with slightly more than $10 billion in managed assets. The firm centralizes its data in Salesforce.com’s CRM system, but the data collection goes beyond clients’ contact details to include asset information and other client records. Although United Capital is in the early stages of using its CRM system for analytics, Capelle believes that consolidating it at Sales-force.com is an essential first step. “We view Salesforce as our integration layer, if you will, and that’s where we con-solidate as much information as we can,” he says.

Such third-party vendors can work with a company’s data. Hathi cites the example of a Schwab RIA affiliate who emailed clients a newsletter and started using a third-party application that linked to his Salesforce.com data. The appli-cation tracked each client’s interaction with the newsletter—how frequently the client opened an article, click-throughs for more information, and so on—and fed the results back to the adviser’s Salesforce.com platform. Those interactions alerted the adviser to topics that potentially concerned or interested the client.

OUTSOURCINGThird-party vendors, including custodians, are moving to fill RIAs’ BD needs. McCarthy cites as an example Fideli-ty’s internal efforts that will probably be offered eventually to institutional clients. A Fidelity retail adviser might work with several hundred clients, making it difficult to contin-uously monitor each client’s details. Predictive BD analysis can help identify which clients are most likely to establish retirement accounts, college savings plans, and so on. “There are control groups of reps who are actually using this pre-dictive analytic,” he says. “The closure rates and the new-product sales on the predictive analytics were much higher [than for advisers not in the control group].”

Several companies offer specialized analytics, cover-ing a range of business functions, on a subscription basis. Bethesda, Maryland–based Weal-thEngine uses BD to identify pro-spective wealth management cli-ents. According to James Dean, senior vice president and head of the firm’s financial services prac-tice, the firm aggregates an enor-mous amount of data. “We have over 230 million individuals in our database, about 15 million of them

have a net worth of $1 million plus, and we’re getting the data from about 75 different disparate sources,” he says. “We’re pulling in all of this mass amount of information and our technology allows us to map it in a sophisticated way.”

WealthEngine’s analyses estimate wealth and income, but that’s just the first layer, Dean says. The reports can provide details on family information, marital status, eth-nicity, employment, business ownership interests, and life-style, among other attributes. Mapping technology cross-references database entries so advisers can see the con-nections among individuals and use that information for business development. He shares the hypothetical example of an adviser who has a 6 handicap in golf, conducts busi-ness frequently on the golf course, and works with older lawyers looking to transition out of their practices. The company’s FindWealth 8 service helps the adviser iden-tify members of that cohort who also play golf. Armed with that information, the adviser can attempt to connect with the prospects through a shared connection or market directly to them.

Analyzing economic and investment market data is another use for BD. Raj Udeshi, co-founder of HiddenLevers in New York City, says the firm collects over 100 economic indicators—the “levers”—and prices for multiple securi-ties, including stocks, exchange-traded funds, American Depositary Receipts, mutual funds, currencies, fixed-income instruments, and options. The firm’s website describes the analytic approach: “The HiddenLevers model is currently composed of two levels: a regression model that calculates the relationships between every economic lever and every asset, and an intelligent filtering process that separates out correlation from causation within this large universe of regression data.”

The analytics allow users to measure how different macroeconomic scenarios—the Iran conflict, hyperinfla-tion, and so on—affect the different levers and how those changes flow through to industries and specific securities. HiddenLevers integrates with numerous partners—includ-ing Advent, Envestnet, Fidelity, and Pershing—so advisers can stress-test clients’ portfolios under different scenarios to identify risk exposures.

LOOKING AHEADSeveral sources noted that in their experience, using more data has proven better than using less. But from a practi-cal perspective, how will the new analytics fit into firms’ workflows? For instance, will advisers be forced to hire additional specialized staff to review, distribute, and imple-

ment an influx of analytic results? As BD becomes more prevalent, perhaps the next wave of hiring in private wealth management will be for data managers instead of addi-tional wealth managers.

Ed McCarthy is a financial writer in Pas-coag, Rhode Island.

“The Signal and the Noise: Making Sense of Big Data,” CFA Institute Take 15 Series [www.cfawebcasts.org]

“The Devil’s in the Data,” CFA Institute Confer- ence Proceedings Quarterly (19 June 2014) [www.cfapubs.org]

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PROFESSIONAL PRACTICECAREER CONNECTION

The Disconnected, the Overloaded, and BeyondBy Lori Pizzani

Noteworthy findings about career and employment during 2014 came from a variety of sources and involved a wide range of topics. This article rounds up some of the stray items that might be of interest to investment profession-als. Also, looking to 2015 and beyond, three experts were asked to share their predictions for emerging trends that will affect people working in the investment management industry over the next one to three years.

THE DISCONNECTEDIn February, the HR firm Randstad US released the results of its “Engagement Study,” which found a discon-nect between what employees want and what employers are actually providing in terms of promotions and bonuses, flex-ible work arrangements, com-fortable but stimulating work environments, encouraging employees to share ideas and opinions, and investing in employee training, pro-fessional development, and continuing education. Rand-stad’s chief HR officer, Jim Link, pointed out that orga-nizations with a high level of employee engagement saw a 22% higher level of produc-tivity and that employers that

“get it right” will find they have a workforce committed to both personal achievements and the overall mission.

Randstad’s handful of recommendations to employers for better employee engagement still apply:

• Foster a culture in which employees’ time away from the office is truly their time. The blurring of lines between work and home—constant connectivity—does not necessarily equate to increased productivity.

• Cultivate a more dynamic work force and determine the right cultural fit by asking less conventional questions during can-didate interviews. Employers ranked a good cultural fit as the most important factor after work ethic.

• Satisfy employees’ hunger to continue learning and enhancing skill sets through workweek training/development programs. At least 40% of employees said that training and devel-opment are among the most important skills for grow-ing careers.

• Establish a social media policy and ensure that employees understand the guidelines. Social media, such as Facebook, can often absorb an hour or more of employees’ time each day, so be sure they understand the rules and use their time productively.

• Provide employees with a defined career path. It’s important for employees to know they are valued and are part of the company’s long-term business plan.

THE OVERLOADEDA January 2014 workplace trends report from Sodexo in Gaithersburg, Maryland, based on a study of 488 employ-ees (10% from the financial services industry), suggested ways to combat the technology and communication overload that plagues many of today’s always-connected employees:

• Stop multi-tasking. Successful multi-tasking doesn’t really exist. Multi-tasking is actually a “shifting of attention” between tasks that fosters mistakes and reduces produc-tivity. The better way is to eliminate tech distractions and focus on one task.

• Take short breaks. Energize your work by taking a one-min-ute break between tasks and a 10- or 15-minute break every few hours to recharge.

• Set boundaries. Reduce work–life conflict by establishing rules, such as turning off your cell phone during family meals.

• Manage expectations. Alert superiors and co-workers that you will not immediately respond to emails/texts after a certain hour.

• Turn off and tune in. Train yourself by putting away your cell phone and focusing on a single task, such as when having a meal.

• Break bad habits. Technology habits are formed through repetition and become automatic. To break habits, try simple steps, such as turning off your smartphone and minimizing open windows on your laptop.

• Recharge. Switch off work-related tasks and thoughts by engaging in hobbies, community and sporting events, or fitness activities and by focusing on important relationships.

Higher employee engage-ment (a less disconnected workforce) is associated with significantly higher productivity, according to one recent study.

Multi-tasking is actually counterproductive and reduces individual produc-tivity, and simple behavioral mistakes can damage pros-pects for career success.

Within the next few years, according to one expert, demand for “breadth of skills” will cause “a shift in hiring demands and promo-tion opportunities at invest-ment management firms.”

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ORGANIZATIONS WITH A HIGH LEVEL OF EMPLOYEE ENGAGEMENT SAW A 22% HIGHER LEVEL OF PRODUCTIVITY.


THE MISGUIDEDEveryone makes mistakes, but according to Wall Street vet-eran Ben Carpenter, 10 big mistakes in particular can sab-otage careers, as outlined in his book The Bigs: The Secrets Nobody Tells Students and Young Professionals About How to Find a Great Job, Do a Great Job, Start a Business, and Live a Happy Life. These mistakes, and Carpenter’s advice, include the following:

• Succumbing to distractions. Don’t allow personal or pro-fessional outside activities or responsibilities to get in the way of doing your best work at your full-time job.

• Being too patient. If you work hard but feel invisible and your present employer cannot/will not give you the oppor-tunities you need to advance, find a new job.

• Faking it. Don’t try to fake it till you make it if you don’t under-stand something. Speak up and ask questions as needed.

• Being unresponsive. Always respond within 24 hours to bosses, co-workers, and clients, even if it is only to say that you are working on the issue.

• Not owning your mistakes. Always own up to your inevitable mistakes and see them as chances to learn and improve.

• Griping about the job. Complaining to sympathetic co-work-ers is a no-no. If you must complain, do so to family and friends and raise tangible issues with your boss.

• Getting embroiled in office drama. Don’t participate in and don’t instigate office drama. Doing such things can lead to your downfall.

• Badmouthing co-workers. Stay away from gossip. Nega-tive comments about co-workers have a way of coming back to bite.

• Putting your interests ahead of those of your company and boss. If you’re a rookie, prove you’re the team’s most valu-able player by putting your needs last.

• 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.

THE ROUTE TOO MUCH TRAVELEDThe results of the “Emerging Work-force Study” (also conducted by the Harris Poll for Spherion), released in June 2014, showed that 61% of the workers polled agreed that “changing jobs every few years is usually damaging to a person’s long-term career advancement,” up from 47% in a similar 2002 poll. A full 70% of respondents agreed that their level of commitment to their employer depends on the likelihood of long-term job security. Moreover, 83% of workers agreed that “loy-alty is being willing to stay with an employer for the long haul,” a 12% increase since 2002.

Also in June, a report from CIBC World Markets in Toronto revealed that job stability in Canada is stronger than ever—despite earlier projections that in the “new economy,”

employers would increasingly see employees as disposable and turn-over would ratchet up. CIBC found a 60% chance that Canadians will stay with an employer after com-pleting their first year, with a reten-tion rate of nearly 95% for those working five or more years at a company. Why the change? CIBC pointed to several factors, includ-ing changing employer needs, rising job vacancy rates, and a sustained unemployment rate.

Lori Pizzani is an independent financial and business journalist based in Brews-ter, New York.

