CFA 2010 Conference Highlights

CFA 2010 Conference Highlights

In a nutshell

Here are highlights of what I heard and you might find of interest; any errors or misrepresentations are my fault alone as the following may not accurately represent the views of various speakers mentioned.

-financial industry: lost its way, not obeying laws of capitalism, capitalism’s price mechanism doesn’t work in this industry, Vanguard is only “mutual”(i.e. investor-owned) fund management company, we know we are in trouble when the language of business (product, distribution, shelf space) infects the language of a profession (investment management), in business you give customer what he wants but if you do that in a profession (e.g. medicine) you might kill him (need to re-professionalize investment management and financial advice), investment manager must be fully co-invested in his fund (no man can serve two masters), business innovation is about better goods/services at netter prices but innovation in financial services is almost exclusively in the interest of the seller, Credit Default Swaps toxic since holder wants to force company into default

-“behavioral finance”: importance of psychology in economics is not well understood but growing (complementing, not replacing, “efficient market” views), design of environment strongly influences outcomes (defaults), “good people” put in “conflict of interest” situations will fail, “animal spirits” drive behavior, “snake oil” is proof that capitalism works too well because it doesn’t just produce what people want but also what they think they want

-regulation: sometimes regulation is required to save us from ourselves, SEC’s focus is on international accounting standard and on bringing transparency to opaque markets

-modeling market behavior: realistic assessment (and creation) of policy portfolios may need to include multiple regimes and transitions between regimes, rather than just using a single normal distribution (which is perceived as not having adequately modeled the recent stock market swoon)

-emerging markets: gained as a result of the crisis from 25% to 32% of global economy and are increasing share at 1%/year, represent 28% of global equity markets but are only 13% of MSCI, BRICs did particularly well because they are countries run by governments, in war between state and company- the state will triumph

-U.S. wealth management opportunity: wealth management industry which is built on ‘bank secrecy’ (e.g. Switzerland, Islands) is doomed in a world of growing transparency thus creating opportunity for ‘real’ wealth managers

-gold (and commodities or collectibles): a love hate relationship, most agree that gold doesn’t have the characteristics of an investment in that it has no associated cash flows, but many feel that gold is an insurance/hedge against the current debasement of paper currencies

-sovereign debt: developed countries’ debt typically >100% of GDP (some >200%) whereas emerging countries’ debt <50%, debt is Achilles’’ heel of democracies and bond markets will eventually force emergency action, at debt >90% of GDP slower growth sets in, when 50% of the voters receive government handouts then reform becomes impossible in a democracy

Ken Rogoff- Understanding Financial Crises

-after a wave of international banking crises, a wave of sovereign debt crises often follows within a few years

-type of debt is important: external (public and private) debt in Europe >200% of GDP; Europe has heavy external debt, some developed countries at 200% of GDP; once debt >90% GDP slower growth sets in

-housing is the best leading indicator of coming financial crisis, while rating agencies are the worst leading indicator

-Peak-to-trough changes in previous financial crises: housing= -36% (over 5 years), equity prices= -56% (over 3.4 years), unemployment= +7% (over 4.8 years) and real GDP per capita= -9.3% (over 1.7 years)

-best measure of exchange rates is PPP

Jeremy Grantham- Move Your Assets

-financial industry lost its way; it is not obeying the laws of capitalism

-mutual fund industry after economies of scale, increased fees; so capitalism’s price mechanism didn’t work

-we allowed the deterioration of ethical conduct, because we didn’t move assets from the least ethical firms; nobody in the world knew that those in the”engine room” were predicting that the market will collapse

-his 7 year forecast is that high quality U.S. stocks (low debt, consistent earnings growth) will do well/best…for over/under-valuation using P/E must use 10 years backward looking at least (as done by Shiller)…but today low risk (bonds) is actually bad and pensioners (in fixed income securities) will be wiped out

-U.K. and Australia have largely avoided the crash of the housing bubble…at least until now

Cliff Assness- Hedge Funds

-what hedge funds say they do is: skill; what they actually do is: market returns (beta) and “dynamic returns” (or ‘hedge fund beta’ like pure value. Momentum, arbitrage etc strategies)

-there were many disappointments with hedge funds, but they have generally outperformed equities over last ten years and during credit crisis

-hedge funds still have a role in asset allocation if: positive expected returns are uncorrelated (especially to equities), and are liquid!

