CFA Magazine July Aug 2013

July/August 2013
The Member Magazine for Investment Professionals
The Great Disparity: Stock market vs The economy Replacing analysts with artificial intelligence? Cross-cultural challenges for investors
Northern Exposure
Should investors be early movers in North Africa?
Commodities
Currencies
Equities
Fixed Income
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July/August 2013
COVER STORY
30 Northern Exposure
30
As five markets in North Africa start over, is it time for investors to engage?
By Chris Wright
36 New Frontiers
Economist Dambisa Moyo believes many people are overlooking the most important developments shaping frontier markets
36
By Jonathan Barnes
40 Test Flights
Are investment applications of neuroscience ready to fly?
By Cynthia Harrington, CFA
44 Found in Translation
40
Nick French explains the crosscultural challenges of client relationships, the perils of naming investment products, and more
By Jonathan Barnes
Cover illustration
Robert Meganck
44
July/August 2013
CFA Institute News

6 In Focus Visible and Tangible Steps
By John Rogers, CFA
8 EMEA Voice Seeking Greater Value from Auditors

By Vincent Papa, CFA
9 APAC Focus Advancing Our Mission in China

By Paul Smith, CFA
6
In the light of these ethical lapses, the climate for asset managers has changed completely.
12 Financial Analysis at Jungle Speed
Viewpoint
15 Aftershocks
What drives the great disparity between the stock market and the economy?
By Nick Sargen
18 Board Governance and Risk

Investors have a role to play in improving risk management
By Mark Garbin, CFA, and Rick Funston
15
49
19 Letters
Professional Practice
20 European property investing for non-property investors 24 Will artificial intelligence replace analysts?
49
26 Applying better risk metrics for private wealth 28 Want to change track? Try the inside lane
Ethics and Standards

48 Market Integrity and Advocacy
Is the financial system safer today? Coordinating financial reporting globally GIPS Standards: not just for asset managers
53 Professional Conduct
55
Self-disclosure can help rebuild trust
in the industry
3 In Summary 55 Chapter 10
IN SUMMARY
The Time to Be Calm

Worry is a dividend paid to disaster before it is due. Ian Fleming, On Her Majestys Secret Service
James Bond is not a worrier. If he had never pursued a career as international super spy 007, his ability to face risk with coolness of nerve and clarity of mind might have made him a superb portfolio manager. It certainly makes him a formidable gambler. In fact, as depicted in Flemings novels, Bonds attitude toward money in general may offer lessons for investors. For one thing, he prefers to earn a return by putting capital at risk rather than receive wealth in the form of a guaranteed endowment. Too much money is the worst curse you can lay on anyones head, he says in rejecting an offer of financial security. The right amount of wealth, in his view, is not quite enough. Anything more can lead to decadence, excessive risk aversion, and distorted decision making, which may partly explain why emerging and frontier markets are poised for dynamic growth while their developed counterparts are prone to decline, according to economist Dambisa Moyo (New Frontiers, 36). Although Bond is a free-wheeling high-stakes player in certain respects, he also understands the importance of managing tail risk. Quicker than anyone else in the room, he sees that a notorious villains new scheme aims not at physical destruction but at financial devastation. If the plan succeeds, Bond explains to government ministers, our currencyll literally go through the floorand the country with it. A civil servant with his acumen might have been a valuable adviser for policymakers trying to mitigate systemic risk after the global financial crisis (Is the Financial System Safer Today? 48). What Bond seems to grasp intuitively is acceleration of risk, a concept that governing boards might do well to learn more about (Board Governance and Risk, 18). Five years on, the crisis still casts a pall of uncertainty over markets and investors in all sorts of ways. As investment strategist Nick Sargen notes, One of the conundrums for investors is to reconcile the 25% annualized return for U.S. equities since March 2009 with the 2% annualized growth of the economy (Aftershocks, 15). Beyond market dynamics, reputational damage to the investment industry remains a vexing problem. The recent CFA Institute annual conference renewed the call for investment professionals to explore the challenges facing the industry and examine ways to help shape the future of finance (In Focus, 6). Dorothy Kelly, CFA, points out that Self-disclosure is one way to help rebuild trust (Professional Conduct, 53). Continuing economic and market turbulence would suit an asset manager of Bonds temperament. Not only does he refuse to pay a dividend to potential disasters in the form of anxiety, but he concentrates even more intensely during actual moments of turmoil, when danger is momentarily
forgotten in the joy of speed, technique, and mastery. Likewise, investors who can keep their poise under pressure may find that profitable opportunities abound, from markets getting a new start in North Africa (Northern Exposure, 30) to European property investing (Portfolio Performance, 20). Perhaps because spies must be shrewd observers of behavior, 007 has a keen sense of behavioral finance, notably how framing effects can influence perception. For example, He always reckoned his private funds in Old Francs. It made him feel so rich. On the other hand, he made out his official expenses in New Francs because that made them look smaller. One way to avoid being misled by human foibles would be to eliminate them altogether and replace human analysis with machine learning (Aye, Robot, 24). Yet, with the pervasive use of quantitative techniques and artificial intelligence, investors increasingly find themselves confronting trading glitches and algorithmic errors that resemble errant animal behavior, as the fourth installment of our Biological Investor series reports (Test Flights, 40). If Bonds approach to his adventures could be summed up in one sentence, it would be: When the odds are hopeless, when all seems to be lost, then is the time to be calm (or, putting the same idea in technical terms, to address the incremental return requirement that stems from perceived future uncertaintyLetters, 19). He is a thrill seeker who avoids the pitfalls of fatalism. One self-destructive character tells him, I will always be able to beat you. You want to stay alive. This is a key difference. Bond doesnt have a death wish. Deciding whether to take desperate action in a scrape, he calculates the likely risk premiumWere the odds in any way within reason? They were notand waits for a better chance. Ultimately, prudence and patience lead to superior returns.
Roger Mitchell, Managing Editor (roger.mitchell@cfainstitute.org)
July/August 2013 CFA Institute Magazine 3
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July/August 2013 Vol. 24, No. 4
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As the finance industry continues to grow more globally interconnected, investors are increasingly seeking standards of investment performance measurement and reporting that are reliable and comparable across markets. The GIPS Standards Annual Conference is the only conference of its kind focused on the implementation and application of the Global Investment Performance (GIPS) standards. Subject experts share best practices and speak to the key issues and major developments in performance measurement, making this conference essential for any performance or compliance professional.
In conjunction with the GIPS Standards Annual Conference: The FUndAMenTAlS oF PerForMAnCe MeASUreMenT And ATTrIBUTIon
This hands-on event is led by performance and risk expert Carl Bacon, CIPM, and is ideal for beginners and experienced analysts alike.
GIPS STAndArdS InTerACTIve WorkShoP

