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The Member Magazine for Investment Professionals

May/June 2014

Expanding
Horizons
Global expansion is
a tricky balancing act
for asset managers

May/June 2014

COVER STORY

30 Expanding Horizons
Global expansion is a tricky
balancing act for asset managers

30

By Rhea Wessel

34 The Art of Knowing


Nothing Brilliantly
How does a successful quant
know which strategies will work?
First, throw out the word know,
says Cliff Asness

34

By Nathan Jaye, CFA

38 Hope and Uncertainty


Members of CFA Society Ukraine
describe changes in their lives
and business
By Nathan Jaye, CFA

40 Double, Double Toil


and Trouble

38

If inflation metrics are wrong,


mischief could be brewing
for markets
By John Rubino

40

COVER ILLUSTRATION

Kelly Alder

Why become an
independent RIA on
Interactive Brokers platform?

Please see the answer at:

interactivebrokers.com/cfa

Interactive Brokers

for Institutions

Interactive Brokers LLC is a member of NYSE, FINRA, SIPC.

01-IB14-724CH657

May/June 2014

CFA INSTITUTE NEWS


6 In Focus
Shaping the Future of Finance Together

AS ONE CHAPTER CLOSES AND


ANOTHER BEGINS IN THE MIFID
SAGA, CFA INSTITUTE WILL REMAIN
RESOLUTE IN STANDING UP FOR
INVESTOR INTERESTS IN THE
REGULATORY REFORM PROCESS.

48

By John Rogers, CFA

9 EMEA Voice
The Ethical Gap between Principle and Practice
By Nitin Mehta, CFA

10 APAC Focus
Asia Pushes Back
By Paul Smith, CFA

VIEWPOINT
14 In the Dark
The latest allegations about market rigging
by high-frequency traders overlook more
serious problems
By Dennis Dick, CFA

50

16 Job Satisfaction and Investment


Professionals
Professionals who focus on compensation may
deceive themselves and mismanage others
By Usman Hayat, CFA

17 The Value of Geopolitical Analysis


Although most investors say geopolitical
analysis is important, many fail to grasp
its real significance
By Jason Voss, CFA

PROFESSIONAL PRACTICE
20 Finding profitable high-yield anomalies
24 Compensation trends for analysts
27 Stopping boards disorganized crimes

ETHICS AND STANDARDS


46 Market Integrity and Advocacy
Crowdfunding and investor protection
Reforming preemption rights in Asia

56

CFA Institutes role in the MiFID II debate


Are self-regulatory organizations obsolete?

55 Professional Conduct
Notices of disciplinary action
5 In Summary
56 Chapter 10

WORLD-CLASS CURRICULUM

Rank
ked by U.S. Ne
ews and World Report Am
mong the
e Top
p 20 Graduate
Fina
ancce Pro
ograms

Creightons MSAPM faculty is comprised of


educational professionals who have all earned the
CFA charter as well as advanced academic degrees.
The faculty includes:
Robert Johnson, Ph.D., CFA: Former Deputy
CEO of the CFA Institute
Randy Jorgensen, Ph.D., CFA: MSAPM
Program Director
Lee Dunham, Ph.D., CFA: Associate Editor, CFA Digest
Charles Braymen, Ph.D., CFA
Marc LeFebvre, M.S., CFA
Ken Washer, D.B.A., CFA
Melissa Woodley, Ph.D., CFA

EARN A PRESTIGIOUS MASTERS DEGREE WHILE PREPARING FOR YOUR CFA EXAMINATIONS.
TO LEARN MORE, CALL 866-717-6365 OR VISIT ONLINE.CREIGHTON.EDU/CFAMAG
*CFA Institute does not endorse, promote or warrant the accuracy or quality of the products or services offered by Creighton University. CFA Institute, CFA,
and Chartered Financial Analyst are trademarks owned by CFA Institute. The CFA Institute is the sole grantor of the CFA Charter designation.

May/June 2014 Vol. 25, No. 3

CFA Institute Magazine (ISSN 1543-1398, CPM 400314-55) is published bimonthlyin


January, March, May, July, September, and Novemberby CFA Institute. Periodicals
postage paid at Charlottesville, VA, and additional mailing offices. POSTMASTER: Send
address changes to CFA Magazine, 915 East High Street, Charlottesville, VA 22902.
Statements of fact and opinion are the responsibility of the authors alone and
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Copyright 2014 by CFA Institute. All rights reserved. Materials may not be
reproduced or translated without written permission. CFA, Chartered Financial
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Annual subscription rate for CFA Institute members is US$40, which is included
in the membership dues. Annual nonmember subscription rate is US$50.
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4 CFA Institute Magazine May/June 2014

CFA INSTITUTE PRESIDENT & CEO


John Rogers, CFA
john.rogers@cfainstitute.org

PUBLISHER
Ray DeAngelo
ray.deangelo@cfainstitute.org

MANAGING EDITOR
Roger Mitchell
roger.mitchell@cfainstitute.org

ASSISTANT EDITOR
Michele Armentrout

ONLINE PRODUCTION COORDINATOR


Kara Hite

GRAPHIC DESIGN
Communication Design, Inc.
tim@communicationdesign.com

ADVERTISING MANAGER
Tom Sours
tom.sours@cfainstitute.org

CIRCULATION COORDINATOR
Jennette Townsend
jennette.townsend@cfainstitute.org

EDITORIAL ADVISORY TEAM


Shanta Acharya
Bashir Ahmed, CFA
Jim Allen, CFA
Jonathan Boersma, CFA
Jarrod Castle, CFA
Michael Cheung, CFA
Josephine Chu, CFA
Franki Chung, CFA
Darrin DeCosta, CFA
Nick Dinkha, CFA
Jerry Donohue, CFA
Alison Durkin, CFA
Kenneth Eisen, CFA
William Espey, CFA
Julie Hammond, CFA
Burnett Hansen, CFA
M. Mahboob Hossain, CFA
Vahan Janjigian, CFA
Andreas Kohler, CFA

Aaron Lai, CFA


Kate Lander, CFA
Casey Lim, CFA
Michael Liu, CFA
Bob Luck, CFA
Farhan Mahmood, CFA
Dennis McLeavey, CFA
Sudip Mukherjee
Jerry Pinto, CFA
Linda Rittenhouse
Craig Ruff, CFA
Christina Haemmerli Schlegel, CFA
David Shen, CFA
Arjuna Sittampalam, ASIP
Larry Swartz, CFA
Jacky Tsang, CFA
Gary Turkel, CFA
Raymond Wai Pong Yuen, CFA
James Wesley Ware, CFA
Jean Wills

2014 Creighton University

Taught exclusively by faculty who have earned the


prestigious CFA charter, Creighton Universitys
Master of Security Analysis and Portfolio
Management program allows students to
earn a highly-respected masters degree while
simultaneously preparing for success in the CFA
Program.* The practitioner-based knowledge
and skills students acquire are essential to those
seeking top jobs in the competitive and challenging
eld of investment management. This state-of-theart curriculum is delivered either exclusively online
or in residence.

IN SUMMARY

Riding a Bicycle in the Dark without a Lamp


A mans brain whizzes along for years exceeding the speed
limit, and something suddenly goes wrong with the steering-gear
and it skids and comes a smeller in the ditch.
P.G. Wodehouse, Right Ho, Jeeves

VWUDWHJ\:KHQKHQGVKLPVHOIDWDQHYHQWZKHUHHYHU\thing is about to go wrong in spectacular and embarrassing fashion, he tells the reader, The essence of strategy on
these occasions is to be as near the door as possible. For
investors, the gravest danger comes when everyone suddenly perceives a threat simultaneously and tries to get
through the door at the same time. Under such conditions,
those with a proper understanding of geopolitical analysis
may have an advantage because it can provide high levels
of predictability, according to Jason Voss, CFA (The Value
of Geopolitical Analysis, 17).
One of the predictable patterns examined by Voss is Russias interest in Ukraine and the Crimea region in particular.
As a result of recent developments, members of CFA Society
8NUDLQHQGWKHPVHOYHVGHDOLQJZLWKFLUFXPVWDQFHVWKDW
their professional colleagues in many other markets never
have to contemplate, yet they persevere in trying to advance
a vision of progress. In the words of Anna Reshetova, the
societys administrative director, Its our great hope and
H[SHFWDWLRQWRTXDOLWDWLYHO\FKDQJHWKHQDQFLDOPDUNHWLQ
Ukraine (Hope and Uncertainty, 38).
For investors in more stable environments, hope is a
tricky thing because it can easily turn into optimism. Naive
optimism is invariably where Bertie goes wrong when he
decides to help someone without consulting Jeeves. The
two have very different approaches. The wise valet operates
with a shrewd understanding of psychologyhow people
will actually behave in a given situationbut Bertie usually proceeds on wishful thinking. According to high-yield
specialist Jochen Felsenheimer, the same thing can happen
with investment models. Its never the model, he says. Its
always the people putting assumptions into their models
ZKRDUHWRRRSWLPLVWLF 7KH2PQLYRUHV'LHW 
Is the latest controversy over high-frequency trading a case
RIRSWLPLVPJRQHZURQJ +)7UPVJHWWLQJFDUULHGDZD\E\
irrational high-speed exuberance) or a knee-jerk overreaction
based on widespread ignorance of market microstructure?
7DNLQJDWUDGHUVH\HYLHZRIPDWWHUV'HQQLV'LFN&)$
argues that people are overlooking the most serious probOHPVFDXVHGE\KLJKIUHTXHQF\WUDGHUV ,QWKH'DUN 
Some of us can identify with the situation in which Bertie
QGVKLPVHOIQHDUWKHHQGRIRight Ho, Jeeves. When one
of Jeeves plans appears to have gone awry (temporarily),
Bertie must ride a bicycle at night over unfamiliar roads to
a village nine miles distant. For life or investing, riding a
bike in the dark without a lamp often seems like an apt metaphor. Bertie would advise us to remain calm, pour a restorative drink, and make ourselves comfortable. After all, as
he says, It isnt so dashed easy to stagger when youre sitting in an arm-chair.

For a man with no practical responsibilities, Bertram Bertie


Wooster has a rather complicated simple life. An amiable
young English gentleman educated at Eton and Oxford and
endowed with family wealth, he seems to spend most of
his time doing little more than living in high style. But he
always manages to entangle himself in the absurdly convoluted misadventures of old school chums and family relations. Again and again, the task of rescuing Bertie and comSDQ\IURPVRFLDOUXLQIDOOVWR%HUWLHVYDOHWWKHXQDSSDEOH
and all-knowing Jeeves.
If the servants of 1930s-era British upper classes had a
professional code analogous to the CFA Institute Code of
Ethics and Standards of Professional Practice, Jeeves would
exemplify the highest standard of conduct. A case study in
servant leadership, he would embody the ideal that every
GD\\RXUDFWLRQVQRWRQO\UHHFW\RXURZQFKDUDFWHUEXW
DOVRLPSDFWWKHUHSXWDWLRQRI\RXUUPDQGWKHSURIHVVLRQ
more broadly (In Focus, 6). Berties friends and relations
trust Jeeves to advise them on untying the most perplexing
knots of personal life and business affairs. Whereas many
people in much loftier professions deceive themselves into
believing that ever-greater compensation will lead to satisfaction, Jeeves presumably would agree with Usman Hayat,
CFA, when he explains why results, recognition, and relationships are worth more than material rewards (Job Satisfaction and Investment Professionals, 16).
Bertie marvels at Jeeves loyalty when people try to hire
Jeeves away and offer to double his pay, a method of acquiring talent that has become less familiar where the comSHQVDWLRQRIQDQFLDODQDO\VWVLVFRQFHUQHG 3D\'D]H
24). Why Jeeves stays with Bertie is unclear. I suspect that
KHFRXOGQHYHUQGDQRWKHUPDVWHUVRJHQLDOZKRZRXOG
also be an inexhaustible source of amusing follies. And he
would miss Berties penchant for uttering ridiculous proverbs, such as Spilt milk blows nobody any good or There
is a time for studying beetles and a time for not studying
beetles. Perhaps Jeeves also would have enjoyed working
for AQR founder Clifford Asness, whose quick wit leads to
more truly insightful quips. For example, Asness puts the
NQRZOHGJHEHKLQGSURWDEOHLQYHVWPHQWVWUDWHJLHVLQSHUspective when he says, First, throw out the word know. We
dont actually know anything. We make bets that are right
a little bit more than 50% of the time, and we congratulate ourselves on that track record long term when it really
adds up (The Art of Knowing Nothing Brilliantly, 34).
Although Bertie is more like a short-term market timer Roger Mitchell, Managing Editor (roger.mitchell@cfainstitute.org)
than a long-term investor, he does have a keen sense of

May/June 2014 CFA Institute Magazine 5

CFA INSTITUTE NEWS


IN FOCUS

Shaping the Future of Finance Together


By John Rogers, CFA

Just over a year ago, CFA Institute


launched the Future of Finance initiative, a long-term global effort to shape a
WUXVWZRUWK\IRUZDUGWKLQNLQJQDQFLDO
industry that better serves society. Our
purpose was to identify the issues that
are most important to the future of the
industry and determine where we have
the greatest ability to make a difference.
We have learned much along the way.
)LUVWZHOHDUQHGWKDWWKLVLVGLIFXOWEXWLPSRUWDQWZRUN
$VDQRUJDQL]DWLRQZHKDYHHQJDJHGLQDGYRFDF\HIIRUWVIRU
many years and published countless articles on best practices
IRUWKHSURIHVVLRQ\HWWKLVLQLWLDWLYHKDVEURXJKWRXURUJDQL]DWLRQWRJHWKHULQDQHZZD\WRVHHWKHEURDGHUUDPLFDWLRQVRI
our work. While the list of challenges remains daunting, we
have been encouraged by comments from many who view our
RUJDQL]DWLRQDVXQLTXHO\TXDOLHGWRWDFNOHWKHWRXJKLVVXHV
Our years of excellence in administering the CFA Program,
combined with our steadfast dedication to ethical principles,
give us great credibility in the global marketplace.
The Future of Finance initiative has drawn on wisdom
from leaders throughout the profession, and through conversations with hundreds of volunteers, members, and other
LQGXVWU\H[SHUWVZHLGHQWLHGVL[IRFXVDUHDVIRUWKH)XWXUH
RI )LQDQFH SXWWLQJ LQYHVWRUV UVW QDQFLDO NQRZOHGJH
transparency and fairness, retirement security, regulation
and enforcement, and safeguarding the system.
Second, we have seen how we can have greater impact
ZLWKDXQLHGYRLFH7KH)XWXUHRI)LQDQFHKDVEHFRPHD
platform to demonstrate to our members, the clients we
serve, and the public that we are more than a membership
RUJDQL]DWLRQRIFRPSHWHQWDQGHWKLFDOSURIHVVLRQDOVZH
also are a leadershipRUJDQL]DWLRQIRUWKHLQGXVWU\
Our effort has been supported by the Future of Finance
Advisory Council, which is an esteemed group of experts
ZKRKDYHOHGDVVHWPDQDJHPHQWUPVVHUYHGDVUHJXODtors, run sovereign wealth funds, and published extensively.
Moreover, the Future of Finance initiative has been fueled
by the passion and enthusiasm of our members, with more
than 50 of our member societies actively involved already.
The Future of Finance has inspired such efforts as the FinanFLDO)LWQHVV5XQRUJDQL]HGE\&)$6RFLHW\3KLOLSSLQHV7KLV
society of approximately 130 members recently held a race
with nearly 3,000 runners, featuring a different right from
the Statement of Investor Rights at each kilometer marker.
Meanwhile, other societies are holding gatherings for local
leaders to talk about improving business practices and hosting educational events for their members, often collaboratLQJZLWKRWKHULQXHQWLDORUJDQL]DWLRQV
6 CFA Institute Magazine May/June 2014

Third, it is a long journey toward industry change, and


we can all play a part. Although our members are globally
dispersed, we share a common experience: dedicating long
hours to exam study, awaiting results after test day, and recRJQL]LQJWKDWEHFRPLQJDFKDUWHUKROGHUVKRXOGPHDQPRUH
than adding three letters after your name. This is our industry, and we are part of a community of exceptionally talented investment professionals. While we cannot predict the
future, we can do our part to make it better and to better
prepare ourselves for it. Our global advertising campaign
states, The Future of Finance Starts with You, and there
are many ways to participate. Every day, your actions not
RQO\UHHFW\RXURZQFKDUDFWHUEXWDOVRLPSDFWWKHUHSXWDWLRQRI\RXUUPDQGWKHSURIHVVLRQPRUHEURDGO\

THE FUTURE OF FINANCE IS A PLATFORM


TO DEMONSTRATE THAT WE ARE MORE
THAN A MEMBERSHIP ORGANIZATION OF
COMPETENT AND ETHICAL PROFESSIONALS
WE ALSO ARE A LEADERSHIP ORGANIZATION FOR THE INDUSTRY.
:HHQFRXUDJH\RXWRYLVLWZZZFIDLQVWLWXWHRUJIXWXUHnance, where we will continue to publish research and principles that support the focus areas of the Future of Finance.
Read through the Integrity List of 50 action items to disFRYHUZD\VWREXLOGWUXVWDQGHQKDQFH\RXUUPVUHSXWDWLRQ(QFRXUDJH\RXUUPRUWKHUPV\RXKLUHWRDGRSW
the Asset Manager Code of Professional Conduct or to have
employees outside the investment process sit for the Claritas exam. Give the Statement of Investor Rights to your
clients. Join one of our online forums to debate important
issues. Participate in CFA Institute member society events
WKDWKLJKOLJKWWKHSXWWLQJLQYHVWRUVUVWWKHPHHVSHFLDOO\
GXULQJWKHPRQWKRI0D\'R]HQVRIVRFLHWLHVDUHGRLQJDFWLYities, ranging from getting a US state governor to declare
D3XWWLQJ,QYHVWRUV)LUVW'D\WRSDUWQHULQJZLWKORFDOVWRFN
exchanges for bell-ringing ceremonies to holding member
events. They are all working together to raise awareness
of the importance of aligned incentives and doing the right
thing for clients.
We are building tools for change. We invite you to use
WKHPDVZHVKDSHWKHIXWXUHRIQDQFHWRJHWKHU
John Rogers, CFA, is president and CEO of CFA Institute.

Everyone who works in finance helps shape its future.


Kamolwat Ratanachai,
Student,
Claritas Certificate Holder

THE
FUTURE
OF FINANCE
STARTS
WITH
YOU
We all play a role in bringing positive change to the finance industry.
Explore cfainstitute.org/FutureFinance to learn more.

#FutureFinance
CFA Ins
nstit
stit
tiittute
ti
ute 20
20114.. CFA, CIPM
CIP
IPM
M, and
d Clarittas ar
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#FutureFinance

2014
INVESTMENT
MANAGEMENT
WORKSHOP
711 July 2014
Harvard Business School
Boston, Massachusetts, United States
Offered by CFA Institute and Harvard Business School

For more than 40 years,


the Investment Management Workshop has played an essential role
in shaping the principles and practices of investment management
across the globe. This renowned program brings together highly
accomplished faculty and leading executives from around the world
to confront the ever-changing challenges that define the investment
management industry.

The program was a useful insight into


alternative investment approaches
available to our clients; it gave me a
better understanding of the broad
competitive landscape and our place
in client portfolios.

KEY TOPICS FOR 2014


The effects of changing macroeconomic risks on asset allocation
Investment management products and services in the global
marketplace
Liquidity management in uncertain times
Risk management in a portfolioand in a business
Disruptive innovations in the money management industry

JOHN KELLY-JONES
Partner and Chief Operating Officer
Independent Franchise Partners, LLP
2012 IMW attendee

Learn more and apply now at www.cfainstitute.org/execed


Questions? Contact us at university@cfainstitute.org

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2014 CFA Institute

CFA INSTITUTE NEWS


EMEA VOICE

The Ethical Gap between Principle and Practice


By Nitin Mehta, CFA

In 2013, CFA Institute commissioned


the Economist Intelligence Unit (EIU) to
undertake research with C-suite executives from across the investment industry to understand the view from within
on ethics and educationat the highest
levels of organisations and institutions.
The results (published this past November in the report titled A Crisis of Culture:
Valuing Ethics and Knowledge in Financial Services) are fascinating and highlight some of the areas
where work is still needed to address the gap between principle and practice in upholding ethical standards.
In the study, we asked executives from across key sectorsasset, wealth, and fund management; commercial,
investment, private, and retail banking; and insurance
DQG UHLQVXUDQFH UPVDERXW WKH VWDQGDUGV LQ SODFH DW
their organisations, how these standards were adapted and
enforced, and where the knowledge gaps exist. One message
was clear: There was a resounding acknowledgement of the
importance of codes of conduct as a driver of reputation and
value, with 91% of respondents placing equal importance
RQHWKLFDOEHKDYLRXUDVRQQDQFLDOVXFFHVVDWWKHLUUP
More worryingly, however, 53% went on to say that career
SURJUHVVLRQDWWKHLURUJDQLVDWLRQVZRXOGEHGLIFXOWZLWKRXWEHLQJH[LEOHRQHWKLFDOVWDQGDUGVDQGMXVWIHOW
WKDWWKHLUUPVQDQFLDOUHVXOWVZRXOGLPSURYHDVDUHVXOW
of better ethical conduct.
This response demonstrates that although businesses in
the investment industry understand that they must display
an ethical culture externally, enforcement of ethical standards is not yet embedded in the reward systems and daily
SUDFWLFHVRIUPV
This research addresses a great need in our Future of
Finance Starts with You campaign as we try to understand
the views of those leading the industry, because it is clear to
all involved in this mission that change must come from the
top. CFA Institutes own Global Market Sentiment Survey
shows that CFA charterholders remain much more acutely
aware of the importance of upholding ethical standards,
with over half of our members believing that the lack of
HWKLFDOFXOWXUHLQQDQFLDOUPVKDVEHHQWKHELJJHVWFRQtributor to the lack of trust in the industry.
The EIU study also found that even though 97% of
UHVSRQGHQWVVDLGWKDWWKH\DUHZHOOTXDOLHGIRUWKHLURZQ
role, 62% admit that their colleagues know very little about
ZKDWJRHVRQLQGHSDUWPHQWVEH\RQGWKHLURZQ7KLVQGing shows that a silo culture is pervasive in the industry,
with departments acting unilaterally rather than viewing
themselves as part of the wider business, which suggests

that integrated functional and management approaches for


ULVNSURRQJRUJDQLVDWLRQVUHPDLQZHDN
I believe that our role is to tackle these issues with a
solutions-focused approach, which is why we continue to
engage our global membership in this debate and to broaden
the product portfolio that we can offer the industry. The
launch of the Claritas Program last year, which includes a
strong focus on ethics as part of a curriculum aimed at all
participants in the industry (whatever their profession), is
an important part of this effort.
Ignorance can be no excuse for failings in conduct, and
all parties must fully understand the consequences of this
VRFDOOHGH[LEOHDSSURDFKWRULJRURXVHWKLFDOVWDQGDUGV
The report examines case studies of institutions facing sigQLFDQWJOREDOUHSXWDWLRQDOFKDOOHQJHVWKDWKDYHUHVXOWHG

THIS RESEARCH ADDRESSES A GREAT


NEED IN OUR FUTURE OF FINANCE
STARTS WITH YOU CAMPAIGN AS WE
TRY TO UNDERSTAND THE VIEWS OF
THOSE LEADING THE INDUSTRY, BECAUSE
IT IS CLEAR TO ALL INVOLVED IN THIS
MISSION THAT CHANGE MUST COME
FROM THE TOP.
from reckless investment behaviour, losses for clients, and
the decline in public opinion about particular brands, and it
showcases examples of projects being undertaken to restore
trust, improve performance, and bring about the cultural
changes within organisations that are long overdue.
With this valuable information about how executives see
the world, CFA Institute cantogether with our membershipwork with our partners in industry to address areas
in the chain of command that may still need reinforced messaging about the importance of robust conduct, enforcePHQWDQGLQFHQWLYLVDWLRQWREXLOGDQLQGXVWU\WIRUWKH
future, with the interests of clients, colleagues, and companies addressed in equal measure.
The report A Crisis of Culture: Valuing Ethics and Knowledge in Financial Services can be downloaded at www.cfainstitute.org.
Nitin Mehta, CFA, is managing director of Europe, Middle East, and Africa
(EMEA) at CFA Institute.

May/June 2014 CFA Institute Magazine 9

CFA INSTITUTE NEWS


APAC FOCUS

Asia Pushes Back


By Paul Smith, CFA

Domestic Fund vs. Cross-Border Fund Registrations


Nearly 30 years after Europe invented the
highly successful UCITS (Undertakings
for Collective Investment in Transferable
6HFXULWLHV VFKHPH$VLDLVQDOO\WDNLQJ
serious steps toward its own version of
funds passporting. The plans will allow
direct cross-border distribution of Asian
investment products and are thus expected
to develop the breadth and depth of the
regions investment management industry.
At the moment, three initiatives toward this goal are
under way:
the Hong KongChina mutual fund recognition scheme;
the Association of Southeast Asian Nations (ASEAN)
Framework for Cross-Border Offerings of Funds, proposed
by Malaysia, Singapore, and Thailand; and
WKH$VLD3DFLF(FRQRPLF&RRSHUDWLRQ $3(& $VLD5HJLRQ
Funds Passport, proposed by Australia, New Zealand, Singapore, and South Korea.

Country

Number of
domestic funds*

Number of foreign
cross-border funds
notified for sale*

% of foreign funds

China
Hong Kong
Japan
Singapore
South Korea
Taiwan

913
233
4,176
558
9,488
613

Not available
1,240
89
2,125
280
855

Not permitted
84%
2%
79%
3%
58%

Source: PricewaterhouseCoopers.

As of Q4 2011.

have stepped up their efforts to build a regional passporting scheme. And investment managers have found getting
8&,76SURGXFWVDXWKRUL]HGLQ$VLDLQFUHDVLQJO\DUGXRXV
Moreover, strategically, the effect of product domiciliation on job creation has become increasingly apparent.
When UCITS exploded in use in Asia after the 1998 Asian
QDQFLDOFULVLVORFDOSURGXFWIDPLOLHVZHUHOLTXLGDWHGRU
collapsed into European-domiciled funds. Asset managers
RIWHQIRXQGLWHTXDOO\FRQYHQLHQWWRFHQWUDOL]HDVVHWPDQDJHPHQWUROHVLQ(XURSH%DFNRIFHRSHUDWLRQVIROORZHGDORQJ
Today, the balance of power is shifting. European asset
PDQDJHUV QHHG $VLDQ LQYHVWPHQW IXQG RZV PRUH WKDQ
Asian investors need European products. This new era will
be less hospitable to foreign-domiciled products. The change
VKRXOGEHJRRGIRU$VLDQQDQFLDOVHUYLFHVLQWHUPVRIMRE
prospects and for Asian investors as products are developed
primarily for local market needs.
Of the three initiatives, the Hong KongChina mutual recognition scheme has the most potential to excite. However,
while a game changer, it is not a Big Bang. The scheme
is likely to start as a conservative pilot program, applying
only to Hong Kong-domiciled, SFC-approved unit trusts and
products approved by Chinas Securities Regulatory Commission. The pace will be measured, and UCITS funds are
unlikely to be rendered obsolete overnight.
What is Chinas motivation in entering into a passporting
scheme with Hong Kong? Probably not to open its market
to foreign players but rather to strengthen the capability
of domestic fund management companies to compete globally. The Chinese industry is young and lacking in depth of
product experience. But it does have access to one of the
worlds largest pools of domestic savings. China will use
Hong Kong, with its international expertise, as a learning
ground to master how to run world-class asset management
FRPSDQLHV:KHQ&KLQHVHFRPSDQLHVQDOO\GROHDUQWKHVH
skills, it wouldnt be surprising if they give the big global
players a run for their money.