-the hedge fund of the future should: have rational/investable/alternative strategy, sufficient transparency to allow investor to understand source of returns/sustainability/liquidity, appropriate liquidity, fees commensurate with alpha/beta being delivered, and honor high-water marks

-know where returns come from (skill, hedge fund beta, market beta) and make sure that fees are appropriate to the source of returns

Dan Ariely- “Predictably Irrational”: The hidden forces that shape our decisions

-people designing environments (context) strongly influence the outcome (e.g. different levels of organ donation sign-up in European countries depending on whether you ask “sign here if you want to donate your organs” as opposed to “sign here if you don’t want to donate your organs” (already applies in U.S. where default for 401(k) is set to participate, i.e. you must take action to opt-out)

-defaults are everywhere and they are more important in the presence of complexity; how to design good defaults? (and be careful about “good for whom?”)

-a lesson we must remember is that we have irrational tendencies, but we don’t see them

-good people put in “conflict of interest” situations will fail; all people are susceptible and disclosure of conflict of interest may actually backfire, so better disclosure won’t solve the problem

Bookstaber- Risk management revisited

-why not add another risk/variance and correlation matrix which would be representative of the new environment (“regime change” was a repeating theme at the conference from Blackrock, State Street as well)

-sometimes regulation is required to save us from ourselves

Agtmael- Emerging Markets (“The Emerging Markets Century”)

-the “global crisis” was really only a “half-global crisis”…it turned out to be mostly a developed market crisis…emerging markets have: some of the world’s largest reserves, lower debt…

-emerging markets gained as a result of the crisis and have increased their share of the global economy from 25% to 32% (increasing about 1%/year)! The crisis actually accelerated the rise of the BRICs

-emerging market are 28% of global equity market but MSCI understates it at 13%

-GDP of (current) emerging market countries will be approximately equal to (current) developed countries in about 20 years

Mary Shapiro (SEC Chair)

-SEC mission: global accounting standards, transparency to opaque markets (e.g. OTC, derivatives, HF trading, etc), restructuring the SEC to close gap between the resources available to the SEC and those it regulates

Seth Klarman of Baupost – Interviewed by WSJ’s Jason Zweig(Klarman’s “Margin of Safety” book is out of print but is apparently selling for $1000 on eBay)

-on ‘stocks for the long run’…yes but you have to be around for the long-run…but what really important is your ‘entry point’

-worried about: what will happen to market if/when government intervention/manipulation stopped, will the ‘dollar’ be worth anything (if government continues intervening), worried about all paper money, worried that it’s easier to create inflation than to fix problems, and worried that government cooks the numbers (inflation higher than the numbers indicate)

-tipping point in government debt is unknown (“how did you go bankrupt”…gradually and then suddenly”)

-commodities are really not an investment (except perhaps gold due to fear of paper money)…just like collectibles, commodities don’t have the characteristics of an investment because they have no ‘cash flows’ associated with them

-to hedge inflation risk he doesn’t like TIPS (since government measures inflation), instead he uses way-out-of-money puts

-while he sees a change (deterioration) in the moral fiber and ethics of the financial industry, he had a visceral distaste of the Goldman Congressional hearings (Goldman’s customers are big boys and should remember “caveat emptor”)

-shorts do a much better job analyzing securities than longs, so he believes that they are overall a positive force

-individuals who buy Credit Default Swaps (CDSs) and want company to file for bankruptcy are bad for the country! (This theme was echoed a number of times at the conference)

Recommended books: Graham and Dodd-Intelligent Investor, books covering markets/economics/history, Greenblatt (You Can Be a Stock Market Genius), Whitman, Jim Grant

Ian Bremmer- The end of the free market: Who wins the war between states and corporations (The short answer is: the State)

-which countries came out the best in the recent crisis? Countries run by governments- the BRICs

-coming changes in government controlled countries: lower (but still higher than in developed countries) economic growth, politically directed investments, multinationals with exposure to state capitalism will have to adapt or leave

-in case of war between state and companies, companies will lose (e.g. Google in China, where China didn’t want too much competition for Baidu)

-India will benefit from China’s position; corporations will start hedging with serious money into India

-every U.S. CEO complains that they don’t like Obama but corporate power in the U.S. is very strong

Marcovici- International wealth planning for families

-Swiss wealth management industry not as clean as the country

-Swiss private banking based on ‘bank secrecy’ (also in Singapore, Islands…and U.S.)

-world is changing…move to transparency…and transparency is just starting

-U.S. has “Qualified Intermediary” rules which forces foreign institution to report ‘suspicious activity’

-this increase in transparency is opportunity for (U.S.) wealth management industry that is focused at the real needs of families…very positive for the industry

-always start with home country tax system (Canada is residency based, U.S. is citizenship based, and U.K. is domicile based)

– Trusts have great advantages; does every family need a trust?