“The Career Paths of Mutual Fund Managers: The Role of Merit,” Financial Analysts Journal (July/August 2014) [www.cfapubs.org]

“The Importance of Effective Leadership,” CFA Institute webcast (22 May 2014) [www.cfawebcasts.org]

“Career Intentionality and Using Data to Make Career Decisions,” CFA Institute webcast (20 March 2014) [www.cfawebcasts.org]

“Networking and Relationship Building Skills for Your Career,” CFA Institute webcast (20 February 2014) [www.cfawebcasts.org]

“The Inefficient Frontier: Work–Life Balance,” CFA Institute Magazine (January/February 2014) [www.cfapubs.org]

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Coming Soon: A Preview of Future Career and Industry Trends“Within the next one to three years, investment managers will have no choice but to engage in increased risk taking while demonstrating a commitment to protecting inves-tors, as clients will expect outsized performance over an extended period. Analysts and portfolio managers will need to wear multiple hats and commit to risk management and compliance as well as continuing education.” — Roy Cohen, New York City career coach and author of The Wall Street Pro-fessional’s Survival Guide

“A breadth of skills will be at a premium in a world driven by clients demanding more complex investment solutions that encompass a sophisticated set of asset/liability tools, not just specialized asset class relative performance. This trend is already strong in the institutional separate account world and is moving into the retail universe. This will lead to a shift in hiring demands and promotion opportunities at invest-ment management firms toward rewarding professionals with a breadth of skills.” — George Wilbanks, founding partner at Wilbanks Partners, an executive recruiting firm in Stam-ford, Connecticut

“Just as there is ‘price discovery,’ which allows firms to determine a market price for an asset, the future will see ‘value discovery,’ which will allow firms to determine a cus-tomized investor profile based upon individual investors’ attitudes, time horizons, wealth level, risk tolerance, knowl-edge about investing, and what each wants to do with their money. This will become as individualized as fingerprints or the iris of your eye.” — Charles D. Ellis, CFA, chair of the White-head Institute board of directors, author of more than 17 books (including most recently, What It Takes: Seven Secrets of Success from the World’s Greatest Professional Firms), and former managing partner of Greenwich Associates


By Nathan Jaye, CFA

Financial crises are widely believed to be caused by greed, corruption, or lack of regulation. But what if the cause is simply the variability of cross-border investment inflows? That’s the model developed by Robert Aliber, professor emeritus of international economics and finance at the University of Chicago Booth School of Business. Aliber, editor and co-author with Charles P. Kindleberger of the 1978 classic Manias, Panics, and Crashes: A History of Financial Crises, predicted the Icelandic banking crisis 18 months before it happened. In an interview with CFA Institute Magazine, Aliber offers a different view on the cause of financial crises, discusses why banking crises almost always coincide with currency crises, and explains why cross-border investment flows should be moderated.

What’s the main storyline of your research?We’ve seen four waves of banking crises in the past 30 years, all very similar. The first wave was in Mexico, Brazil, Argentina, and 10 other developing countries in the early 1980s. Japan and several of the Nordic countries were involved in the second wave in the early 1990s. The third wave was the Asian financial crisis in July 1997, and the fourth is what I call the “Anglo-Saxon real estate crisis,” which became apparent in September 2008.

Each country that experienced a banking crisis previously had an economic boom and an increase in cross-border investment inflows, which led to increases in the prices of its secu-rities and to an increase in the price of its cur-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 borrow-ers’ 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 secu-rities. The prices of real estate and securities decline, loan losses surge, and the country expe-riences a banking crisis. It’s also a currency crisis in that many of the borrowers default on their liabilities denominated in the foreign currency.

GOWITH

FLOWFinancial crises are caused by cross-border investment flows, not misbehavior, says economist Robert Aliber

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How did you become aware of this pattern?Gradually, over more than 10 years. I was visiting a class-room at London Business School in April 2006. A young man from Iceland was there—he spoke about his coun-try’s economy and the soaring stock prices—and I had a bizarre experience. I could complete all of his sentences, even though I knew nothing about Iceland. He had a set of facts, and I had a model. The two fit together quite nicely.

I went to Iceland in June 2007 and spoke with 10 or 12 economists at the central bank, in the private banks, at the University of Iceland. I was convinced there was a massive asset price problem. A few months later, I wrote a paper on Iceland, and I gave a lecture in Reykjavik in May 2008. I said they were sitting on a volcano of credit and it would soon implode. The price of the currency would fall, and the price of securities would fall sharply. Four months later, in September 2008, Iceland imploded.

How does your model explain the 2008 crisis in the United States?Beginning in 2003, cross-border investment flows to the United States increased sharply. Foreigners were buying more US dollar-denominated securities; the Chinese trade surplus had surged. China’s reserve managers bought sev-eral hundred billion dollars of IOUs in Fannie Mae and Fred-die Mac, which enabled these institutions to buy more mort-gages and more mortgage-backed securities.

At the same time, Fed Chairman [Alan] Greenspan fol-lowed an extremely expansive monetary policy. Thus, the rapid increase in the domestic supply of credit complemented the increase in the supply of credit to American borrowers from the investment inflows. The United States had a mas-sive housing boom. If Chairman Greenspan had been less expansive, the United States still would have had a housing boom and a subsequent crisis, but it would have occurred later and might not have been as severe.

Iceland, Ireland, Britain, and Spain had banking crises at the same time as the United States. Every banking crisis is preceded by an excess supply of credit; the crisis occurs when credit market conditions suddenly tighten.

How does your model differ from the dominant interpretation of the 2008 crisis?The dominant interpretation (the Washington-policy-estab-lishment consensus, including nearly everyone connected with the Federal Reserve) is that the US banking crisis was the fault of lenders, such as Countrywide Financial, Lehman Brothers, Bear Stearns, Washington Mutual, and several hundred others, because they acquired too many “risky loans.” The public officials have been successful in creat-ing the impression that the crisis would not have occurred if the private lenders had behaved responsibly.

But these crises are not caused by the misbehavior of the private sector lenders. If the credit is there, it has to go someplace. Why does subprime become important? Because there aren’t enough prime borrowers. The only reason Countrywide and Washington Mutual went scroung-ing for borrowers was because the credit was there. They

calculated that the spreads between the interest rates they could earn when they bought mortgages and the interest rates they had to pay when they sold their own IOUs were sufficiently large so that the loans would be very profitable. In my model, these firms are channels for the distribution of credit. They compete fiercely for market share, but they do not determine the supply of credit.

The Washington policy establishment interpretation cannot explain why the US banking crisis occurred in 2008 rather than in 1988 or in 1998. The character of Lehman et al. did not change between 1988 and 2005; instead, the change was in the credit market conditions. The Washing-ton policy establishment is unwilling to connect the dots that link their own policies with the subsequent banking crisis. They want to ignore the relationship between the monetary policy in 2003 and 2004, the surge in property prices, and the subsequent bust. And they ignore the sim-ilarity of events in the United States with those in many other countries.

The monetary instability of the last 30 years is unprecedented. The title of Chairman Greenspan’s book is The Age of Turbulence. The book is in its second edition, but Green-span still has not been able to iden-tify the source of turbulence.

What are the sources of credit flows?If we look at the 1982 crises, the credit inflows came from the major international banks that bought the US dollar–denominated loans of the governments and government-owned firms in Mexico, Brazil, and Argentina. The investment inflows that pre-ceded the banking crises in Norway, Sweden, and Finland involved the sale of IOUs of the Nordic banks to banks in London and other foreign centers; the Nordic banks repa-triated the money that they lent to commercial borrowers and real estate developers, who acquired the currency risk.

What factors determine supply of credit?Often, the increase in the cross-border investment inflows is stimulated by a boom in the economy of the country that experiences the investment inflow. At other times, the increase is a response to a relaxation of regulations that pre-viously had limited cross-border investment flows, which was the Nordic experience.

In the 1990s, Mexico was being prepared for adherence to the North American Free Trade Agreement, and the lib-eralization of economic regulations in Mexico was exten-sive. Moreover, macroeconomic initiatives to reduce infla-tion (after several years when inflation was higher than 100%) led to extraordinarily high real interest rates on peso-denominated securities, which attracted money market mutual funds. American, Japanese, and European firms were investing in Mexico as a low-cost source of supply for the American market.

Robert Aliber

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Does the boom cause the credit inflow, or vice versa?Cross-border investment inflows contribute to the booms by elevating securities prices in the countries experiencing the inflows; as household wealth increases, consumption spend-ing increases. Higher levels of spending lead to increases in GDP growth rates and higher anticipated returns on the securities available in these countries, which attracts even larger investment inflows. Some countries have had booms without increases in investment inflows, but investment inflows have almost always led to booms when currencies have not been anchored to parities.

How do you distinguish between structural and monetary causes of shocks?One of the major arguments advanced in support of a move toward a floating exchange rate system in the 1950s and 1960s was that economies would be better able to adjust to structural shocks. Structural shocks are oil price shocks, bad harvest shocks, new discoveries of North Sea gas, etc.

Monetary shocks are largely (not exclusively) changes in investor demand for securities dominated in the foreign currency, which immediately leads to a change in the price of the country’s currency. The shocks in my narrative are virtually all monetary shocks.

Are banking crises always associated with currency crises?When I started looking at this, what struck me was that banking crises and currency crises were twinned. There was a very strong overlap. I began to wonder, what was the relationship between them? Did one cause the other? Did a banking crisis cause the currency crisis?

Ninety percent of banking crises have been associated with a currency crisis, and every currency crisis has been associated with a banking crisis. But I now realize these are not different crises. These are different manifestations in different markets of reductions in investment inflows.

Are you saying a banking crisis is predictable?Yes. Banking crises are predictable—with uncertain dates. Are earthquakes predictable? If you live along the San Andreas Fault or the Hayward Fault, earthquakes are pre-dictable, but you can’t really predict the exact date when one will occur. But I’ve predicted some of these crises, including those in Iceland, Mexico in 1994, Thailand and Malaysia in 1997, and Argentina in 2001.

Is there a tipping point when a banking crisis is inevitable?I fly small airplanes, and in one of my Walter Mitty moments, I imagine that I’m at Roosevelt Field in 1927 advising Charles Lindbergh. I say, “Charlie, when you cross the 19th merid-ian, you can’t turn back. The winds will be against you, and you won’t have enough fuel.” That’s the concept of “the point of no return,” which can be modified to “the date of no return.” What is the date after which a crisis is inevitable?