The Hong KongChina mutual fund recognition scheme is


expected to be achieved sooner than the other two initiatives. (The APEC passporting is scheduled to be operational
by 2016.) In anticipation, three-quarters of the top 100 global
fund managers have established a licensed entity in Hong
Kong over the past few years. They hope to get a free pass
into the Chinese market under the scheme.
Why the urge now to integrate the fund management
markets in Asia? The answer is simple: Asian regulators are
SXVKLQJEDFNDJDLQVWWKHLQX[RI(XURSHDQPDGHLQYHVWment products and the increasingly inappropriate regulations that come with them. The Asian regulators are trying
WRWDNHJUHDWHUFRQWURORILQYHVWPHQWRZVLQWRWKHLUPDUkets. A majority of the funds sold in Hong Kong, Singapore,
and Taiwan are currently UCITS funds established in LuxHPERXUJDQG'XEOLQ2QO\DERXWRIIXQGVFXUUHQWO\
DXWKRUL]HGIRUVDOHLQ+RQJ.RQJDUHORFDOIXQGV
)ROORZLQJWKHJOREDOQDQFLDOFULVLVDQGWKHFRQVHTXHQW
focus on product mis-selling, regulators are asserting control over the regulations of products that are sold in their
markets, especially the more complex UCITS III and IV products. In Hong Kong, for example, every UCITS fund disWULEXWHGLQWKHPDUNHWKDVWREHVFUXWLQL]HGDQGDSSURYHG
by the Securities and Futures Commission (SFC). This was
relatively easy under UCITS I, when regulations were basic
and straightforward. As UCITS has evolved, regulators in
Asia have become increasingly uncertain that these more
VRSKLVWLFDWHGSURGXFWVWORFDOUHWDLOPDUNHWV7KH/HKPDQ
PLQLERQGDVFRLQLQ+RQJ.RQJDQG6LQJD- Paul Smith, CFA, is the CFA Institute managing director for the Asiapore supports this uncertain feeling. Thus, Asian regulators Pacific region.
10 CFA Institute Magazine May/June 2014

CFA INSTITUTE NEWS

President, CEO Departure Announced


CFA Institute President and CEO John
'5RJHUV&)$ZLOOVWHSGRZQIURP
his position at the end of the current
VFDO\HDU5RJHUVKDVOHG&)$,QVWLtute since January 2009.
I have thoroughly enjoyed my time
with CFA Institute. I believe that the
RUJDQL]DWLRQLVLQDSRVLWLRQRIVWUHQJWK
UHOHYDQFH DQG LQXHQFH DQG LV YHU\
well placed to move to the next level of
success and impact. The extraordinary
warmth and commitment of my colOHDJXHVKDVLQVSLUHGPHWKHVHSDVWYH
plus years during which we have taken
great strides towards delivering the
mission of CFA Institute, said Rogers.
Charles Yang, CFA, chair of the CFA
Institute Board of Governors, paid tribute to Rogers achievements: John
has been an inspiring leader throughout his tenure and has successfully
advanced the CFA Institute mission to
lead the investment profession globally
by promoting the highest standards

of ethics, education, and professional


H[FHOOHQFHIRUWKHXOWLPDWHEHQHWRI
society. I cannot thank John enough
for his tremendous contribution to our
RUJDQL]DWLRQ
'XULQJKLVYH\HDUVDW&)$,QVWLWXWH
Rogers has been instrumental in leading several calls to action to the investment industry, most recently through
its Future of Finance initiative, which
aims to shape a trustworthy, forwardWKLQNLQJQDQFLDOLQGXVWU\+HKDVRYHUseen the launch of a new educational
program, the Claritas Investment CerWLFDWHDIRXQGDWLRQOHYHOSURJUDPRQ
WKHHVVHQWLDOVRIQDQFHHWKLFVDQG
investment rolesand supported the
advancement of CFA Institute to that of
DWUXO\JOREDORUJDQL]DWLRQZLWKPHPbership in more than 145 countries.
The Board of Governors of CFA
Institute will initiate a global search
WRVHOHFWWKHRUJDQL]DWLRQVQH[WSUHVLdent and CEO.

Online Quiz Guides Students to Finance Careers


CFA Institute is reaching out to university students around the world with a new
prospecting campaign. Engaging and relevant, the campaign is built around a
Career Quiz, which encourages students to register their interest in a career
in finance before taking the quiz. In most cases, the students arent familiar
with CFA Institute, but through a series of 10 career-oriented questions, they are
guided toward suggested finance roles they might consider.
The CFA Institute marketing team is using the data collected to keep in
touch with the students who take part by providing periodic updates about the
industry, sharing relevant content from CFA Institute, and encouraging them to
register for the Claritas Investment Certificate Program or the CFA Program. Take
a look at the new quiz by visiting careermapping.cfainstitute.org, or share it with
a student who is interested in pursuing a career in finance.

New eBook Focuses on Career Planning and Management


Career Success: Navigating the New Work Environment examines the changing
HQYLURQPHQWLQZKLFKLQYHVWPHQWSURIHVVLRQDOVQGWKHPVHOYHVPDQDJLQJWKHLU
careers. This free, downloadable content includes a model of intentional career
PDQDJHPHQWDQGFDUHHUSODQQLQJWKDWHPSKDVL]HVGHHSDZDUHQHVVRIVHOIDQG
the professional setting. Guided exercises and case studies for applying the principles learned, as well as multimedia content and interviews with leading
investment professionals, help put this new work landscape into perspective.
Work/life balance and other contemporary topics encountered in todays
PRGHUQZRUOGEXWQRWWUDGLWLRQDOO\WDNHQLQWRFRQVLGHUDWLRQLQWKHQDQFHSURfession are handled respectfully and thoughtfully by the authors.

Global Brand Awareness


Campaign Launches
$ UHYLWDOL]HG JOREDO FDPSDLJQ VXSporting the CFA Institute brand and
the Future of Finance initiative was
launched in March and runs through
July. What sets this innovative campaign apart from past efforts is that
it promotes the mission of CFA Institute while representing all of our programsthe CFA Program, the CIPM
Program, and the Claritas Program.
To launch the campaign, eight members of the CFA Institute community
participated in an intensive three-day
interview and photo-shoot session in
New York City in order to be featured in
video spots as well as digital and print
media. The resulting collateral focuses
on CFA charterholders, a CIPM profesVLRQDODQGD&ODULWDVFHUWLFDWHKROGHU
who bring the you to The Future of
Finance Starts with You message.
You can view the videos by visiting
the Future of Finance hub on the CFA
Institute website, which is also where
\RXFDQQGWKHODWHVWXSGDWHVLQRXU
effort to shape a trustworthy, forwardWKLQNLQJQDQFLDOLQGXVWU\WKDWEHWWHU
serves society.

Out-of-the-Box
Thinking (Literally)
Wins Video Contest
Gan Jun Mao and Cheah Zi Chuin
from the University of Malaya won
the CFA Institute Future of Finance
Video Contest. As part of the 2014
Global Research Challenge, students were asked to create a video
to answer the question, What
should the financial industry do to
better serve investors and society? Using a common household
item, the winners creative portrayal of how to help investors feel
secure impressed the judges. You
can watch the video on the Future
of Finance hub at the CFA Institute
website or on YouTube.

May/June 2014 CFA Institute Magazine 11

CFA INSTITUTE NEWS

Research Prizes Recognize Asia-Pacific Projects


Academic research plays a crucial role in enhancing our
comprehension of capital markets and the complexity of
RXULQGXVWU\7RUHFRJQL]HYDOXDEOHFRQWULEXWLRQVWRDFDdemic literature and the sharing of this knowledge with
global investment practitioners, CFA Institute recently
DZDUGHGUHVHDUFKSUL]HVWRSURIHVVRUVIURP7VLQJKXD8QLversity, Sungkyunkwan University, and Sogang University.
Professor Jia Ning of Tsinghua University in Beijing was
awarded the CFA Institute Research Award 2013 for her
ZRUNRQWKHUHVRXUFHVDQGVWUDWHJLHVWKDWIRUHLJQUPVFRQducting an initial public offering (IPO) can use to reduce
cross-border information friction and its associated costs.
-LDVVWXG\VKRZHGWKDWDSUH,32QDQFLQJUHODWLRQVKLSZLWK
investors from the country of listing can effectively mitigate
cross-border information asymmetries at the time of the IPO
and reduce the cost of foreign equity issuance. Jia, an associate professor of accounting and the associate director of
the China Business Case Center at the School of EconomLFVDQG0DQDJHPHQWZDVDZDUGHGWKHSUL]HDWWKH$XVWUDOasian Finance and Banking Conference (AFBC) in Sydney.
&)$,QVWLWXWHDOVRUHFRJQL]HGUHVHDUFKHUVIURP6XQJN\XQNwan University and Sogang University in Seoul, South Korea,

ZLWKWKH$VLD3DFLF&DSLWDO0DUNHWV$ZDUGGXULQJWKH
Auckland Finance Meeting in Auckland, New Zealand. The
study by Professor Park Tae-jun, Professor Lee Youngjoo, and
Professor Song Kyo Jik on trading before earnings shocks proYLGHVLQVLJKWRQZKHWKHULQVWLWXWLRQDOLQYHVWRUVWUDGHSURWably around positive or negative earnings surprises. The study
showed that the trading volume decreases only before negative events because of information asymmetry among investors. They also found that institutions sell their stock prior to
an earnings shock whereas individual and foreign investors
do not anticipate the bad news. Park is a professor at Sungkyunkwan University and senior researcher at Korea Capital
0DUNHW,QVWLWXWH/HHLVDSURIHVVRURIQDQFHDWWKH6RJDQJ
Business School of Sogang University, and Song is a profesVRURIQDQFHDW6XQJN\XQNZDQ8QLYHUVLW\$OOWKUHHSURIHVsors are based in Seoul.
&)$,QVWLWXWH5HVHDUFK3UL]HVDUHDZDUGHGWRUHVHDUFK
projects to improve the standards of practice of the investPHQWFRPPXQLW\LQWKH$VLD3DFLFUHJLRQ7KHZLQQLQJ
research papers are posted on the CFA Institute website,
cfainstitute.org. Go to the Insights & Learning menu and
VHOHFW5HVHDUFK)RXQGDWLRQWRQGWKHRFFDVLRQDOSDSHUV

CFA PROGRAM
SCHOLARSHIPS
ARE AVAILABLE
www.cfainstitute.org/scholarships
scholarships@cfainstitute.org

ACCESS SCHOLARSHIPS
Access Scholarships provide needs-based
scholarship opportunities for those unable
to afford the full price of the CFA Program
enrollment and registration fees.

AWARENESS SCHOLARSHIPS
Awareness Scholarships are
designated for key influencers in the
academic and financial communities
and the media. University faculty and
students enrolled in CFA Institute
Program Partners and Recognized
Universities and employees of
governmental securities regulators
and central banks are eligible to apply.

Awareness Scholarships available:


Student Scholarships
Professor Scholarships
Regulator Scholarships
Media Scholarships

CFA Institute 2014. CFA, CIPM, and Claritas are registered trademarks of CFA Institute in many
countries throughout the world.

12 CFA Institute Magazine May/June 2014

2014
CFA INSTITUTE
RESEARCH AWARD
Congratulations to the winners of the CFA Institute
Asia-Pacific Capital Markets Research Prizes!
CFA Institute Asia-Pacific Capital Markets Research Prizes are
presented at reputable academic conferences in the region:
Asian Finance Association (AsianFA) Annual Conference
Auckland Finance Meeting (AFM)
Australasian Finance & Banking Conference (AFBC)
Financial Market Association (FMA) Asian Conference
The research prizes are designed to encourage research projects that will further improve the standards of practice of the
Asia-Pacific investment community.
Submit your research paper at those conferences and apply to
be considered for the prize. Papers are selected based on value
to practitioners, quality of content, readability, and presentation.
To learn more about the awards, please contact William Boivin:
william.boivin@cfainstitute.org.

CFA Institute Asia-Pacific Capital Markets


Research Award Winners 2013

Professor Jia Ning


of Tsinghua University in China

Professor Park Tae-jun and


Professor Song Kyo Jik
of Sungkyunkwan University
and
Professor Lee Youngjoo
of Sogang University in South Korea

Professor Matthias Buehlmaier


of The University of Hong Kong

VIEWPOINT

In the Dark
THE LATEST HYPE ABOUT HIGH-FREQUENCY TRADING OVERLOOKS DEEPER PROBLEMS
By Dennis Dick, CFA

Is the market rigged?


That is the question
that many investors
have been asking
ever since Michael
Lewis made the allegation on the TV
show 60 Minutes. In
his new book Flash
Boys, Lewis outlines
his perspective on how the market is
rigged against the little guy, with highfrequency traders using their speed to
rip off individual investors.
Is this true? Is the market really
rigged? In many areas, it always has
been.
Before electronic trading, market
makers and specialists had a virtual
PRQRSRO\RQWKHWUDGLQJRRU7KH\
FRQWUROOHGWKHRUGHURZLQWKHLULQGLvidual stocks and held the order book,
giving them a tremendous informational advantage over every other participant. They could lean on the orders
in their book and step ahead of those
orders when it was advantageous to
do so. But they were the market intermediaries, providing valuable liquidity
by quoting a two-sided market. When
someone wanted to buy the stock, the
market maker would be the seller. If
someone wanted to sell the stock, the
market maker would be the buyer. They
provided the liquidity that allowed participants to get in and out of their stocks.
Their payment for providing this service was the bidask spread.
But with the rise of the internet
and the evolution of electronic trading, competition in the market-maker
space became intense. Electronic traders started playing a market-making
UROHDQGRQFHGHFLPDOL]DWLRQFDPHLQ
2001, these electronic traders had the
XSSHUKDQG6SUHDGVJRWWLJKWHUVTXHH]ing traditional market makers out of
the game. In their place, a new type of
market maker thrivedthe automated
14 CFA Institute Magazine May/June 2014

market maker, or (as automated traders are now known) the high-frequency
trader (HFT).

THE NEED FOR SPEED


These automated market makers are
much more efficient at doing their
job than are their human counterparts, which is why speed is essential.
Market makers are always trying to
balance their return (the spread) with
the adverse-selection risk (the risk of
getting picked off by a more informed
trader). HFTs can quickly adjust their
market-making orders to account for
all new information. Whether the new
information takes the form of fundamental news, a movement in the S&P
IXWXUHVRUDVXGGHQRUGHURZLPEDOance, HFTs are constantly cancelling
and adjusting their orders to avoid getting picked off.
The most common adjustment is
made by HFTs when the quote is about
to roll, which means when the bid is
about to become the offer.
For example, assume stock XYZ is
bid at $20.00 for 20,000 shares and
offered at $20.01 for 20,000 shares.

about to roll, and they can do this in


a matter of milliseconds. This speed
advantage allows them to lean on the
rest of the quote (and the slower traders) for protection. If they just bought
the stock at $20.00, they can quickly
sell it back at $20.00 when the quote
is about to roll, scratching the trade
in a worst-case scenario. This method
works as long as they stay at the top of
the order queue.
$QG+)7VDUHYHU\HIFLHQWDWVWD\ing at the top of the order queue. Colocation and speed help, but there are
also other advantages, such as special
order types. For example, take the hidenot-slide order (which Lewis mentions
in his book). This order is designed to
automatically jump to the top of the
order queue whenever the quote rolls.
Again, this approach allows the participant using this order to lean on the
back of the order queue for protection.
But while speed and order types can
help HFTs to stay at the top of the order
queue, some significant advantages
arent focused around speed.
Manoj Narang, CEO and founder of
+)7UP7UDGHZRU[UHFHQWO\DSSHDUHG

THE REAL ADVANTAGES ARENT RELIANT ON


SPEED AT ALL. THE REAL ADVANTAGES ARE
BUILT ON RELATIONSHIPS. AND THIS IS WHERE
THE MARKET STARTS TO GET SHADY.
You could say this quote is in equilibrium. But suddenly, the offer starts to
grow and the bid starts to transact. The
new quote is $20.00 for 5,000 shares by
$20.01 for 30,000 shares. This quote
is getting ready to roll. The HFTs quickly
cancel their remaining shares that they
are bidding at $20.00 and hit the rest
of the $20.00 bid. By using co-location
and direct data feeds, they can very
accurately predict when the quote is

on Bloomberg TV and said, Speed matters less in todays market than it has
ever mattered. After that comment,
critics were quick to attack his statement, challenging his claim, but I completely agree with him. While speed
helps to avoid getting picked off, the
real advantages arent reliant on speed
at all. The real advantages are built on
relationships. And this is where the
market starts to get shady.

DARK ADVANTAGES
OTC (over the counter) market-makLQJ+)7UPVNQRZQDVLQWHUQDOL]HUV
actually have built relationships with
online brokers in which they buy order
RZ IURP UHWDLO EURNHUDJHV WR WUDGH
directly against incoming marketable
orders. They pay the retail broker a fee
IRUWKHSULYLOHJHRIJHWWLQJUVWGLEV
on retail orders. The fee is known in
WKHLQGXVWU\DVSD\PHQWIRURUGHURZ
Going back to our original example,
assume stock XYZ is bid at $20.00 for
20,000 shares and offered at $20.01 for
20,000 shares. Any participant placing
an order to buy the stock at $20.00 on
that exchange would be behind the
other 20,000 shares that were there
UVW SULFHWLPHSULRULW\ %XWWKH+)7
LQWHUQDOL]HUFDQWUDGHGLUHFWO\DJDLQVW
the retail market orders that they have
SXUFKDVHGDFFHVVWR UVWGLEV H[HFXWing against these orders off exchange.
The only regulatory requirement is
that they match or beat the displayed
national best bid or offer (NBBO). This
DUUDQJHPHQWJLYHVWKHPDVLJQLFDQW
advantage.
For example, if a retail trader sells
1,000 shares at the market in stock
;<=WKHLQWHUQDOL]HUFDQEX\IURPWKH
retail trader at $20.00 directly, jumping
ahead of the other 20,000 shares that
are in the order queue on the public
exchange. If another retail trader sends
a market order to buy 1,000 shares of
VWRFN;<=WKHLQWHUQDOL]HUFDQWUDGH
directly against that order as well, selling the stock at $20.01 and jumping the
public order queue once again. In effect,
LQWHUQDOL]HUVFDQJHWDIUHHULGHRII
the public quote, because they know
that if the quote starts to get out of
equilibrium, they can quickly sell the
stock they just bought from the retail
trader at $20.00 to the market participant that is bidding at $20.00 on the
public exchange and scratch the trade.
7KLVSD\PHQWIRURUGHURZUHODWLRQship they have with the retail broker
allows them to jump the order queue
continuously and lean on the public
order queue for protection. Its a slick
system, but who is being disadvantaged
by this? The person that is actually bidding on the exchange at $20.00, because
WKDWSHUVRQVOLPLWRUGHULVOHIWXQOOHG
The limit order would have been

H[HFXWHGLIWKHLQWHUQDOL]HUKDGQWLQWHUcepted the incoming market order. This


situation discourages displayed liquidity
providers, and they quickly learn that
the only time their order is executed is
when they are getting picked off by a
high-frequency trader. As a result, nonHFT traders quote less.

DEPENDENCE ON HFT LIQUIDITY


The only traders that can avoid getting picked off by the HFTs are the
other HFT players (again because of

do. At this time, we dont even have a


UPGHQLWLRQRIKLJKIUHTXHQF\WUDGLQJ:KLFKUPVZRXOGEHIRUFHGWR
quote? Would such a requirement throw
out the riskreturn incentive for them
to continue providing liquidity?
I think a better solution would be
WR LQFHQWLYL]H RWKHU W\SHV RI SDUWLFLpants to provide liquidity againparticipants who wont cancel their orders
at the slightest sign of risk. A good start
ZRXOG EH WR UHJXODWH LQWHUQDOL]DWLRQ
DQGSD\PHQWIRURUGHURZEHFDXVH

WHAT IS THE POINT OF PROVIDING LIQUIDITY


ON THE PUBLIC EXCHANGE WHEN A PRIVILEGED
PARTICIPANT CAN STEP AHEAD OF YOUR LIMIT ORDER
AT THE MOMENT IT IS ABOUT TO BE EXECUTED?
WE ARE DRIVING TRADERS TO THE DARK.
their speed). Therefore, these are the
only participants that can properly balance the riskreturn tradeoff to play a
market-making role. Unlike traditional
OLTXLGLW\SURYLGHUVKRZHYHU+)7UPV
KDYHQRDIUPDWLYHREOLJDWLRQVWRPDNH
a two-sided market. They do not have
to be the buyers of last resort. When
the going gets tough (as we saw in the
DVKFUDVKRI WKH\FDQVLPSO\
stop making markets and cancel all
their orders. With very few other types
of participants providing liquidity, we
can be left with a vacuum in which
very little liquidity is left in the book.
In other words, the liquidity that is
on the exchange is becoming too homogeneous. Too many liquidity providers
with similar short-term time frames and
playing similar market-making strategies are providing the majority of our
markets liquidity.
Some industry experts estimate that
although HFT accounts for 50%-60% of
volume, as much as 95% of the visible
liquidity on the exchange is being supplied by high-frequency traders. That is
a scary number. Have we become too
dependent on HFT liquidity being supplied by traders who can cancel their
orders hundreds of times in the blink
of an eye? Should we slap these HFT
UPVZLWKDIUPDWLYHREOLJDWLRQVDQG
PDNHWKHPTXRWH"7KDWLVGLIFXOWWR

these practices deter market participants from providing liquidity. What


is the point of providing liquidity on
the public exchange when a privileged
participant can step ahead of your limit
order at the moment it is about to be
executed? It is little wonder that offexchange trading volumes continue to
climb, approaching nearly 40% of US
trading volumes last year. We are driving traders to the dark.
There are always going to be some
traders that are faster than others.
Speed is a hard thing to regulate. But
the greater concern is an issue that
Lewis barely touches on in his book
Flash Boysthe handshakes behind the
VFHQHVZLWK+)7UPVSD\LQJUHWDLO
EURNHUVWRJHWDUVWORRNDWWKHLURUGHU
RZ7KHVHGHDOVHIIHFWLYHO\HOLPLQDWH
the need for speed because it eliminates the competition. This area is
where our regulators need to look and
where the market needs improvement,
because this is the area of the market
that appears to be rigged.
Dennis Dick, CFA, is a proprietary trader at Bright
Trading in Detroit and a member of CFA Society Detroit.

May/June 2014 CFA Institute Magazine 15

VIEWPOINT

Job Satisfaction and Investment Professionals


THOSE WHO FOCUS ONLY ON COMPENSATION MAY MISLEAD THEMSELVES AND OTHERS
By Usman Hayat, CFA

'R\RXKDYHGD\VZKHQ\RXIHHODELW
GLVVDWLVHGZLWK\RXUMRE"'D\VZKHQ
you cant help wondering whether all
the toil and stress is really worth it?
But do you know what would increase
\RXUMREVDWLVIDFWLRQWKHPRVW"7RQG
an answer, I conducted an anonymous
opinion poll of readers of the CFA Institute Financial NewsBrief: What would
increase their job satisfaction the most?
The results, although far from being
VWDWLVWLFDOO\JHQHUDOL]DEOHDUHUHYHDOing. Perhaps unsurprisingly, for 37%
of our 888 respondents, the answer
was greater compensation. The obvious problem here is that even the most
highly paid want more money, which
does not seem to make them any more
VDWLVHG:KDW,QGPRUHLQWHUHVWLQJ
is that more than 60% of respondents
did not select greater compensation.
1HDUO\DIWKRIUHVSRQGHQWVVHOHFWHG
a better worklife balance, and it is
easy to understand why. In the daily
seesaw of work and life, work seems to
easily outweigh life. It is your work that
pays your bills, so your exercise workout can wait for tomorrow; children can
be kept busy with electronic gadgets;

hobbies can be saved for retirement; and


your loved ones will hopefully understand. After worklife balance, the two
other choices that received double-digit
responses were more recognition for
your contributions and more authority and responsibility for doing your
work. Together, these three answers
received 45% of the votes, a greater
percentage than those who responded
more money (37%).
In the decision to run this poll, I
ZDVLQXHQFHGE\$OH[DQGHU.MHUXOID
'DQLVKPDQDJHPHQWFRQVXOWDQWZKR
SUHIHUVWKHMREWLWOHFKLHIKDSSLQHVVRIcer. Speaking at the 2012 CFA Institute European Investment Conference
in Prague, Kjerulf argued that we feel
happy at work because of three R
words: results (achieving something
that makes a difference), recognition
(receiving praise for achievements),
and relationships (having colleagues we
like). Kjerulf would probably be happy
to know that our poll respondents tend
to agree with him.
If you are wondering what the business case for improving job satisfaction is, consider the cost of employee

turnover. It includes productivity losses


when someone leaves a job, costs of
hiring and training the new employee,
and lower productivity until the new
employee catches up. There is also some
academic research that shows employee
satisfaction improves company performance rather than representing excessive non-monetary compensation (for
H[DPSOHVHH$OH[(GPDQV'RHVWKH
stock market fully value intangibles?
Employee satisfaction and equity prices
Journal of Financial Economics (September 2011). The Center for American Progress (CAP), a US-based think
WDQNKDVDQDO\]HGWKHFRVWRIWXUQRYHU
After reviewing 30 case studies in 11
research papers, CAPs analysis found
WKDWEXVLQHVVHVVSHQGDERXWRQHIWKRI
an employees annual salary to replace
that worker and jobs that are very
complex and that require higher levels
RIHGXFDWLRQDQGVSHFLDOL]HGWUDLQLQJ
tend to have even higher turnover costs.
,IWXUQRYHURIGLVVDWLVHGHPSOR\HHV
is not bad enough, their staying on is
ZRUVH'LVVDWLVHGHPSOR\HHVDUHOLNHO\
to change behavior against the interest of the employer. They may spend a

What would increase your job satisfaction the most?

Greater compensation

37%

Better work-life balance

19%

More recognition for your contributions

14%

Additional responsibility and


authority for doing your work

12%

A promotion
Friendlier work environment
Other

16 CFA Institute Magazine May/June 2014

9%
5%
4%

THE OBVIOUS PROBLEM HERE IS THAT EVEN THE


MOST HIGHLY PAID WANT MORE MONEY, WHICH
DOES NOT SEEM TO MAKE PEOPLE ANY MORE
SATISFIED. WHAT I FIND MORE INTERESTING IS
THAT MORE THAN 60% OF RESPONDENTS DID
NOT SELECT GREATER COMPENSATION.