This one-day workshop offers an in-depth overview of the GIPS standards and helps participants master the fundamentals, including composite construction, performance calculation, and creating a compliant presentation.
learn more about these special events: www.cfainstitute.org/events
CFA INSTITUTE NEWS

IN FOCUS
Visible and Tangible Steps

By John Rogers, CFA
Investment professionals from around the world converged in Singapore in May for the 66th CFA Institute Annual Conference, marking the first time our annual conference has taken place in the AsiaPacific region. Twenty-five years ago, a small group of charterholders in Singapore spotted an opportunity. They recognized that forming a CFA Institute member society could benefit the local finance industry and in turn be of service to Singapores social and economic progress.That society was our first in Asia, and CFA Singapore fast became a vibrant force. Today, there are more than 2,300 CFA Institute members who proudly claim Singapore as their home. As Singapore has grown and prospered, so has the Asia-Pacific region. We now count more than 18,500 members in the region, with 17 member societies. Demonstrating the sophistication and importance of the area, Asia Pacific provides our largest regional pool of candidates, with more than 95,000 individuals studying for the CFA exams. The goal of the conference in Singapore was to offer delegates the opportunity to explore the challenges facing the industry and examine ways to help shape the future of finance. More than 1,200 conference attendees spent three days sharing ideas, expanding their professional competence, and joining our efforts to restore trust in finance and raise standards in ethics, education, and professional excellence. The conference featured Tharman Shanmugaratnam, deputy prime minister and minister of finance in the Singapore Cabinet, as guest of honor. The conference included more than 35 scheduled presentations and panels with 48
Tharman Shanmugaratnam, deputy prime minister and finance minister in the Singapore Cabinet, was our guest of honor.
A conference delegate peruses the program literature for the new CFA Institute educational initiative, Claritas Investment Certificate, which was launched globally and celebrated on 20 May.
speakers, including Ng Kok Song, adviser and chair of global investments, Government of Singapore Investment Corporation; George Friedman, CEO and founder, Stratfor; Dambisa Moyo, international economist, author, and investment strategist; and Michael Woodford, former president and CEO, Olympus Corporation. At the conference, I spoke to the attendees about the importance of overhauling six critical areas of the financial industry to restore levels of trust to those of pre-financial crisis days. I defined the areas as putting investors first, financial knowledge, retirement security, transparency and fairness, regulation and enforcement, and safeguarding the system. These six topic areas are central to CFA Institutes Future of Finance project. (To watch the video of my opening speech and learn more about the Future of Finance initiative, see http://bcove.me/1wu2p5fi.) I firmly believe that these six topics are critical building blocks toward a financial system that can receive the trust and confidence of people everywhere. Without professionals like you to put these solutions into action, however, it just isnt possible to move the needle forward. The future of finance depends on all of us in the investment industry to actively engage and drive change specifically in these critical areas. Go back to your firms and your communities and address these issues. We can all help shape an investment industry that serves the greater good. Another exciting highlight of the conference was the global launch of the Claritas Investment Certificate. The
CFA Institute Board of Governor Aaron Low, CFA (left), presents the Thomas L. Hansberger Leadership in Global Investment Award to Ng Kok Song to honor his outstanding contribution to the investment industry through his work with integrating organizations and capital markets worldwide.
Nitin Mehta, CFA (left), managing director for Europe, Middle East and Africa at CFA Institute, takes the opportunity to network with conference delegates in Singapore. Michael Woodford, former president and CEO of Olympus Corporation, speaks to conference delegates about putting integrity into practice. He also held a signing of his book Exposure: Inside the Olympus Scandal: My Journey from CEO to Whistleblower.
development of this learning program came in response to the financial crisis as part of our call to action for industry participants to play their part in raising the level of knowledge among participants in the industry. This follows feedback from industry leaders, government regulators, academics, and investors that revealed a need for an accessible, foundation-level program that gives a clear understanding of the investment industry and the professional responsibilities within it. The Claritas program provides a thorough understanding of how the investment industry works, and represents a new international education and ethics standard across the financial services sector. Global registration for the Claritas Investment Certificate is now available on the CFA Institute website. The industrys enthusiasm for the Claritas certificate has been confirmed through a pilot program, which launched in January 2013. More than 3,300 candidates from 70 companies in 50 countries served as pilot participants. Feedback from pilot participants also supports the need for the pro gram: 84% of participating employers said they would recommend the program to other employees, and 85% of employees who took the course would recommend it to colleagues. John Bowman, CFA, managing director and co-lead of education for CFA Institute, confirmed the organizations commitment to establishing a new global education benchmark: We have an obligation to be a proactive voice in both restoring trust and raising investment acumen across the industry, said Bowman. The Claritas certificate is a visible and tangible step for any company that wants to demonstrate an institutional commitment to ethics, offering employees a strong opportunity to develop their skills and competence in the industry.
John Rogers, CFA, is president and CEO of CFA Institute.
Dambisa Moyo, international economist and best-selling author, speaks to conference delegates on frontier markets in Africa. She also held a signing for her most recent book Winner Take All: Chinas Race for Resources and What It Means for the World . For more, see interview with Moyo on page 36.
CFA INSTITUTE NEWS