In the Icelandic case, Iceland had a massive capital account surplus after 2005. It had a very high level of debt relative

to its GDP, both domestically and externally. It was predict-able that when the lender stopped providing money in the form of the loans to the borrowers, some of the borrowers would default and the currency would collapse.

When the krona collapsed, many of the IOUs of the Ice-landic borrowers were denominated in foreign currencies. For example, the Icelandic banks were helpful in enabling Icelandic households to borrow, to finance the purchase of cars and homes with loans denominated in the Japa-nese yen, the Swiss franc, the euro. When the price of Ice-landic krona fell very sharply, the krona equivalent of the liabilities denominated in the foreign currency increased in proportion to the decline in the price of the krona and many of these borrowers were then bankrupt. In this way, the cur-rency crisis intensifies the banking crisis.

If the borrowers’ expenditures (exclusive of interest pay-ments) are larger than revenues, then it must follow that the increase of indebtedness is larger than interest payments. That’s an explosive relationship; it cannot continue. This logic can be applied to a family, to a firm, and to a govern-ment. Indebtedness cannot grow more rapidly than interest payments. It may for one, two, or several years, but indebt-edness cannot grow more rapidly than interest payments for an extended period of time.

Do you use an actual model?I count the cranes [for construction] in the urban landscape and whether they are moving or stationary. I look at the rela-tion between rental rates of return and mortgage interest rates. If rental rates are less than mortgage interest rates, property prices are in bubble territory. Moreover, I look at the pattern of cash flows and the relationship between the increase in the indebtedness of the borrowers and their incomes and also the increase in the borrowers’ indebted-ness and the interest rates on their indebtedness. If some of the borrowers have primary deficits and are dependent on the increase in their indebtedness for some of the cash to pay interest on their loans, then I know that the borrow-ers are on a non-sustainable trajectory and that they will be obliged to reduce their consumption when the lenders become more cautious.

One question is when the lenders will realize that the borrowers are on a non-sustainable trajectory. Another ques-tion is whether the borrowers can adjust to the decline in their ability to increase their indebtedness and adhere to their debt-servicing commitments.

What are the implications of your research?One set of implications is for investors: when to buy for-eign stocks and bonds and when to sell domestic stocks and bonds. Investment practitioners should follow the money and momentum strategies; increases in prices of securities are correlated with increases in the prices of currencies. And they should always ask, “How long can the borrowers continue to have a primary deficit?”

The second set of implications is for domestic financial regulations: whether bank capital requirements should be high or low, whether banks need living wills, and whether


large banks are too big to fail. The current stance of bank regulation increases the costs that banks (and hence both borrowers and depositors) incur.

The third set of implications is for central banks and the management of monetary policy. Many central banks, including the Federal Reserve, operate as if they were in a windowless silo. They ignore the impacts of changes in cross-border investment inflows on the prices of securities, household wealth, and consumption spending.

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 (IMF) presides over a dysfunctional financial arrangement; the IMF is like the three monkeys—deaf, dumb, and blind. Every banking crisis has resulted from highly variable cross-border investment flows, and investment flows are much more accelerated when currencies are floating than when they are pegged. When money begins to flow into a country, whether it’s to Iceland or to the United States, the coun-try has a boom, rates of return increase, and the inflow of money brings even more money.

Should credit flows be moderated or regulated?At the minimum, we need to do something to moder-ate cross-border investment flows. We could go back to a modified Bretton Woods arrangement with a much larger range of movement of currencies around a central parity. We could rely on exchange controls—or on some combi-nation of the two.

What are the chances of this happening?Every now and then, the IMF makes a noise as if it will allow some sort of margin control or prudential require-ment—that’s the term they use; it sounds less offensive than “control”—some form of ad hoc control. But I want to min-imize the ad hoc controls. I want to return to a system. We don’t have a system now. We now live in a world in which anything is feasible and many of the measures adopted by foreign countries have had very high cost to the United States, to the US export industry. Asian countries in partic-ular have kept the prices of their currencies extraordinarily low. That’s cost millions of manufacturing jobs in the United States. That’s because we do not have a rule-based system.

Haven’t we always had changes in credit flows?In the 19th century, cross-border investments often financed large infrastructure investments. The United States bene-fited greatly from the investment inflows from Britain and a few other countries that financed much of the US rail-road system. In the last few decades, investment inflows have stimulated consumption booms and real estate booms.

I’ll give you a personal anecdote. In August 2004, I received an announcement from my credit card company MBNA, and the announcement was that I had been preap-proved for a balance transfer for one year at zero interest rate. When I called MBNA, I asked, “What is my credit line?” They said US$100,000. I said, “Fine, please wire $100,000

to my account at LaSalle Bank in Chicago.” I had to pay a $75 fee. I sold my 1998 Cessna and went to the factory and bought a new Cessna.

MBNA essentially was going to make me a zero inter-est rate loan because the supply of credit available through MBNA was extremely large and very cheap. And MBNA had calculated for every 100 people who take advantage of this offer, 95 would be on the hook at the end of the first year and would then pay an annual interest rate of 15% or 20%. This anecdote demonstrates that the supply of cheap credit was super-abundant.

Why does credit funnel into consumption whereas in the past it financed infrastructure?I don’t have a good answer. But if there is a large flow of money, it’s going to go into the housing market and to con-sumers; housing loans offer the lenders the security of collateral. One difference is that in the 19th century, the cross-border investment flows were long term. More recently, these investment inflows are short term or term loans with interest rates that change when a base interest rate changes. In the 19th century, infrastructure investments were financed in the private sector, but now, they’re in the public sector for a variety of reasons. The public sector is reluctant to increase borrowing to finance infrastructure investments.

How does your model contradict monetarist economic theories?The “constitution” for the international financial arrange-ment that we have today is founded on a set of articles by my colleagues at Chicago (Milton Friedman and Harry John-son) and by other scholars, such as Fritz Machlup at Prince-ton and Gottfried Haberler at Harvard. Their description of the adjustment process when currencies are floating is the counterpart of the “rules of the game” of the gold standard.

The proponents said that if currencies were allowed to float, the changes in the prices of currencies would be grad-ual and that the deviations of the market prices of curren-cies from long-run equilibrium prices would be much smaller than when currencies were pegged. They told us that there would be fewer currency crises and that the demand for international reserves would be smaller. They claimed that countries would be better insulated from foreign shocks. Every one of their claims is now challenged by the data.

Nathan Jaye, CFA, is a member of CFA Society San Francisco.

WHY DO WE HAVE SO MANY BANKING CRISES? THE INTERNATIONAL MONETARY FUND (IMF) PRESIDES OVER A DYSFUNCTIONAL FINANCIAL ARRANGEMENT.



EXPRESSEXPRESSBy Sherree DeCovny

Until the Stock Connect program, foreign investors seeking to trade in China had to be licensed as a Qualified Foreign Institutional Investor (QFII) or a Renminbi Qualified For-eign Institutional Investor (RQFII) by the China Securities Regulatory Commission. To open an account, foreign investors also needed to be approved by China’s central bank. In the case of a QFII, capital had to be fully injected in US dollars onshore in China and converted to RMB, and then investments were subject to a lock-up period.

Now, via the northbound trading link of Stock Connect, individuals and institutions worldwide can invest in eligible shares listed on the Shang-hai Stock Exchange (SSE) through a broker licensed to trade on the Hong Kong Exchange. Individual investors on the southbound trad-ing link must hold a minimum aggregate bal-ance of RMB500,000 in their securities and cash accounts to qualify as an investor in eligi-ble shares listed on the Hong Kong Exchange.

Eligible shares listed in Hong Kong are the constituent stocks in the Hang Seng Compos-ite LargeCap Index and Hang Seng Composite

MidCap Index. Also eligible are all H-shares that are not included in these indexes but that have corresponding A-shares listed in Shang-hai. Eligible shares listed in Shanghai are the constituent stocks of the SSE 180 Index and SSE 380 Index. All SSE-listed shares not included in these indexes but that have corresponding shares listed and traded in Hong Kong are also eligible.

China is still a closed market, and the gov-ernment is sensitive to foreign currency fluctu-ations. To this end, the program has a quota to control the flow of capital in and out of China. The quota is considered generous for a pilot scheme, being close in size to the total quota approved under the existing QFII or RQFII schemes. The advantage of the Stock Connect program is that the aggregate quota is net of all buys and sells. In addition, the program applies only to long positions, which means that inves-tors can sell at any time.

In the traditional QFII/RQFII channel, when investors sell and repatriate their capital from the principal, they lose their quota and they have to go back into the queue to reapply. They also have to obtain regulatory approval to repa-triate funds, and the QFII/RQFII is subject to China’s capital gains tax. With Stock Connect, when foreign investors want to sell mainland China shares, they place an order with their Hong Kong broker. Once the shares are sold, they are paid cash in RMB in the Hong Kong market the following day.

Stock Connect is a critical path to RMB inter-nationalization because all transactions are set-tled in offshore RMB. Previously, RMB was only allowed to flow cross-border freely for purpose

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

When China’s government unveiled a bold set of reforms in November 2013, linking up the stock markets of its two major financial centers (Hong Kong and Shanghai) was a key goal. Set to launch in October 2014, the Shanghai–Hong Kong Stock Connect program (also called the “through train”) is essential to the government’s master plan to further open its capital market to the world and could represent a transformational breakthrough.

SHANGHAI

Illu

stra

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by

Tim

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EXPRESSEXPRESS


of trade settlement. With Stock Connect, RMB is allowed to flow cross-border freely from main-land China to Hong Kong for settling invest-ment transactions. The program will increase liquidity in the offshore RMB market and enable individuals and institutions to potentially earn a higher yield by investing their offshore RMB deposits in the stock market.

OPERATIONAL ISSUESThe two exchanges worked on the program in secrecy for about 18 months prior to announc-ing it to the market in April 2014. The tech-nical operating details were released in May, and since then, market participants have been scrambling to fine-tune the model before the launch. There is a huge political push to get Stock Connect off the ground. Most financial institutions have a project underway to ensure that the compliance, operations, risk, IT, and fund management teams have the capabilities to access the program.

“It’s intense in Hong Kong,” says Nick Ron-alds, managing director and head of equities at the Asia Securities Industry and Financial Markets Association. “A project of this scale requires significant systems and programing changes. Everything is affected.”