The more I read about job satisfaction from different sources, the more I
am convinced that what really makes us
GLVVDWLVHGDWZRUNKDVDORWWRGRZLWK
ZKDWWHQGVWRPDNHVXVGLVVDWLVHGLQ
OLIHLQJHQHUDOXQIDLUQHVV2UJDQL]Dtions where things other than reason
and evidence winand win consistentlyand where people routinely
treat others the way they would not
VLJQLFDQWDPRXQWRIWLPHSUDFWLFLQJ could save their employer from wasting like to be treated themselves probably
the art of look busy, do nothing with- resources. Employees could speak up to have unfairness built into their culture.
out being detected by the radar of cor- encourage employers to avoid buying No matter what an employer tries
porate accountability. According to the expensive equipment or services that family fun days or free drinksthe
2013 Wasting Time at Work Survey by WKHLURUJDQL]DWLRQFRXOGGRZLWKRXWRU work environment wont be very satisSalary.com, 69% of the people surveyed point out that a certain idea is not worth I\LQJ$WVXFKRUJDQL]DWLRQVPRUHMRE
said they waste time at work every single spending time and money on because satisfaction has to mean more money
day, and the most common method, it was tried before and found useless. DGLQQLWXP%XWRWKHURUJDQL]DWLRQV
XQVXUSULVLQJO\LVVXUQJWKHLQWHUQHW %XWKLJKO\GLVVDWLVHGHPSOR\HHVDWDQ\ ZLOOQGPRUHKRSHDQGPRUHZRUN
Life, however, is seldom as simple as level may look the other way as orga- to doin what Kjerulf calls results,
GLVVDWLVHGHPSOR\HHVPD\ZDVWHWLPH QL]DWLRQDOUHVRXUFHVJRXSLQVPRNH recognition, and relationships.
until they leave. Consider, for instance, It is little wonder that job satisfaction Usman Hayat, CFA, is director of Islamic Finance
that employees are often in a position is something that eludes measurement and ESG at CFA Institute, London.
in which by taking small actions, they but must be managed.

The Value of Geopolitical Analysis


By Jason Voss, CFA

In a world of bewildering informational complexity, an understanding of the ways that people, power, personal preferHQFHVDQGJHRJUDSK\FRQYHUJHWRLQXHQFHIXWXUHWUHQGV
is essential to investment management success. Studying
these convergences is better known as geopolitical analysis.
Careful application of the precepts of geopolitical analysis
not only provides insight into current events, such as the
recent crisis in Ukraine, but also sometimes leads to accurate predictions of future events. To some degree, many
investors appear to be aware that geopolitics is important.
A recent poll of readers of CFA Institutes Financial NewsBrief shows that 63% of respondents believe geopolitics is
very important to their analyses, with an additional 30%
stating it is slightly important. (See chart for complete
survey results.)
Yet, in my experience, people often misunderstand geopolitical analysis, thinking that it is simply an awareness of
the internal politics of a nation and how that affects overall
global politics. Instead, geopolitical analysis is much more
KROLVWLF'HVSLWHLWVVHHPLQJVXUIDFHOHYHOFRPSOH[LW\DQ
understanding of geopolitics leads to simpler, clearer, and
more accurate predictions of globally important events. In
other words, understanding geopolitics is one pathway to
investment management success.

GEOGRAPHY
Geopolitical analysis takes into account a nations geography and the inevitable consequences of that geography.

How important is an understanding of geopolitics


to your investment decision-making process?

Very important

63%

Slightly important

Not important

30%

7%

Important examples include an examination of the constraints imposed on a nation by its natural resources, its
ease of access to the outside world, and its internal transportation systems. For instance, if a nation has limited access
to natural sources of energy, then a constant concern will
be how the nation can get energy sources and what must
be exchanged for that access. Further, landlocked nations
have fewer natural trading partners than those that have
access to seas and oceans, and being landlocked will likely
lead to stunted economic growth and cultural peculiarities.
As for internal transportation, consider that a geographical advantage of the United States is that it has navigable
May/June 2014 CFA Institute Magazine 17

VIEWPOINT

ULYHUVWKDWRZQRUWKDQGVRXWKDVZHOODVHDVWDQGZHVW
Because water transportation is much less costly than overland transport, the US has a permanent cost advantage compared with other major countries.
Geography also either blesses or curses nations with
neighbors. Ukraine sits poised between two much larger,
better-resourced entities: Russia and Europe. Furthermore,
when considering some of the previously-mentioned constraints (and ease of access to the outside world in particular), you can see that Russia has a much larger vested interest in Ukraine than does Europe. Ukraines location constrains Russias access to the oceans and thus its ability to
trade and project power globally. Additionally, because the
border between Russia and Europe is a vast plain, Russia
requires buffer states to secure its national boundaries. So, if
Ukraine is not in Russias orbit, access to Russias heartland
will be largely unobstructed by geographic obstacles, such
as mountains. For all these reasons, Russia is permanently
interested in Ukraine in a way that European powers, such
as Germany, are not and in a way that is almost unimagiQDEOHWRFLWL]HQVRIWKH8QLWHG6WDWHV
In short, geography provides almost unshakable advantages and disadvantages for nations. For analysts, the
permanent quality of geography provides high levels of
predictability.

DQGWKHH[SHFWDWLRQVRISHRSOHDERXWZKDWTXDOLHVDVEDVLF
needs. Basic needs of Russia include its famous need for
access to a warm-water port and its need for energy to heat
homes during its long winters.

APPLYING GEOPOLITICAL ANALYSIS

For a concrete example of how geopolitical analysis works,


consider how it would apply to Greece. First, consider its
geography and the constraints of that geography. Greece
occupies a very mountainous peninsula with very little arable
land and few natural resources, yet it rests in the middle of
one of the worlds most important seas, the Mediterranean.
Because mountains protect and insulate a nation, it is not
surprising that Greece as a nation has retained a distinct
cultural identity through thousands of years and that it has
been conquered only via sea invasion. Further, Greeces lack
of natural resources and its mountainous terrain constrain
its capital base. (Lenders would want to factor this in before
lending!) Given that Greece cannot be an important exporter
of agriculture or of natural resources, you would expect
Greece to be an exporter of culture and for its economy to
be based on its unique geographical position, poised as it
is in the middle of an important sea. Not surprisingly, the
Greeks throughout history have been known for their seafaring, and they are still one of the worlds leading shippers.
From the 14th through the 19th centuries, the Ottoman
Empire (now Turkey) occupied Greece. Thus, you could
CULTURE AND HISTORY
Geopolitical analysis also considers the cultures and his- reasonably expect the history of Greece and Turkey to be
tories of nations and even peoples within nations. In this one of mutual suspicion and enduring enmity. This obserregard, culture and history are studied as living entities, vation helps one to understand the politics of Cyprus, a
not static ones. Often, past relationships among nations nation divided by the Greeks and the Turks. Greeces geogDQGSHRSOHVDUHXQGLIIHUHQWLDWHGIURPWKHRZRIFXUUHQW raphy and consequent capital-base constraints also make it
eventsthe cultural course, once set, is hard to change. a natural candidate for allegiances that protect the nation.
Put another way, alignments and differences between cul- Again, analysts using geopolitical analysis would not be
tures are hundreds of years in the making and their iner- surprised that the nation has partnered with more powertia allows for a high level of predictability in analyses. For ful nations since the ancient classical period of its history.
A similar geopolitical analysis can also illuminate potenexample, knowing the cultural and historical enmity between
Turkey and Greece allows an analyst to better assess the tial global hotspots. The narrow Strait of Malacca is the
likelihood of Turkeys admittance into the European Union. seaway used to deliver much of Chinas energy. Given Chinas
Or an understanding of the Chinese and Japanese cultures growing energy needs, analysts should expect China to be
and their mutual histories allows a deeper understanding focused on the nations around the Strait and for those same
of why China might balk at Japan modifying its constitu- nations to be thinking carefully about China. Will there be
DFRQLFWLQWKLVUHJLRQ",WLVLPSRVVLEOHWRDEVROXWHO\SUHtional stance on national defense.
dict such an outcome, but given the constraints of geography, culture, history, and expectations about needs, you can
NATIONAL NEEDS AND EXPECTATIONS
Geopolitical analysis also relies on an understanding of UHDVRQDEO\FRQFOXGHWKDWDFRQLFWLVOLNHO\LQWKHIXWXUH
The world is ever more interconnected by the global neta peoples basic needs as well as expectations about basic
needs. Expectations about needs are largely created by a works of transportation, communications, culture, and capnations geography, its history, and the resulting culture. ital. An understanding of the nature of these interconnecUnderstanding differences in expectations about basic tions, as illuminated by geopolitical analysis, is an imporneeds helps to explain why different countries, such as tant part of the future success of investment managers.
%UD]LODQG/X[HPERXUJKDYHGLIIHUHQWQDWLRQDODJHQGDV,Q Jason Voss, CFA, is a content director at CFA Institute. A shorter version
other words, geopolitical analysis treats a nations politics of his discussion of geopolitical analysis was previously posted on the
as almost entirely determined by its unmoving geography, Enterprising Investor blog (blogs.cfainstitute.org/investor).
its unchangeable history, its long-lived cultural distinctions,
18 CFA Institute Magazine May/June 2014

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PROFESSIONAL PRACTICE
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The Omnivores Diet


WHY ONE HIGH-YIELD SPECIALIST USES NEARLY ALL EXISTING FINANCIAL INSTRUMENTS

KEY POINTS

By Rhea Wessel and Fran Melville

As managing director at asset management boutique XAIA


Investment in Munich, Germany, Jochen Felsenheimer has to
VDWLVI\FOLHQWVZKRZDQWWKHUPWREHFUHDWLYHLQH[SORLWing pricing anomalies in the high-yield space. Yet, with all his
expertise, he still faces a very steep learning curve by his
own account: On the high-yield side, its a different game,
says Felsenheimer. Its learning by doing and learning by
making mistakes.
Co -founder of X A I A ,
where he is also co-responFocusing on implied default
sible for portfolio manageprobability, not default rate,
ment, Felsenheimer holds
is the key to finding profa doctorate in macroecoitable pricing anomalies in
nomics and is the author of
the high-yield space.
several books and research
The current low-yield enviarticles focused on credit
ronment has led to a diverderivatives and credit margence between yields and
kets. He started his career in
the risk of default.
the research department of
Hypovereinsbank, a member
The current spread level
of UniCredit Group, where he
may not provide enough
served as the head of global
compensation for future
credit strategy research, covdefault risks, and the next
ering credit derivatives and
big move in the credit
structured credit markets.
market could be a widening.
The predecessor company
to what was rebranded as
;$,$ ,QYHVWPHQW ODXQFKHG LWV UVW IXQG LQ $SULO 
Today, XAIA Investment manages more than 2.8 billion in
six different funds, with a focus on negative basis and capital structure arbitrage concepts. In addition to using tradiWLRQDOWRROVRIFUHGLWDQDO\VLVWKHUPGHYHORSVWHVWVDQG
implements sophisticated proprietary mathematical models.
In this interview (conducted February 2014), Felsenheimer shares his views on whats ahead as high-yield markets contend with a low-yield environment and the US Federal Reserves tapering policy, the variety of risks faced by
FUHGLWLQYHVWPHQWVDQGKRZKLVUPXVHVDQXQFRQYHQWLRQDODSSURDFKWRLGHQWLI\LQHIFLHQFLHVDQGH[SORLWSULFing anomalies between market segments.

What is your investing approach?


We are very active in the high-yield space; however, we
never have long-only high-yield exposure independent
of a corresponding hedge. We gain high-yield exposure
both via credit default swaps and via bonds, but we always
simultaneously pair default risk with a hedge. Thats what
makes us different from traditional high-yield investors.

20 CFA Institute Magazine May/June 2014

For example, if theres a pricing discrepancy between a


high-yield bond and a high-yield credit default swap, and
they reference the same underlying entity, then we exploit
WKLVPDUNHWLQHIFLHQF\

How do you exploit the price difference?


We exploit the price difference within the credit market but
also between credit and equity. For instance, we purchase
a high-yield bond and use equity derivatives as a hedging
instrument.
This is a pure arbitrage strategy. Hence, our focus is not
RQ DQDO\]LQJ GHIDXOW UDWHV RU WKH SUREDELOLW\ RI GHIDXOW
The idea is not to seek out and buy the survivors. Thats
not our approach.

It is unusual. Most credit shops focus on credit


analysis, but you rely on quantitative models?
Thats why my answers in this interview will be different
from [the answers of] others. If you interviewed a typical long-only, high-yield investor, he or she would probaEO\VD\HYHU\WKLQJLVFKHDSDVORQJDV\RXDUHDEOHWRQG
the survivors and avoid the fallen angels. My answers are
less straightforward.
Traditional high-yield investors focus on single-name
fundamental analysisthat is, on the fundamental credit
KHDOWKRIDEXVLQHVVEDVHGSULPDULO\RQQDQFLDOVWDWHPHQWV
They look at credit protection ratios and try to understand
if the market is over- or underestimating default rates for
VSHFLFQDPHV,IWKHLQYHVWRULVFRQYLQFHGWKDWWKHPDUNHW
premium for a high-yield bond overcompensates for the risk
of default, then the investor will buy the bond. In this bottom-up approach, the analysis focuses on single names.

You dont care about default rates?


I only look at the implied default probability, which you get
compensated for in different market segments.
Heres a very simple example: If I earn a spread of 1,000
bps from a high-yield bond and, at the same time, Im able
WREX\SURWHFWLRQYLDWKH&'6>FUHGLWGHIDXOWVZDS@PDUNHW
on the same company with the same maturity and I pay
only 800 bps for this protection, then obviously, I can perform a very nice trade.
,FDQEX\WKHERQGDQGVLPXOWDQHRXVO\XVHWKH&'6DVD
hedge by buying default protection. I earn 1,000 bps, and
at the same time, I pay 800 bps, which means 200 bps stay
with me, independent of whether the company defaults
or not. Hence, our analysis focuses on pricing anomalies
between different market segments as opposed to the probability of default.

What about counterparty risks, especially in light of


what the markets experienced at the height of the
financial crisis?
We have implemented collateral management for all outstanding derivatives trades. This means that there is a daily
exchange of cash collateral covering marked-to-market
PRYHVDQGFRQVHTXHQWO\ZHPLQLPL]HFRXQWHUSDUW\ULVN

Looking forward into 2014, what do you see as the


impact of the US Federal Reserves tapering policy on
the high-yield market?
If you look at the monetary policy we have seen over the last
couple of years, then obviously, this kind of policy supports
lower-rated issuers, simply due to the fact that in the lowyield environment, more and more investors are forced to
implement yield-enhancement strategies. They are looking
IRUKLJKHU\LHOGZKLFKWKH\QGLQWKHKLJK\LHOGXQLYHUVH
Many asset/liability managers, such as insurance compaQLHVDUHIRUFHGE\ZD\RIWKHLU[HGOLDELOLWLHVWRPDLQtain a minimum yield on their investments. In the current
low-interest-rate environment, many investors have been
forced to move down the bond universe quality curve and
purchase more risky, higher-yielding bonds. The increased
demand in the high-yield segment, resulting from the lowLQWHUHVWUDWHPRQHWDU\SROLF\RIFHQWUDOEDQNVKDVLQDWHG
high-yield prices and thus created a divergence between
yields and the risk of default.
When [former Federal Reserve Chairman] Ben Bernanke
UVWWDONHGDERXWWKHSRVVLELOLW\RIWDSHULQJODVW0D\WKDW
was enough to lead to a 200 bp widening in the US highyield space, which is quite substantial.
We must keep in mind that Bernanke only announced a
reduction in liquidity from the open-market bond-purchasing
program, not an end to liquidity itself. The actual tapering
DQQRXQFHPHQWWKLVSDVW'HFHPEHUKDVQRWKDGWKDWPXFK
of an impact on the high-yield market.

What is the story behind that?


Right now, we have a multi-year low in high-yield spreads,
not only in the US but also in Europe. Right now, people
believe in higher growth rates in the future, and that is the
reason that the tapering announcement did not trigger any
dramatic widening in high-yield spreads. The only way out
of the policy of excessive money printing is that people buy
into risky assets due to positive growth expectations and no
longer due to the availability of easy money.

within the banking industry. This is triggering asset price


LQDWLRQDVUHHFWHGLQWKHFXUUHQWORZVSUHDGHQYLURQPHQW
I dont believe that the current spread level provides one
with enough compensation for future default risks. Many
spreads are just too tight due to the fact, as stated earlier,
that more and more investors are forced to invest in the
high-yield market simply to cover their liability side. As
more investors, such as insurance companies, are forced
WRPRYHLQWRWKHKLJK\LHOGPDUNHWWRJHQHUDWHVXIFLHQW
yield income, the market becomes more frothy and, eventually, a bubble begins to form. This is a very risky situaWLRQDQG,GHQLWHO\EHOLHYHWKDWZHDUHLQWKHODVWVWDJHRI
this phase of spread tightening.
I expect the next big move in the credit market to be a
widening.

What is your take on the expansion of high-yield


exchange-traded funds?
Again, I see a dangerous development because of the dramatic demand for high yield, not only from traditional highyield investors but also from more and more people who are
forced to move into the lower-rated segment.
Exchange-traded funds (ETFs) are becoming more important as market players. Just think back to the May/June move
after the tapering discussion. We saw that ETFs can trigger
dramatic volatility in the high-yield market as they behave
very similarly in the case of exogenous shocks.
(7)VLQWKHPHDQWLPHRZQXSWRRIVRPHVSHFLF
issues in the US high-yield market. Yet ETFs do not perform
in-depth, single-name analyses. ETFs do nothing but map
LQRZVDQGRXWRZVLQWKHHYHQLQJDQGVHOORUEX\DOOWKH
underlying vehicles in a corresponding volume.
Thats not easy. If you manage a huge ETF, your sheer
volume means you are affecting the price. I believe that
dominant high-yield players, such as ETFs, contribute to
rising spread volatility.
Personally, I like this situation very much. Things become
cheap if there is negative news, and the reaction in the highyield market is more pronounced and volatile than in other
market segments.

Are you using single-name swaps?

From my perspective, the market is too tight. It is not too


tight when you look at the historical data, but historical data
is something I dont believe in. I believe in the current situation, and I do not think that the economic environment
will stay as supportive as people think.

,XVHPDQ\VLQJOHQDPH&'6EXW,DOVRXVHVLQJOHQDPH
derivatives on the equity sidemost frequently, put options.
I buy a bond, and at the same time, I buy put options to protect me against any default risk.
If the company goes bust and I lose money on my high\LHOGERQGWKHHTXLW\YDOXHPXVWEH]HUREHFDXVHWKHKLJK
yield bond is senior to equity in the capital structure (think
of the 1974 Merton model of option pricing).
One reason I use credit default swaps is simply that its
a very liquid market. Its far more liquid than the singlename bond market.

Why is that?

Are they cheaper than the put options?

The problem is simply that the transmission mechanism of


monetary policy doesnt work. The money printed by central banks does not arrive in the corporate sector; it stays

,WGHSHQGV,ILWLVFKHDSHUWRXVHD&'6DVDKHGJH,XVHD
&'6,ILWLVFKHDSHUWRXVHHTXLW\GHULYDWLYHV,XVHHTXLW\
derivatives.

And moving forward?

May/June 2014 CFA Institute Magazine 21

PROFESSIONAL PRACTICE
PORTFOLIO PERFORMANCE

the quantitative modelwas close to worthless, and the


other bond was paid back 100% due to the governing legal
regime. Therefore, this qualitative analysis is very imporWDQWEHFDXVHWKHUHDUHVRPHVSHFLFIHDWXUHVLQFUHGLWLQYHVWing that cannot be covered by models. You have to combine
You wrote a book about some of the incidents that
may have contributed to the credit crisis. People blamed both qualitative and quantitative analysis.
The fundamental analysis that you learn as part of the
models for errors of judgment. Do you see people
CFA Program is a very important part of the story, but
shunning models in the meantime?
We spent a lot of timeespecially between 2005 and 2008, besides this, the legal, political, and regulatory risks are
until Lehman implodedexplaining models on the credit very important features for determining the credit risk of
side. Even normal credit models can be rather tricky, but if a company or a bond.
When I started to work in credit research 14 years ago,
\RXJRLQWRWKHFROODWHUDOL]HGGHEWREOLJDWLRQ &'2 VSDFH
the work we did was a joke compared with today. Thats
for example, it becomes exponentially more complicated.
%HIRUHWKHQDQFLDOFULVLVZHGHYHORSHGPDQ\PRGHOV the process of learning. To be honest, I have done nothNearly everyone who developed models was aware of the ing else for more than a decade, but I still have a learning
potential shortfalls of the models. Obviously, the world is FXUYHWKDWLVYHU\VWHHSEHFDXVHVRPDQ\FUD]\WKLQJVKDYH
very, very complicated. We use just a few parameters to deter- happened over the last years. This doesnt mean that you
mine default probability. That is clearly wrong, and most can skip all the fundamental analysis. Thats a very imporpeople knew it was wrong. I see many parallels between the tant part, but its only one part of the process. You have to
SUHQDQFLDOFULVLVHQYLURQPHQWDQGWKHFXUUHQWVLWXDWLRQ do many other things simultaneously to understand credit
'XHWRWKHIDFWWKDWHYHU\ERG\ZDVVXSHUSRVLWLYHDQG risk and how it should be compensated.
rating agencies were very positive in their views, many
investors had a lot of liquidity and they wanted to partic- Lets go back to your Greece example. In theory, the
LSDWHLQWKHFUHGLWK\SH7KH\MXVWVWDUWHGJHWWLQJOD]\LQ market should have built in the difference in price
doing a proper analysis. I would not blame models; I would between the two legal structures of the bonds, right?
EODPHSHRSOHZKRSXWVSHFLFSDUDPHWHUVLQWKHLUPRGHOV Exactly. Now everybody gets it. But at some point, the UK-law
that were too optimistic.
bonds were even cheaper than the Greek-law bonds. UnbeThis is the psychology that we have seen during every lievable. But in 2010, that was indeed the case.
boom period. People are too optimistic. I dont want to say
Now that people are aware of this, they implement it
that the models we are using are 100% correct. You have into their analyses. Now, I would argue almost every credit
to see them as an additional tool. You can use them, but its investor makes sure that the legal risk is included in the
not the only tool you should use. Its never the model. Its bond documentation. They put much more focus on anaalways the people putting assumptions into their models O\]LQJWKDWULVN%XWIRXU\HDUVDJRQRERG\GLGLWRURQO\
who are too optimistic.
a very small part of the community [did].
Our clients pay us to operate creatively. We use nearly
DOOH[LVWLQJQDQFLDOLQVWUXPHQWVLQRUGHUWRH[SORLWSULFing anomalies.

How reliant are you on models with your current


strategy compared with qualitative credit analysis?

How do you stay ahead of the curve in understanding


what you need to include in your qualitative analysis?

There are many things you simply cannot put into a model.
It doesnt work because you cannot quantify these things.
Our analyses are very simple. For example, if I play a high\LHOGERQGYHUVXVHTXLW\ZKDW,KDYHWRGRUVWLVUHDGWKH
prospectus of the high-yield bond because there might be
VRPHVSHFLFFRYHQDQWVRUODQJXDJHWKDWVXEVWDQWLDOO\DOWHU
WKHULVNSUROHRIWKHERQG
For example, I was very active in Greece. We made highyield investments on the sovereign side as well as the corporate side. We did not buy the Greek government bonds
that were governed by Greek law. We just bought the international bonds, which were based on UK law.
Obviously, Greece defaulted and investors lost a lot of
money on the bonds that were based on Greek law. But
those who had invested in bonds governed by UK law got
all their money back, even though it was almost an identical bond to the Greek-law bond.
Its as simple as this: The same bondthe same risk in

I think its very important to talk to completely different


types of people in the investment industry about how they
see the bond documentation. If you talk to legals, they will
always have the legal perspective. If you talk to economists,
they will have the economists perspective. Putting all this
together is very important, especially in times like these,
when these risk factors are becoming more important.
Another point is that credit analysis is something that
LVYHU\VSHFLFDQGLGLRV\QFUDWLF1HDUO\HYHU\SRWHQWLDO
investment opportunity is unique. You couldnt, for example, accurately distill the entire credit evaluation process
into a textbook because there is no common rule for anaO\]LQJFUHGLWULVN
7KHUHDUHVRPDQ\XQLTXHDQGVSHFLFWRSLFV,I\RXMXVW
look at the situation in Europe, a simple example is that
many corporates are guaranteed by the governmentat the
local, state, regional, or sovereign level. European governments provide certain corporate entities with guarantees.

22 CFA Institute Magazine May/June 2014

It is true in Hungary, Ukraine, Portugal, Italy, and so on. To


get an idea what the guarantee is worth, you need to implement a process that allows for a detailed analysis of how
strong the guarantee is and ultimately what value it has.
This sounds simple, but normally, an ETF player, for
example, doesnt do this and might not be equipped to do
so. Many huge fund investors, which are forced to move
down the credit quality curve just because they have to earn
a higher yield on their investments, do not have the expeULHQFHWRORRNDWWKHVHVSHFLFPLQXWLDHSURSHUO\,ZRXOG
DUJXH'RQRWEX\DQ\WKLQJ\RXGRQRWXQGHUVWDQG
Today, you can buy Greek asset-backed security (ABS)
structures that are backed by Greek airspace rights. They are
VLQJOH%UDWHG7REHKRQHVW,FDQQRWDQDO\]HWKLVZLWKLQWZR
KRXUV,FDQQRWDQDO\]HLWZLWKLQRQHGD\$IWHUWZRGD\V,
came to the conclusion that these ABS structures were not
attractive investments. Normally, if we go through our universe, we come to the conclusion that at least 75% of the
names or target investments are not attractive opportunities.

not simply deciding to buy Caesars credit risk. I have 50 different alternatives to buying Caesars risk. I dont need to
QGRQHRSSRUWXQLW\,QHHGWRQGWKHEHVWRSSRUWXQLW\
out of these 50.
Scenarios and convoluted capital structures, such as
Caesars, make the investment processes more complicated.
7KHUHDUHPDQ\ERRNVWKDWWHDFK\RXKRZWRDQDO\]HFRPpanies. But on the high-yield side, its a different game [compared with single-name credit analysis on the investmentgrade side]. Its learning by doing and learning by making
mistakes. You have to discuss many topics with many different professionals to fully understand the many dimensions of the investment. I do not know a single guy who can
DQDO\]HDFRPSOH[VWUXFWXUHOLNH&DHVDUVDQGFRPHXSZLWK
DGHQLWLYHHYDOXDWLRQRIWKHFDSLWDOVWUXFWXUHDQGRXWORRN
RIWKHUP:HDUHLQFRQWDFWZLWKVHYHUDOSHRSOHWRGLVcuss many different features, such as the default schemes
in the United States. Its hardcore teamwork.

Whats your outlook for spreads in the high-yield market?