EMEA VOICE
Investors Seek Greater Value from Auditors

By Vincent Papa, CFA
Although auditors cannot be blamed for the financial crisis, the issuance of unqualified audit opinions months before the collapse of Lehman Brothers and before states rescued or guaranteed more than 100 European banks has raised the question of how auditors can more effectively and visibly serve the interests of investors. Many investors are asking why auditors cannot provide better disclosures regarding the basis on which they make going-concern judgments (i.e., the assumption that the business will continue to operate for the foreseeable future without the threat of liquidation) because that is the basis on which financial statements are prepared. The need to ensure that auditors fulfill their public interest mandate and act in the interest of investors has underpinned a range of measures, including the European Commission (EC) audit reform proposals orchestrated through a consultative green paper and recently voted on by the representative parliamentary legal affairs committee (JURI). The reform focuses on such key matters as enhancement of the auditor report, limits on auditor tenure through mandatory rotation, and prohibition of non-audit services. These measures are aimed at enhancing the value, independence, and quality of audits as well as encouraging competition within the audit market. Greater competition is expected to foster innovation and mitigate the systemic risk associated with the possibility of one of the big four audit firms failing. Contributing to the debate on how audit firms can meet the needs of investors, CFA Institute recently moderated an event in Brussels that was hosted by EuroFinUse (the European Federation of Financial Services), an organisation dedicated to defending the rights of financial services users. The event elicited perspectives from audit firms and investor representatives regarding how investors could be served under the different pillars of the proposed EU reform. There was general consensus among the attendees regarding the need to foster better communication between auditors, audit committees, and investors. The focus of proposed reforms seemed to be shifting toward mandatory auditor retendering (as opposed to enforced rotation). But in April, the representative parliamentary legal affairs committee voted for the requirement of mandatory auditor rotation every 14 years, extendible in certain circumstances to a back-stop of 25 years. The Financial Times reported this requirement as being beneficial for the big audit firms largely because the rotation horizon is considerably longer than had been advocated by several stakeholders. One of the underlying assumptions of the EC audit reform
proposal for mandatory rotation is that the oligopolistic dominance of the big audit firms undermines overall auditor independence and ultimately adversely affects quality. This assumption is especially true in regards to blue chip company auditsthe big four audit 99% of the FTSE 100 banks and 31% of the FTSE 100 companies have had the same auditor for more than 20 years. The U.K. Competition Commission examined this assumption in a report, Statutory Audit Services for Large Companies Market Inquiry, which found that the lack of competition is likely to lead to higher prices, lower quality and less innovation for companies as well as a failure to meet the demands of shareholders and investors. But the report did not present any conclusive evidence that directly showed how auditor tenure affects audit quality. That being said, there appears to be a tendency for the audit reform debate to get caught up in the structural aspects of audit service provision (e.g., length and type of rotation for audit tenure) and not address the question of who should be paying for audit services. There is also a risk of not paying sufficient attention to the primary question of how to enhance audit quality. Audit quality includes the ability of auditors to detect misstatements and thereafter communicate any misstatements in a timely manner to investors. Audit quality also needs to incorporate auditors that provide greater assurance under the existing reporting framework, which is characterized by requirements for measurement under uncertainty (e.g., fair value for financial instruments), and a provision for forward-looking information (e.g., risk disclosures). Because of the audit-quality issues, CFA Institute has emphasized the pivotal nature of an enhanced auditor report, which is something our members have shown support for in a number of surveys. The current unqualified auditor report is an abbreviated pass/fail communication that conveys little insight about the basis of the auditor opinion. In a world where accounting shenanigans and corporate misreporting occur, it matters how well auditors act on behalf of investors and how they exercise professional skepticism, independence, and objectivity. Auditors need to step-up in regard to their ability to elicit evidence and test whether all the reported numbers truly reflect the economics of the business. There is also a need for auditors to include their views on critical accounting policies, risk, materiality, and assumptions underpinning the amounts recognized in the financial statements. If auditors can effectively fulfill these imperatives, while keeping in mind the interests of investors, there is likely to be less need for regulatory intervention.
Vincent Papa, CFA, is director of financial reporting policy (EMEA) at CFA Institute.
CFA INSTITUTE NEWS