Although the rehearsals have gone smoothly, market participants will have to live with some inconveniences, imperfections, and uncertain-ties. For example, China has a 10% capital gains tax for foreign investors, including QFIIs. The government has not clarified who needs to col-lect the tax and how it has to be collected. Until now, registered QFIIs have been making a tax provision so they can pay when China is ready to collect it. With Stock Connect, brokers are con-cerned that if they do not collect the tax from their customers and their customers close their accounts, then they could be liable for paying the tax. The current view is that there will be an exemption for at least three years.

Significant operational issues need to be resolved. Stock Connect shares cannot be mingled with onshore shares. A particular share bought via Stock Connect may be the same equity as one bought via a QFII, but they must be treated as separate and have different symbols. New sym-bols must be developed and incorporated into brokers’ systems, and staff need to be trained.

The mainland settlement cycle is different from the settlement cycle of developed markets. The mainland settles securities on T (investors buy and receive the share today), but cash is settled T + 1, whereas the settlement cycle is T + 2 in Hong Kong and T + 3 in the United

States. Thus, with the US and Hong Kong sys-tems, the security and cash are transferred simultaneously to minimize counterparty risk. This kind of cycle is known as receipt versus payment/delivery versus payment (RVP/DVP). Mainland China’s “free of payment” arrange-ment is risky because the securities and cash are exchanged at different times, creating coun-terparty exposure.

Short sales of A-shares are not permitted, so investors who want to sell must move their shares from the custodian to the broker the day before or on the trade date before 7:45 a.m. Because of the time difference, US investors must pre-deliver two days before the shares are sold. The exchange checks all brokers’ positions at 8:00 a.m. daily to confirm how many shares they are entitled to sell.

The initial plan for Stock Connect was to have the transfer occur between 6:30 p.m. and 7:30 p.m. on the day prior. Because US mutual funds are required to hold their shares with a qualified custodian, they would not be able to transfer them to the Hong Kong broker and leave them there overnight. To fix this problem, a morn-ing window was added to allow shares to be

moved between 7:15 a.m. and 7:45 a.m. on the trade date.

“It’s a step ahead, but it doesn’t necessar-ily solve all the prob-lems,” notes Cindy Chen, Hong Kong head of securities and fund services at Citi.

Investors are only allowed to submit mar-ket-limit orders, and if

the market price moves away, they may not sell their shares on that day. This restriction means they have to move the shares back from the broker to the custodian, which is burdensome for investors outside of Hong Kong.

Citi has partnered with the Hong Kong Exchange to address these issues. Banks cannot lend RMB to foreign investors onshore, but they can lend in the offshore market in Hong Kong. Although Chen is not offering to sell or solicit an offer to enter into a transaction with Citi, she notes that the bank could help facilitate RVP/DVP settlement for securities and cash to settle on T. That arrangement could help over-come the concerns about counterparty risk. For example, Hong Kong brokers could borrow the RMB and pay the investors on T instead of on T + 1 when the investor sells the shares. For

Cindy Chen

“IT’S A STEP AHEAD, BUT IT DOESN’T NECESSARILY SOLVE ALL THE PROBLEMS.”


example, if an investor uses Citi for execution, custody, and clearing, the shares already will be in the bank’s records, which means it will be unnecessary to pre-deliver the shares.

MARKET REACTIONMarket participants will differ in how they respond to the Stock Connect initiative, with reactions fitting in three broad categories.

One group of participants is excited and eager to enter the Chinese equity markets. For them, Stock Connect provides an opportunity to develop cross-border RMB businesses. Hedge funds, fund managers, and Chinese brokers with a strong presence in Hong Kong and the mainland fall into this category.

“The scheme will help open up the enor-mous mainland China market for Hong Kong investors in the long run,” says James Su, direc-tor of investment at Hai Tong Asset Manage-ment (HK) and Haitong International Asset Management. “Our existing and potential cli-ents will be exposed to more diversified invest-ment opportunities to optimize their portfolio.” Over time, the RMB will become more impor-tant and investors will increase their allocation to the currency via an array of assets, includ-ing stocks, bonds, and exchange-traded funds.

The second group of potential participants is interested in the program but likely will wait to see if the legal and operational issues are resolved before the launch.

Leon Goldfeld, director of investment at Amundi in Hong Kong, notes that the value of mainland China’s market has declined but there are still some bargains. Ultimately, Shanghai is a large, liquid market—albeit one dominated by mainland China investors—with a long history of price setting. He believes Hong Kong insti-tutions will look for opportunities unavailable in their own local market. Further, both Hong Kong–centric and mainland China–centric port-folios will start to increase their allocation to A-shares rapidly.

Hong Kong–based fund managers are famil-iar with the stocks that are dual listed in Hong Kong and on the mainland, but building research on mainland China companies will take time. Although large-cap- and mid-cap-listed com-panies are accustomed to meeting analysts, small-cap companies are still on a learning curve. In addition, language may be a barrier for global investors.

“There are practical challenges across a breadth of areas, but this also creates opportu-nities,” says Goldfeld. “I don’t think Hong Kong institutions and other foreign institutions will

be shy about participating. A fund that today has zero allocation in Asia, maybe in a year’s time will have a 10% or 15% allocation. I don’t think it will be 50%.”

A third group of participants—long-only insti-tutions with stringent due diligence require-ments—will likely wait until all of their issues are resolved. Some fund managers’ mandates do

not recognize Shang-hai as a stock exchange for investment. They are concerned about the beneficial owner-ship structure and set-tlement process, both of which may require changes to prospec-tuses. And if institu-tional investors have to pre-deliver shares, they will not be able

to react to immediate developments (such as economic, political, or share-specific news) the way they would normally.

“Those operational issues are not at all triv-ial for a lot of institutional investors because they require practices in their trading and port-folio management approaches that are differ-ent from their customary practices,” says Ron-alds. “You can’t just change your investment approach at the snap of a finger.”

Moreover, passive funds must be able to enter and exit stocks in the appropriate proportions so they can adhere to their benchmark index. The Stock Connect quota introduces execution uncertainty. Passive funds that are already par-ticipating in China will likely continue to par-ticipate via their QFIIs, but generally, they will wait until the restrictions are lifted and their questions are resolved.

Stock Connect may open China’s markets faster than people expect. If the pilot is suc-cessful, it could be extended to a Shenzhen–Hong Kong Stock Connect program and might include other asset classes. The quota could be increased soon and be eliminated altogether. Meanwhile, mainland China investors can learn about the dynamics of the Hong Kong market, supporting the government’s goals of reforming the financial and securities industry. In turn, the Hong Kong market will benefit from increased liquidity and a more diversified investor base.

Sherree DeCovny is a freelance journalist specializing in finance and technology.

Nick Ronalds

“YOU CAN’T JUST CHANGE YOUR INVESTMENT APPROACH AT THE SNAP OF A FINGER.”

Is investment management a science or an art? And how have recent events, especially the global financial crisis, changed the consensus about the correct relationship between theory and practice? To answer such questions, three authors teamed up to investigate the state of invest-ment management’s body of knowledge, how it should be taught by business schools, and what attributes investment firms are seeking in job candidates. Their analysis and con-clusions are reported in the recent book Investment Man-agement: A Science to Teach or an Art to Learn? published by the CFA Institute Research Foundation.

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.

Are changing opinions

about investment

theory and practice

altering the way hiring

firms look at candidates?

Two researchers

share their findings.

By Nathan Jaye, CFA


ARTARTARTMANAGEMENT

AND INVESTMENT


Broad Vision and Rigorous Analysis“Recent crises have made employers more skeptical of persons with sophisticated mathematical skills but no economic or business understanding,” says Caroline Jonas, managing partner of The Intertek Group in Paris.

What are asset management HR managers looking for in candidates?It’s difficult to offer a general answer to this question. Much depends on the style of management—for example, traditional versus quant. But I think it’s fair to say that there is a sort of rebalancing going on. Most persons we talked to at asset management firms remarked that they are looking for candidates that combine solid economic reasoning, including an understanding of the global macro and the geopolitical, with the ability to work with statistics and modeling, understanding that a statistic or a modeling result always requires a critical evaluation. Even for quants, firms are looking for people with broad vision, able to formu-late judgments on the global macroeconomic environment.

How is what they are looking for changing?Again, one big change we noted in doing the study was the emphasis asset managers now put on sound macroeco-nomic reasoning. Together with that, certainly, the amount of data now available makes it imperative for anyone want-ing to work in the industry to be able to work with data, to determine patterns in data and separate signal from noise. Even fundamental managers now run their data through models and screening and are trying to learn how to read the data using analytics.

Are engineers, mathematicians, and physicists as sought after as previously?I would say yes, with a caveat: Candidates must also show economic understanding. Certainly, such areas as multi-asset or systemic fund management, market and credit risk measurement, or derivatives pricing will always require persons with a high level of mathematical skills. And note that these areas are those that are growing in the industry. However, recent crises have made employers more skepti-cal of persons with sophisticated mathematical skills but no economic or business understanding.

Is there a tradeoff between business school training and out-of-the-box thinking?I think it’s fair to say that in an industry dominated by the need to outperform one’s competitors, out-of-the-box think-ing is appreciated only if it helps identify profit opportuni-ties that others have not found. The teaching in finance pro-grams tries to give students the classical intellectual tools to find sources of profit.

Is macroeconomic theory (and historical perspectives on it) undervalued by job seekers? How sought after is this knowledge by employers?It’s not so much a question of macroeconomic theory as of macroeconomic understanding, reasoning. The theory doesn’t really bring much to the job. What matters is that the future investment professional have the ability to reason on how changes in the geopolitical environment, the economy, trade patterns, trends in specific industry sectors, and so on might impact a given portfolio. Such an understanding is essen-tial to protecting the client’s investments—and his or her [the investment professional’s] job and the firm’s business.

What qualities in job applicants are in shortest supply?Persons we talked to said that the skill most difficult to find in a candidate was the ability to combine reasoning on the “big picture,” the global macroeconomic outlook, with the ability to make a rigorous analysis, including the ability to use, or at least understand, model results and their even-tual shortcomings.

Which attributes are overabundant in the industry?None! Perhaps what are overabundant are applicants for jobs in the industry. Like finance in general, there are more applicants than job openings in investment management. A job in asset management is attractive—it is intellectually challenging and financially rewarding. But while schools continue to form students for jobs in finance, jobs in asset management are still not back to their pre-crisis levels.