Credit crises run in cycles. There are only two alternatives
for credit markets in a low-yield environment while equity
markets are at very high levels. You can increase your profits by moving down the credit quality curve, or you can put
leverage on your trades, which can be done easily with credit
GHULYDWLYHVDQGVHFXULWL]DWLRQ,I\RXEX\LQWRD&'2\RX
have leverage on the trade. You probably have better quality with respect to the underlying names compared with the
Investing in high-yield and other convoluted structures high-yield market, but you put leverage on it. Thats what
is a very tedious and time-consuming job. Its easier to buy we saw in an extreme case during the 200507 pre-crisis
equities because an equity is an equity. When you invest in a HUD7KHUHZDVWKHUHFRUGLVVXDQFHRI&'2VDQG&/2V>FROVWRFN\RXGRQRWKDYHWRDQDO\]HKRZWKHVWUXFWXUHOHJDODQG ODWHUDOL]HGORDQREOLJDWLRQV@DQGZHVDZVXSHUWLJKWVSUHDGV
otherwise, affects the value of the investment. When invest- in the high-yield market.
ing in credit, even something as simple as a vanilla bond,
We also see super-tight spreads in the high-yield market
RQHPXVWDQDO\]HWKHVWUXFWXUHDQGODQJXDJHRIWKHVHFXULW\ right nownot as tight as it was six or seven years ago but
In the case of a high-yield bond, you are in the unfavor- close to those levels. Currently, we are also seeing a comeable situation that in the capital structure, you are the sec- EDFNRIVHFXULWL]DWLRQDQGFUHGLWGHULYDWLYHV
ond-biggest loser after the equityholder if the company goes
Id say were in a situation now that is similar to that
bust. Look at the recovery rate you normally get in the high- of 2006 and 2007. If theres a blowout, that will allow us
\LHOGPDUNHWZKLFKLVLQVRPHFDVHVFORVHWR]HUR+HQFH WRQGYHU\DWWUDFWLYHQDQFLDODVVHWV,ZRXOGQWEHVXUtheres not much recovery for the investor in the case of a prised if there are some sharper corrections. I dont know
default. On the other hand, you just get a coupon in the LILWZLOOEHRUEXWLWLVGHQLWHO\LQWKHFDUGVLQ
best case. You cannot make 100% or 200%, as is the case the short run.
if you buy distressed equity.
,QKLJK\LHOG\RXUSRWHQWLDOSURWLVFDSSHGDQG\RXU Would you like to summarize?
potential loss is as huge as it is on the equity side. Therefore, We are focused on and in contact with many universities
it is of utmost importance to be very meticulous regarding about the implementation of models that cover legal, regthe details. I am not talking about
ulatory, and political risks.
the BB ratings or crossover names
My message for investors is to
KEEP GOING
with one investment-grade rating
be careful with political, legal, and
and one high-yield rating. Im talkregulatory risk in credit investCurrent Conditions and Outlook for Corporate
and Sovereign Credit Markets CFA Institute
ing about CCC or B rated entities.
ments. It will become very imporConference Proceedings Quarterly (18 March 2014)
For example, it took us two
tant over the next couple of years.
[www.cfapubs.org]
weeks of very detailed analysis to
Rhea Wessel is a freelance writer based
Contingent Convertible (CoCo) Bonds: A First
understand the capital structure of
in Frankfurt. Fran Melville is the director of
Empirical Assessment of Selected Pricing Models
industry relations at CFA Institute.
Caesars Entertainment, with all the
Financial Analysts Journal (March/April 2014)
[www.cfapubs.org]
loans outstanding and many different bonds and cross guarantees. Its

BE CAREFUL WITH POLITICAL, LEGAL,


AND REGULATORY RISK IN CREDIT INVESTMENTS. IT WILL BECOME VERY IMPORTANT OVER THE NEXT COUPLE OF YEARS.

May/June 2014 CFA Institute Magazine 23

PROFESSIONAL PRACTICE
CAREER CONNECTION

Pay Daze
WITH ASSETS UNDER MANAGEMENT RISING, WILL COMPENSATION FOLLOW?

KEY POINTS

By Lori Pizzani

7KHIRUHFDVWIRUFDUHHUVDQGSD\SDFNDJHVIRUQDQFLDODQDlysts and other investment professionals can vary according to which expert you ask, but most of those who shared
their perspectives for this report are cautiously optimistic
about what lies ahead for 2014.
There is more movement, more activity, although that
activity is not necessarily a lot more hiring, says Roy Cohen,
a New York City career counselor, executive coach, and author
of The Wall Street Professionals Survival Guide: Success Secrets
of a Career Coach. In his view, the risk appetite among Wall
6WUHHWUPVKDVGHQLWHO\LQFUHDVHGDVWKHQHHGWRFUHDWHQDQcial security for individuals,
including those facing retirement, has become a priority.
Compensation patterns for
0DQ\UPVKDYHVHWWKHLU
financial analysts and other
sights on attempting to generinvestment professionals
DWHRXWVL]HGUHWXUQVIRULQYHVvary widely within domestors as the economy becomes
tic markets and across geomore and more stratified
graphic regions.
and increasing numbers of
Since 2008, hiring and compeople are building enormous
pensation (salaries and
wealth. Cohen sees notable
bonuses) have been congrowth of positions within
strained as US firms conthe structured products area
tinue to rein in expenses.
(e.g., credit derivatives) and
for compliance and wealth
Although assets under manmanagement jobs.
agement for US firms have
started increasing again,
the implications for compensation are still unclear.

A CHANGING LANDSCAPE

The market for equity and


fixed-income analysts has
If rising profitability doesnt
changed. I am seeing differlead to compensation gains,
ent analysis, not as in-depth,
employee turnover could
and research analysis that is
increase in 2014.
more designed to generate
trading activity, says Cohen.
In particular, he has observed
a decline in investment bank white papers and research
reports. Instead, he notes, banks want analysts to come up
with trade ideas, especially because as a practical matter,
trading revenue pays for those research ideas. Moreover, traders arent necessarily interested in reading lots of analytical
reports these days. The focus has shifted to actionable ideas.
7KHQXPEHURI:DOO6WUHHWUPVKDVFRQWLQXHGWRFRQtract, and promising start-up hedge funds have often failed
because of their inability to generate interest, even when big
names and great reputations have been involved.
'HVSLWHWKHJORRP&RKHQSRLQWVRXWDVLOYHUOLQLQJ7KH
CFA designation, as a professional accomplishment and
24 CFA Institute Magazine May/June 2014

critical professional resource, is even more desirable now.


CFA charterholders work in a wide range of capacities
around the globe. As of October 2013, self-reported data from
nearly 111,000 CFA charterholders show that, on average,
22% work as portfolio managers, 15% as research analysts,
and 7% as chief-level executives. Another 11% fall into the
catchall other category. Additional career categories are
FRQVXOWDQWV  FRUSRUDWHQDQFLDODQDO\VWV  QDQcial advisers (5%), relationship managers (5%), risk managers (5%), investment banking analysts (4%), managers
of managers (3%), strategists (3%), accountants/auditors
(3%), and traders (3%), with 4% reporting as unemployed.
(The numbers sum to more than 100 because of rounding.)
7KHJHQHUDOQXPEHUVFRQFHDOVRPHVLJQLFDQWUHJLRQDO
differences. For example, 17% of CFA charterholders in the
United States and 20% of charterholders in the United Kingdom work as research analysts, but in Canada the number
drops to 10%. Also, a higher proportion of charterholders in
the US and the UK (24%) hold positions as portfolio managers as compared with those in Canada.
The most recent Occupational Outlook Handbook released
by the US Bureau of Labor Statistics estimates the number
RIQDQFLDODQDO\VWVZRUNLQJLQWKH8QLWHG6WDWHVLQDW
DQGSURMHFWVDQDGGLWLRQDOQDQFLDODQDO\VW
jobs by the end of 2022. The BLS analysis forecasts a 16%
JURZWKUDWHIRUMREVLQWKHQDQFLDODQDO\VLVHOG LQFOXGing not only buy-side and sell-side analysts but also portfolio managers, fund managers, ratings analysts, and risk
analysts) over the 10-year period, which is well above the
average 11% growth predicted for all occupations.

RECENT COMPENSATION TRENDS


Current and accurate data for salaries, bonuses, and other
QDQFLDOLQFHQWLYHV VXFKDVSURWVKDULQJ DUHGLIFXOWWR
obtain. Results vary greatly depending on who is asked and
ZKRKDVEHHQVXUYH\HG'DWDDOVRYDU\ZLGHO\DFFRUGLQJWR
JHRJUDSKLFUHJLRQVFRXQWULHV\HDUVRIH[SHULHQFHWKHVL]H
and type of the employer, and other factors.
$VLQYHVWPHQWSURIHVVLRQDOVDQGQDQFLDODQDO\VWVDGYDQFH
in their careers, CFA charterholders often grow out of their
QDQFLDODQDO\VWWLWOHVDQGLQWRWLWOHVWKDWFDQLQFOXGHPDUketing and sales executives, portfolio managers, fund managers, and a bevy of C-suite positions. For example, the posiWLRQRIFKLHILQYHVWPHQWRIFHUEHORQJVLQDGLIIHUHQWFDWHJRU\DQGSD\OHYHOIURPWKDWRIDQDQFLDODQDO\VW7KXV
DVVHVVLQJFRPSHQVDWLRQEHFRPHVPRUHGLIFXOW
One way to get an idea of compensation is to cull inforPDWLRQIURPRQOLQHDQGRILQHVRXUFHVDQGSXWWRJHWKHUD
kind of composite picture. This method shows broad ranges

FIRMS HAVE LITTLE NEED TO PUSH


of salaries and bonuses rather than compact or narrowly
GHQHGSD\OHYHOV%HQFKPDUNLQJDJDLQVWWKHPHGLDQDQG
FOR SIGNIFICANT BONUS INCREASES,
RUDYHUDJHJXUHVPDNHVWKHPRVWVHQVH
AS COMPETITOR HIRING IS PUTTING
According to the job search website Indeed.com, the averLITTLE UPWARD PRESSURE ON
age annual US salary for jobs that require candidates to be
OVERALL TURNOVER LEVELS.
CFA charterholders was US$101,000 as of January 2014
64% higher than the average salary for all job postings.
Additionally, Indeed.com notes that the average annual
VDODU\IRUDSHUVRQZLWKWKHMREWLWOHRILQYHVWPHQWRI- top talent, points out George Wilbanks, founder of Wilbanks
cer is US$78,000. For a senior investment consultant, 3DUWQHUVDQH[HFXWLYHVHDUFKUPLQ6WDPIRUG&RQQHFWthe salary rises to US$109,000 annually; for a VP of prod- icut, that caters to the asset management industry. Those
trends came to an abrupt stop in 2009, when compensation
uct management, it is US$136,000 per year.
PayScale.com, the creator of a global database of indi- IRUPDQ\HPSOR\HHVZDVFXWE\DQGPDQ\UPVHLWKHU
YLGXDOFRPSHQVDWLRQSUROHVUHSRUWVWKDWWKH86QDWLRQDO laid off employees or stopped recruiting new employees.
%\ODWHVRPHUPVVWDUWHGKLULQJDJDLQEXWWKHQ
PHGLDQDQQXDOSD\IRUQDQFLDODQDO\VWVZLWKRXWD&)$
FHUWLFDWLRQLV86DQGULVHVWR86IRUWKRVH stopped in 2010 and 2011. Since 2010 and into the fall of
KLULQJZDVDW:LOEDQNVVD\V7KHLQYHVWPHQWPDQwho hold the CFA designation.
According to the London-based website Emolument. agement industry was hiring only replacements on an ascom, which has assembled a proprietary database of salary QHHGHGEDVLV,QPRVWUPVZHUHVWLOOZRUNLQJZLWK
LQIRUPDWLRQIRUYDULRXVQDQFLDOLQGXVWU\RFFXSDWLRQVLQ D]HUREDVHGEXGJHW7KHPRVWVWHDGIDVWUPVZHUHVWLOO
Europe, the median annual base salary for research ana- paying well, but defensively paying salaries as a practice
lysts in London is US$72,328, with salaries ranging from a ]]OHGRXWDQGRQO\IUDFWLRQDOERQXVHVZHUHSDLG
In 2013, with equity markets higher, the investment manminimum of US$44,602 to as high as US$104,153. Additionally, the median bonus for a research analyst is US$8,036, agement industry began growing assets under management
again, although expenses remained conservative. By late
but bonuses can run as high as US$32,146.
Moving up the corporate ladder in London, vice presi- DQGHDUO\SURWDELOLW\KDGUHWXUQHGIRUPDQ\
dents of research earn a median salary of US$171,981 plus UPV7KHELJTXHVWLRQLVZKDWZLOOUPVGRZLWKWKDWSURIa median bonus of US$51,433, and managing directors of itability? says Wilbanks. Firms could begin adding to their
research can expect a median salary of US$347,176 and a sales/marketing teams and to their research group, or they
median bonus of US$401,825. Annual salaries can be as could expand distribution channels to include the instituhigh as US$482,190, with maximum bonuses reaching more tional market or could expand internationally. [For more on
the implications of international expansion for investment
than US$1.45 million.
'DWDFROOHFWHGLQVKRZHGWKDWFDVKERQXVHVZHUH UPVVHH([SDQGLQJ+RUL]RQVRQSDJHLQWKLVLVVXH@
Firms have little need to push for significant bonus
YHU\FRPPRQLQDOPRVWDOORFFXSDWLRQW\SHVLGHQWLHGLQWKH
survey. The most important determinants of cash bonuses were increases, as competitor hiring is putting little upward pres LQRUGHURILPSRUWDQFH WKHRYHUDOOSHUIRUPDQFHRIWKHUP sure on overall turnover levels, Wilbanks explains. The
the performance of the business unit/division, and then fac- vast majority of professionals in the asset management business will not see compensation increases equal to the rise in
tors related to the performance of the individual employee.
This survey also showed that long-term incentivessuch SURWDELOLW\LQWKHLUUPV(PSOR\HUVDUHJHQHUDOO\DYRLGDVSURWVKDULQJSODQVVWRFNRSWLRQVDQGVWRFNDZDUGV ing large upfront signing bonuses and multiple-year guaranwere more common for certain occupations (portfolio man- WHHV$GLVSURSRUWLRQDWHVKDUHRIVXUJLQJSURWDELOLW\ZLOOJR
agers, sell-side traders, sell-side sales representatives, strat- toward equity shareholders (for a public company), a parent
egists, and private bankers) than for others. The median company, or C-suite executives whose compensation takes
total compensation package for CFA charterholders who the form of revenue sharing or equity-related incentives.
If such trends cause a perception
were equity portfolio managers
of unfairness among employees,
ZLWKIHZHUWKDQYH\HDUVRIH[SHKEEP GOING
the result could be rising employee
rience was US$205,000 annually.
turnover. Thus, Wilbanks concludes,
For those with 10 or more years of
Shades of Great: How can investment professionals align their careers with great firms?
the natural equilibrium will be
experience, the range extended up
CFA Institute Magazine (September/October 2013)
restored in the 2014 compensation
to US$499,000.
[www.cfapubs.org]
cycle as managers respond to this
7KRVH JXUHV UHHFW WKH UHDOSell-Side Analysts and Gender: A Comparison
higher turnover by raising bonus
ity of the 200607 period, but
of Performance, Behavior, and Career Outcomes
compensation for performance yearWKHZRUOGRIQDQFLDOVHUYLFHVKDV
Financial Analysts Journal (March/April 2013)
[www.cfapubs.org]
end bonus programs.
changed dramatically since 2008.
In 2007 and 2008, overall Wall
Poll: What Would Increase Your Job Satisfaction
Lori Pizzani is an independent financial
the Most? Enterprising Investor (6 March 2014)
Street pay was reaching an all-time
and business journalist based in Brews[blogs.cfainstitute.org/investor]
ter, New York.
KLJK DQG UPV KDG EHHQ SD\LQJ
defensively to retain and attract
May/June 2014 CFA Institute Magazine 25

ENVIRONMENTAL
MARKETS: A NEW
ASSET CLASS
Richard L. Sandor, Nathan J. Clark,
Murali Kanakasabai, Rafael L. Marques
In todays dirty, depleted, and dangerous
world, environmental markets are the key
both to short-term tactical opportunities and
to longer-term transformational ones.

For more information, search Environmental


Markets on www.cfainstitute.org
2014 CFA Institute

RESEARCH
FOUNDATION:
YEAR IN REVIEW
2013
Learn more about manager selection, ethics,
asset/liability management, derivatives, life
annuities, tail risk, and other timely topics
with these informative summaries.

For more information, search Year in


Review 2013 on www.cfainstitute.org
2014 CFA Institute

26 CFA Institute Magazine May/June 2014

PROFESSIONAL PRACTICE
ANALYST AGENDA

Board Stiff
TO FIX GOVERNANCE, CHANGE INCENTIVE STRUCTURES FOR CORPORATE BOARDS
By Sherree DeCovny

In his many years as an economist and professor at the Wharton School at the University of Pennsylvania, Bernard Munk
learned that stories too good to be true generally are not
true. As the owner of an oil business, he intuitively walked
DZD\IURP(QURQVGHDOVEHFDXVHKHFRXOGQRWJXUHRXWZKDW
ZDVLQLWIRU(QURQ'XULQJDFRQVXOWDQF\HQJDJHPHQWKH
discovered Enrons power supply contracts involved a sigQLFDQWDPRXQWRIFRQFHDOHGULVNDQGKHDGYLVHGKLVFOLHQW
WRGURSWKHSURMHFW7KHQDQFLDOFULVLVRIZDV
dj vu, with the common threads being high-risk taking
by management, board of directors lack of understanding
of the risks, and massive destruction of shareholder value.
In his new book Disorganized Crimes, Munk points out
misaligned incentives for managers as one reason such crisis
events occur. Many companies promote executives using a
rank and yank system. Over time, the high-risk takers who
produce great returns move up the ladder, whereas cautious
PDQDJHUVSURJUHVVVORZO\OHDYHRUDUHUHG
The incentive structure were offering managers is telling them to move to the tails because thats how they get
paid, Munk explains. The fundamental law of portfolio
management is if you want to make a higher rate of return
than average, the only way you can do this is take more risk.
That is not to say that companies should not take higher
risks, but the board has a responsibility to monitor managements activities and disclose when the risk frontier of the
company has changed. If market participants do not have
current information about a change in the risk frontier, they
cannot price the companys securities properly.
7KHUHDUHQDWXUDOFRQLFWVRILQWHUHVWEHWZHHQWKHPDQDJHment, the board, and the shareholders. The board is supposed
to work on behalf of the shareholders, but in reality, directors are captured by the management and are fed biased
information. Effectively, the regulated capture the regulators.
1RIRUPDOPHFKDQLVPH[LVWVIRUSHQDOL]LQJWKHQHJOLJHQFH
of a board failing to detect and rein in increases in excessive risk taking. In fact, directors are legally protected by
the rule of business judgment. Managers can be sued, but
WKH\DUHJHQHUDOO\SURWHFWHGE\RIFHUVOLDELOLW\LQVXUDQFH
Today, a board member only has an upside, says Munk.
But if director incentives dont also embody a downside,
ultimately capture takes place.
Munk calls the SarbanesOxley Act (Sarbox) of 2002 a
telling example of legislating through the rearview mirror.
The legislators were already thinking about disclosure and
UHVSRQVLELOLW\RIVHQLRURIFHUVEHIRUHWKHVFDQGDOVDW(QURQ
WorldCom, and Global Crossing occurred. In the aftermath,
WKH\GHWHUPLQHGWKDWWKHQDQFLDOVWDWHPHQWDXGLWLQJSURcess was problematic and that management must sign off on

the accounts to verify that there are no material changes.


Sarbox doesnt focus on risk and information about risk,
KHZDUQV%\WKHWLPHWKHQDQFLDOVWDWHPHQWVDUHVLJQHG
off, the damage has already been done. The security has
been mispriced all during the period in which those risks
were incurred and until they turn sour.
If the board does not have a good idea of which strategic business units are producing the earnings, they have no
way of assessing the risk embedded in these activities. Each
DFWLYLW\KDVDGLIIHUHQWULVNUHWXUQSDUDGLJP7KHQDQFLDO
crisis showed that seemingly uncorrelated business activities can become perfectly correlated in a macro shock.
Disorganized Crimes lays out a framework for remediation. For starters, Munk suggests paying managers partially
with stock instead of stock options, thus putting them on
an equal footing with shareholders. In addition, he recomPHQGVVWLSXODWLQJDQLQLWLDOYH\HDUYHVWLQJSHULRGDQGD
VXEVHTXHQWYH\HDUVLQZKLFKVXFKVWRFNDZDUGVFDQEH
sold. Managers will think twice before taking high risks,
and a higher percentage of risk-conscious managers will
progress to the upper echelons.
He proposes that a risk management committee of the
board should regularly provide the board of directors a
statement of changes in risk. Then, it would be up to the
board to decide when and how to disclose the change in
risk to the shareholders.
I believe that any meaningful regulation on directors
behavior has to take into account that they had a chance
to stand down, he says. If they dont stand down, theyre
standing up for the risk.
By imposing term limits and rotating board members
more frequently, board capture is less likely to take place.
In addition, board members will take their responsibilities more seriously if they can incur penalties for failing
to observe risks that are detrimental to the shareholders.
The book also discusses other issues, including director
LQGHSHQGHQFHVHSDUDWLQJWKHRIFHVRIWKHFKDLUPDQDQG
CEO, and using outside compensation experts. It addresses
the need to deal with capital market conspirators and reevaluate the role of rating agencies and bank intermediaries.
The corporate scandals of the early 2000s and the recent
QDQFLDOFULVLVZHUHQRWFDXVHGE\DQRUJDQL]HGJDQJRIFULPLQDOV0XQNH[SODLQV5DWKHUWKH\ZHUHGLVRUJDQL]HGFULPHV
UHVXOWLQJIURPVHSDUDWHDFWLRQVE\PDQ\GLIIHUHQWUPV
massive failures of corporate governance and highly suspect
government policy. Munks book provides an interesting perspective on how such disasters can be avoided in the future.
Sherree DeCovny is a freelance journalist specializing in finance and
technology.

May/June 2014 CFA Institute Magazine 27

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contained herein is for general information and reference purposes only and does not constitute legal, tax, accounting or other professional advice nor is it an offer or solicitation of securities or services or an endorsement thereof in any
jurisdiction or in any circumstance that is otherwise unlawful or not authorized. 2014 The Bank of New York Mellon Corporation. All rights reserved. Eagle Investment Systems LLC is a subsidiary of BNY Mellon.

28 CFA Institute Magazine May/June 2014

STOXX LIMITED

MINIMUM VARIANCE
SET FREE.

As a prudent investor, you probably know about minimum variance


indices. They benchmark managed volatility equity strategies to
minimize risk. But when youre tied to the benchmark, can you truly
optimize against risk?
You can with the STOXX Minimum Variance index family.
Its different. It has two versions. The constrained version is the one
that were all familiar with. It tracks the benchmark, so there are
no surprises.

250
200
150
100
50

The second version is unconstrained. It offers true risk optimization


by not following the benchmark so closely. And when your portfolio
JTTFUGSFFGSPNUIFCFODINBSL ZPVDBOOFUVOFVOUJMZPVWFUSVMZ
maximized your reward potential while minimizing your risk.
No one else but STOXX offers the unconstrained version.
One index, two versions. Another innovation from STOXX.

0
2004

2006

STOXX Global 1800

2008

1800 GR

2010

2012

1800 Min. Var. GR

2014

1800 Min. Var. Unc. GR

Source: STOXX Ltd. - Data from January 2, 2004 to January 29, 2014

www.stoxx.com
STOXX
STOXX
STOXX
Global 1800 Global 1800
Global 1800
GR Min. Var. GR Min. Var. Unc. GR
Annualized performance
Volatility
Sharpe ratio*
Maximum drawdown

5.8%
15.4%
0.32
-53.7%

8.9%
13.2%
0.66
-39.4%

8.1%
9.9%
0.64
-26.7%

*EONIA rate used as proxy for riskless returns


Source: STOXX Ltd. Data from January 2, 2004 to January 29, 2014

INNOVATIVE. GLOBAL. INDICES.


STOXX is a part of Deutsche Brse and SIX
45099k*OEJDFTBSFQSPUFDUFEUISPVHIJOUFMMFDUVBMQSPQFSUZSJHIUT45099JTBSFHJTUFSFEUSBEFNBSL5IFVTFPGUIF45099k*OEJDFTGPSOBODJBMQSPEVDUTPSGPSPUIFSQVSQPTFTSFRVJSFTBMJDFOTFGSPN
4509945099EPFTOPUNBLFBOZXBSSBOUJFTPSSFQSFTFOUBUJPOT FYQSFTTPSJNQMJFE XJUISFTQFDUUPUIFUJNFMJOFTT TFRVFODF BDDVSBDZ DPNQMFUFOFTT DVSSFOUOFTT NFSDIBOUBCJMJUZ RVBMJUZPSUOFTTGPS
BOZQBSUJDVMBSQVSQPTFPGJUTJOEFYEBUB45099JTOPUQSPWJEJOHJOWFTUNFOUBEWJDFUISPVHIUIFQVCMJDBUJPOPGUIF45099k*OEJDFTPSJODPOOFDUJPOUIFSFXJUI*OQBSUJDVMBS UIFJODMVTJPOPGBDPNQBOZJOBO
JOEFY JUTXFJHIUJOH PSUIFFYDMVTJPOPGBDPNQBOZGSPNBOJOEFY EPFTOPUJOBOZXBZSFFDUBOPQJOJPOPG45099POUIFNFSJUTPGUIBUDPNQBOZ'JOBODJBMJOTUSVNFOUTCBTFEPOUIF45099k*OEJDFTBSF
JOOPXBZTQPOTPSFE FOEPSTFE TPMEPSQSPNPUFECZ45099$POUBDUT&VSPQF )2;VSJDI  5IF"NFSJDBT /FX:PSL  "TJB1BDJD )POH,POH 

Global expansion is
a tricky balancing act
for asset managers
By Rhea Wessel

E X PA ND IN G

HORIZONS
30 CFA Institute Magazine May/June 2014

Illustration by Kelly Alder

Already one of the most global industries, investment management may become even more so as
UPVORRNWRLQFUHDVHWKHLUDVVHWVXQGHUPDQDJHPHQWDQGQGQHZFOLHQWV
KPMGs 2013 Investment Management Business Outlook survey of 100 senior executives at US mutual funds,
private equity funds, hedge funds, trusts, managed funds,
and other types of funds found that the top area for increased
spending in 2013 was geographic expansion, which ranked
even higher than IT investment.
Successful expansion is the product of thorough planning, a well-thought-out strategy, and stamina in execution,
says Marc Haynes, leader of the global investment practice
at Greenwich Associates in London and an author of the
2013 report Managing International Expansion: A Strategic Framework for Investment Managers.
Firms that expand internationally without adequate planning and preparation risk lower investment performance
EHFDXVHRIWKHSUHVVXUHSXWRQWKHUPVE\SURJUDPVWKDW
struggle, which tends to divert resources. Moreover, companies
may harm their brand at home if an expansion goes wrong.
One example of a successful expansion effort is UK-headquartered Schroders PLC. The largest listed asset managePHQWUPLQ(XURSH6FKURGHUVDSSHDUVWRKDYHDYRLGHG
missteps and has developed a strong brand in Europe, Asia,
DQGWKH8QLWHG6WDWHV1RWRQO\GLGWKHUPUHSRUWDUHFRUG
SURWLQEXWLWQRZKDVRILWVDVVHWVXQGHUPDQagement outside the United Kingdom.
The asset manager has followed a strategy of organic
growth, to which it recently added complementary acquisitions. In 2012, Schroders took a stake in the Indian asset
management business of Axis Bank Limited and fully acquired
WKHYDOXHRULHQWHG86LQYHVWPHQWJUDGH[HGLQFRPHPDQDJHU67:)L[HG,QFRPH0DQDJHPHQW,QWKHUP
PDGHDGRPHVWLFDFTXLVLWLRQ&D]HQRYH&DSLWDO1RZ6FKURGHUVKDVRIFHVLQFRXQWULHVSURYLGLQJLQYHVWPHQW
products to local and international clients.
Global expansion made New Yorkbased BlackRock the
worlds largest asset manager. Its acquisition of UK-based
%DUFOD\V *OREDO ,QYHVWRUV LQ  VROLGLHG %ODFN5RFNV
SRVLWLRQDQGWKHUPLQFUHDVHGLWVSUHVHQFHLQ(XURSHLQ
July 2013 by purchasing the Credit Suisse ETF platform.
BlackRocks iShares channel brought in more than US$5
ELOOLRQRIRZVIURP(XURSHLQWKHWKLUGTXDUWHURI
BlackRocks Aladdin investment management platform,
which combines risk analytics with portfolio management,
trading, and operations tools, is core to BlackRocks global
expansion, analysts have said. In the companys third-quarter 2013 earnings call, BlackRock CFO Gary Shedlin said
WKH$ODGGLQEXVLQHVVJUHZ\HDURYHU\HDUEHQHWLQJ
from trends that favor global investment platform consolidation (among other factors).
The growth stories of Schroders and BlackRock may
seem appealing, but caution is advised.