Seth Alexander (MIT endowment)- Managing Investments through Turbulent times

-endowment model: equity orientation, diversified and emphasis on illiquidity (premium of inefficient markets)…investment strategy matched the institution’s character (can tolerate more volatility and less liquidity)

-MIT, Yale, Harvard, Princeton have competitive advantage: stable capital base, access to best-in-class managers due to reputation of the university, and leads generated by community of students, parents, professors

-until 2008 it all worked great, but some things then went wrong: uncoordinated investment and budgetary areas, management of liquidity, cheap credit benefits seller of asset not buyers, over-reliant on broad asset class allocations which turned out to be correlated…

-current endowment model is still the best for the elite universities (highly capitalized) but: must separate musts and wants, and must have more liquidity contractually…this model is inappropriate for smaller endowment funds without the competitive advantages

Akerlof- “Animal Spirits”

-mathematics used for economic is not “fuzzy” enough

-the importance of psychology in economics not well understood and underestimated

-Keynes understood and discussed “animal spirits” but followers eliminated it from economic thought

-irrationality and non-economic motives often drive behavior, but government action can counterbalance the negative shocks of irrationality

-Snake oil: capitalism doesn’t just produce what people want, but also produces what people think they want (e.g. Raters and accountants have inherent conflict and if unregulated they generate ‘snake oil’…what a surprise?!?)

-capitalism does work, but too well (snake oil)

John Bogle and Chris Davis: Rebuilding the financial services industry

-in 1949 the fund industry was about “stewardship’

-in the past 3 years Vanguard became the largest fund management company by taking in 66% of all new money going into mutual funds (perhaps U.S. retail investors actually are starting to understand they are on the bottom ladder of the financial industry)

-of the major investment management firms 8 are private, 31 are public, 23 are conglomerates and only ONE is mutual (Vanguard)

-we are in real trouble when the language of business (product, distribution, shelf-space) infects the language of a profession

-in business you give customer what he wants, but in a profession is you do the same, you might kill him (e.g. medicine)…so the problem in the financial services industry is not just the fees, but the nature of advice as well (fiduciary role is essential)

-no man can serve two masters (manager should be co-invested fully in his fund)

-there is a huge difference in the approach to governance when one is (long-term) “owner of the stock” as opposed to “renter of the stock” (i.e. just a short-term trader)

-U.S. government’s unfunded pension liabilities are $42T

-innovation: generally better goods and services at better prices, but in the financial services industry almost all innovation is in the interest of the seller

Niall Ferguson- History in the making: Lessons and legacies of the financial crisis

-there is a debt explosion in the developed world and historically there are only three ways out: cut, print or default; only Britain (1815-1914) succeeded to escape debt through economic growth due to the industrial revolution and because property owners were actually governing

-democracies deal with debt through inflation

-debt of developed countries >100% of GDP and of emerging countries <50% of GDP

-debt is the Achilles’ heel of western democracies and bond markets eventually force emergency action (or else it has non-linear effect)

-sometimes it is different: due to short-term debt structure rates rise before inflation, that leads to rising real long rates, which in turn negates growth in a highly leveraged economy and results in political conflict and default

-democracy and debt: when 50% of the voters are recipients of government handouts, then reform is impossible (Europe is already there)

-dollar will remain strong for a while, but at some point sustainability will be questioned before the next presidential election

-paradigm shift: could be some corporations will be AAA rated, but not governments

Multi-regime Models and Dynamic Asset Allocation

-in the search for new ways to tackle policy portfolios (after the perceived failure of the models previously used) based on the assumption that market behaviour can be adequately described by a normal random variable, a number of speakers mentioned the need to perhaps think of the market as having multi-regimes rather than just a single-regime

-for example in the Blackrock/iShares paper “The new policy portfolio” Dopfel argued that perhaps “The wide dispersion can be explained by the presence of economic and financial market regimes—both good and bad. Each regime has distinct asset class assumptions, represented by higher or lower expected returns and volatilities” and then looked at the implications on the (institutional or individual’s) portfolio. In each regime (‘good’, bad’ and transitions), asset classes would have different characteristics. The paper demonstrates how ‘fat-tails’ and ‘skewness’ can be modeled using the sum of two normal distributions (which is not normal). The proposed models allow investors to assess their portfolio outcomes using a more realistic model and could result in new policy portfolios.


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