APAC Focus
Advancing Our Mission in China

By Paul Smith, CFA
The first half of 2013 has been eventful for CFA Institute in China. In April, we launched our first-ever society in China. Led by founding president David Xie, CFA Society Beijing serves more than 900 members in and around the Chinese capital. The launch of CFA Society Beijing marks a significant milestone in CFA Institutes globalization. In 1995, only one candidate in all of China was enrolled in the CFA Program. By 2010, Shanghai was the worlds fourth-largest test center for our June exams and Beijing the fifth largest. In 2012, more than 30,000 people took the CFA exams in China. We expect that by FY2016, the number of registrations in China will surpass 37,000. Chinas fast-growing member and candidate base requires greater capacity to meet its continuing education and professional development needs. The country spans a land area nearly as big as that of the United States. In contrast, our U.S. members benefit from the presence of more than 60 societies that organize local continuing education and learning events. We have a long way to go in China to reach that level of penetration, but we have implemented initiatives to begin the process. In August, our China Investment Conference in Beijing will take stock of Chinese economic reforms. By the time you read this article, CFA Institutes first Chinese-language publication initiative by members in China will already be available. The publication will carry translations of select articles from CFA Institute Magazine, the Financial Analysts Journal, and other CFA Institute publications, as well as some original articles, and will reach all of our members and candidates in China. We hope the publication will not only satisfy the demand for reliable, practice-based, and indepth investment and financial content in China but also act as a springboard for great ideas and fresh viewpoints on how CFA Institute can advance our mission in the country.
about RMB36 trillion (US$5.8 trillionor 69% of GDP) by year-end 2012, according to JP Morgan. That number makes Chinas shadow banking industry larger than the combined annual GDP of France and the United Kingdom. Chinese regulators are increasingly concerned about this industry, which primarily involves trust company structures and wealth management products (WMPs). Shadow banking has resulted from capital allocation inefficiency, which constricts credit to small and mid-sized enterprises, forcing them to seek expensive financing from nonbank credit sources. This inefficiency also limits investment options for individual investors, leading them to speculate on property and high-yielding WMPs. Sold mainly by large banks, WMPs are repackaged bonds, equities, derivatives, and bank and trust loans. Regulators are worried that WMP investors are unaware of default and liquidity risks because the products are sold as safe investments similar to bank deposits. Because more than RMB14 trillion is invested in these products, WMPs represent a major potential systemic risk that Chinese regulators are currently struggling to manage. We have seen cracks in the system already. Last January, a WMP sold by a Shanghai-based bank collapsed, triggering protests from investors. (A guarantor later repaid investors principal.)
An Ethical Leader in the Industry

Against this background, the values of CFA charterholders are even more crucial. Commitment to education, international best practices (via our codes and standards), and ethics are vital for all market participants. Chinese regulators value the standards that CFA Institute espouses, and we must ensure that industry participants equally realize the value of employing our members. As a not-for-profit, independent organization, CFA Institute and its members are credible partners to regulators and industry players in promoting professional education and development, investor education, corporate governance, market integrity, and regulatory reforms. In our 2013 member survey, three-fourths of respondents in China said CFA Institute is seen as an ethical leader in the industry. This is our call to action. Some organizations focus only on the upside when entering the Chinese market. We have even more compelling reasons to increase our footprint in China during these challenging times.
Paul Smith, CFA, is the CFA Institute managing director for the AsiaPacific region.
A New Era
CFA Society Beijing and this new Chinese publication mark only the beginning of our deeper engagement in China as the country enters a new era, marked by a shift from an exportdriven economy to a consumption-led one, increasing global economic and political clout, and rising personal wealth. Chinas rapid growth is not without risk to global financial stability. In the past few months, we have seen warnings about the countrys fast-growing corporate and local government debt levels and a ballooning shadow banking industry. The latter is broadly estimated to have been worth
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CFA INSTITUTE NEWS
Financial Analysis at Jungle Speed