What’s a description of the ideal candidate—if there is one?It’s difficult to describe an ideal candidate given the vari-ety of jobs, for example, in client relations, marketing and sales, fundamental analysis, systemic management, or risk management. I think it’s fair to say that all would need a good macro understanding, some statistical and mathemat-ical skills, and the ability to use technology, but the balance will depend on the specific job, which is great because that leaves the door open to many profiles.

How much added value are top schools and MBA programs delivering to job applicants?That’s a difficult question. I suppose it varies from one coun-try to another, one firm to another, and among jobs. Clearly, in the United States, those holding an MBA are sought after for jobs in marketing and sales while engineers, mathema-ticians, and physicists are more sought after for the quant-oriented jobs. In Europe, with perhaps the exception of sub-sidiaries of US asset management firms, the MBA is not so important. The economics and finance departments of uni-versities form students for jobs in finance—typically with a sound grounding in macroeconomics.

Certainly, firms do not want to pay for value that is not

Caroline Jonas


delivered, any more than they want to overpay for the assets they invest in. While we didn’t get much feedback on spe-cific evaluation programs, it’s clear that HR tracks the per-formance of recent graduates, the schools they come from, and their pay relative to their performance. One comment often heard is that recent hires that come from MBA pro-grams have high expectations in terms of salary and a fast career path, which means that to deliver added value, they have to outperform candidates without an MBA. Some per-sons we talked to reported that this is not necessarily the case. Another remark with a bearing on the return on invest-ment is that MBA candidates tend to be more ideological, arrogant, and unlikely to change their minds when con-fronted with others’ opinions or new information.

What are some “untaught” skills that companies are looking for?Certainly, the ability to think out of the box is not a skill typically taught to students of finance! Finance tends to be taught dogmatically in terms of theories—often nonvali-dated theories—such as efficient markets and the capital asset pricing model. This does not encourage students to be open minded, to examine alternative ways of thinking about a problem. Of course, being too open minded might not always be an advantage in an organization!

How impressed are HR managers with the CFA designation?What we heard for this study—and, by the way, for past studies—is that the CFA designation is an important indi-cation of a commitment to the profession and the willing-ness to continue to learn. The latter is particularly impor-tant in an industry where nothing stands still. Financial innovation is high, and the global macro environment and technology are continually changing.

What surprised you about responses from HR managers?HR managers—and indeed the whole industry—seem to put much more emphasis on the need for global macroeco-nomic reasoning, while this seems to be the poor stepchild of most academic programs.

Market Noise and Complex Reasoning“To gain a better understanding of markets, we would need a more robust theory based on a different type of mathemat-ics,” says Sergio Focardi, visiting professor of finance at Stony Brook University.

Should finance professors teach market efficiency as a timeless truth, an idea found to be deeply flawed, or something in between?It really depends on how market pricing efficiency is taught. In my opinion, the classical, mainstream concept of market

efficiency is flawed. Let me explain why. According to the original definition of efficiency introduced by Eugene Fama, markets are efficient if prices reflect all available informa-tion. Translated into the language of mainstream finance theory, market efficiency means that actual prices are equal to theoretical prices. But there is no agreement on theoreti-cal prices, so we can’t really teach market efficiency as the timeless truth that actual prices equal theoretical prices. It is an idealization.

More recently, market efficiency has been recast as the unforecastability of returns. Now, if markets were efficient in the sense that actual prices always equal theoretical prices, then returns would indeed be unforecastable. But the con-trary is not true. Returns can be unforecastable without implying that prices reflect a theoretical value. So, if we teach that market efficiency means the unforecastability of returns, we have to be careful not to confuse this concept with the classical concept of market efficiency.

The notion of market efficiency as unforecastability of returns might create some confusion. The classical argu-ment in favor of the unforecastability of returns dates back to Paul Samuelson’s 1965 paper “Proof That Properly Antic-ipated Prices Fluctuate Randomly [Industrial Management Review, Spring 1965].” Samuelson’s argument does not rely on the notion of theoretical prices but runs like this: If returns were forecastable, then investors would immedi-ately try to exploit their forecasts to make a profit or avoid a loss and, in so doing, would invalidate the forecast. This argument is very general; it applies to any forecast made by an intelligent processor of information whose action can change the course of events. For example, if I can forecast that tomorrow a car will hit me when crossing a given street, I will not cross that street, thereby invalidating my forecast.

Students of investment management should understand the difference between forecasting stock prices, which leads to the unforecastabil-ity of returns but does not imply theoret-ical prices, and forecasting future cash flows, which leads to theoretical prices and implies the unforecastability of returns.

Forecasting is a fundamental con-cept in finance. Basically, every task in finance depends on the ability to forecast the future. In a broad sense, forecasting is the basic task of science. The objective is to determine what will happen in the future or what is happening in other places, having knowledge of events here and now. Students should grasp the central role of forecastability and its lim-itations, including the fact that any notion of perfect fore-castability, even in a probabilistic sense, is subject to poten-tial contradictions.

As with many other concepts in finance, the forecast-ability of returns is a purely intellectual concept. In prac-tice, no investor can make perfect forecasts of returns as we cannot make perfect forecasts of future cash flows on which returns depend.

Market efficiency is an approximate quantitative con-cept that implies that markets are difficult to forecast and

Sergio Focardi


that, generally speaking, prices are equal to a valuation on which there is substantial agreement. In some conditions, it’s very difficult to make forecasts and markets are said to be efficient. In other conditions, markets are easier to fore-cast and there are profit opportunities, which is to say that markets are less efficient. But these are pragmatic concepts, difficult to formalize.

Is finance theory an empirical science or more of a social science?I think it’s fair to say that it’s a mix of both. Finance theory is the theory of the behavior of a human artifact—finan-cial markets—but the laws of financial markets and finan-cial markets themselves are subject to change. A number of facts related to financial markets are pretty general and can be handled with the methods of empirical science. For example, we can empirically ascertain with some degree of accuracy the probability distribution of returns and other facts, such as cointegration or regime shifting of financial time series. These facts are not the universal laws that we have in the hard sciences but can be modeled as empirical regularities, albeit with uncertainty. Tick-by-tick data (fre-quently referred to as ultra-high-frequency data) provide a database with strong empirical regularities. We have a rea-sonably good idea of the behavior of high-frequency data, including the distribution of the time between successive market orders and many other facts.

But political or social changes with a bearing on finan-cial markets are not so easy to model. In many instances, we need complex reasoning, which is very difficult to formal-ize. It’s in such circumstances that finance becomes more of a social science, requiring broader knowledge (such as the history of economic thought or the history of econom-ics and finance) and, incidentally, more creative thinking.

It’s interesting to note that while most today would agree that a scientific theory requires empirical validation, there is a strain in economic thought going back to the Austrian economist [Ludwig] von Mises (and shared by some contem-porary mainstream economists) that the study of the econ-omy can be done with idealized models and thought experi-ments and that our theory does not need empirical validation.

Does finance theory have “physics envy”?Well, that has been suggested, hasn’t it? Finance theory has created huge mathematical frameworks, similar to those of physics, especially in the realm of derivatives. Macroeco-nomics has done the same. But by the standards of modern physics, the validation of our finance theory is very weak. As remarked by the late Fischer Black in his famous paper “Noise,” by the very nature of financial markets, little infor-mation is available; noise, which is the term we use for unpredictable disturbances, prevails.

It’s difficult to believe that the motivation for building this huge conceptual edifice, which has such a weak empir-ical basis, was “physics envy.” Actually, the mathematiza-tion of, for example, derivatives pricing, although scientif-ically weak, has opened the door to a very profitable busi-ness for some financial firms. Another example is the CDO

(collateralized debt obligation) and other more complex con-tracts behind the subprime mortgage crisis that brought on the recent financial crisis. Thomas Kuhn’s classical analysis of scientific revolutions made clear that behind the adoption of scientific theories there are political and economic consid-erations as well as purely intellectual ones. Physics envy is only one, but perhaps not the strongest, motivation behind the adoption of the framework of classical physics in finance.

How problematic is it that many economic and financial terms are not observable?Any empirical science is based on observables. In physics, many terms are not directly observable but are linked to observables through the theory itself. Temperature is one such term. What we observe is not the temperature itself but the readings of an instrument, in this case, of a thermome-ter. These readings are connected by the theory. Any mean-ingful physical theory must be observationally complete.

In finance, there are terms that are neither observable nor able to be linked to observables through the theory itself. Any formulation of a theory based on terms that are intrinsically not observable is intrinsically weak. Consider, for example, a notion such as the “infinite stream of future cash flows” originated by an asset. Well, as you might imag-ine, an infinite stream of cash flows is not observable, nor are the utility functions of market participants.

In practice, “proxies” are used. But a proxy is not a the-oretically well-defined term. To use a proxy would require a theory of the proxy—clearly an oxymoron. Again, we encounter another weakness of our mathematical theory: a theory that relies on a proxy for key terms is a weak theory.

Is there an overreliance on mathematics in the teaching of finance?That’s a difficult question. The problem is not with the teach-ing of finance but with the theory itself. For example, the mathematization based on the representative agent is prob-lematic because, as demonstrated by a famous theorem of Sonnenschein, Debreu, and Mantel, we cannot consistently aggregate utility functions. Or consider the so-called vola-tility smile—it’s clearly an indication of the uncertainties in derivatives pricing.

Despite the lack of true scientific validation of our theory, mathematization has created significant profit opportuni-ties—at least for some players. The incentive to abandon a scientific paradigm that supports a profitable business is understandably low. But from the scientific point of view, if we want to gain a better understanding of markets, we would need a more robust theory based on a different type of mathematics, likely more in line with the theory of com-plex systems or even biomathematics. But personally, I don’t think we’re anywhere near achieving this.

Also, don’t lose sight of the fact that finance departments at business schools and universities prepare students for jobs in the industry, so it’s important for them to ensure that their graduates have the skillset the industry requires, even if the validity of the theory taught and the appropriateness of the math are questionable. Certainly, for those students


wanting to go into a job that requires a lot of math, such as derivatives pricing, systemic or multi-asset fund manage-ment, or risk management, one cannot say that there is an over-emphasis on teaching mathematics.

That being said, professors of finance and investment management should make students aware of the limits of methods currently used and perhaps progressively introduce students to a different type of mathematics that might better capture the complexity of financial markets and investment decision making.