Firms should evaluate their international expansion


efforts with the same rigor and due diligence as a portfolio
manager evaluates a new investment decision, says Haynes.
Managers who successfully grow assets may equate that
with the ability to successfully manage and grow a business
internationally. That is not necessarily the case.

COMMON PITFALLS
2IWHQSDUWLFXODUO\IRUVPDOOHUUPVDVVHWPDQDJHUVPD\
QG WKDW WKHLU EXVLQHVV LQDGYHUWHQWO\ EHFRPHV LQWHUQDtional. Investors may seek out the asset manager after
learning about strong performance. The asset managers
wind up with a promising book of business and then decide
to expand from there, even if the jurisdiction is relatively
new to them. In the long term, however, the move could be
costly. Acquiring a new customer is far less expensive than
maintaining a customer over the long term, given the high
levels of service that are necessary and the people-related
costs of the business.
3HUIRUPDQFHLVQRWRULRXVO\FNOHZKLFKPHDQV\RXQHHG
to establish deep relationships based on mutual understanding in order to get through the tough times, says Haynes.
It takes time to develop these relationships, and doing so
can be costly. The costs and complexities only multiply when
you add in the international dimension.

RIGHT STRATEGY, RIGHT MARKET


Experts argue for creating a well-deliberated, strategic plan
WKDWLVDGDSWHGVSHFLFDOO\IRULQGLYLGXDOPDUNHWV)RUDVVHW
managers serving institutional clients, a common approach
is the hub-and-spoke model, in which portfolio managers
stay at home while distribution and marketing are set up
in the new country.
A critical step is to hire a team in the new country that
has a fundamental understanding of the local distribution
PRGHODQGKRZLQVWLWXWLRQDOLQYHVWRUVIXOOOPDQGDWHVWKHUH
The new team will also need a variety of contacts with
investment consultants or contacts for direct sales. If the
market is dominated by investment consultants, the asset
manager will need to work closely with and manage some
of these consultants.
In each new market, companies must ensure access to
institutional investors, have a chance to present their offerLQJDQGQGDZD\WREHRQWKHDJHQGDRIWKHLQVWLWXWLRQDO
investors when they have new mandates to give, says Sven
Bischof, a senior consultant at Roland Berger Strategy Consultants in Zurich.
MacKay Shields, a New Yorkbased investment managePHQWUPIRFXVHGRQ[HGLQFRPHKDVH[SDQGHGLQWHUnationally and is now looking to build that presence even
more, with staff outside the United States who are focused
on business development and client relations. The move is
part of a broad, long-term strategy to add new clients selectively and become close to those clients at the same time,
according to Jeff Phlegar, chairman and CEO at MacKay.
May/June 2014 CFA Institute Magazine 31

The company currently has about US$80 billion in assets


under management, with much of its growth in recent years
coming from outside the United States. Looking forward,
MacKay sees opportunities internationally in the tradiWLRQDODQGQRQWUDGLWLRQDO[HGLQFRPHVSDFHDVSHQVLRQ
IXQGVJRYHUQPHQWVQDQFLDOLQVWLWXWLRQVIDPLO\RIFHV
high-net-worth individuals, endowments, foundations, and
retail clients continue to strategically increase allocations to
non-equity, income-oriented strategies, a MacKay specialty.
MacKays strategy, formulated with the senior leadership
team, includes a variety of approaches, such as hiring people
RQWKHJURXQGLQFHUWDLQPDUNHWVDQGSDUWQHULQJZLWKUPV
in others. In London, the company has established a physical presence, and it is taking a direct approach in Canada.
But in Japan, MacKay is working with partners.
Were trying to be closer to clients in key markets, says
John Akkerman, CFA, the companys global head of distribution and executive managing director. Over time, we
gained new clients in different parts of the world through
referrals. Now we want to bring the story closer to them.
:KLOH0DF.D\V[HGLQFRPHEXVLQHVVRIWHQSURYLGHV
niche and tailored investments for clients, having client
services, sales resources, and partners in international markets keeps the engine well oiled, adds Akkerman.
)RUUPVFRQVLGHULQJH[SDQVLRQ3KOHJDUUHFRPPHQGV
building off of a strong distribution network at home as a
way to create an international footprint. Our core competency is all about investment performance, he says. Now

that weve got strong advocacy from consultants, its an


ideal time to use our distribution momentum.

ASIA, ANYONE?
Many asset managers are attracted to the growth potential
in Asia. According to strategy consulting company Roland
Berger, institutional and retail assets in Asia are set to grow
at an annual rate of roughly 7%9% because of economic
JURZWKDQGQDQFLDOPDUNHWSHUIRUPDQFH7KHIRUHFDVWLV
EDVHGRQDPRGHOGHYHORSHGE\5RODQG%HUJHUWRVL]HWKH
asset management market.
'HPRJUDSKLFVULVLQJSURVSHULW\DQGFKDQJLQJUHJXODtions in various countries are driving pension fund growth
in the region. In the old days, says Bischoff, families were
the social security networks of the people. Step by step, pension funds are taking over part of that role.
6FKURGHUVKDVDSDUWLFXODUO\VROLGSRVLWLRQLQ$VLD3DFLF
according to the companys interim 2013 earnings presenWDWLRQE\6FKURGHUVFKLHIH[HFXWLYH0LFKDHO'REVRQ&RQsidering only the asset management business (e.g., excluding private banking), Schroders had very strong perforPDQFHLQ$VLD3DFLFLQWKHUVWKDOIRILQERWKWKH
intermediary and the institutional markets, with 4.1 bilOLRQRIQHWLQRZV
Companies should carefully plot their moves in Asia, cautions Bischof. Outsiders have been known to rush in without full consideration of the local differences. Market maturity, structure, and demand patterns in emerging onshore

Empowering People
FOR TALENT RECRUITMENT AND DEVELOPMENT, THE
CLARITAS PROGRAM PROVIDES A TREMENDOUS SELFREINFORCING POSITIVE-FEEDBACK LOOP
Young Lee, CFA, general counsel and a senior managing director
at MacKay Shields, was instrumental in bringing the Claritas Program to his firm and its parent company, New York Life. He also
helped pave the way for the Claritas Program at law firms and
industry groups, such as the New York Hedge Fund Roundtable.
As a result of his involvement, Lee heard about the experience
of the Claritas Program from many different perspectives and
agreed to share his views in a brief interview.

Youve had contact with many participants in the


Claritas Program. What was the general direction of the
feedback about the program?
People working within non-investment-decision-making groups
in the investment industry, such as legal, compliance, finance,
technology, marketing, and operations, said they were rewarded
with a deeper understanding of the investment industry. People
from these groups often had only minimal formal training in
investment concepts, if any at all. The Claritas experience helped
to demystify concepts that were once esoteric and confusing.
People said that their enhanced understanding of financial
concepts and ethical obligations will empower them to make
even more meaningful and thoughtful contributions to the firms
32 CFA Institute Magazine May/June 2014

where they work.Claritas certificate holders said they feel a


strong connection with other like-minded professionals and
part of a global investment community.

What was the first reaction to the Claritas opportunity


at organizations where it was implemented?
The reception for the Claritas Program was tremendous. People
from all different backgrounds and job functions, whether they
worked in the mailroom or spent a lifetime in our industry facing
clients, were excited about the benefits that the program offered.

What culture changes or differences did you notice in


relation to the Claritas Program?
I observed that people felt more clued in about the business
and many experienced noticeably higher levels of confidence.
Allan Dowiak, the senior managing director of human resources at New York Life Investment Management, told me something
similar. He said that after putting in lots of hours and sweat
capital, people had a sense of pride to have the certification, and
it gave them and their role more credibility in the marketplace.
For me, knowing more colleagues have a basic understanding of the industry gives me a higher degree of trust in the
people I work with.
Its a tremendous self-reinforcing positive-feedback loop.
I am looking forward to seeing how far these people will go in
their careers as a result of the Claritas experience.

PDUNHWVVXFKDV&KLQDDQG,QGLDGLIIHUVLJQLFDQWO\IURP
WKRVHLQWKHUHJLRQVQDQFLDOFHQWHUVVXFKDV+RQJ.RQJ
and Singapore.
BlackRock also sees promise in the region, particularly
LQ&KLQDEXWZDUQVDERXWFUHGLWJURZWK7KHUPV
Investment Outlook points out that history shows rapid
credit expansion usually ends in tears. With China generating a record amount of credit in 2012 (much of which was
obscured in off-balance-sheet constructions, such as wealth
management products), BlackRock sees the risk of duraWLRQPLVPDWFK0DQ\SURGXFWVRIIHUVKRUWWHUPQDQFLQJ
for long-term assets and thus are very vulnerable to liquidLW\VTXHH]HV%XW%ODFN5RFNVRXWORRNDOVRVHHVWZRUD\V
of light amid the gloom: Regulators appear aware of the
risks, and are taking action to curtail growth and avoid a
EXVW>DQG@&KLQDVQDQFLDOV\VWHPLVQRW \HW LQWHJUDWHG
with the rest of the world, so any credit implosion appears
to pose limited global systemic risk.

Four steps for going international


Four steps are critical for international expansion, according to Marc Haynes, leader of the global investment practice
at Greenwich Associates in London and an author of the 2013
report Managing International Expansion: A Strategic Framework for Investment Managers.
First, he says, companies should consider whether the
initiative fits with long-term strategic goals and make sure
the motivation to expand internationally is not driven by
pressures or opportunities in the short term.
Second, firms should look at how viable the option really is and whether potential partners have overlaps in the
business. If theres a fit, the third step is to develop a market
entry approach, usually choosing from a go-it-alone strategy,
a joint venture, or an acquisition.
Finally, companies must consider business plan elements, such as targets, timelines, budgets, and metrics for
measuring success.

CONFUSION ABOUT THE UK MARKET


For US-based companies looking to Europe, the United KingGRPPD\DSSHDUWREHDUVWVWHSLQWKHULJKWGLUHFWLRQ%XW
VRPHUPVIDLOWRDSSUHFLDWHKRZGLIIHUHQWWKHPDUNHWVDUH
For instance, companies offering target-date funds in the
86 N PDUNHWKDYHVWUXJJOHGWRJDLQVLJQLFDQWDVVHWV
ZLWKVLPLODUSURGXFWVLQWKH8.GHQHGFRQWULEXWLRQPDUNHW
%HQHWFRQVXOWDQWVLQWKH8.DUHLQFUHDVLQJO\ORRNLQJ
to participate in the design and management of the investPHQWSURSRVLWLRQIRUGHQHGFRQWULEXWLRQVD\V+D\QHV
An asset manager which comes around with a one-stop
solution threatens to dis-intermediate the powerful consultants in this market. If that happens, the consultants arent
going to allow them to eat their lunch.

SHRSOHZKRKDYHHDUQHGWKH&ODULWDV,QYHVWPHQW&HUWLFDWH
says Lee, who has been involved in developing the strategy
for MacKays growth outside the United States. [For more
on the impact of the Claritas Program for staff development,
see the sidebar Empowering People on page 32.]
The CFA charter is respected as the gold standard around
the world precisely because it cultivates dedicated investment professionals that are committed to the highest standards in our industry, Lee explains. Asset management
UPVVHHNLQJWRSHQHWUDWHQHZPDUNHWVQHHGWRKDYHSHUsonnel that are able to consistently perform at a high level,
often across multiple disciplines. The CFA designation helps
employers identify that type of talent.

THE PEOPLE DIMENSION


Of course, having a solid distribution network and extending
that geographically wont help if products and pricing arent
QHWXQHGWRWKHPDUNHWDQGLIUPVKROGEDFNRQWDOHQW
'RQRWVHQG\RXUVHFRQGWLHUSHRSOH6HQGWKRVHZKR\RX
expect to lead the company in the future, says Charles Ellis,
CFA, a consultant to large institutional investors, governPHQWRUJDQL]DWLRQVDQGZHDOWK\IDPLOLHVZKRKDVDGYLVHG
companies around the world on their strategies. The reason
youre successful in your home market is thats where your
top-tier people are committed. If you want to be successful in a new market where nobody knows you, you have to
send your very best people.
They may be considerably younger, Ellis continues.
They may not have the fancy titles. But you know inside
\RXURZQRUJDQL]DWLRQZKRDUHWKHSHRSOHLQWKHLUHDUO\
RUPLGVZKRDUHVXUHWREHOHDGHUVRIWKHUPLQWKH
future. These are people who have a tremendous amount
of energy, lots of capability, and they really, really want to
SURYHWKH\UHWHUULF
Young Lee, CFA, general counsel and a senior managing
director at MacKay, also sees talent as a make-or-break part
of a new business in a new location abroad. When recruiting talent, companies should look for CFA charterholders or

GOOD JUDGMENT
With an ambitious team backed by the leadership at home
and working on a strategy tailored for individual markets,
an asset manager should have a strong basis for international expansion, but its reputation could still be at risk.
The way an investment manager implements an international expansion strategy is telling, according to Brett CornZHOO&)$DYLFHSUHVLGHQWDQG[HGLQFRPHLQYHVWPHQW
consultant for Callans Global Manager Research group who
DQDO\]HV[HGLQFRPHPDQDJHUVDQGDVVLVWVSODQVSRQVRUV
in searches for them.
,I,ZHUHHYDOXDWLQJDQDVVHWPDQDJHPHQWUPDQGWKH
UPZDVORRNLQJWRH[SDQGWKHSURGXFWOLQHRULWVEXVLness globally, I would want to know that the company has
checked all the boxes to make sure theyre setting themselves up to execute the strategy, he says. A failed expansion could raise questions for me about how the investment
manager is managing other aspects of its business. You dont
want to see an asset manager lose its ability to attract and
retain employees or make a misstep that could ultimately
UHHFWRQLWVLPDJH
Rhea Wessel is a freelance journalist based in Frankfurt.

May/June 2014 CFA Institute Magazine 33

THE ART
OF KNOWING
NOTHING
BRILLIANTLY
By Nathan Jaye, CFA

If you want to know how a successful quant


converts research into profitable strategies,
first, throw out the word know, says Cliff Asness,
founder of AQR Capital Management
Clifford Asness has gained a well-earned reputation as a Give us a view of the process.
master of applying academic research to real-world invest- If we see a new academic paper we havent
exploredit can be a small tweak to something
ment strategies, which is attested to by an array of presti- that weve been looking at for years or brand
JLRXVKRQRUVLQFOXGLQJPXOWLSOH*UDKDP 'RGGDZDUGV newwe try to replicate the results. Youd be
for articles published in the Financial Analysts Journal shocked (thankfully, I have no names to name)
as well as the James R. Vertin Award (periodically given how often its hard to get exactly the result the
academic got.
E\ &)$ ,QVWLWXWH WR UHFRJQL]H D ERG\ RI UHVHDUFK WKDW
If that happens, its often a sign that the result
KDV SDUWLFXODU VLJQLFDQFH IRU LQYHVWPHQW SURIHVVLRQ- is not what geeks like to call robust. Maybe it
als). As founder of AQR Capital Management, a quanti- ZRUNVXQGHUWKHYHU\VSHFLFFKRLFHVWKHDFDWDWLYHLQYHVWPHQWPDQDJHPHQWUPZLWKQHDUO\86 demic made, but if you make slightly different
choices, it doesnt hold up. We also worry a lot
billion in assets under management, he is also a lumi- more than many academics about things like
nary of the hedge fund world. In this interview, Asness transaction costs and capacity; could someone
discusses AQRs methods for converting research into run the strategy for an institutional investor of
practical innovation, the dangers of over-reliance on data, GHFHQWVL]H"
But lets assume it held up under replication,
the US$100,000 AQR Insight Award, and the mysterious that it seemed robust. Say an academic has
HIFDF\RIPRPHQWXPLQYHVWLQJ
written a paper on a way to choose US stocks,
for example. An obvious thing to dowhich is
sometimes done by the academic, sometimes
QRWLVWRJRRXWVLGHWKH86'RHVLWKROGXS
I dont think the process is super-formulaic. Its elsewhere?
A less obvious thing to dowhich weve
not take academic research, turn crank, produce result. We start out with a little bit of cyn- made our bread and butter on since the early
icism. We love academia. But it can produce a 1990sis to ask, Are there related investment
WRQRISDSHUVE\SHRSOHLQFHQWLYL]HGWRSURGXFH decisions? Maybe its which countries to be in,
papers. Not all research will pass the many tests even which bond markets, which currencies. An
of whether it can make money in the real world. DFDGHPLFPLJKWEHZULWLQJDERXWRQHVSHFLF

How do you convert great academic


research into innovation?

34 CFA Institute Magazine May/June 2014

Can you have too much academia?


If anything, Id like more rather than less. I like ideas that
get people thinking really hard, even if theyre early in
the food chain and closer to pure research. Some of this
UHVHDUFKPD\QRWDOZD\VOHDGWRSURWVLQWKHVKRUWWHUP
but were long-term greedy. I dont think were close to the
point where we have too many people doing pure academic
work. I do acknowledge that you could go too far, but I dont
think were close.

Cliff Asness

situation. We could transpose that and say, Well, if their


theory is right, that people do X when they see Y, then this
is what we should see in a currency market.

Whats the next step?


If it holds up in many of these ways, we start to believe
theyre on to something. These are usually what are called
out-of-sample tests. Ive been joking for years that statisticians dont dream about cars or the opposite sex; they
dream about out-of-sample tests. As a quantitative manager,
our enemyand probably the enemy of many qualitative
managers DVZHOOLVEHLQJDSULVRQHURIWKHSDVWDQGQGing odd relationships that have worked in the past because
your computers and databases are big. Theyve worked for
no reasonjust for randomness. Were pretty hard-nosed
about requiring an economic story as to why something
works. I cannot think of anything we trade where we say,
We have no idea why this works. Its just phenomenal.
7KLQJVKDYHWRWLQWRDQHFRQRPLFIUDPHZRUN

Youve written that a three- to five-year data horizon for


decision making is suboptimal. Why is that?
We rely on data almost as a crutch. Theory and economic
intuition should play a bigger role. Im not saying dont look
at data. I would never invest in something without at least
taking a look at how its behaved over time. But Im calling
for less of a pure reliance on data.
The data that the industry largely focuses on are probDEO\ WKH ZRUVW GDWD WR UHO\ RQWKLV WKUHH WR YH\HDU
periodbecause I believe most things act contrarian at
WKUHHWRYH\HDUV
If you sort all the managers (or asset classes or styles)
LQWKHZRUOGE\WKUHHWRYH\HDUUHWXUQV,WKLQN\RXZLOO
get a mild tendency to pick the wrong ones (by picking the
ZLQQHUVLQWKHWKUHHWRYH\HDUWHUP 3HRSOHRYHUUHO\
on data, and of all the data they over-rely on, I think they
over-rely the most on the data that lead to a mildly backward result.

Why is thinking in terms of equilibrium concepts


underused?

Equilibrium is a very general term in economics. Its simply


a constraint; we know that everything has to add up. Why
people dont use this more, I dont know. Its often forgotten. Sometimes I think people just dont like the answers
they get. One of the constraints is that if you add us all up,
Does AQR have dedicated people looking out for
there is no beating the market. For everyone who beats the
academic papers?
,WVLQRXU'1$8OWLPDWHO\ZHUHDQDSSOLHGVKRSEXWRXU market, somebody loses to the market.
By the way, saying all our active positions add up to
researchers are naturally plugged into academia. Part of
the reason we still write papers is to be really plugged in. ]HURGRHVQWPHDQWKDWDQLQGLYLGXDOPDQDJHUGRHVQWKDYH
alpha. It just means we have to take [alpha] from someone
Participating is the best way.
We started something a number of years ago called the else. Thats an equilibrium constraint for me. The notion
AQR Insight Award. That was a bit of giveback to an indus- of it bothers many people.
There are so many places where you can step back
try thats been kind to us, but we also admittedly had a bit of
DVHOVKSXUSRVHWRVWD\DVFORVHDVZHFDQWRWKHSDSHUV and say, If I added all these up, what has to be the total
Theyre not nonpublic papers. Were not seeing things other answer? I think people dont even bother with that. So you
people dont see. But to get close to the authors, hear it from end up with silly comments like Cash moved off the sidethe authors own mouths, debate them ourselves, force our- lines today. That is a nice example of equilibrium thinking
selves to debate themall are very positive for us.

To what extent do you work with authors of papers?


Weve started consulting relationships with a few people
whove written papers that we really liked. We think highly of
our own research abilities, but were not so arrogant that we
think other people dont have insights, particularly the original creators. Its public when people write things, so its easy
for us to just test the idea; but often having that relationship
with the creator gives you just the extra insight you need.

FAILURE IS THE MOST UNDERRATED


THING IN THE WORLD. A FAILURE
IS SUCCESS IF WE LEARN WHAT
DOESNT WORK.

May/June 2014 CFA Institute Magazine 35

being violated. For everyone who moved off the sidelines


in a given day, somebody moved onto it, so nobody moved
off the sidelines in aggregate.

Do we simply have trouble seeing outside our own shoes?


Yeah, absolutely. A future paper of ours is very related to
this. Its tentatively titled Whos on the Other Side? It
means if you have a non-market tilt, or a tilt in your portfolio toward a certain risk factor, somebody has to have
the opposite tilt. To explain why you should win over time,
you have to explain why somebody else will lose over time.
The reasons can be all the classic reasons. Other people
systematically make certain mistakes and overprice certain stocks, the darlings of the market. They can be more
risk based. I will make money because the stocks I own are
riskier, and I get paid for that, and somebody else is happy
to earn less, because theyre taking less risk.
I like asking, Who is on the other side? Its a great
disciplinary process that you can apply to stock picking
and fundamental managers as well. I put it more bluntly
in meetings: Whose money are you taking? That phrase
can be a little misleading. Im one who believes this [prinFLSOH@PDNHVPDUNHWVPRUHHIFLHQWDQGSULFHVPRUHDFFXrate, so I dont mean taking money in the sense of harming
anyone. If youre making market-beating returns for whatever reason, Whos on the other side? is the equivalent
of saying, Whos paying you? Whos losing money so you
can make money?

That reminds me of The Art of War.

<HDKZHOODORWRISHRSOHFRQIXVHPHZLWK6XQ7]X

Whats more useful to an investor:


fearfulness or fearlessness?
Fearlessness, I think, is a disastrously bad idea. I think being
rationally fearful and coupling that with a resistance to panic
is not the same as being fearless. Being fearless can lead to
some very stupid things. For example, owning your single
favorite stock is fearless. Instead of a small edge (in that
case), an investor has a tiny edge with a giant amount of risk.
:KDWZHH[LVWWRGRLVPDNHDORWRIGLYHUVLHGVPDOOEHWV
not one big bet. Fearlessness can lead to taking too much
leverage in a portfolio that allows it. I like to think I exist in
a state of paranoid fearfulness as opposed to fearlessness.
:KDW\RXZDQWLVVWLFNWRLWQHVV$IWHU\RXYHDQDO\]HG
everything going on and still believe what youre doing is
right at a reasonable level of risk, thats stick-to-it-ness. Its
QRWIHDUIXOQHVV,WVEHLQJWHUULHGWKHZKROHZD\EXWGRLQJ
it anyway. That, I think, can be quite lucrative for clients and
IRUWKHUPLQTXHVWLRQ)HDUOHVVQHVV,GUXQIURPVFUHDPLQJ

Lets talk momentum as a strategy. Does it have further


to go (in terms of acceptance, use, evolution)?
7KLVLVGHQLWHO\RXU$45YLHZ,ZURWHP\GLVVHUWDWLRQRQ
momentum in the very early 1990s, so this is not a new
thing for me. I think momentum is as important as the
famous value strategy and more important than the famous
VPDOOFDSWLOWVWUDWHJ\,PGHQLQJLWLQWHUPVRIVWUDWHJLHV
36 CFA Institute Magazine May/June 2014

that have taken on very important roles in both the institutional and the mutual fund world. I believe momentum
should and will be as important as those two. And you can
trade momentum successfully in many other places besides
stock selection.

How much does the investment world agree with you?


I think theyre coming around, in large part because Im not
the only guy to write about it. Its all over academia. Almost
every academic paper that looks at returns will consider
returns in the context of the value, small-cap, and momentum effects. In academia, its almost taken on equal status
at this point.
We woke up one day about 15 years after my dissertation and said, Why do people have easy, reasonably priced,
GLYHUVLHGZD\VWRLQYHVWLQYDOXHDQGVPDOOFDSEXWQRW
PRPHQWXP":HFRXOGQWJXUHLWRXW:HUHQRWWKHRQO\
ones, but were certainly leading the charge to give investors alternatives, either as a standalone momentum investment or one of our own mixes of value and momentum.
Its one of these paradoxes in the market. If youre right,
how come this [change] hasnt happened already? If everyone thinks that way, it never happens. We think its a great
opportunity, and we think history will bear us out.

Why have momentum strategies been slower to grow?


Its my judgment DQGPRVWSHRSOHLQWKHHOGs judgment)
that behavioral stories are the dominant ones for momentum. Its very hard to come up with a non-behavioral story
for momentum. That may be why the growth in these strategies has been slower, though we view this as an opportunity.
Im a believer that value investing works for both behavLRUDODQGZKDWDUHRIWHQFDOOHGULVNEDVHGHIFLHQWPDUNHW
type reasons. Many value investors really focus on the
risk-based stories. For them, theres a natural, almost cognitive dissonance in adding a factor that is more reliant on
the behavioral stories. We start out closer to Fama. Our
UVWLQVWLQFWLVWRWKLQNLQWHUPVRIHIFLHQWPDUNHWV,WVLQ
some ways a cynical place to start versus the more popular
assumptions. Markets are simply hard to beat.
Now, we do think behavioral effects exist, meaning markets arent perfect. Thats more in the Shiller direction. I
think thats probably slowed the growth of momentum investLQJWRRXUEHQHW,PLJKWDGGEHFDXVHWKDWDOORZHGXV
to look up 15 years later after doing a whole lot of other
things and say, Nobodys introduced this [momentum] to
the market in a pure kind of form. Weve used momentum in our institutional and hedge fund products for a long
time, but Im speaking about products that focused solely on
momentum or momentum and valuethe simpler, cleaner
versions, the more transparent versions.
,P D EHOLHYHU WKDW ERWK HIFLHQW PDUNHWV ULVNEDVHG
stories and behavioral stories have some truth, but if you
EHOLHYHLQRQO\RQHRIWKRVHSDUWLFXODUO\WKHHIFLHQWPDUkets risk-based storiesits harder to get your mind around
momentum. Its very possible that [widespread belief in
HIFLHQWPDUNHWV@VORZHGWKHJURZWKMXVWHQRXJKWRJLYH
us this opportunity.

WE DONT ACTUALLY KNOW


ANYTHING. WE MAKE BETS THAT
ARE RIGHT A LITTLE BIT MORE
THAN 50% OF THE TIME, AND WE
CONGRATULATE OURSELVES ON
THAT TRACK RECORD LONG
TERM WHEN IT REALLY ADDS UP.

lead whats been going up to keep going up, at least for a


little while. The pure momentum strategy, again, gives
up trying to pick the turning points as it needs to see the
PRPHQWXPFKDQJHUVW

Youve said we havent done much to avoid


another financial crisis. What might be some steps
in the right direction?