Wroclaw University team wins 7th CFA Institute Research Challenge
By Michele Armentrout
The CFA Institute Research Challenge wrapped up its seventh competition on 12 April in London with a new global champion: Wroclaw University of Economics. The five-member winning team from Poland included Jan Kasperowicz, Katarzyna Kowalczyk, Piotr Lembas, Kamil Saklaski, and Marta Szudzichowska, who served as the teams captain. Szudzichowska explained that in addition to extensive preparation for each challenge event, an important element of the teams winning strategy was their ability to handle stress. To relieve pressure and regain their focus, the team enjoyed playing a card game called Jungle Speed. In the The winning team from Wroclaw University of Economics celebrates their victory with the CFA Institute end, before our final presentation, only Research Challenge silver cup and individual awards: (from left) Kamil Saklaski, Katarzyna Kowalczyk, one thing really mattered: how to deal Marta Szudzichowska, Jan Kasperowicz, and Piotr Lembas. with the stress, said Szudzichowska. The card game really helped us cool off and enabled us to 11 April). The winners from each regional then advanced to the final competition on 12 April and included: go into the Q&A session with clear heads. As part of the research challenge competition, students Narsee Monjee Institute of Management Studies, worked in teams to write an initiation-of-coverage report representing the Indian Association of Investment on their assigned subject company. Some teams are then Professionals. invited to present and defend their buy, sell, or hold University of Nevada, Las Vegas, representing recommendation to a panel of industry experts. This is no CFA Society Nevada, CFA Society New Mexico, small task. Students spend hundreds of hours preparing for CFA Society Phoenix, and CFA Society Tucson. the competition while enrolled in full course loads (some Fordham University, representing the New York times at the graduate level), working, and managing other Society of Security Analysts. personal and professional commitments. Team member Kamil Saklaski learned many lessons Wroclaw University of Economics, representing CFA Society Poland. from the experience, especially when it came to collaboration. The research report that we had to prepare on KGHM The Wroclaw University of Economics team members forged Polska Mied z S.A. required different expertise, approaches, close personal relationships, and their ability to work well and ideas. Each of us improved our analytical skills while together proved extremely valuable under pressure. We working on each section, keeping in mind the whole struchave known one another for 3 yearsand were in the same ture and the character of our investment story. On the university study groupso we were very excited about other hand, we gained a lot of soft skills too, like teamtaking part in the research challenge because we were able work, time management, task planning, and a broad array to share tasks effectively, set deadlines that we could meet, of presentation skills. and had fun during meetings and discussions about crucial More than 3,500 students from more than 775 universities but complicated issues. Szudzichowska adds. participated in local competitions held in 55 countries this Saklaski says the entire experience boosted his self-conyear. Winners from each local-level competition, organized fidence and gave him more direction in where he might by volunteers at CFA Institute member societies, advanced to go after graduation. The research challenge gave us all a one of three regionals hosted by CFA Institute: Asia Pacific broader view of the financial industry, and by participating (held in Kuala Lumpur on 23 February), the Americas (held we feel it is a signal to our prospective employers that we in Toronto on 21 March), and EMEA (held in London on
Members Help to Build a More Trustworthy Financial Industry

Results from the CFA Institute Annual Disseminating transparent, accurate Member Survey are in and we think youll and timely information be interested in the key findings. For examCreating an ethical work culture that ple, did you know that members are helpallows constructive criticism ing to build a more trustworthy financial industry by creating an ethical work culture Helping clients focus on risk as much that allows constructive criticism; dissemias they do on performance nating transparent, accurate, and timely Bringing an ethical dimension to information; and helping clients focus on discussions of business strategy risks as much as on performance? The graphic to the right explains what memEncouraging colleagues and friends to commit bers are currently doing to help improve to a code of ethics and professional conduct trust and integrity in the industry as well as Actively disclosing all compensation what they plan to do in the future. arrangements to clients The Annual Member Survey was conducted from 12 March through 24 March Recommending companies with fair 2013. Of the 45,000 members invited to practices and good corporate governance participate in the survey, 6,550 responded Requiring training on ethical decision for an overall response rate of 15% and a making for yourself and your firm margin of error of 1.1%. To view additional results and find out Advocating for stronger regulations more about member needs, preferences, that protect investors and satisfaction with CFA Institute, Recommending adoption of the Asset please visit http://cfainstitute.org/about/ Manager Code within your firm research/surveys
72% 12% 71% 20% 67% 17% 59% 21% 51% 26% 44% 19% 41% 24% 31% 35% 25% 36% 15% 42% Plan to do (of those not currently doing) Currently doing
know the subject well, are hard-working people not afraid of team praised the judges for their challenging questions as difficult tasks, and have a great appetite for new challenges. well as other participants and competition administrators For team member Katarzyna Kowalczyk, winning the for creating such an enjoyable atmosphere. I really enjoy working with students, especially taking competition was not only thrilling but validating. She says that at each level of the competition it was both amaz- into account their enthusiasm and hard work, Jajuga says. ing and surprising to hear the name of our university as a My role as an industry mentor was to provide some practiwinning team. At times, she says, it was almost surreal. cal approach to equity research, sometimes provide direction When we stepped onto the stage to receive congratula- and good advice, and cross my fingers during the finals! Jajuga says he came to realize as the competition protions from CFA Institute President and CEO John Rogers, we couldnt help but feel that this cant be real. Winning gressed that the students were learning much more than they the CFA Institute Research Challenge proved to us that our knew at the time. In addition to their thorough analysis and ideas, analysis, and knowledge are valuable, Kowalczyk says. report preparation, these student analysts had to develop communication skills as well as a deep All five team members voiced their comprehension of company and indusdesire to encourage other students to try specificsit was absolutely necestake part in the CFA Institute Research sary for the team to deal with the Q&A Challenge. Although preparations sessions with industry leaders. require months of hard work, students The 20132014 competition season get an opportunity to prepare an extenkicked off on 15 May. If you have sive equity research report and presquestions about participating, please ent the results of analysis to a panel of e-mail researchchallenge@cfainstiindustry experts, draw on the expertute.org or visit www.cfainstitute.org/ tise of the industry mentor and faculty researchchallenge for news, photos, adviser, and exchange ideas with stuand developing details for the upcomdents from all over the world, Kowing competition season. alczyk adds. The team agreed that their success Michele Armentrout is a communications spewould not have been possible without cialist at CFA Institute and assistant editor of CFA Institute Magazine. the support of their faculty adviser Team Captain Marta Szudzichowska answers questions from the judges at the finals competition Tomasz So nski and industry mentor in London while teammates Katarzyna Kowalczyk Grzegorz Jajuga, CFA. Likewise, the and Jan Kasperowicz listen.
CFA INSTITUTE NEWS
Research Competition Helps Launch Career