Are we seeing a sea change in finance theory—or just the onset of a newer generation of theorists (because as physicist Max Planck once said, “Science advances one funeral at a time”)?Actually, we’re seeing surprisingly little change if you con-sider that over a period of 20 years, we have had at least three significant stock market crashes, that of 1987, the collapse of the dot-com bubble between 1999 and 2001, and the more recent crisis originating with subprime mort-gages. Market crashes are not taken into consideration by neoclassical finance theory, which is deeply rooted in the notions of rational expectations, optimization, and equi-librium. Finance departments are staffed with professors versed in neoclassical finance theory; business schools and universities are reluctant to make radical changes in their finance programs; and innovative theories and mathemat-ical approaches have difficulty getting published in main-stream journals. We’ve seen a lot of technical innovation with, for example, derivatives pricing, high-frequency trad-ing, and CDOs but little innovation as regards the funda-mental theory. For example, despite the most recent finan-cial crisis, the role of the banking system or liquidity in determining asset prices is generally neglected in standard courses and in research papers.

Are we seeing a reexamination of the “dominant think-ing?” What does that mean?I think it’s fair to say that most of the reexamination of the dominant thinking is coming from the domain of econom-ics, where a number of leading academics are questioning the foundation of the prevailing economic theory. Perhaps the most radical innovation is to consider any economy as a complex system made of many interacting agents. Ironi-cally, this idea is not new. It comes from Adam Smith! Smith conceptualized markets as complex systems governed by an invisible hand. Later, the liberal Austrian economist Fried-rich Hayek advanced the idea of the economy as a system made up of independent units. These ideas, however, were lost in mainstream economics.

In finance theory, some attempts are being made to “com-plete” the theory (for example, adding liquidity and the banking system). But as far as I know, there is little ques-tioning of the fundamentals.

How much have closed-end publication policies affected finance theory?Unfortunately, closed-end publication policies have put a damper on what many consider to be the necessary reexam-ination of some of the fundamentals in our finance theory. Academic careers depend on publication in a number of “select” journals. These journals are typically edited by mainstream economists or finance theorists. Referees are chosen from among mainstream theorists. As a result, inno-vative papers that poke holes in mainstream theory tend to get rejected. Even papers that report empirical facts—if the findings cannot be explained by or are in disagreement with mainstream theory—get rejected. As a result, many research-ers have to publish their work in journals such as Physica A, but these publications have little impact on the domi-nant thinking and are typically not read by the profession.

The result is that young economists and finance theo-rists who want to make a career in these disciplines tend to research subjects and publish papers that are not controver-sial. We see many papers that are technically brilliant but that lack the fundamental spirit of research by accepting the usual long list of what I would call false assumptions.

Is diversification still considered universally beneficial?Generally speaking, a well-diversified portfolio is better than a poorly diversified one. In this sense, diversification certainly is not dead. However, blind reliance on diversifi-cation is by now an obsolete thing of the past. Perhaps what was lacking earlier in the practice of diversification was the notion of changing market conditions. A dynamic view of the markets calls for reviewing the allocation of assets as market conditions change. The dominant paradigm now is dynamic asset allocation, which we might simply call dynamic diversification. Of course, dynamic asset allocation does not have the simple robust character of naive diversification. It implies dynamic forecasting of returns over different time scales and complex optimization methods.

What is trend diversification? How is it implemented?Asset prices follow what we call local trends; that is, the average value of returns remains constant or nearly con-stant for a while and then changes to a different value, pos-itive or negative. This is what gives the central direction of prices. But generally speaking, all asset classes do not trend in the same direction (that is, up or down). Just like with classical diversification, where you do not want to put all your eggs in one basket, so with trend diversification, you do not want to put all your assets in classes that trend in the same direction. There might well be extended periods where most return trends are negative, but there must be some asset classes where the return trend is positive. The objective, of course, is to diversify on asset classes that do not trend in the same direction. Trend diversification can be implemented, for example, by clustering time series of prices around common trends.

Nathan Jaye, CFA, is a member of CFA Society San Francisco.

Join CFA Institute and colleagues from around the world as we discuss geopolitical developments and their potential effects on investment portfolios, examine market trends, and gain insights into the industry’s most pressing issues today.

CFA INSTITUTEANNUALCONFERENCE26–29 April 2015 | Frankfurt, Germany


SPEAKERS INCLUDE:

• IAN BREMMER, President and Founder, Eurasia Group• JOHN COATES, Senior Research Fellow in Neuroscience and Finance,

University of Cambridge; Author, The Hour Between Dog and Wolf• CHARLES DE VAULX, Chief Investment Officer, Partner, and Portfolio

Manager, International Value Advisers, LLC• HANS-WERNER SINN, President, The Ifo Institute• MARTIN WOLF, Chief Economics Commentator, Financial Times, London

Hosted with CFA Society Germany

CFA INSTITUTEANNUALCONFERENCE26–29 April 2015 | Frankfurt, GermanyINVESTING WITH PURPOSE

Learn more at annual.cfainstitute.org

Save €300 when you register by 31 December 2014

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

By Kurt N. Schacht, JD, CFA

In a recent article for CFA Institute Mag-azine, I examined whether regulators listen to organizations like CFA Insti-tute when issuing new rules impact-ing investment products and services. In a rapidly changing policy landscape, one way we know we are registering is whether regulators seek regular dialog with us. Not only are they inviting our input on regulatory consultations, but they cite CFA Institute member surveys in their policy proposals. They also seek

our participation on advisory councils and other initiatives that can benefit from our technical expertise and strong investor perspective. Ultimately, we can help these global policymakers understand what matters most to investors. It is a voice that is welcomed openly by regulators because it is typically under-represented in the regulatory process around the globe.

In the European Union, we’re gaining one such impor-tant platform via our recent appointment to the Group of Economic Advisers, a key advisory body for the European Securities and Markets Authority (ESMA). Members of this advisory group, who are considered specialists in financial stability and economic issues related to financial markets, will offer guidance on monitoring, assessing, and measur-ing market developments, systemic risk, and other imped-iments to financial stability. It is a critical time in the reg-ulation of systemic risk as regulators continue to grapple with “too-big-to-fail” issues and emerging risks within the shadow banking sector.

We’ve also been named to ESMA’s Secondary Markets Standing Committee consultative group, which will give CFA Institute increased visibility when providing input on ESMA regulatory proposals, including the Markets in Finan-cial Instruments Directive (MiFID II) in particular. As the cornerstone of EU securities market legislation, MiFID II is still evolving as policymakers develop technical standards and devise guidelines to implement the legislation, including rules for the structure and organization of trading venues and off-exchange markets and measures to increase price transparency and investor protection.

Our work in the EU is just one way in which we are directly supporting the work of policymakers and work-ing to restore the trust of the invest-ing public in financial markets. We’re also partnering with the International Accounting Standards Board (IASB)

to promote its new investor education initiative. The IASB had reached out to CFA Institute to explore possible collab-oration, given our extensive investor network and exper-tise in communicating with investors. Through our recently launched joint webcast series, we’ve updated investors on newly released standards that have a bearing on investment analysis, including new rules aimed at plugging loopholes in off-balance-sheet accounting (an issue that came into sharp focus during the financial crisis) as well as updated accounting requirements designed to help investors better assess financial instruments–related risk exposures. This alliance illustrates that CFA Institute is a valued partner in the accounting standard-setting process.

In the case of the Global Investment Performance Stan-dards (GIPSTM), the training of regulators is where we have a direct impact on how the principles of fair representation and full disclosure (and the core elements of compliance) are addressed in practice. To that end, the GIPS standards team is currently providing training to US Securities and Exchange Commission (SEC) examination staff in all 11 regional offices, which offers an opportunity for SEC exam-iners to ask questions and have direct access to CFA Insti-tute staff responsible for the GIPS standards.

Sometimes, the themes of our research and thought leader-ship resonate with the policymaker community to the degree that we’re invited to present our findings to regulatory staff. One such recent example is an invitation from the Securi-ties and Futures Commission of Hong Kong for an in-depth discussion of our report on non-preemptive share issues in Asia, in which we advocate for greater transparency among companies seeking mandates to waive pre-emptive shares and recommend that regulators consider tightening rules to better protect the interests of minority shareholders.

While we may not always agree with the ultimate policy outcome, having a seat at the table means that our advo-cacy voice is not only heard but valued.

Kurt N. Schacht, JD, CFA, is managing director of Standards and Financial Market Integrity at CFA Institute.

ETHICS AND STANDARDSMARKET INTEGRITY AND ADVOCACY

Follow the Market Integrity Insights blog: http://blogs.cfainstitute.org/marketintegrity

Follow us on Twitter: @MarketIntegrity

KEEP GOING

ULTIMATELY, WE CAN HELP THESE

GLOBAL POLICYMAKERS UNDERSTAND

WHAT MATTERS MOST TO INVESTORS.


Society Members Go to CongressBy 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 members who set financial regulatory policy in touch with CFA Institute society members in their home districts, the program enables member societies to promote the advo-cacy message of CFA Institute. The lessons learned from the six events held this year will help us prepare for an even greater effort in 2015. Topics of discussion included a uni-form fiduciary standard, oversight of investment advisers, and Dodd–Frank Act reforms.

Kicking off the 2014 District Dialog season was CFA Soci-ety West Michigan, which hosted Representative Bill Hui-zenga (who represents Michigan’s second congressional district) as part of the society’s “Putting Investors First” 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 district, which is home to a number of society members. In the House, Rep. Posey serves on the Financial Services Committee and its financial institutions and monetary policy subcommittees, which have direct jurisdiction over the financial services industry.

The Orlando meeting contributed to Rep. Posey’s aware-ness and understanding of CFA Institute and the ethical and market-based foundation of its positions on capital market issues. As a follow-up to the meeting in Orlando, CFA Insti-tute capital market staff and a member of the Orlando soci-ety have already arranged to meet with Congressman Posey and his staff in Washington.

More than 50 CFA Society Philadelphia members attended a luncheon presentation with Senator Tom Carper of Dela-ware on 19 July. Senator Carper spent time meeting with the board leadership of the Philadelphia society, individual society members, and CFA Institute staff over lunch before speaking to the audience about issues facing Delaware and the nation, concluding with a lively question-and-answer session. The event not only provided society members who live and work in the Philadelphia area with an informative program but also raised the profile of CFA Institute for the senator and his staff. Given its diverse membership, CFA Society Philadel-phia plans to host several additional District Dialog events for society members in both Pennsylvania and New Jersey.