Thats a great question. One-year price momentum is still


a nontrivial part of what we do. Sometimes I joke about
the simplest strategy on earth. You need two newspapers:
one from a few days ago and one from a year ago. Look at
whats been going up and whats been going down, and
overweight whats been going up, and underweight or short
whats been going down. Remember, we would never recommend doing this alone. We always think it works better
in concert with a value strategy.

,QWHOOHFWXDOO\,EHOLHYHOHWWLQJDOOWKHUPVIDLOZRXOGKDYH
worked out better, even in the crisis. Im not sure I would
have had the guts to let it happen in October 2008 either.
But I think we would have conquered too big to fail forever, and I dont think the US would have slid off into the
3DFLF2FHDQ
Letting people fail is not a very pro-banker policy. Its
not a very proWall Street policy. Capitalism needs to have
two sides. Failure is the most underrated thing in the world.
Knowing there are two sides and knowing that if youre on
the wrong side, that you have skin in the gameto borrow
a phrase Nassim Taleb has been using quite well lately
is just vital. I think we could have taken many steps, and
going forward can still take many steps, to make failure
more common and more acceptable. A failure is success if
we learn what doesnt work.

How do the two complement each other?

What would more failure look like?

Value works well over time, and these two strategies [momentum and value] are negatively correlated; they hedge each
other well. They both work over the long haul, but when
one fails, the other one tends to be having one of its better
SHULRGV0RUHJHQHUDOO\ZHEHOLHYHEHWWHUULVNGLYHUVLFDWLRQFDQLPSURYHDOPRVWDOOSRUWIROLRVDQGIHZGLYHUVLHUV
are as good as the combination of value and momentum.
Weve been working on how to make these measures
better. I will tell you the simplest ways still carry weight
with us. For instance, momentumnot just in price, but
in fundamentals, such as earnings, earnings surprise, and
HDUQLQJVUHYLVLRQVKDVEHHQVKRZQWRKDYHHIFDF\RYHU
time. Some investors, including us, have looked at momentum net of industry and other risk exposures as opposed to
the simple price momentum I told you before. There are all
kinds of ways to do it.

7KLVLVDQRYHUVLPSOLFDWLRQEXW\RXFDQVHHQDQFLDOFULVHV
as markets challenging the government, saying, Now that
its really bad, you certainly wont let us fail. If youve actually ever let someone fail, you have a lot more credibility,
and markets dont gain by challenging you in that way.
Its not a perfect prescription. I make no claim this is easy.
There will be countless eventsfrom monetary policy
WRVSHFLFEDQNLQJIDLOXUHVWRVSHFLFLQGXVWULDOIDLOXUHV
for government to demonstrate that it will, in fact, permit
failure and painful times to occur. Then, over time, I do
EHOLHYHPDUNHWVJHWWKHPHVVDJHDQGSHRSOHUHDOL]HWKH\
do have skin in the game. They dont challenge government quite as much.

What kind of data gives you a gauge on momentum?

Whats next for you and AQR?

I guess this would be a bad time to announce my retirement.


No, Im joking; I love what Im doing. AQR and I, I hope,
will have the same answer for a long time: We want to conHow do you know when momentum will turn?
:HOOUVWWKURZRXWWKHZRUGNQRZ:H dont actually tinue to innovate. I think weve been a force for good in the
know anything. We make bets that are right a little bit more industry toward fairer feescharging different amounts
than 50% of the time, and we congratulate ourselves on that for alpha versus market exposure versus strategies in the
middle. Being a force for good lines up with long-term greed.
track record long term when it really adds up.
A pure momentum strategy gives up ever trying to pick I think those go together quite nicely.
I have the pleasure of hiring people smarter than myself,
a turning point. Its just buying whats been going up and
selling whats been going down. It sells something it used so were surrounded by great intellect, and to grow the
to ownsomething that was a really big winner for a year. UPDORQJWKRVHOLQHV,PH[FLWHGDERXWLW<RXFDQODXJK
Now, its fallen enough that its no longer a big winner. It DWPHWKDWLWVRXQGVXII\EXW,YHJRWQRWKLQJHOVH,I,
GLGQWFDWFKWKDWE\GHQLWLRQEXWLWQGVRQFHLWVQRWDELJ KDGVRPHWKLQJPRUHVSHFLF,ZRXOGQWWHOO\RXEHFDXVH
it would be alpha.
winner, theres no reason to own it.
I know, historically, its been a good strategy, even while Nathan Jaye, CFA, is a member of CFA Society San Francisco.
not getting the turning points precisely right. I predict going
forward it will continue to be. I think basic human biases
May/June 2014 CFA Institute Magazine 37

AND

HOPE
UNCERTAINTY
Members of CFA Society Ukraine describe
changes in their lives and business

By Nathan Jaye, CFA

Recent events in Ukraine are world news, but how do they


affect the CFA Institute members who live and work there?
Three members of the 87-member CFA Society Ukraine
shared their experiences as well as their hopes and expectations. At the top of the list of
concerns are political instability,
capital controls, currency devaluation, and, of course, the tension
with Russia.

ON HOLD
Life in Ukraine is a waiting game.
Whether in business or personal
lifeor even the scheduling of
events at CFA Society Ukraine
political instability has put much
Andriy Klymchuk, CFA
on hold.
Earlier this year, CFA Society Ukraine was set to host
the 2014 Central and Eastern European Investment Conference in Kyiv [Kiev] in either October or November. That
meeting is now postponed. We were making plans, says
Andriy Klymchuk, CFA, founding president of CFA Society
Ukraine. It was going to be in Kyiv, but now unfortunately
not. We are ready to host the conference as soon as the sitXDWLRQVWDELOL]HVZLWK5XVVLD
Society members are hoping to work with the new UkraiQLDQJRYHUQPHQWLQUHEXLOGLQJWKHFRXQWU\VQDQFLDOV\VWHP
We are planning to work with the State Commission for
Regulation of Financial Services Markets and the [MinisWU\@RI(FRQRPLF'HYHORSPHQWDQG7UDGHWREDVLFDOO\EULQJ
the CFA Institute standards into the country, says Klymchuk. Those plans are still going forward, even in the face
of greater regional uncertainty.
Instability in Ukraine is affecting investment and business
as well. Klymchuk, who is CFO of modnaKasta, an online
retailer of discounted apparel, footwear, and home appliances
(with more than 2 million subscribers in Ukraine), says that
orders from the disputed region of Crimea have decreased.
In fact, the companys delivery service provider to Crimea
recently interrupted its service to the region altogether.
Clients are saying they need stability, political stability,
says Andrey Bespyatov, CFA, managing director of research
DWLQYHVWPHQWEDQN'UDJRQ&DSLWDOZKLFKLQYHVWVLQ8NUDLnian companies, some of which are listed on exchanges in
London, Warsaw, and Germany. Clients want to understand what is going on. What is happening with Crimea?
38 CFA Institute Magazine May/June 2014

How will our northern neighbor decide to act or not act?


*HRSROLWLFDOFRQFHUQVWKHFRQLFWZLWK5XVVLDDUHWKH
number one issue for our (mostly foreign) clients at this
VWDJH(FRQRPLFLVVXHVDQGWKHQDQFLDOPDUNHWVDUHDOVR
very important. Of course, sooner rather than later, theyll
want to see real reforms in the economy as well.
So far, existing clients are staying put, says Bespyatov,
who is also the current president of CFA Society Ukraine.
But new investment is on hold for the time being. Our comSDQ\ZLOOKDYHDFRQIHUHQFHIRUIRUHLJQFOLHQWVLQWKHUVW
weeks of April. I dont feel [that] clients have an uncontrolled fear about the situation in Ukraine. But theyre looking quite closely.
$QRWKHUPDMRULVVXHLVFXUUHQF\XFWXDWLRQ7KH8NUDLnian hryvnia dropped more than 20% compared with the
US dollar during the recent upheaval. So, our suppliers
are more cautious about inventory, says Klymchuk of modnaKasta. Theres a disincentive to sell inventory because
theyre expecting the currency to devalue even more in
WKHFRPLQJIXWXUH&XUUHQF\GHYDOXDWLRQDOVRVLJQLFDQWO\
impacts us [because] prices are going up as well. Our company is majority-owned by foreign investors, and they are
fortunately supporting us in all means possible. But of
course, they are cautious about investing.

CAPITAL CONTROLS
Instability in Ukraine has led the
new government to impose capital controls. I was going to buy a
house in the coming months, says
Klymchuk, but the banks have
IUR]HQ VRPH DFFRXQWV %DVLFDOO\
the only way to do business currently is to pay in cash.
Limits on withdrawing money
from deposits held in foreign currency stand at approximately
Andrey Bespyatov, CFA
US$1,400 a day, says Klymchuk.
We are able to leave our savings in US dollars and euros as
well as Ukrainian currency. There is no limit on local currency withdrawals, but foreign currency accounts are basiFDOO\IUR]HQDQGOLPLWHG7KHFHQWUDOEDQNKDVVDLG\RXDUH
not able to withdraw more than 1,000 or US$1,400 a day
in foreign currency. They are worried that people will take
all the money from the banking institution.
Some private banks with internal liquidity problems are

not able to give depositors even 1,000, says Klymchuk. In


my case, its an unnerving situation because you dont know
what will happen. I have personal exposure to a few banks;
RQHLVVLJQLFDQWH[SRVXUH,ZRUU\WKDW,PLJKWORVHDOOP\
savings. And of course, I should give up the idea of buying
a house for the time beingprobably for the yearbecause
the funds I would use to buy the house are in US dollars.
Additionally, Klymchuk says that one of modnaKastas
Ukrainian banks is not able to process payments in time,
even in local currency. For processing salary, they arent
sending the payments. Fortunately, our primary bank is
more stable.
Clearly, the country needs a lot of reform, says Bespyatov, but the general initial sentimentin the time after the
change of power in Kyiv and before the dispute with Russia
in Crimeawas very positive. I would compare the situation with what Ukraine went through 10 years agothe
so-called Orange Revolution, which foreign clients took very
positively. Then, the market doubled in just a few weeks.
In fact, Ukraines UX Index bolted 20% in late February
(when the new government took control), but pulled back
slightly more recently.
Ukraine didnt have the best track record 10 years ago,
admits Bespyatov, when promises were high but delivery was
below expectations. So, we need actions behind our words.
7KHQ,WKLQNZHOOGHQLWHO\VHHPRUHLQYHVWRUVFRPLQJLQ

RESEARCH CHALLENGE

Anna Reshetova

outcomes, explains Bespyatov. The problem for an analyst


is if you have too many variables, you cannot predict accurately. So, in such an unstable and vastly changing environment, accuracy of forecast is a major challenge.

NEW GOVERNMENT HOPES


Reshetova hopes the new authorities will provide more
awareness of the CFA designation and other professional
TXDOLFDWLRQV. She and others are waiting for reforms
WKDWFRXOGLPSURYHWKH8NUDLQLDQQDQFLDOPDUNHWVLQWKH
future. We are becoming a part of the history, she says.
Its our great hope and expectation to qualitatively change
WKHQDQFLDOPDUNHWLQ8NUDLQH
I think we could work with our authorities and become
D SDUW RI WKH EXLOGLQJ RI WKH QHZ QDQFLDO VWUXFWXUH RI
Ukraine, she continues. Its a challenging time for all the
Ukrainian people, but I hope its also a new stage of UkraiQLDQQDQFLDOPDUNHWVDQGKLVWRU\3HRSOHIHHOWKH\KDYHD
responsibility in making history.
On a personal level, its challenging psychologically,
says Bespyatov. Weve been living in this situation for the
last four months. But people are still coming to work and
life is going on because you have work to do.
Sometimes you hear its very dangerous in Kyiv and you
can be hurt and so on, he says. I would like to say that in
most casesexcept for a few streets in Kyiv during the most
tense period in JanuaryFebruaryit is normal for many
people to go to work and even to go for peaceful demonstrations. A lot of people I know were involved in helping
this political change in a peaceful manner.
Klymchuk reiterates that currency devaluation could be
a major challenge because this will bring caution to suppliers, so we would have limited sourcing of products for our
customers. Also, the overall buying power of people would
decrease, mostly because of the currency devaluation. It
could be the main problem.
Everything depends on the development with Russia,
VD\V.O\PFKXN,IWKHUHLVDQHVFDODWLRQLQFRQLFWDQGWKHUH
is warnot only in Crimea but also in the eastern or southern part of Ukrainethen that would be a huge challenge.
'HVSLWHWKHFKDOOHQJHVDQGXQFHUWDLQW\8NUDLQLDQVDUH
hopeful, says Klymchuk. I think over the last few months,
8NUDLQHDVDQDWLRQKDVUHJDLQHGFRQGHQFHDERXWZKDWZH
can do and how we can shape the future. Sooner or later,
8NUDLQHZLOOEHDEOHWRUHDOL]HLWVSRWHQWLDO

Anna Reshetova is administrative director of CFA Society


Ukraine and coordinator of the CFA Institute Research Challenge in Ukraine. Because of demonstrations in the capiWDOWKHORFDOQDORULJLQDOO\VHWIRU)HEUXDU\KDG
to be rescheduled. Because of the uncertainty and limited
public transportation in Kyiv, people from some cities were
afraid to come to Kyiv, adds Klymchuk. We had to postpone it one week because it was one of the most dramatic
weeks of this revolution.
,QDOOWHDPVFRPSHWHGLQWKHQDODOWKRXJKRIWKH
teams competed online via Skype. The two teams were
competing via Skype because they were affected by worries of military actions in Kyiv. They were from the eastern
and southern regions, so they were uncomfortable going to
Kyiv, says Reshetova, herself a winner of the 2011 Research
Challenge in Ukraine.
Even so, says Reshetova, conditions in Kyiv are relatively stable. Its not so dangerous in Kyiv now, she says.
Mostly, everybody is waiting for some political decision.
People want political and economic reforms from our government. Ukraine QHYHUIXOO\UHFRYHUHGIURPWKHQDQFLDO
crisis, and the latest instability has made conditions worse.
,WFDQEHDFKDOOHQJHWRQGSURSHUZRUNQRZEHFDXVH
we have such uncertainty, adds Reshetova. A number of
CFA society members are searching for a job. Still, the CFA
[charter] is very valuable in Ukraine. Its possible some who
are involved in investment banks and portfolio management
will move into real sector companies.
Actual investment research has become problematic
DVZHOO0\ELJJHVWFKDOOHQJHLVGLIFXOW\LQHVWLPDWLQJ Nathan Jaye, CFA, is a member of CFA Society San Francisco.

May/June 2014 CFA Institute Magazine 39

If inflation metrics are


wrong, mischief could be
brewing for markets
By John Rubino

Statistically speaking, 2013 was a


strange year indeed. The US reported
YHU\PRGHVWFRQVXPHUSULFHLQDWLRQRI
1.5%, whereas the European Union and
Japan came in even lower, at 0.86%
and 0.36%, respectively. But during
the same period, a painting by Francis
Bacon called Three Studies of Lucian
Freud sold for $142.4 million, the
highest price ever paid for a painting
at auction; a 59-carat diamond sold
for $83.2 million, the highest price
ever paid for a diamond at auction;
trophy real estate prices in Manhattan, London, Sydney, and many other
places soared past previous records; a
limited-edition batch of Kentucky sour
mash whiskey sold out at nearly $4,000
per bottle; and, of course, most developed-world equity markets marched
in lockstep to new highs.
The emergence of so many bubble-like niches
LQDQRVWHQVLEO\ORZLQDWLRQZRUOGLVFXULRXV
For instance, if the value of such major currencies as the dollar and euro is stable, why
were all these assets becoming so much more
pricey? That is, after all, the same thing as
VD\LQJWKDWZKHQYDOXHGLQQHDUWRU/RQGRQ
penthouses, the worlds major currencies were
actually plunging. Either those hot asset classes
were simply random bits of foam in a vast, othHUZLVHFDOPGLVLQDWLRQDU\VHDRUWKHJHQHUDOO\DFFHSWHGGHQLWLRQRILQDWLRQLVLQVRPH
IXQGDPHQWDOZD\DZHG
A growing number of analysts now opt for
the latter explanation, claiming that the mainVWUHDPWDNHRQLQDWLRQLVQRWRQO\ZURQJEXWLV
also blinding policymakers and money managers to the true, highly precarious state of todays
QDQFLDOPDUNHWV

40 CFA Institute Magazine May/June 2014

Illustration by Alex Nabaum

DOUBLE,
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WHAT IS INFLATION, REALLY?


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FIGURE 1

FIGURE 2

Central Bank Balance Sheets (20092014)

US Total Debt (19952013)

(cumulative % change)

(US$ trillions)

350

70

300
250

European Central Bank


Federal Reserve
Bank of Japan

60
50

200

40

150

30

100

20

50

10

0
2009

2010

2011

2012

2013

2014

Source: Based on US Federal Reserve, Bank of Japan, and European Central Bank data.

1995

2000

2005

2010

Source: Based on US Federal Reserve data.

May/June 2014 CFA Institute Magazine 41

FIGURE 3

TABLE 1

Oil Priced in Gold, Euros, and US Dollars, 19502010

Real Estate Price Increases in Selected Markets

(base = 100)
Rank
1
2
3
4
5
6
7
8
9
10

6,000

US$ Oil Price


Gold Oil Price
Oil Price

5,000

4,000

3,000

2,000

1,000

Country
Dubai, UAE
China
Hong Kong
Taiwan
Indonesia
Turkey
Brazil
Colombia
Germany
United States

12-month change
28.50%
21.60%
16.10%
15.40%
13.50%
12.50%
11.90%
11.80%
11.20%
11.20%

0
1950

1960

1970

1980

1990

2000

2010

* Data for deutschmark used prior to the euros 2002 introduction


Source: Based on data from the US Federal Reserve, European Central Bank,
and London Bullion Market Association.

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42 CFA Institute Magazine May/June 2014

Note: 12-month change through third quarter 2013.


Source: Based on data from Knight Franks Global House Price Index.

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IT IS IMPLAUSIBLE THAT THE FED WINDING


DOWN SUCH AGGRESSIVE MONETARY
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ON GLOBAL MARKET LIQUIDITY.
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May/June 2014 CFA Institute Magazine 43

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John Rubino, a former financial analyst, is author of The Money Bubble.

Are US Inflation Numbers Fake?


In the early 1980s, John Williams was an economic consultant
who specialized in forecasting interest rates and economic
activity. I had models that forecast, say, retail sales and used
this to predict interest rates three or six months into the future,
he recalls.
But then his models stopped working. What happened was
that over time, the federal government made changes to the
reporting methodology of inflation. These changes had nothing
to do with the real world and actual experience of consumers or
investors. The Bureau of Labor Statistics, for instance, began
lowering the reported rate of inflation to account for improved
product quality (a practice called hedonic modeling). It also
assumed that consumers would substitute cheaper products
for those that went up in price and began giving less weight to
parts of the basket that were rising and more to those that were
stable or falling.
The net effect was to transform the consumer price index
(CPI) from a measure of what it costs to maintain a constant
standard of living to a measure of the cost of a declining
standard of living, says Williams. The changes got to be so
significant that [government statistics] became almost worthless for forecasting. So, I started a newsletter called Shadow
Government Statistics that would present key numbers the way
they had been calculated before these changes in methodology
and that were a lot closer to common experience than what the
government was reporting.
Since then, the gap between the official inflation rate and
Williamss corrected version has become a chasm (as shown in
the chart comparing official versus ShadowStats). The US reports inflation of around 1.5% per year right now, but if you look
at the changes theyve made in their methodologies compared
44 CFA Institute Magazine May/June 2014

Official vs. ShadowStats US Inflation Rate


15%

10%

5%

0%

Official CPI

ShadowStats
Alternative

-5%
1970

1980

1990

2000

2010

Source: Based on Shadow Government Statistics data.

with what was done in 1980, the CPI is being understated by


about 7 percentage points each year.
This change in methodology might by itself explain the inflation-measurement conundrum: Perhaps consumer prices do
indeed portray an inflationary worldwhen calculated correctly.
But the effects of this statistical sleight-of-hand go far beyond
perception. Among other things, an artificially lowered inflation
rate decreases the budget deficit on the backs of pensioners.
Had they not made those changes, the average Social Security
check would be double what it is today, says Williams.
And it adds yet another layer of complexity for money
managers and financial planners. Your job is, at a minimum, to
keep clients ahead of inflation, but if you only beat the reported
number, [your client] is not earning enough to keep up with the
cost of living as he experiences it, says Williams. Youre not
beating the actual rate of inflation.

EVENTS

STAY
CONNECTED

EDUCATION
E

to the people
and ideas shaping
the future of
the profession.

Robert C. Merton

ENVIRONMENTAL
MARKETS: A NEW
ASSET CLASS

...

CAREER SUCCESS:
Navigating the new
environment

...
work

23

Khalid Ghayur, CFA and Dwight D. Churchill, CFA

...

OUTREACH

Renew your CFA Institute and


CFA Society memberships at
www.cfainstitute.org/renew

Meeting the Global Challenge


of Funding Retirement

Richard L. Sandor
Nathan J. Clark
Murali Kanakasabai
Rafael L. Marques

NETWORKING

1
www.cfainstitute.org

CAREER
CODE OF ETHICS
AND STANDARDS OF
PROFESSIONAL CONDUCT

ETHICS AND STANDARDS


MARKET INTEGRITY AND ADVOCACY

Does Crowdfunding Pose a Threat to Investors?


By Kurt N. Schacht, JD, CFA

In the March/April 2014 issue of CFA risky and that they should not invest unless they can afford
Institute Magazine, CFA Institute capital to lose the entire investment. Additionally, investors may
PDUNHWVSROLF\GLUHFWRU0LU]KDGH0DQXHO cancel their investment commitments for any reason up
discussed crowdfunding developments in until 48 hours before the offering deadline and must reconthe United States and Europe, including UPWKHLULQYHVWPHQWFRPPLWPHQWVLQZULWLQJLIPDWHULDO
the potential impact on investor protec- changes are made to the offering. Issuers and intermediartion as well as on economic growth and ies are also subject to a range of disclosure requirements
and prohibitions (including those related to promotional
job creation.
In recent weeks, weve had an oppor- activities) aimed at preventing investor confusion and conWXQLW\ WR DQDO\]H WKHVH GHYHORSPHQWV LFWVRILQWHUHVW
more closely, particularly with the US
SEC hard at work crafting rules that will NEED FOR ADDITIONAL SAFEGUARDS
JUDQWVPDOODQGPHGLXPVL]HGHQWHUSULVHV 60(V IURP Although we support many aspects of the proposal, the
startups to more established businesseseasier access to investor protection problems with investing in venture cappublic equity capital.
ital startups are pervasive and, in certain cases, unresolvAnd although the US appears to be leading the way on a able. We have recommended additional provisions aimed
course to implement crowdfunding regulations, other coun- at alerting potential investors to the risks of investing in
tries are not far behind. Similar interest is brewing in Europe, such startups. For example, we suggested a quiet period
where the European Commission has issued a consultation between promotional activities of offerings that rely on difto assess whether rule making in Europe would be useful. fering exemptions to avoid investor confusion, additional
Among individual EU member states, Italy already has cre- disclosures by issuers related to the effect of market risk on
ated a framework for crowdfunding and the United Kingdom their businesses, and heightened prominence of the warnhas proposed allowing crowdfunding in equity securities. ings that issuers must provide in offering documents relatIn recognition of crowdfunding gaining global momen- ing to the risks of this type of investing.
WXPWKH,QWHUQDWLRQDO2UJDQL]DWLRQRI6HFXULWLHV&RPPLV7KH6(&KDVLQGLFDWHGDSSURYDORIDQDOUXOHLVRQD
sions (IOSCO) has issued a report providing a global over- short track; many expect completion of the rule-making
view of the crowdfunding industry and identifying current process before the middle of the year. The SECs Investor
investor protection issues as well as longer-term problems. Advisory Committee, of which CFA Institute is a member,
Although the crowdfunding market is still relatively small, has expressed similar deep concerns about investor protecWKH,26&2SDSHUQRWHVWKDWLWLVQHDUO\GRXEOLQJLQVL]HHDFK tions, but more importantly the appropriateness of these
year. That expansioncoupled with potential cross-border investments for small savers.
complexitiescarries the possibility that crowdfunding will
:HKDYHORQJDUJXHGWKDWVDFULFLQJLQYHVWRUSURWHFWLRQV
pose a growing set of investor protection risks in the future. in the capital markets isnt worth the purported economic
However, proponents of crowdfunding have expressed EHQHWVRIDOORZLQJHPHUJLQJFRPSDQLHVUHODWLYHO\XQIHWconcern that things are moving too slowly, particularly in tered access to public capital. Nonetheless, crowdfunding is
the US, where the SEC took 18 months to issue a crowd- now law, and regulators are obliged to advance the formal
funding rule proposal. But lets not forget that when the rules. As this issue plays out in the US and globally, we will
Jumpstart Our Business Startups (JOBS) Act passed both continue to raise concerns about investor protection. Too
houses of Congress and earned President Obamas backing much is at stake; without proper safeguards, crowdfunding
in mid-2012, it happened with alarming speed. Investor pro- could become a breeding ground for fraud and claim victection advocates can take some solace in the fact that the tims of the most vulnerable segmentsthose saving and
SEC was very deliberate in its development and release of investing for retirement.
its crowdfunding proposal. And when
Kurt N. Schacht, JD, CFA, is managing director
WKH SURSRVDO ZDV QDOO\ UHOHDVHG LQ
of Standards and Financial Market Integrity at
KEEP GOING
CFA Institute.
October 2013, there was plenty for us
to comment on.
Follow the Market Integrity Insights
blog: http://blogs.cfainstitute.org/
A few of the positive elements include
marketintegrity/
the SECs proposal to require offering
Follow us on Twitter: @MarketIntegrity
documents to contain legends alerting
investors to the fact that investing is
46 CFA Institute Magazine May/June 2014

Reforming Preemption Rights in Asia


By Padma Venkat, CFA

Preemption rights allow shareowners to maintain their proportional ownership of a company without stock dilution
and are an important investor protection. But many Asian
companies seek approval for a shareowners mandate at
annual general meetings (AGMs) to issue shares without
these preemptive rights. Such mandates give management
the right to issue shares to handpicked investorsusually
at a discount to the market price.
The reasons for such mandates vary. One reason is to convert bondholder debt to equity, thus improving the capital
structure of the company. Other reasons include introducing a new strategic investor or a friendly investor. These
mandates expire annually, but fresh mandates can be sought
at the next AGM. The main concern for minority shareowners is that the cumulative effect of such multiple placements
FDQVLJQLFDQWO\GLOXWHWKHLULQWHUHVWV
Given that markets in Asia have such stark differences in
the complex regulations governing non-preemptive share
issues, CFA Institute set out to shed light on this important
issue and determine whether minority shareowners interests are being unduly diluted. The resulting report, Non-Preemptive Share Issues in Asia: Role of Regulation in Investor
Protection, aims to create greater awareness of the rights,
roles, and responsibilities of various stakeholdersincluding investors, regulators, company management, and board
members, as well as controlling and minority shareowners
ZLWKLQDQRUJDQL]DWLRQ

COMPARISON WITH THE UK MODEL?