By Rose Fry
The chair of the CFA Institute Nicol Rolando is living up to the Research Challenge in Italy and curpromise he showed as captain of rent chair of university outreach for the winning team for the 2011 CFA CFA Society Italy, Giuseppe Quarto Institute Research Challenge. di Palo, CFA, described the team. After less than two years as an I was immediately impressed. You equity analyst at Citi Research, he could see at first glance that they began overseeing coverage of his were incredibly disciplined. But first company, Piaggio, the same company the team analyzed during Nicol celebrates with his teammates after winning the Global more than that, they were also very Final in Omaha, Nebraska, in April 2011. From left to right are interested in what you had to say, the competition. Stefano Vigan, Anna Belli, Nicol Rolando, Francesca Claudio, and they applied what you advised. In December 2012, Rolando pub- and Giacomo Saibene. Team mentor Dal Santo also lished his first report as lead analyst on the stock, which resulted in the Bloomberg headline homed in on what may have brought them their competiPiaggio Rallies as Citi Upgrades to Buy, Sees Co. Back to tive edge: All five had one characteristic in commonthey Growth. With such enormous responsibility, Rolando takes were all able to go beyond their limits. But Rolando really shone during the competitions Q&A on his new assignment with a mixture of confidence and causession, during which a panel of highly distinguished industion. But he admits that he loves the intensity of the work. Such pressure must feel familiar to Rolando, given his try professionals probed students on their recommendation teams performance in the research challenge. That year, and asked them to defend their thesis. Dal Santo explained the Italian team bested competitors from more than 500 that Rolando was able to understand the judges most difficult question, to interpolate and get the answer where universities worldwide. Rolandos journey on this road to investments is somewhat others might have faltered. I believe that answer was key to the win, said Dal Santo. atypical for one so successful early in his career. Rather than Such a competition often demands more out of individmoving resolutely toward a fixed goal, Rolando was more interested in philosophy than finance or mathematics as an ual competitors than they believe themselves capable of, undergraduate. But during his graduate studies in management Dal Santo explains. Certainly, the participants must demengineering at Politecnico di Milano, he began considering onstrate skill and tenacity through several levels of compotential jobs that met one requirement: The job must help petition. But whats characteristic of captains is their dedhim satisfy his curiosity about the world and how it worked. ication, their leadership, their incredible capacity to learn, And still yet, at the start of the competition season in and their understanding of their own limitations and that 2010, he had no real idea what a job as an analyst entailed. mentors and teammates can help them overcome whatever lies in their way. Instead, he says, the job found him. And that, in the end, seems to be the goal of CFA Institute It started when he joined four other hard-working students to form the team that would take their equity research Research Challenge mentors, faculty advisers, local hosts, report all the way to the top. With two members studying judges, the companies being analyzed, and even the stuin Stockholm while the other three were in Milan, they dents themselves: to take raw talent and shape the promisworked primarily via Skype, except for one intensive ses- ing individuals into skilled professionals with tremendous sion in Switzerland during Christmas vacation. The team poise who will be able to contribute to their field. Quarto di Palo described Rolando as a great example cumulatively put hundreds of hours into the effort. The teams mentor at the time (and current CFA Soci- of how the CFA Institute Research Challenge can catapult ety Italy board member and scholarship chair), Andrea Dal a brilliant student to a successful career. Perhaps Rolando captured the essence of his own launch Santo, CFA, instilled in the team a winning mentality. He often used this phrase to inspire them: You are the win- best when he commented after the competition, It has been ners unless you are proven wrong. The course he charted a long and tough experience, but the result has been well for them was clear from day one: winning the global final. worth it. We have learned a lot and have also realized that Determined to do whatever it took to win, the team paid there is still much more to learn. He is currently scheduled to sit for Level I of the CFA attention to every detail. They even arrived in Omaha, Nebraska, the site of the final event, several days before the exam in June. last competition began because they wanted to be in good Rose Fry is a writer based in Richmond, Virginia. shape for the finals.
VIEWPOINT
Aftershocks
why are markets and investors still recovering from the financial crisis?
By Nick Sargen
September will mark the fifth anniversary of the worst financial crisis in the post-war era, one that has culminated in the most extensive overhaul of regulations affecting the financial system since the Great Depression. Along the way, the global economy has struggled to overcome subpar growth and inflation has fallen to record lows. Yet equities and other risk assets have rebounded to record highs. Consequently, many investors are perplexed by the dichotomy between the soft global economy and robust financial markets. To understand this dichotomy, the place to begin is examining the factors that made the crisis so severe and then assessing the progress U.S. households,
businesses, and financial institutions have made adjusting to it. The next consideration is whether the rally in risk assets is solidly based or likely to become another bubble. Finally, I conclude by drawing some practical lessons for investors.
What Made the Crisis So Severe?