On 20 August, the Boston Security Analysts Society board hosted a District Dialog with Representative Michael Capuano, a member of the House Financial Services Com-mittee. Notably, Congressman Capuano represents the sev-enth congressional district of Massachusetts, where approx-imately 80% of Boston society members work. The Boston society board informed the congressman of CFA Institute’s

“Putting Investors First” advocacy efforts and its “State-ment of Investor Rights.” He showed particular interest in the society’s financial literacy initiative and descriptions of the CFA Program and the Claritas Program, and he invited the Boston society and CFA Institute to maintain a dialog with him on key issues facing the financial services indus-try, stressing that he looked forward to future collaboration.

At the last Dialog of the season, held by CFA Society Houston, a delegation of society leaders met with Repre-sentative Al Green at his local office in the ninth congres-sional district of Texas. Congressman Green specifically rec-ognized the benefits of working with society members when he told member Elizabeth Burdine that he could have used her knowledge of the real estate market in 2007 to help him understand what was happening as the crisis began.

The District Dialog program is gaining traction because of the work of local society leaders who have arranged the meetings (and the venues as well in some cases). Through their efforts, these volunteers have increased the recognition and credibility of CFA Institute’s policy initiatives. We are excited to note that several other societies are planning to host similar meetings in the coming months. The net impact of this collaboration will benefit members directly and will enhance our ability to achieve CFA Institute’s primary goal of serving the interests of investors through better regula-tion of fair and efficient capital markets.

Jim Allen, CFA, is head of Americas capital markets policy at CFA Insti-tute, and Bob Luck, CFA, is director of society advocacy engagement at CFA Institute.

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 DISTRICT

DIALOG PROGRAM ENABLES MEMBER

SOCIETIES TO PROMOTE THE ADVOCACY

MESSAGE OF CFA INSTITUTE.



Investor RedressEFFECTIVE MEANS OF RESOLVING DISPUTES CAN IMPROVE “MARKET DISCIPLINE”

By Lori Pizzani

CFA Institute has released a new report detailing and ana-lyzing the various processes for investors to resolve dis-putes within the financial services industries in the Amer-icas, Europe, and Asia. Titled Redress in Retail Investment Markets: International Perspectives and Best Practices, the report also offers recommendations for enhancing current practices to improve handling of investor complaints and resolution of disputes.

The concept of investor redress refers to how the rights of retail investors are enforced within the different regu-latory frameworks of the global financial services industry when monetary harm is caused by illegal activity or mis-conduct, such as mis-selling.

ALTERNATIVE PROCEDURESDispute resolution that takes place outside of the court system can provide an easier, faster, and less expensive way for investors to have financial business disputes equi-tably resolved. These “alternative dispute resolution” (ADR) mechanisms can often adequately and fairly compensate investors for mone-tary losses incurred through misconduct (but not losses resulting from market risk or other legitimate risks) without imposing any of the punitive damages associated with the court system. In contrast, because turning to the court system can prove to be costly and less flexible and can involve lengthy proce-dures, it is often seen as the tool of last resort for investors. It is important to note, however, that ADR procedures are typically consid-ered only for cases in which efforts at direct settlement fail.

The CFA Institute report also explores case studies and how the process unfolded for each and compares and con-trasts investor-redress frameworks across geographic regions.

WIDER SIGNIFICANCEThe importance of investor redress goes beyond the inves-tors directly affected by misconduct or other wrongful action. “Redress does not merely satisfy an individual inter-est; it also incites market discipline, which benefits other market participants,” says Mirzha de Manuel Aramendía, director of capital markets policy at CFA Institute. Fur-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

instigated by the investor to the service provider, with a potential settlement deal between the two as the goal. In this regard, CFA Institute recommends five best practices for the internal management of investor disputes:

• Senior management should take responsibility and perform oversight.

• Firms should handle complaints effectively and fairly.

• Firms should have transparent procedures for filing a complaint.

• Firms should identify recurring problems and take remedial actions.

• Supervisors should play an active role in identifying emerging risks so as to reduce instances of external ADR.

ASSESSING GLOBAL PROGRAMSIn 2011, the High-Level Principles on Financial Consumer Protection were issued and endorsed by the G-20. Accord-ing to these principles, consumers, including investors in

financial products, ought to have access to ADR complaint-handling and redress mechanisms that are affordable, inde-pendent, fair, accountable, timely, and efficient. As the CFA Institute report outlines, however, these programs are not always available and not all service providers are required to participate. For Europe in particular, CFA Institute recommends several policy changes, including further interpretive guid-ance on the application of these prin-

ciples, strengthening the financial dispute resolution net-work across European nations, and developing a common supervisory approach.

Even with ADR mechanisms in place, the processes can vary greatly among countries and jurisdictions. For exam-ple, the amount of award that can be sought under an ADR program differs dramatically. The costs passed on to inves-tors also vary, with more complicated and labor-intensive cases being more of a costly burden on investors. More-over, whereas some countries allow for investors to have legal representation, which can add to costs, other coun-tries actively deter legal representation.

Lori Pizzani is an independent journalist based in Brewster, New York.

The full report Redress in Retail Investment Markets: International Perspectives and Best Practices is available online at www.cfainstitute.org and www.cfapubs.org. For more information on investor rights, see CFA Institute’s “Statement of Investor Rights,” which is available at investorrights.cfainstitute.org.

KEEP GOING


Does Proxy Access Benefit Shareholders?By Rhea Wessel

CFA Institute recently commissioned a report on a proxy access rule developed by the US Securities and Exchange Commission (SEC) that was vacated by a court decision. The study indicates that proxy access can be beneficial to shareholders and markets, but the matter needs a compre-hensive assessment by the SEC.

Proxy access allows major shareholders to make their own nominations for board members instead of accepting only those candidates proposed by a governance or nominating committee. The practice is commonplace in markets around the world for shareholders who hold a minimum number of shares. The US is a notable exception, in the sense that shareholders do not have the ability to nominate directors to the corporate ballot unless a company’s bylaws allow it.

The SEC tried to make the practice mandatory under Rule 14a-11, but the proposed rule was struck down by the DC Circuit Court in July 2011.

Supporters of proxy access say shareholders should be able to nominate their own representatives in order to ensure board accountability and that a board member’s job is, in part, to represent shareholders. Opponents of proxy access usually point to the chance that activist sharehold-ers might pursue special interests if they gain access to the board with a representative.

Matt Orsagh, CFA, director of capital markets policy at CFA Institute, worked closely with the research institute that produced the report. “We want to raise the idea of proxy access again,” he said. “Our study shows that proxy access can be beneficial to shareholders and the markets at very little cost to the market. We invite the SEC to do its own study on the matter.”

More companies appear to be deciding to implement proxy access under “private ordering,” which allows inves-tors to put forth a resolution to change a company’s bylaws to allow proxy access. For example, Hewlett-Packard’s board proposed proxy access, and the proposal passed with 68% support in 2013. The threshold was set at 3% of shares out-standing, held for three years, with a nomination threshold of up to 20% of board seats. The same year, Verizon Wire-less also passed a proposal having the same thresholds with 53.3% support. The proposal was made by C.W. Jones, the head of the Association of BellTel Retirees, and it passed despite the board’s recommendation against the proposal.

COSTS OF PROXY ACCESSOne concern regarding proxy access is the costs involved. Proxy contests usually feature shareholders who want to install directors to gain control of a board, whereas proxy access is often used to get a seat at the table so as to influ-ence the conversation on a board. When contests are held, both the investor and the company have to spend money on marketing, printing, and contacting investors to persuade them of their opinion.

Understanding the cost of proxy contests, especially in comparison with proxy access, is important, according to Orsagh. “Proxy access would likely be cheaper,” he said.

CONTEST OF IDEASChristian Faitz, CFA, a senior analyst at Macquarie Securi-ties in Frankfurt, says a key point is board accountability.

“If an activist investor has ownership, like 3%, then why shouldn’t the investor have a say? It’s a good thing to have activist shareholders. Not because they’re always right, but because they tend to have a point from time to time,” said Faitz.

In general, a company’s proxy access policy is not some-thing Faitz or his team of analysts track in their equity cov-erage, yet he welcomes shareholders having the ability to nominate directors.

“I think proxy access should be implemented voluntarily, not as a rule. Having the voice of more activist investors on the board would put more control in the shareholders’ hands, as opposed to the management. And that’s where it should be. They can pressure the board to focus its opera-tions,” said Faitz.

Of course, getting a hand-picked director on the ballot is different from getting him or her on the board, and once on the board, a director is still subject to a contest of ideas. “If a shareholder with 4% tries to push through a measure, that shareholder still has to convince at least 46% that he or she is right to have the majority. That’s a very high bar,” said Orsagh. “If someone is agitating for no good reason, over time, the person will lose their reputation as a fair arbiter.”

The proxy access debate could benefit from a focus on board independence, according to Kathrin Schwesinger, a lawyer in New York who is an expert on corporate gover-nance. “A good director who is capable of doing the job well is best if he or she is independent and safe,” said Schwesinger. “You’re not going to get directors who are more indepen-dent by tying them closer to shareholder interests any more than tying them to management’s interests. This is getting lost in the proxy access debate.”

STUDY METHODOLOGYCFA Institute hired Industrial Economics (IEc) to assess the costs and benefits of proxy access on a preliminary basis. The resulting study included a comprehensive literature review and analysis of seven event studies related to the perceived wealth effects of proxy access.

The authors of the report said that the underlying fun-damentals of event studies suggest that proxy access was received more positively than negatively by financial markets.

When the results of the studies are extended for over-all US market capitalization, the estimated positive impact of proxy access reform ranges from $22.8 billion to $363 billion, or 0.1% to 1.9% of total US market capitalization.Rhea Wessel is a freelance journalist based in Frankfurt.



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

With initiatives under way by standard setters and regula-tors around the world to reform financial reporting disclo-sures, CFA Institute has sought to contribute the investor viewpoint to the dialog with a new report titled Forward-Looking Information: A Necessary Consideration in the SEC’s Review on Disclosure Effectiveness.

The US Securities and Exchange Commission (SEC) has launched a review of the effectiveness of disclosures under Regulation S-K, which sets requirements for public company disclosures outside the financial statements, and Regula-tion S-X, which concerns disclosures within the financial statements. As the SEC conducts its review, CFA Institute believes that “forward-looking information” is an essential part of the disclosure debate.