POLICY RECOMMENDATIONS
To further enhance investor protection, CFA Institute recommends measures in three main areas: cumulative caps,
transparency and disclosure, and shareowner approval.
First, CFA Institute recommends a maximum limit over
a three-year rolling period implemented through regulations (i.e., stock exchange listing rules or the Companies
Act, which mandates a total cap over a three-year rolling
period). Second, in regard to transparency and disclosure,
CFA Institute stresses the importance of adequate disclosure
of placees and discount details of prior share issuance. Where
companies have placed shares based on general mandates
in the immediately preceding three years, we recommend
that management clearly disclose the number and percentage of shares issued in those earlier placings, the discount
at which the shares were issued, and details of the actual
placees (including criteria for selecting those placees) in
the proxy materials at the next AGM for shareowner information. Furthermore, there must be adequate disclosure of
how share-issuance proceeds are used. CFA Institute recommends that companies avoid generic reasoning, such
as future working capital or future investment opportunities. As a best practice, they should articulate clearly the
intended uses for the funds to be raised through the general mandates. For companies that have raised capital in
the immediately preceding three years through earlier mandates, we further recommend that the actual utilisation of
proceeds raised earlier be included in the proxy materials
at the next AGM for shareowner information.
Finally, shareowner approval is essential. CFA Institute
recommends that share mandates require more than a simple
majority approval; a three-fourths majority requirement
would provide more equitable protection of minority shareowners in most Asian markets. Our study of Hong Kong
showed that at a 75% approval level, 15% of the general
mandate requests would have been rejected in 2012, 17%
in 2011, 10% in 2010, and 14% in 2009.
All market participants and stakeholders have a role to
play in creating a stronger corporate governance framework in Asia. As a start, companies must be more transparent and provide detailed disclosures when they seek mandates to waive preemptive rights. Meanwhile, regulators in
Asia should consider tightening rules to better protect the
interests of minority shareowners. Investors should attend
AGMs, ask questions, and vote on resolutions. By making
their voices heard, investors ultimately can make a difference.

The reportpart of our continued effort to raise the bar on


corporate governance principles in Asia and to build trust
and transparency among the various stakeholders in Asias
capital marketsexamines regulations governing non-preemptive share issuance based on general mandates across
four jurisdictions in Asia: Hong Kong, Singapore, Malaysia,
and Thailand. The report then compares these market practices with UK preemption guidelines and highlights the differences between jurisdictions. This is important because
some of the Asian markets featured in the report derive
their regulatory framework from the UK system.
In addition to looking at the regulatory environment
in the four Asian markets, we looked at four years of data
from the Hong Kong market, which revealed that companies routinely resort to non-preemptive share issues without making adequate disclosure to minority shareowners
and that the ease and extent to which minority shareownHUVLQWHUHVWVFDQEHFRPHGLOXWHGLVIDLUO\VLJQLFDQW6KDU- Padma Venkat, CFA, is director of capital markets policy at CFA Institute.
eownersespecially minority shareownersgrant these mandates without
KEEP GOING
fully understanding the consequences
of their actions.
Non-Preemptive Share Issues in Asia:
http://cfa.is/1g7UpMX

May/June 2014 CFA Institute Magazine 47

ETHICS AND STANDARDS


MARKET INTEGRITY AND ADVOCACY

CFA Institute and the MiFID II Policy Debate


By Rhodri Preece, CFA

derivatives. These requirements go beyond MiFID I, which


applied transparency rules only to equity markets. There
are also more restrictive rules governing trade transparency in equity markets.
In particular, broker crossing systems (a type of dark
pool) that previously operated outside the regulatory perimeter will be brought into the MiFID framework. MiFID II
also limits dark pool trading according to a double volume
cap mechanism. Under this mechanism, trading volume
in a given stock on any venue operating under a pre-trade
transparency waiver (e.g., a dark pool) cannot exceed
4% of total volume on organised venues and total trading
under these waivers (across all venues) for a given stock
cannot exceed 8%.
CFA Institute has published research on market structure
issues and dark pools and met with European Commission
RIFLDOVDQGSROLF\PDNHUV,QRXUSDSHU7KH6WUXFture, Regulation, and Transparency of European Equity
Markets under MiFID, we advocated leveling the playLQJHOGDPRQJWUDGLQJYHQXHVVRYHQXHVFRQGXFWLQJVLPilar types of business would be bound by the same rules.
The provision to bring broker crossing systems under the
MiFID regulatory framework for trading venues is consistent with this principle.
,QDGGLWLRQRXUSDSHU'DUN3RROV,QWHUQDOL]Dtion, and Equity Market Quality reported that high levels
of dark trading can result in deterioration in market quality, although such systems also serve a useful purpose and
DUHQRWKDUPIXODWORZOHYHOV1H[WWRWKRVHQGLQJVWKH
double volume cap restrictions on dark pool trading seem
VRPHZKDWDUELWUDU\DQGXQQHFHVVDULO\UHVWULFWLYH2XUGDUN
pools paper also advocated for a price improvement requirement for dark transactions. Consistent with this recommendation, MiFID II requires reference price systems (i.e.,
dark pools passively matching orders based on prices established on exchanges) to provide price improvement at the
midpoint of the bidoffer spread. This requirement should
PRUHIDLUO\EDODQFHWKHEHQHWVRIRIIH[FKDQJHWUDGLQJZLWK
MARKET STRUCTURE
The market-structure aspects of MiFID II were a source of the opportunity costs and adverse selection risks facing disheated debate throughout the reform process, with banks played liquidity providers.
In the area of non-equity markets, MiFID II introduces
and exchanges taking opposite stances over rules for dark
pools and off-exchange trading practices. The rules include new pre- and post-trade price transparency requirements,
the establishment of a new category of trading venue for although much of the detail will be left to the European
WKHWUDGLQJRIERQGVGHULYDWLYHVVWUXFWXUHGQDQFHSURG- Securities and Markets Authority (ESMA), which must
ucts, and emission allowances called the organised trad- develop technical standards for implementation. CFA InstiLQJIDFLOLW\ 27) 7KH27)LVRVWHQVLEO\WKH(8VDQDORJXH tute published An Examination of Transparency in Euroto the US Swap Execution Facility under the DoddFrank SHDQ%RQG0DUNHWVLQZKLFKVXSSRUWHGWKHLQWURWall Street Reform and Consumer Protection Act. Pre- duction of post-trade transparency requirements in Europe,
and post-trade transparency requirements are also estab- noting that the information to be reportedand the timelished for trading in non-equity markets, such as bonds and liness with which that information is reportedshould

The political agreement reached in January over the revised Markets in Financial Instruments Directive (MiFID II)
the European Unions cornerstone piece
of securities market legislationmarks
the end of a lengthy and often tumultuous reform process. Almost two and
a half years in the making, the revised
GLUHFWLYHWRXFKHVDOOSDUWVRIWKHQDQcial markets, establishing new rules for
the structure of markets and the tradLQJRIQDQFLDOLQVWUXPHQWVDQGVHWWLQJ
higher conduct of business standards over the provision of
LQYHVWPHQWVHUYLFHV$VWKHOHJLVODWLRQLVQDOL]HGLWLVWLPH
to take stock of where CFA Institute stands on key aspects.
A central theme of the MiFID II reforms is increased
transparency. MiFID I focused on opening up markets to
greater competition, and MiFID II seeks to shine greater
light on business practices and bring more trading activities to transparent, organised trading venues. In doing so,
MiFID II seeks to directly address some of the shortcomings
UHYHDOHGE\WKHQDQFLDOFULVLVVXFKDVRSDFLW\LQGHULYDtives and other over-the-counter markets.
7KHOHJLVODWLRQDOVRWDNHVDFFRXQWRIQDQFLDOPDUNHW
developments since the original legislation was developed,
such as the rise in algorithmic and high-frequency trading, and contentiously prescribes rules designed to limit
WKHHIIHFWVRIVXFKDFWLYLWLHVRQQDQFLDOPDUNHWV2WKHU
aspects of the reforms include position limits in commodity markets to curb speculative activity and strengthened
LQYHVWRUSURWHFWLRQVWDQGDUGVGHVLJQHGWRWDFNOHFRQLFWV
RILQWHUHVWLQWKHSURYLVLRQRIQDQFLDODGYLFH$OPRVWQR
stone has been left unturned.
CFA Institute has been engaged in the MiFID policy process for the past three years. Here, we review our contributions to the key aspects of the debate.

48 CFA Institute Magazine May/June 2014

controls, algorithm testing, and harmonised circuit breakers or trading halts across exchangesrather than trying
to intervene in the trading process itself.
Consistent with this principle, we have advocated against
imposing minimum resting times or maximum order-totrade ratios; exchanges should be left to determine whether
RUGHUWRWUDGHUDWLRVVKRXOGEHUHVWULFWHGRUWD[HGWRUHHFW
bandwidth consumption, rather than being arbitrarily set
by regulators.
ESMA will be subsequently tasked with developing techCONSOLIDATED TAPE
CFA Institute has consistently called for the introduction nical rules over matters such as establishing consistent tick
RIDFRQVROLGDWHGWDSHLQ(XURSHZHUVWDGYRFDWHGIRU VL]HVDQGFLUFXLWEUHDNHUPHFKDQLVPVDVZHOODVLQFRUSRsuch a proposal in our 2009 report Market Microstruc- rating order-to-trade ratios when setting exchange pricture: The Impact of Fragmentation under the Markets in ing structures.
)LQDQFLDO,QVWUXPHQWV'LUHFWLYH7KDWSDSHUUHSRUWHGGHFLHQFLHVLQWUDGHUHSRUWLQJVWDQGDUGVVLQFH0L),'ZDVUVW INDUCEMENTS
implemented in 2007. The absence of a consolidated tape In response to a wave of mis-selling scandals in Europe,
has been keenly felt in Europe, given its fragmented equity 0L),',,UHYLVHVWKHUXOHVDURXQGLQGXFHPHQWVVXFKDVWKH
market structure, with orders and transactions dispersed payment of commissions associated with the sale of investover multiple trading venues. Consolidated trade data vir- PHQWSURGXFWVE\QDQFLDODGYLVHUV6SHFLFDOO\DGYLVHUV
tually links fragmented markets, improves transparency, operating under the independent label will be prohibited
lowers search and access costs, and facilitates the accom- from being remunerated via inducements in order to elimplishment and measurement of best execution.
LQDWHWKHSRWHQWLDOFRQLFWRILQWHUHVWEHWZHHQWKHDGYLVHU
0L),',,LQWURGXFHVFRPSUHKHQVLYHVWDQGDUGVRYHUGDWD (the agent) and the client (the principal). This developreporting, collection, and aggregation, thereby enabling ment follows actions already taken in the United Kingdom
the emergence of commercial consolidated tape providers and the Netherlands, where independent advisers must be
(CTPs). CFA Institute supported a commercially driven con- remunerated directly by the client instead of by the prodsolidated data solution but cautioned that regulators should uct manufacturer via a commission.
retain the ability to mandate a single consolidated tape utilAdvisers will also be required to meet minimum levels of
ity if commercial CTPs fail to meet investors needs.
professional knowledge and competency, for which ESMA
ZLOOEHUHTXLUHGWRGHYHORSJXLGHOLQHV7KLVLVDVLJQLFDQW
development that should raise standards of professionalALGORITHMIC AND HIGH-FREQUENCY TRADING
0L),',,LQFOXGHVQHZSURYLVLRQVRQDXWRPDWHGWUDGLQJ ism and integrity among investment advisers, a key invesincluding algorithmic and high-frequency trading (HFT). tor-protection mechanism.
CFA Institute recently published a report on inducements
Firms engaged in these activities will have to notify regulators with details of their trading strategies, conduct test- that examines the state of inducements in various markets
ing of algorithms, and establish controls to reduce the pro- around the world and considers possible reforms. Noting the
pensity for errant algorithms to propagate shocks through potential for unintended consequences from a full induceWKHQDQFLDOV\VWHP%URNHUGHDOHUVSURYLGLQJ+)7UPV ments ban and consumer aversion to paying upfront for
with direct electronic access to markets will also have to advice, CFA Institute has focused on reforming commisHVWDEOLVK FRQWUROV DQG SUHWUDGH OWHUV WR PLWLJDWH ULVNV sion structures, along with greater transparency over fees
exchanges will also have to put in place various procedures from all sources, rather than eliminating the commissionbased model completely.
to mitigate system stress.
With the legislation now agreed on, ESMA is tasked with
&RQWHQWLRXVO\0L),',,DOVRUHTXLUHVWKDWHOHFWURQLFWUDGLQJUPVSXUVXLQJDXWRPDWHGPDUNHWPDNLQJVWUDWHJLHVSUR- developing around 100 technical rules, a process that will
YLGHOLTXLGLW\RQDFRQWLQXRXVEDVLVIRUDVSHFLHGSURSRU- OLNHO\VWUHWFKIURP0D\WKURXJK'HFHPEHU$V
tion of time during trading hours. Given that todays markets RQHFKDSWHUFORVHVDQGDQRWKHUEHJLQVLQWKH0L),'VDJD
are critically dependent on the provision of HFT liquidity, CFA Institute will remain resolute in standing up for invescare must be taken to avoid excessively onerous measures tor interests in the regulatory reform process.
To review the CFA Institute research highlighted in this
that could hamper liquidity. At the same time, other invesWRUVFRXOGVWDQGWREHQHWIURPDUHGXFWLRQLQHHWLQJ article, please visit www.cfapubs.org/loi/ccb.
liquidity often associated with HFT activity.
Rhodri Preece, CFA, is head of capital markets policy for the Europe,
&)$,QVWLWXWHUHFRJQL]HVWKHZHLJKWRIDFDGHPLFHYLGHQFH Middle East, and Africa (EMEA) region at CFA Institute.
suggesting that HFT has a broadly positive effect on market
OLTXLGLW\HIFLHQF\DQGSULFHGLVFRYHU\$WWKHVDPHWLPH
absent adequate safeguards, automated trading can pose
V\VWHPLFULVNV:HKDYHWKHUHIRUHUHFRPPHQGHGWKDWUPV
and regulators focus on risk managementpre-trade risk
WDNHLQWRDFFRXQWOLTXLGLW\IDFWRUVVXFKDVWKHVL]HRIWKH
WUDGHUHODWLYHWRWKHVL]HRIWKHLVVXHDQGWKHOHYHORIUHFHQW
trading in that issue. In addition to calibrating the transparency framework, we recommended adopting a phasedin approach and consistent data reporting standards. We
FDXWLRQHGWKDWSUDFWLFDOGLIFXOWLHVPD\DULVHZKHQLPSOHmenting pre-trade transparency standards in a market in
which transactions are largely conducted over the counter.

May/June 2014 CFA Institute Magazine 49

ETHICS AND STANDARDS


MARKET INTEGRITY AND ADVOCACY

Notification Requirement for GIPS Compliance


Adoption of the Global Investment Performance Standards
(GIPS) has expanded to 37 countries since their introduction in 1999. Although the number of countries formally
endorsed as GIPS country sponsors is readily available, the
QXPEHURILQYHVWPHQWUPVWKDWFODLPFRPSOLDQFHZLWKWKH
*,36VWDQGDUGVLVPRUHGLIFXOWWRGHWHUPLQH,QGXVWU\VXUveys and consultant databases indicate that approximately
RILQYHVWPHQWUPVFODLPFRPSOLDQFHEXWWKHGDWD
DUHOLPLWHGE\SDUWLFLSDWLRQW\SHRIUPDQGJHRJUDSK\
As sponsor of the GIPS standards, CFA Institute is conVLVWHQWO\DVNHGWRSURYLGHUPFRPSOLDQFHVWDWLVWLFVZKHQ
engaging with regulators and conducting outreach with
WKHPHGLD:LWKRXWFRQFOXVLYHGDWDIURPLQYHVWPHQWUPV
claiming compliance with the GIPS standards, however,
CFA Institute can offer only estimates when responding to
requests for such information.
To remedy the situation, the GIPS Executive Committee
(the governing body for the GIPS standards) is seeking comPHQWVRQDSURSRVDOWKDWZRXOGUHTXLUHLQYHVWPHQWUPV
that claim compliance with the GIPS standards to submit
certain information to CFA Institute. The purpose of this
proposed requirement is to address the needs of stakeholders across the globe for more information related to GIPS
compliance. The ability to have a comprehensive understanding of the market allows us to better serve our stakeholders, says Jonathan Boersma, CFA, executive director
of the GIPS standards. We can identify segments of the
market that need attention and better communicate with
FRPSOLDQWUPVVRWKH\FDQVWD\DEUHDVWRIDQ\FKDQJHVRU
interpretations as they are issued.
5HTXLULQJUPVWRQRWLI\&)$,QVWLWXWHUHJDUGLQJWKHLU
claim of compliance with the GIPS standards would have
VHYHUDONH\EHQHWV
Information gathered through the process would help identify geographic and industry-segment trends in the adoption of the GIPS standards, markets or industry segments
that need more resources, and areas where more promoWLRQDOHIIRUWVVKRXOGEHIRFXVHG6SHFLFUPLQIRUPDWLRQ
JDWKHUHGZRXOGEHFRQGHQWLDOEXWVXPPDU\LQIRUPDtion and/or statistics collected may be made publicsuch
DVWKHQXPEHURIUPVFODLPLQJFRPSOLDQFHE\FRXQWU\
region, asset class, and/or product type.
The proposed process also would help obtain more accuUDWHHVWLPDWHVRIWKHQXPEHURILQYHVWPHQWUPVWKDWKDYH
EHHQYHULHGWKXVJLYLQJPRUHYDOLGLW\DQGFUHGLELOLW\WR
UPVFODLPLQJFRPSOLDQFHZLWKWKH*,36VWDQGDUGV9HULFDWLRQGHPRQVWUDWHVDQHYHQKLJKHUOHYHORIGLOLJHQFH
DPRQJWKRVHUPVFRPSO\LQJZLWKWKH*,36VWDQGDUGV
Having access to information about global investment
UPFRPSOLDQFHUDWHVZRXOGKHOSUHJXODWRUVDYRLGUXOHV
WKDWZRXOGFRQLFWZLWKWKH*,36VWDQGDUGVZKLFKDUH
50 CFA Institute Magazine May/June 2014

Status of GIPS Adoption


(As of April 2014)

Countries with GIPS Country Sponsors


Countries with interest in becoming GIPS Country Sponsors

JOREDOO\UHFRJQL]HGDVWKHJROGVWDQGDUGIRUUHSRUWLQJ
and presenting investment performance.
Providing the investment industry with statistics regarding
the uptake of the GIPS standards would potentially motiYDWHWKHUPVQRWFXUUHQWO\FODLPLQJFRPSOLDQFHWRGRVR
The anticipated effective date of the requirement is 1 January 2015. Firms will be required to submit their information via an online form by 31 March 2015, with data as of
'HFHPEHU
The GIPS Executive Committee is seeking public comment on this proposal until 1 July 2014 and would greatly
appreciate industry feedback.
Visit www.gipsstandards.org for more detailed information on the requirement or to provide feedback.

GIPS Standards Volunteer Opportunities


CFA Institute is seeking volunteers to serve on the GIPS
Executive Committee and GIPS Technical Committee.
The GIPS Executive Committee serves as the governing body of the Global Investment Performance Standards
(GIPS), a set of industry-wide ethical standards for calculating and presenting investment performance. The GIPS Executive Committee is responsible for the strategic development,
promotion, and implementation of the GIPS standards. The
GIPS Technical Committee is responsible for the technical
oversight of the GIPS standards.
We are looking for volunteers representing a broad
spectrum of geographical areas (countries and regions) and
industry and investor groups (plan sponsors, consultants,
investment managers, regulators, individual investors, verifiers, and performance measurers).
Please contact standards@cfainstitute.org to request a
GIPS nomination application.

Simplifying Private Company Accounting


Standards: Understanding the Costs
By Mohini Singh, ACA

When the International Accounting Standards Board (IASB)


SXEOLVKHG DQ LQWHUQDWLRQDO QDQFLDO UHSRUWLQJ VWDQGDUG
(IFRS) for small and medium-sized enterprises (SMEs) in
WKHUHJXODWLRQZDVDVLPSOLHGVWDQGDUGDLPHGDW
reducing the reporting requirements for SMEs. It emerged
in response to a common complaint expressed by SMEs:
that their time and resources could be better spent on activities other than complying with standards not relevant to
their business.
A similar movement is afoot in the United States to create
VHSDUDWHDQGVLPSOHUQDQFLDOUHSRUWLQJVWDQGDUGVIRUSULvate companies. In May 2012, the Financial Accounting Standards Board (FASB) established the Private Company Council
3&& WRGHWHUPLQHZKHWKHUH[FHSWLRQVRUPRGLFDWLRQVWR
existing US generally accepted accounting principles (GAAP)
are necessary for private companies. Private companies are
somewhat different, however, from SMEs: Neither private
companies nor SMEs have publicly traded securities, but
SULYDWHFRPSDQLHVPD\KROGDVVHWVLQDGXFLDU\FDSDFLW\

WHO BENEFITS?

*$$37KLVDVSHFWFRQIRXQGVWKHFRPSDUDELOLW\LVVXHDQG
leaves it up to investors to discern the differences.

ADDED COMPLEXITY
$GYRFDWHVRIDVLPSOLHGDSSURDFKKDYHFRQVLGHUHGRQO\WKH
FRVWRISURYLGLQJQDQFLDOLQIRUPDWLRQ1RWKDYLQJDFFHVV
to relevant information can be costly, however, for investors. For example, under the IFRS for SMEs, all intangibles
LQFOXGLQJJRRGZLOO DUHDVVXPHGWRKDYHQLWHOLYHVDQG
DUHDPRUWL]HG7KLVVWDQGDUGLVGLIIHUHQWIURPWKHUHJXODU
,)56XQGHUZKLFKJRRGZLOOLVWHVWHGIRULPSDLUPHQW7KH
accounting alternative for private companies would be simLODUWRWKH60(DSSURDFK:KDWWKHVHVRFDOOHGVLPSOLHG
approaches fail to consider is the loss of information for
investors. Goodwill write-offs, if done in a timely manner,
are of interest to investors in terms of the signal they send
about the value of the companys intangible assets, the companys future earnings prospects, and an assessment of the
amounts paid for acquisitions.

THE SITUATION FOR US INVESTORS WILL

:KRXOWLPDWHO\EHQHWVIURPVLPSOLFDWLRQ"7KHSULQFLSDO
DLPRIQDQFLDOVWDWHPHQWVLVWRSURYLGHLQIRUPDWLRQXVHIXO
ONLY DETERIORATE IF THE FASB EXTENDS
to investors in their capital allocation decisions. But the push
(AS IT IS CURRENTLY CONTEMPLATING)
IRUVLPSOHUVWDQGDUGVKDVQRWEHHQGULYHQE\LQYHVWRUV7KH
FDOOVIRUVLPSOLFDWLRQKDYHFRPHODUJHO\IURPWKHSUHSDUPRIVATE COMPANY SIMPLIFICATIONS TO
HUVRIQDQFLDOVWDWHPHQWVPDQDJHUVRI60(VRU86SULPUBLIC COMPANIES.
YDWHFRPSDQLHVDQGDXGLWRUV
7KHUHIRUHWKHLPSRUWDQWTXHVWLRQLVDVIROORZV:KDW
DUHWKHSRVVLEOHLPSOLFDWLRQVRIDVLPSOLHGDSSURDFKIRU
7KHFRPSOH[LWLHVLQ*$$3DULVHIURPDWWHPSWVWRWUXO\
WKHLQYHVWRUFRPPXQLW\WKHPDLQFRQVXPHUVRIQDQFLDO
capture the economics of the business and its transactions.
VWDWHPHQWV"
%\DSSO\LQJVLPSOLHGVWDQGDUGVWKHHFRQRPLFVRIWKHWUDQVactions are not likely to be captured in the same meaningful
LOSS OF COMPARABILITY
Investors need comparable information for different types of manner and will result in increased complexity for investors.
Furthermore, establishing separate standards for differFRPSDQLHVDQGDFURVVMXULVGLFWLRQV7RVXSSRUWWKHVHLQYHVWment activities, the IASB has a constitutional mandate to ent types of companies adds complexity and cost to other
develop a single set of high-quality global standards. Notwith- GLPHQVLRQVRIQDQFLDOUHSRUWLQJ)RUH[DPSOHGLIIHUHQWVHWV
standing this mandate, the IASB developed a second set of of accounting standards are more costly for standard setters
IFRS, essentially creating a two-tier system across the globe. to develop and maintain, educators to teach, and assurance
Similarly, the creation of standards for private compa- SURYLGHUVWRREWDLQSURFLHQF\LQIRUQDQFLDOUHSRUWLQJ
7KHVLWXDWLRQIRU86LQYHVWRUVZLOORQO\GHWHULRUDWHLIWKH
nies would result in the loss of comparability between the
QDQFLDOVWDWHPHQWVRISXEOLFDQGSULYDWHFRPSDQLHVZKLFK FASB extends (as it is currently contemplating) private comis vital to investors who invest in both types of companies. SDQ\VLPSOLFDWLRQVWRSXEOLFFRPSDQLHV,IVWDQGDUGVDUH
7KHLPSDFWZRXOGEHZRUVHIRU86LQYHVWRUV(QWHUSULVHVIRO- WREHPRGLHGIRUSXEOLFFRPSDQLHVWKH\VKRXOGEHEDVHG
ORZLQJ60(VWDQGDUGVFXUUHQWO\PXVWVWDWHWKDWWKHLUQDQ- on the need for relevant, useful information for investment
cial statements have been prepared in accordance with GHFLVLRQPDNLQJ7KH\VKRXOGQRWEHFKDQJHGMXVWWRVLPthe IFRS for SMEs. Private companies do not have a simi- plify reporting requirements, which may result in lowerODUPDQGDWHKHQFHWKHQDQFLDOVWDWHPHQWVRIERWKSXEOLF quality standards.
DQGSULYDWHFRPSDQLHVLQWKH8QLWHG6WDWHVGHVSLWHWKHGLI- Mohini Singh, ACA, is director of financial reporting policy at CFA Institute.
IHUHQFHVZRXOGVWLOOEHFRQVLGHUHGLQDFFRUGDQFHZLWK86
May/June 2014 CFA Institute Magazine 51

ETHICS AND STANDARDS


MARKET INTEGRITY AND ADVOCACY

The Future of Self-Regulatory Organizations


SROs STILL HAVE AN IMPORTANT ROLE TO PLAY IN FINANCIAL MARKETS
By Sherree DeCovny

8QSUHFHGHQWHGQHVDQGVDQFWLRQVKDYHEHHQOHYLHGDJDLQVW
ILQDQFLDO PDUNHW VHOIUHJXODWRU\ RUJDQL]DWLRQV 652V 
recently, but despite all its failings, self-regulation is still
much needed in todays markets, according to a recent report
by CFA Institute. Published in 2013, the report (Self-Regulation in the Securities Markets: Transitions and New Possibilities) also highlights three critical factors: what contributes
to a successful self-regulatory system, the characteristics
that reinforce the credibility of the system, and the strucWXUHVWKDWPHHWWKHGHQLWLRQRIVHOIUHJXODWRU\
SROs come in various forms, the report explains. Their
DXWKRULW\ PD\ EH UHFRJQL]HG LQ ODZ RU E\ WKH VWDWXWRU\
regulator in a jurisdiction. Some are membership-based
RUJDQL]DWLRQVWKDWDFWDVGHIDFWROHJDODXWKRULWLHVE\VHOI
policing and creating rules and policies for their members.
Others are informal or independent membership associations that serve advisory and educational roles for their
members and other market participants. SROs also can be
quasi-governmental entities that perform selected self-regulatory functions.
7KHVHRUJDQL]DWLRQVDUHPRUHHQWUHQFKHGLQ1RUWK$PHUica than anywhere else in the world. They are formally recRJQL]HGE\VWDWXWHRUUHJXODWLRQDQGDXWKRUL]HGWRHQJDJHLQ
UXOHPDNLQJDQGHQIRUFHPHQWWRGLVFLSOLQHPHPEHUUPV
and to conduct market surveillance. SROs in the US, such
as the Financial Industry Regulatory Authority (FINRA),
are overseen by the SEC and the National Futures Association (NFA), which oversees derivatives.
Canada has two SROs. The Investment Industry RegXODWRU\2UJDQL]DWLRQRI&DQDGD ,,52& RYHUVHHVLQYHVWment dealers and enforces the rules of stock exchanges.
7KH0XWXDO)XQG'HDOHUV$VVRFLDWLRQRI&DQDGD 0)'$ 
oversees the operations, standards of practice, and business
conduct of mutual fund dealers and operates in accordance
with the provincial securities commissions.
Self-regulation plays a minor role in Europe. The UK
recently moved away from self-regulation. In 2013, the UK
VSOLWQDQFLDORYHUVLJKWEHWZHHQWZRHQWLWLHVDGHYHORSment widely seen as a move away from self-regulation. The
Financial Conduct Authority (FCA) supervises behavior at
QDQFLDOLQVWLWXWLRQV7KH3UXGHQWLDO5HJXODWLRQ$XWKRUity, a subsidiary of the Bank of England, oversees banks
and insurers capital holdings, enforces compliance, and
monitors risk.
,QWKHHPHUJLQJPDUNHWV%UD]LODQG&RORPELDKDYH652V
Entities in China, Japan, the Philippines, Romania, ThaiODQGDQG7XUNH\FRQVLGHUWKHPVHOYHVWRKDYHVLJQLFDQWUHJulatory functions and responsibilities, but with the exception of the Philippines, such entities are SROs and industry
52 CFA Institute Magazine May/June 2014

DVVRFLDWLRQV7KLVNLQGRIGXDOUROHLVVLJQLFDQWEHFDXVH
as explained in the CFA Institute report, entities that also
serve as industry associations often perform advocacy and
other functions that tend to dilute their role as purer or
formal SROs.