Our starting point is to consider what occurred to produce the worst crisis since the Great Depression. The underlying causes are well known by now. The prevailing view, as reflected in the report of the Financial Crisis Inquiry Commission (published in February 2011), is the crisis was the culmination of a bubble in housing and a breakdown
in the process of securitizing mortgages. As the report states, it was the collapse of the housing bubblefueled by low interest rates, easy and available credit, scant regulation, and toxic mortgagesthat was the spark. Less understood are the key ele ments that left the financial system so vulnerable to a bust in housing. Unlike during the Great Depression, the financial system did not experience a large number of failures of small and midsized banks that collectively caused the money supply to contract. Rather, the problem arose from the failure, or near failure, of many of the largest investment banks and commercial banks. Today, these institutions are classified as
Illustration by Jesse Lefkowitz
VIEWPOINT
systemically important financial institutions, or SIFIs, and are commonly regarded as too big to fail. The institutions that became troubled had three common attributes. First, virtually all of them had a high percentage of toxic assets on their books. In an environment of low interest rates and narrow margins, these institutions were eager to provide securitized mortgages and other structured products that boosted fee incomes. While they off-loaded most of what they structured, they held on to some senior tranches, believing they were secure. Second, at the same time, these firms sought to boost overall profitability via excessive financial leverage. Investment banks increased debt levels to 3040 times equity capital with the tacit blessing of the U.S. SEC, and commercial banks created off-balance-sheet entities to increase leverage, with the Federal Reserve permitting them to do so. Other institutions that were part of the shadow banking system were also exposed to the housing sector but did not have access to central bank liquidity or FDIC guarantees. Third, the troubled institutions financed long-term holdings with very short-term borrowings. The trigger for disaster was the value of their assets plummeting when the housing bubble burst, and the impact was magnified by the need to de-lever their balance sheets quickly at fire-sale prices. The crisis became systemic in September 2008 when Lehman Brothers failed and investors began liquidating money-market funds. As financial institutions saw their funding sources dry up, banks no longer accepted counterparty risk and credit markets came to a standstill. Households and corporations, in turn, were forced to reduce their indebtedness, which sent the global economy into a severe contraction that culminated in world equity markets plummeting 45%50%. The U.S. authorities finally were able to stabilize financial markets in the spring of 2009. The Federal Reserves program to undertake large-scale purchases of mortgage-backed securities
helped to establish a floor for them. At the same time, the U.S. governments decision to use a portion of TARP proceeds to recapitalize the largest financial institutions lessened concerns about their solvency. Together, these actions helped restore confidence in the financial system.
Post-Crisis Adjustments
In the ensuing period, there was an extensive debate about how long it would take for economies to recover from the financial crisis. Initially, some U.S. forecasters maintained that the U.S. economy would mirror the V-shaped rebounds that were common in the postwar era. However, research by Carmen Reinhart and Kenneth Rogoff (This Time Is Different: A Panoramic View of Eight Centuries of Financial Crises, NBER working paper No. 13882, March 2008) found the retrenchment following a severe financial crisis often takes a decade, and the economic growth rate typically is a full percentage point below the long-term trend rate. Today, it is clear these warnings were very pertinent. Since recovery began in mid-2009, the U.S. economy has grown at only a 2% annualized rate well below the average for previous recoveries and the long-term trend rate of 3.5%. Consequently, if the U.S. follows the typical pattern after financial crises, it may be at the halfway mark. My own assessment, however, is more favorable, as I believe the economy is a year away from achieving 3% growth. The aggregate GDP statistics mask an improvement in private sector spending, which has been growing at a 3% pace for the past two years despite fiscal drag at the federal, state, and local levels. Overall government spending is now 3% below its end-2008 level and 7% below the 200910 level. Taking into account cutbacks in spending and expected revenue increases, the Congressional Budget Office is forecasting the federal budget deficit will shrink to 4% of GDP this year, down from a peak of 10% in 2009. In addition to these trends, there is growing evidence that balance sheets
of households, businesses, and financial institutions are improving steadily: Residential housing is on the road to recovery, as reflected in a pickup in housing starts, decline in inventories of unsold homes, and 10% price appreciation nationally over the past 12 months. This sector, along with autos, typically leads expansions and has wide-ranging effects on the economy. It is the single most important asset for homeowners and a key determinant of household net worth, which is now approaching its previous high in 2007. Moreover, thanks to record low interest rates, the household debt-service ratio is the lowest in four decades, which leaves consumers with more discretionary income. Corporate profits and balance sheets continue to improve. In addition to low interest rates, a key driver of the stock market rally since March 2009 has been the doubling in corporate profits from the lows reached in 2008. While topline growth has slowed recently, the majority of companies have continued to beat analysts estimates of corporate profits, as U.S. businesses have figured ways to make money in a moderate growth environment. With respect to credit markets, moreover, default rates remain near record lows and debt coverage ratios are solid, and companies are sitting on record cash holdings. Financial institutions are more willing to lend to businesses and individuals. Following a two-year hiatus in which bank lending contracted, U.S. banks have been growing their commercial and industrial loan book for the past two years but have been reluctant to increase real estate loans or commercial loans. However, the latest Federal Reserve report of banks lending standards indicates they are now relaxing their standards and are seeking to increase market share. If so, this could be a precursor of increased hiring and capital-expenditure spending by U.S. businesses. In sum, the key sectors of the U.S. economy have made significant headway adjusting to what has been characterized as a balance sheet recession. In this regard, the U.S. experience is very different from Japans lost decade in
the 1990s or Europe today, where there has been much slower progress.
The Great Disparity