In 2013, CFA Institute published Financial Reporting Dis-closures: Investor Perspectives on Transparency, Trust, and Volume, which describes investor perspectives on needed improvements in financial disclosures. Building on this effort, the new Forward-Looking Information report explores the challenge of drawing a dividing line between forward-looking information that belongs within the financial state-ments and forward-looking information that belongs out-side the financial statements.

The report examines the definition and reviews the his-tory of forward-looking information as defined under US securities laws as well as safe harbors for such information under securities laws and SEC rules. However, US gener-ally accepted accounting principles (GAAP) lack a defini-tion of forward-looking information, which has contributed to the debate regarding its location, with companies prefer-ring to include such information outside rather than within the financial statements.

“Investors find forward-looking information to be the most ‘decision-useful’ in the investment decision-making process,” explains Sandy Peters, CPA, CFA, head of financial reporting policy at CFA Institute. “For example, uncertain fair value measurements that reflect current conditions and expecta-tions of future conditions are significantly more useful than measurements like amortized cost, which, though highly certain, only reflect past values and give no indication of current market expectations of value. Investors need dis-closures to understand the inputs to such measurements.”

Indeed, the financial crisis has highlighted the need for further improvements in risk and liquidity disclosures, a type of forward-looking information. But the debate regard-ing the appropriateness of including forward-looking dis-closures in financial statements has delayed the Financial Accounting Standard Board’s (FASB’s) development of new accounting standards and disclosure requirements that could provide additional useful information to investors in their

financial analyses. For example, in 2011, the FASB could not issue requirements for enhanced interest rate and liquidity risk disclosures, even after outreach showed investor sup-port for these disclosures.

The CFA Institute report also examines the misconcep-tion that US GAAP does not include forward-looking infor-mation, demonstrating through the use of examples that financial statements currently include substantial degrees of forward-looking information.

The most obvious instance of forward-looking informa-tion in the financial statements cited in the report is the case of financial instruments measured or reported at fair value. Reporting financial instruments at fair value requires an entity to project future cash flows, often far out into the future and discounted at a rate that market participants would use to discount them. Even fixed assets—such as property, plant, and equipment, which is generally carried at historical cost—include and convey forward-looking information/expecta-tions. The selection of a depreciation period, although typ-ically standard in nature, is nevertheless an indication of management’s estimate of the future useful life of the asset.

“Investors perceive inconsistencies in the argument to exclude forward-looking disclosures, such as liquidity and interest rate risk, in the financial statements yet include for-ward-looking measurements, such as the proposed impair-ment model, in the financial statements,” says Peters.

CFA Institute believes the lack of a conceptual framework for measurement is one of the underlying contributors to the contradictions in the debate regarding the nature of forward-looking information included in the financial statements. The conceptually inconsistent measurement of assets and liabili-ties currently used in financial statements creates confusion for all stakeholders regarding the characteristics of an asset or liability that define how it should be measured as well as the degree to which forward-looking information should be incorporated into the measurements. Furthermore, it leads to a debate regarding the nature of the disclosures neces-sary to make such measurements meaningful for investors.

Investors want clarity on the SEC’s perceived dividing line as part of the disclosure effectiveness review. The cur-rent state of the debate delays progress on improving dis-closures that would be useful for investors. CFA Institute maintains that the pursuit of artificial boundaries regarding where to provide additional forward-looking information simply ends up significantly constraining needed improve-ments to financial reporting information.

Instead, as the CFA Institute report states, “The nature of the improvements, rather than their location in the finan-cial filings, should be of principal concern to policymakers.”


CHAPTER 10

Illu

stra

tion

by

Rob

ert

Meg

anck

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

By Ralph Wanger, CFA

Professional investors are human beings, and as human beings, we have biases. Biases can be bad (for instance, if there is some class of people we are prejudiced against). Biases can be neutral, such as which baseball team you prefer. Some biases can be good in the sense that your investment strategy is logical and successful, even if it is perceived as a bias by the jerk in the next office.

One bias that is very important to us is investors’ regard for active management. In a recent FAJ article, Charles Ellis proclaimed that performance investing was obsolete, so we should spend our time trying to cheer up our clients (“The Rise and Fall of Performance Investing,” Financial Analysts Journal, July/August 2014). Ellis is an experienced, thought-ful investment professional and worth listening to. But many of us decided to become CFA charterholders because we are brilliant, courageous risk takers and swashbuckling top-gun fighter pilots. Passive investing is for airline pilots.

Why is active investing out of favor? I do not think it is theoretically impossible. I do admit that it hasn’t worked very well for the past seven years. Even the self-anointed geniuses in the hedge fund world have had pathetic results. At this point, the realists, such as Ellis, say that financial analysts can be replaced by a $30 piece of software in the same way that fighter pilots are being replaced by drones.

And we are biased to believe that the past three years of data describe a permanent structure.

The world of investing has always been cyclic. There will be periods, such as the past few years, when active investing trails the S&P 500, but there have been and will be other periods in which active investing will do just fine. From a quant point of view, we have been through a period when the correlation of individual stocks with the indexes has increased. Investment returns have been all beta and no alpha. This tight correlation must decrease in the future because no correlation can get higher than 1.0. When stocks become less correlated with the market, alpha will pop up like dandelions in May and active investing will become fashionable again.

Another important bias for portfolio managers is the desire of managers to take on a lot of risk, often more than their clients are comfortable with. Suppose you have just been assigned to run a $50 million mutual fund equity portfo-lio. There are 99 other mutual funds in the same Morning-star category as you. On 2 January, you start with a port-folio of your 50 favorite stocks and are confident that you will do well. In the mutual fund sales arena, you will earn a big bonus if you are in the top five for the coming year. If you end up in the group of the next 45 funds, you will keep


CHAPTER 10

your job but get a small bonus. If you are in the bottom half, your fund will have net outflows and your job will in jeop-ardy. You want to win.

Before you know it, 31 January has arrived. Your port-folio is doing alright, but your fund is ranked only 11th out of 100. There is no need to worry, really, because markets in January are peculiar. Small stocks always do better in January. You can afford to wait and see what happens. But only four weeks later, it is the end of February. Although your portfolio is still performing decently, you now own a few stocks that are lagging noticeably. Your ranking has gone down to 17th.

You sell the five stocks that are the laggards in your port-folio and reinvest the money in fresher, more promising ideas. That actually helps a little, but at the end of the first quarter, your ranking is 21st and you’re fully 2 percentage points behind the leader.

How are you going to catch up? Minor tinkering in the portfolio no longer looks like the right strategy to win the race. The only chance you have is to take more risk. You need to concentrate your portfolio in one or two industries and double your weighting in your favorite stocks in those industries.

As long as it’s just you taking the risk, the world of finance is indifferent to your results. Sometimes, you will

end up gaining the lead in your industry and become rich and famous, although this is not the most likely outcome. Think about the fund group of 100 as a whole. The first-place fund is cruising along cheerfully and is maintaining a sensible portfolio. The other 98 managers are going through the same thought process as you. Everybody starts goos-ing their portfolios by taking more risk. The real losers are the mutual fund shareholders, most of whom do not want to take that much risk, but the risk-seeking bias of portfo-lio managers acts against their interests.

This risk-seeking bias is even stronger for hedge fund managers. They have the dream of making $100 million annually if they can win the race. The risk-seeking bias becomes so strong for these avid competitors that they will use very high degrees of leverage in their portfolios. Their competitive spirit can become so desperate that they may violate the law, which can range from insider trading to Madoff-like fraud.

So what is an investment professional to do? Three steps (in increasing level of difficulty) can help. First, be alert to the biases of other people. Next, recognize bias in your-self. Third, if your bias is harmful, change your behavior.

Ralph Wanger, CFA, is a trustee of Columbia Acorn Trust.

THE

MACHINERY

INDUSTRY

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INDUSTRY GUIDES

9 780938 367796

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ISBN 978-0-9

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9 780938 367819

9 0 0 0 0

ISBN 978-0-938367-81-9

THE PHARMACEUTICAL INDUSTRY

Introducing Industry Guides—a new CFA Institute publication series written by and for CFA Institute members.

Each guide is focused on providing a brief but comprehensive examination of a specific industry, including an overview of its structure, its primary economic drivers, and practical guidance for conducting effective valuation and analysis. Browse and download current titles at www.cfapubs.org or at www.amazon.com.

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

GET THE INSIDER’S VIEW.

• Freedom and flexibility to run your own business.

• No contract.

• Keep 100% of your fees.

• Minimal start up and overhead costs.

• Full White Branding capability with customized statements.

• State-of-the-art trading platform with automated allocation of stocks, options, futures, bonds, CFDs or forex to subaccounts.

• Generate Higher Returns: • Lower commissions, no ticket charges; no

minimums; and no technology, software, platform, or reporting fees.

• Better executions. We do not sell or trade against your orders.

• Low interest rates, and higher loan values on portfolio margin accounts over $100K.

• Model Portfolios, Option Analytics and Algos.

• Automated calculation, billing and withdrawal of management and performance fees.

• Manage clients’ accounts wherever they come from* and wherever they want to trade on over 100 exchanges around the world.

• Solid financials with $5 billion equity1, S&P rating: A-

Interactive Brokersfor Institutions

To find out more, contact an IB representative by calling toll free 855-861-6414 or by visiting:

ibkr.com/cfa

stocks • options • futures • forex • bonds — on over 100 markets worldwide from one account

Why become an independent Advisor on Interactive Brokers’ platform?

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

• Freedom and flexibility to run your own business.

• No contract.

• Keep 100% of your fees.

• Minimal start up and overhead costs.

• Full White Branding capability with customized statements.

• State-of-the-art trading platform with automated allocation of stocks, options, futures, bonds, CFDs or forex to subaccounts.

• Generate Higher Returns: • Lower commissions, no ticket charges; no

minimums; and no technology, software, platform, or reporting fees.

• Better executions. We do not sell or trade against your orders.

• Low interest rates, and higher loan values on portfolio margin accounts over $100K.

• Model Portfolios, Option Analytics and Algos.

• Automated calculation, billing and withdrawal of management and performance fees.

• Manage clients’ accounts wherever they come from* and wherever they want to trade on over 100 exchanges around the world.

• Solid financials with $5 billion equity1, S&P rating: A-

Interactive Brokersfor Institutions

To find out more, contact an IB representative by calling toll free 855-861-6414 or by visiting:

ibkr.com/cfa

stocks • options • futures • forex • bonds — on over 100 markets worldwide from one account

Why become an independent Advisor on Interactive Brokers’ platform?

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

Date post:	26-Jan-2023
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