INSIDE VIEW
Commenting on the CFA Institute report, Mary Schapiro,
former SEC chair and CEO of FINRA, explains her perspective on the importance of SROs.
First, she notes, the primary regulator can leverage SROs
to have much broader coverage of the industry. The examination process is a case in point. The SEC examines only
8%9% of investment advisers annually because there is
no SRO to handle that function. In contrast, FINRA examines about 50% of broker/dealers annually.
Second, the SECs budget is volatile and subject to politiFDOSUHVVXUHV7KHRUJDQL]DWLRQQHYHUNQRZVZKHWKHULWZLOO
be able to maintain its current level of funding from one
VFDO\HDUWRWKHQH[W$VDUHVXOWLQYHVWLQJLQWHFKQRORJ\
SURMHFWVWKDWKDYHDGXUDWLRQORQJHUWKDQRQHVFDO\HDULVD
challenge for the SEC. SROs have much more stable funding,
so they are in a better position to undertake such projects.
Third, when industry participants sit on the SRO board,
WKH RUJDQL]DWLRQ KDV DFFHVV WR D WUHPHQGRXV DPRXQW RI
operational expertise, which is useful in rule making and
enforcement. In contrast, industry participants are not represented directly on the Commission; their input comes
through meetings and comment letters instead.
6FKDSLURDOVRSRLQWVRXWWKDW652VKDYHPRUHH[LELOLW\
Sometimes SROs can respond to an issue more quickly than
the SEC because they dont have the Administrative Procedure Act and a number of other laws to constrain them
from acting quickly, she says.

THE CONTROVERSY
Critics of the system claim that SROs lack transparency and
EUHHGFRQLFWVRILQWHUHVW$OWKRXJKWKH\TXHVWLRQWKHIDLUQHVVRIDV\VWHPLQZKLFKQDQFLDOLQVWLWXWLRQVDUHDEOHWR
propose their own rules, the SEC must approve any rules
before they can take effect.
3HUKDSVEHFDXVHRILWVVL]HEUHDGWKYLVLELOLW\DQGWKH
funding level of executive salaries, FINRA has become a
focal point and lightning rod for many of the questions
raised about the SRO system in general, the CFA Institute
report states. In particular, it bears the brunt of criticism
pertaining to so-called private SROs.
US exchange SROs have also been a target for criticism.
([FKDQJHVXVHGWREHPHPEHURZQHGRUJDQL]DWLRQVDQG

they were granted legal immunity from paying damages


for losses arising from their negligence. Several years ago,
H[FKDQJH652VGHPXWXDOL]HGDQGEHFDPHIRUSURWHQWLties, and they handed over some of their regulatory responsibilityincluding market surveillanceto FINRA. However, the exchange SROs still propose new rules and submit
them to the SEC for review and approval.
'HVSLWHWKHLUFKDQJHLQVWDWXVH[FKDQJHVUHWDLQHGWKHLU
immunity. This issue has been hotly debated, especially in
light of the technology failure during the Facebook IPO (initial public offering).
In a recent speech, SEC Chairwoman Mary Jo White
stated that the special regulatory status of US exchanges
may not best serve investors or public companies. The current nature of exchange competition and the self-regulatory model should be fully evaluated in light of the evolving market structure and trading practices, she said.

FIXING WHATS BROKEN


6FUDSSLQJ WKH 652V LV QRW SUDFWLFDO RU HIFLHQW EHFDXVH
VSHFLDOL]HGH[SHUWLVHLVQHHGHGWRRYHUVHHFRPSOH[QDQcial markets, says the report. That said, SROs should seek
to address areas of weakness.
One way to address weakness is to avoid capture and conLFWVRILQWHUHVWE\DSSRLQWLQJLQGHSHQGHQWGLUHFWRUVDQG
arbitrators. FINRAs arbitration process has been under scrutiny because statistics indicate that the outcome is tipped in
favor of the SRO. To this end, FINRA has changed its arbitration selection process. It now provides all parties with
OLVWVRIFKDLUTXDOLHGSXEOLFDUELWUDWRUVSXEOLFDUELtrators, and 10 nonpublic arbitrators. The parties may strike
IRXUDUELWUDWRUVRIIWKHFKDLUTXDOLHGSXEOLFOLVWDQGIRXU
arbitrators off the public list. However, any party can select
an all-public arbitration panel by striking all of the arbitrators off the nonpublic list. Retail investors currently choose
the all-public panel in about two-thirds of cases.
Moreover, FINRA is supposedly seeking approval from
LWVERDUGWRSUHYHQWDQ\RQHZKRKDVEHHQDIOLDWHGZLWK
the securities industry, including former brokers or attorneys, from representing themselves as a public arbitrator. It
is also proposing to change its rules so that brokers accused
of wrongdoing cannot have their records expunged.
The report recommends increasing the transparency
RIQDQFLDOJRYHUQDQFHDQGUHJXODWRU\PDWWHUVDQGWKH
accountability of the governing bodies to both statutory regulators and investors. To its credit, FINRA recently implemented a new process to provide the SEC with full background information on its proposals.
Thats a step in the right direction, says Linda Rittenhouse, the author of the report and director of capital markets policy at CFA Institute. The primary oversight regulator needs to know the basis for a proposed rule change
so it can strike the right balance between innovation and
investor protection.
Finally, the report suggests that the membership and
governing structure of the Global Investment Performance
Standards (GIPS) provides a useful prototype for voluntary
self-regulation across borders. The GIPS standards may be

Cross-Border SROs
A few cross-border exchanges have been created recently,
including in Latin America, the eastern Caribbean, east Africa,
and the Balkans. Cross-border exchanges allow countries to
pool their resources and raise the aggregate level of capital in
the region. Many emerging markets lack the volume they need
to grow, and regional harmonization could provide them with
the strength they need to develop their markets more quickly
and efficiently.
A harmonized approach for SROs would readily lend itself
to including cross-border licensing, disciplinary actions, joint
examinations, and other licensing issues. By cooperating
across borders, SROs in the emerging markets could jointly
provide the services needed to fuel a developing market, benefiting all participating countries, the CFA Institute report notes.
Emerging markets are moving beyond what we think of
as SROs in their cross-border initiatives, Rittenhouse says.
On the other hand, there are many issues to be ironed out.
Part of the challenge is getting political cooperation among
the countries to enter into bilateral or multilateral contracts.
The political forces have to be amenable to the contractual arrangements that the regulators are making among
themselves, she explains. They have to allow innovation and
recognize that everything doesnt have to be approved at a
governmental level.

instructive for developing new forms of self-regulation in


WKHQDQFLDOPDUNHWV
The market has demanded that participants comply
with the GIPS standards, so they have become a de facto
standard, says Rittenhouse. Primary regulators havent
seen the need to create performance reporting standards
because the self-regulatory system through the GIPS standards is working so beautifully.
Schapiro adds a few recommendations of her own. She
says for the SRO process to work, it is necessary to have a
strong governmental regulator with the will and capacity
to oversee the SRO.
According to Schapiro, it is important to ensure a stable
revenue stream for the SRO that is not dependent on volXQWDU\SD\PHQWVWRWKHRUJDQL]DWLRQ9ROXQWDU\SD\PHQWV
can potentially encourage the SRO to curry favor with
those who pay the fees. Strong governance and independence help prevent any constituency from controlling the
decisions of the board. Finally, the staffs of SROs need to
have the tools and talent to do the jobs that the regulator
is relying on them to do.
Its a model thats not perfect, but Im not sure what
model is perfect, says Schapiro. Given the right institutions and procedures built around them, SROs can be a very
effective way to leverage scarce governmental resources to
do a better job for the public.
Sherree DeCovny is a freelance journalist specializing in finance and
technology.

May/June 2014 CFA Institute Magazine 53

ETHICS AND STANDARDS


MARKET INTEGRITY AND ADVOCACY

Why Fair Value Helps Investors and Markets


By Vincent Papa, CFA

The ongoing drive by European policymakers to stimulate long-term investment


DQGQDQFLDOLQQRYDWLRQDVDEDFNERQH
of Europes economic regeneration is
laudable. But one contentious issue highlighted by the 2013 European Commission Green Paper on long-term investing
in Europe is whether fair value accounting requirements have been leading to
short-termism by investors.
,QYHVWRUVQHHGWREHZHOOLQIRUPHGDERXWWKHQDQFLDO
KHDOWKSURVSHFWVDQGULVNSUROHRIFRPSDQLHVLQZKLFK
WKH\LQYHVW7KLVRYHUDOOQDQFLDOSUROHLVSULPDULO\FRPPXnicated through the reported annual and interim accounts.
Because fully transparent financial statements help to
VWUHQJWKHQLQYHVWRUFRQGHQFHQDQFLDOUHSRUWLQJLQIRUPDtion needs to be guided by effective accounting policies. It
is understandable why the accounting framework has been
a keen focus for European policymakers.
That being said, with the spotlight cast on the application of fair value, it is worth closely examining two claims
of its supposed negative consequences. First, it leads to
short-termism by investors, and second, it has pro-cyclical
effects. CFA Institutes position is that these two concerns
are overstated because they have not been adequately established by evidence.

the wrong tree when focusing on accounting information


as the basis of explaining or attempting to change investor
behaviors oriented toward the short term.

PRO-CYCLICAL DECISION MAKING

'XULQJHFRQRPLFERRPSHULRGVEDQNVWHQGWRJURZWKHLU
balance sheets and have excess leverage. In contrast, during
economic downturns and phases of credit contraction, banks
typically shrink their balance sheets to safeguard their solvency and capital adequacy. In other words, the bank business model is naturally pro-cyclical.
CFA Institute has long contended that fair value information coupled with historical cost information can lead
WRDEHWWHUXQGHUVWDQGLQJRIWKHSURVSHFWVDQGULVNSUROH
RIQDQFLDOLQVWLWXWLRQV,WLVRIWHQFODLPHGWKDWIDLUYDOXH
measurement exacerbates the natural pro-cyclicality of
banks. The argument goes that fair value measurement
requirements force write-downs of assets and this leads to
WKHHURVLRQRIFDSLWDOUHHFWHGRQWKHEDODQFHVKHHW%DQNV
are then forced to sell assets or raise fresh equity capital to
ensure capital adequacy.
But bank regulators in many jurisdictions have the option
WRDOORZEDQNVWRH[FOXGHXQUHDOL]HGIDLUYDOXHJDLQVRUORVVHV
IURPUHJXODWRU\FDSLWDO LHWRDSSO\SUXGHQWLDOOWHUV )RU
example, the European Banking Authority (EBA) applied
SUXGHQWLDOOWHUVWRH[FOXGHWKHJDLQVRUORVVHVRIVRYHUHLJQ
exposures on the bank balance sheets when it was determining the potential capital shortfalls of European banks. The
SHORT-TERMISM
Although we do not dispute that a spectrum exists of differ- erosion of capital cannot be blamed simply on the nature of
ent types of investment asset owners (pensions, insurance, accounting information. Recent academic evidence shows
activist funds, hedge funds, private equity) with differing that fair value information did not lead to capital erosion
LQYHVWPHQWREMHFWLYHVULVNWROHUDQFHDQGKROGLQJKRUL]RQV to the extent that many of its critics tend to claim.
the distinction between long term and short term as a basis
IRUGHWHUPLQLQJQDQFLDOUHSRUWLQJQHHGVIRULQYHVWRUVLV AN ESSENTIAL INGREDIENT
IUDXJKWZLWKYDULRXVGLIFXOWLHV
7KHJOREDOQDQFLDOFULVLVSUHVHQWHGDPRQXPHQWDORSSRUTo allow effective capital allocation, all investors have WXQLW\IRUUHHFWLRQRQDQGUHIRUPRIGHFLHQFLHVRIWKH
a common need for the most transparent information on FXUUHQWQDQFLDOUHSRUWLQJIUDPHZRUN7KHWRSPRVWSULinvestee companies. This type of information includes the ority of policymakers should be on enhancing the overall
fair value of assets and liabilities. Many investors who WUDQVSDUHQF\RIQDQFLDOUHSRUWLQJLQIRUPDWLRQ)DLUYDOXH
KDYHUHODWLYHO\VKRUWKROGLQJKRUL]RQVRIWHQYDOXHFRPSD- LQIRUPDWLRQLVDQHVVHQWLDOLQJUHGLHQWRIWUDQVSDUHQWQDQQLHVEDVHGRQGHWDLOHGUHDGLQJRIQDQFLDOVWDWHPHQWV HJ FLDOUHSRUWLQJLQIRUPDWLRQDQGLVEHQHFLDOIRULQYHVWRUV
0 $KHGJHIXQGLQYHVWRUV 6XFKLQYHVWRUVUHDGQDQFLDO
The interrelationship between accounting information
statements with as much interest as investors who have and behaviours of market participants is also an important
ORQJHUKROGLQJKRUL]RQV HJPDQDJHUVRISHQVLRQIXQG factor, but policymakers need to be cautious about critiassets). Furthermore, CFA Institute member surveys con- cisms of fair value measurement that tend to be aired withducted through the years have shown that investors of all out being backed by considered evidence.
types (long and short term) desire fair value information. Vincent Papa, CFA, is director of financial reporting policy at CFA Institute.
We are not aware of any evidence showing that increased
fair value reporting by investee companies shortens investor
KROGLQJKRUL]RQV+HQFHWKHUHLVDQHOHPHQWRIEDUNLQJXS
54 CFA Institute Magazine May/June 2014

ETHICS AND STANDARDS


PROFESSIONAL CONDUCT

Board Approves Revisions to


Rules of Procedure
Following a 30-day public comment period, the
CFA Institute Board of Governors approved revisions
to the Rules of Procedure for Professional Conduct
at its March 2014 meeting. With an effective date
of 1 May 2014, the 2014 Rules will apply to all
exam-related and industry-related matters opened
after 1 May 2014. For more detailed information,
search 2014 Rules at www.cfainstitute.org on the
CFA Institute website.

Educate and engage the Main Street investors you know.


Go to www.cfainstitute.org and click on the Future of
Finance icon to download a copy of the Statement of
Investor Rights today.

If you are aware of potential violations of the Code and


Standards by a member or candidate, we encourage you
to contact Professional_Conduct@cfainstitute.org.
Members seeking guidance in applying the Code and
Standards to their professional activities should contact
ethics@cfainstitute.org.

DISCIPLINARY NOTICES
SUMMARY SUSPENSIONS
On 5 December 2013, CFA Institute imposed a
Summary Suspension on Daniel Ka-Kuen Lam
(Hong Kong), an affiliate member, automatically
suspending his membership. Because he did
not request a review, the Summary Suspension
became a Revocation on 6 January 2014.
In July 2013, the Securities and Futures Commission (SFC) of Hong Kong revoked Lams securities license after finding that he masterminded
window-dressing activities at the firm where
he served as a responsible officer and managing
director. Specifically, firm funds were transferred
to a company wholly owned by Lam, leading to
a drop in his firms liquid capital to a level below
the amount it was required to maintain under the
SFCs Financial Resources Rules. At the end of the
month, before Lams firm submitted its financial
filings to the SFC, a similar amount of funds would
be returned to the firm either by Lams wholly
owned company or his relatives and friends. The
SFC found that the purpose of these repeated,
intentional, and fraudulent transfers was to inflate
artificially the firms liquid assets, which is in
violation of the SFCs Financial Resources Rules.
On 27 September 2013, CFA Institute imposed
a Summary Suspension on Kevin J. ORourke
(US), a charterholder member, automatically
suspending his membership and right to use the
CFA designation. The Summary Suspension was
affirmed by a Summary Suspension Hearing Panel
and became a Revocation on 19 February 2014.
ORourke served as the president, sole owner,
and principal of Western Pacific Capital Management (WPCM) and controlled the Lighthouse
Fund (Lighthouse), an unregistered investment
pool. On 19 September 2012, the US SEC entered
an Order barring ORourke from, among other
things, associating with any broker, dealer, or
investment adviser, with a right to reapply after
two years subject to the conditions specified
in the Order. The SEC found that ORourke (i)
solicited his clients to invest in an unregistered
stock offering by Ameranth without disclosing

that WPCM would earn a 10% success fee for the


capital it raised, (ii) solicited his clients to invest
in Lighthouse without disclosing that Lighthouse
would initially invest primarily in the Ameranth
offering (for which WPCM would receive a success
fee), (iii) misused Lighthouse assets by causing
Lighthouse to purchase a WPCM clients Ameranth
shares in settlement of a dispute, and (iv) repeatedly misrepresented Lighthouses liquidity to
investors. In addition to the industry bar, ORourke
and WPCM agreed to pay disgorgement of
US$482,745, prejudgment interest of US$169,195,
and a civil penalty of US$130,000.
TIMED SUSPENSION
Effective 4 February 2014, CFA Institute imposed
a Three-Year Suspension of membership and
the right to use the CFA designation on Joseph
Anthony Frohna (US), a charterholder member. A
Hearing Panel found that Frohna violated Standards I(A)Fundamental Responsibilities, II(B)
Misconduct, and V(A)Prohibition against Use of
Material Nonpublic Information of the CFA Institute
Code of Ethics and Standards of Professional
Conduct (1999). This result was subsequently
reviewed and affirmed by an Appeal Panel.
The Hearing Panel found that Frohna, a
portfolio manager, obtained and traded on material nonpublic information from his brother about
the failure of a critical bioequivalence study on
Raptiva, a drug being developed by XOMA and
Genentech. On 3 April 2002, Frohna telephoned
his brother, a physician with a PhD who led the
bioequivalence study, and learned that there were
problems with the study. Frohna understood that
this development would delay the US Food and
Drug Administration from approving Raptiva for
sale to the public. The next morning, on 4 April
2002, after providing inaccurate information to
his firm about his brothers role in the study and
receiving permission to trade, Frohna caused the
fund he managed to sell all of its 332,000 XOMA
shares. The price of XOMAs stock fell 42% that
day, and the fund Frohna managed avoided a loss
of US$954,776.

After the SEC conducted an investigation


into his conduct, Frohna agreed to a permanent injunction against future violations of the
anti-fraud provisions of the US securities laws,
a 12-month suspension from associating with
any investment adviser, and US$2,224,838.57 in
penalties, interest, and disgorgement.
PRIVATE REPRIMAND
Effective 27 December 2013, CFA Institute imposed
a Private Reprimand on a Charterholder Member.
A Hearing Panel found that the Member violated
Standards I(A)Knowledge of the Law, III(E)Preservation of Confidentiality, and IV(A)Loyalty of
the CFA Institute Code of Ethics and Standards of
Professional Conduct (2005).
The Panel found that the Member violated his
duty of loyalty to his employer by divulging the
firms confidential and proprietary client information during his employment at the firm, for purposes
other than to benefit his employer. The Member also
failed to protect and preserve the confidentiality
of personal and financial information entrusted to
his firm by its clients by copying and sharing that
private information with a future employer without
the clients prior knowledge or consent.
RESIGNATIONS
Effective 18 February 2014, Brian David Jorgenson
(US), a charterholder member, Permanently
Resigned his membership in CFA Institute and
in any member societies and his right to use the
CFA designation in the course of an investigation
of an industry-related matter by the Professional
Conduct Program.
Effective 21 October 2013, Stephen Campbell
(Canada), a charterholder member, Permanently
Resigned his membership in CFA Institute and
in any member societies and his right to use the
CFA designation in the course of an investigation
of an industry-related matter by the Professional
Conduct Program.

May/June 2014 CFA Institute Magazine 55

CHAPTER 10

Too Quiet at the Mall


The retail industry had a disappointing
six months. Bad weather in the eastern
half of the country is a partial excuse
and has the virtue of conformity to tradition, for retailers have blamed bad sales
on the weather since the invention of
weather. I dont think the weather excuse
works anymore. Consumer buying patterns have made a major shift. Instead
of driving to the mall, shoppers are
increasingly placing orders online over
their smartphones. This is not a brandnew development, but it is now a big
enough change to seriously impact conventional retail. More and more young
people center their social activities on
phone texting instead of meeting at the
mall. I expect this trend towards e-commerce to destroy many existing stores.
7KLVZLOOKDSSHQUVWWRWKHZHDNHUUHWDLO
franchises, such as JC Penney, Sears,
and Gap. You have seen this destruction happen already with categories like
recorded music, bookstores, movie theaters, and pay phones. You may not miss
the humble phone booth, but where is
Superman going to put his uniform on?
5HWDLO VDOHV JURZWK WUDFNV *'3
growth, up 4% in 2013. E-commerce
is picking up market share, from 2%
in 2003 to 6% now. E-commerce grew
16% in 2013. If 16% growth continues, that will be enough to increase
e-commerces share of total retail by
1% per year.
If the number of retail stores shrinks
as much as I am predicting, you dont
want to own shopping malls either.
What businesses will survive the
longest? Survivors are likely to include
grocery stores, drug stores, beauty parlors, gyms, massage spas, high-end jewelers, and automobile dealers.
One driver of the e-commerce revolution was the sales-tax exemption for
online retail. The exemption meant that
$PD]RQFRXOGFKDUJHOHVVWKDQWKH
now-defunct Borders bookstore chain
for the same cookbook. A state government cannot afford to lose a big hunk
56 CFA Institute Magazine May/June 2014

of its sales-tax revenue. Therefore, the


laws will be changed to collect sales
tax from online retail. This tax increase
might slow down the market shift away
from brick-and-mortar stores, but once
consumer behavior goes through a revolution, it does not go back. E-commerce
works because its labor costs are low.
The effect on employment will be
important. I expect that a couple of million jobs will disappear over the next 10
years, affecting a lot of young people
ZKRDUHDOUHDG\LQDGLIFXOWMREPDUNHW
By no means do I think that all this
is a welcome development. I grew up
in a family that was in the retail business, and the changes we are witnessing are painful to me. However, as we
have all discovered, the universe cares
little for our sentiments.
As a positive offset (for the US economy at least), faster logistics and smaller
inventories will create a need for making
VWXIILQWKH8QLWHG6WDWHV'RPHVWLFPDQufacturing jobs will get a positive boost.
So, conventional retail is in trouble.
The history of retail is one of continuous evolution. In 1910, department
stores, such as Gimbels, Marshall Field,
and May were a dramatic improvement
over little neighborhood shops. Then,
supermarkets, led by A&P, replaced
local grocery stores in the 1920s. By
1950, Sears Roebuck had become the

leading national retailer, with thousands of big stores with parking lots. In
the 1960s, discounters were invented,
with Walmart and Target becoming the
biggest survivors. Conventional retailers were collected into shopping malls
DQGGLGQH1RZWKHELJJHVWSOD\HULQ
UHWDLOLV$PD]RQ2QHPLJKWVD\WKDW
$PD]RQLVWKHFRPSXWHUL]HGYHUVLRQRI
the Sears mail-order catalog business.
'R\RXZDQWWRSXW\RXUPRQH\RQ
$PD]RQ"%HWWLQJRQWKHZLQQHULVXVXally correct. Top-line growth of 20%
is very high but less than the compaQ\V SDVW UHVXOWV RI  3URWPDUgin expansion ought to be doable too,
partly because AMZN is starting from
DEDVHLQ,QYH\HDUVRQH
can imagine a 4.0% margin or a doubling in sales, producing $12 earnings
per share. If you know of another large,
high-grade company that can have EPS
JURZWZHQW\IROGLQYH\HDUVSOHDVH
inform me at your earliest convenience.
%XWZKDWRIYDOXDWLRQ",I$PD]RQ
sold at 50 times earnings in 2018, its
stock would be at $600. As of 21 March,
AMZN was at $366. If it goes to $600
LQYH\HDUVWKHUHWXUQRQDEX\QRZ
ZLOOEHDQQXDOL]HG,IWKHVWRFN
continues to sell at 100 earnings, then
the return will be fantastically high. But
that would be a rare result, and there
are numerous risks. Growing revenues
at 20% and increasing margins at the
VDPHWLPHLVDGLIFXOWWKLQJWRGRDQG
governmental concern could impede
growth, beginning with the aforementioned application of sales tax. Growth
does slow down. Sears is now hoping for
survival, and Walmart is having revenue growth in low single digits, with a
P/E of 13. (I hate it when that happens.
WMT has been 14 years of boredom.)
6R WKH HIFLHQW PDUNHW VHHPV WR
have wrapped itself around AMZN like
DS\WKRQLQWKH$PD]RQ
Ralph Wanger, CFA, is a trustee of Columbia
Acorn Trust.

Illustration by Robert Meganck

By Ralph Wanger, CFA

TAKE A NEW LINE WITH YOUR


EQUITY
Financial Sector SPDR ETF
Top Ten Holdings*

XLF - FINANCIAL
1
2
3
4
5
6
7
8
9
10

Company Name

Symbol

Weight

JP Morgan Chase
Wells Fargo
Berkshire Hathaway B
Bank of America
Citigroup
American Express
American Intl Group
Goldman Sachs
US Bancorp
Metlife

JPM
WFC
BRK.b
BAC
C
AXP
AIG
GS
USB
MET

8.24%
8.15%
8.00%
6.22%
5.92%
3.13%
2.82%
2.80%
2.76%
2.26%

* Components and weightings as of 12/31/13.


Please see website for daily updates. Holdings subject to change.

Potential benets of adding Sector SPDR ETFs to your portfolio include:

Time For A
Stock Alternative

Undiluted exposure to a specic sector of the S&P 500


The all-day tradability of stocks
The diversication of mutual funds
Total transparency

Visit www.sectorspdrs.com

Liquidity

Consumer Discretionary - XLY

or call 1-866-SECTOR-ETF

Consumer Staples - XLP

Energy - XLE

Financial - XLF

Health Care - XLV

Industrial - XLI

Materials - XLB

Technology - XLK

Utilities - XLU

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 gures do not reect 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. Diversication 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.