One of the conundrums for investors is to reconcile the 25% annualized return for U.S. equities since March 2009 with the 2% annualized growth of the economy. These outsized returns have spawned a debate about whether the rally is justified by underlying fundamentals or is another asset bubble in the making. Skeptics believe the rally is mainly a liquidity-driven event in which the Feds ongoing purchases of U.S. Treasuries and agencies have induced investors to rebalance their portfolios into higher-risk assets. While some concede the rebound in corporate profits played a role initially, they point to the run-up of more than 30% in the stock market over the past year as evidence of a momentumdriven market. They also view corporate profitsat more than 10% of GDPas being unsustainably high.
depending on how the economy fares. If the Fed were to phase down its program later this year, market volatility likely would increase and the stock market could experience a pullback. But many of the factors that normally accompany bear markets (notably, stretched valuations, wage and price inflation, and over-investment) are not evident today. Therefore, any stock market setback most likely would be limited, especially if the Fed waits for the economy to strengthen before it alters policy.
Lessons for Investors

Finally, consider some of the main lessons investors have learned over the past five years. The most obvious is what has been an incredibly challenging environment for equity investors. Although the U.S. stock market has risen to a record high, the path has been a roller coaster ride: After falling by 45% in the six months through early March 2009, the market
Those schooled in the principles of modern portfolio theory and efficient markets must be wondering what guidelines, if any, there are for investing after an asset bubble has burst.
But these arguments fail to appreciate the ways U.S. companies have been able to take advantage of record low interest rates, moderate wage growth, and geographic diversification to boost their profit margins. Over the past five years, U.S. firms have adapted to a slow-growth environment by being cautious about hiring full-time workers and making new capital outlays. Consequently, should the economy gain traction, top-line revenue growth is likely to translate into stronger overall profit growth. One risk investors currently are assessing is the possibility the Federal Reserve could begin scaling back quantitative easing, possibly as early as September. Until recently, it appeared the Fed was in no hurry to do so with the unemployment rate well above the threshold of 6.5% and inflation well below the 2%2.5% target. More recently, however, Fed officials have indicated they are prepared to adjust quantitative easing rebounded by 75% over the next 12 months, then gyrated in risk on/risk off mode for two years, before surging in the past 12 months. Virtually no one could have anticipated these twists and turns, and over the past three years only one quarter of U.S. equity mutual funds beat their respective benchmarks. With the markets largely being driven by macro forces, conditions have been especially trying for portfolio managers who consider themselves to be stock pickers. Throughout this period, investors have had to adapt to an environment in which markets have been in disequilibrium. Those schooled in the principles of modern portfolio theory and efficient markets must be wondering what guidelines, if any, there are for investing after an asset bubble has burst. One of the most insightful articles is Jeremy Granthams piece Reinvesting When Terrified (published on his firm
GMOs website in March 2009), in which he discussed the need for investors to put cash to work well before there was evidence the market had reached bottom. He offered the following advice: There is only one cure for terminal paralysis: you absolutely must have a battle plan for reinvestment and stick to it. Since every action must overcome paralysis what I recommend is a few large steps, not many small ones. Remember that you will never catch the low. Granthams insights are particu larly prescient considering the article was written shortly before the market reached bottom in early March 2009. Unfortunately, most retail investors failed to heed this advice, and many have completely missed the markets recovery. From my perspective, the most difficult challenge is to peer inside the black box of the financial system and attempt to identify the extent of leverage, as this was a critical factor influencing the severity of the 2008 crisis. For this reason, it is now essential for investors to look at a broad array of market indicators that will provide clues about possible stresses and strains in the system. For example, the widening in credit spreads versus Treasuries was a good early warning signal leading up to the 2008 financial crisis, and their subsequent narrowing beginning in December 2008 preceded the recovery in equities and the U.S. economy. Furthermore, with the various regulatory bodies now assigning increased importance to systemic risk, the reports they produce on financial stability will become essential reading. Finally, investors were not alone in missing the financial crisis. Most economists also failed to anticipate the impact the decline in housing would have on the economy and financial system. While the economics profession is only beginning to do its soul searching, some prominent economists are pointing fingers at the failure of models to grasp the importance of the credit creation process. Hopefully, the economics profession will take up the challenge of understanding this process better, as it holds the key to assessing potential booms and busts in asset markets.
Nick Sargen is chief investment officer at Fort Washington Investment Advisors in Cincinnati. July/August 2013 CFA Institute Magazine 17
VIEWPOINT
Board Governance and Risk

Investors have a role to play in improving risk management
By Mark Garbin, CFA, and Rick Funston
To improve governance at public companies, professional investors should insist that risk management be a core competency at the board level. We cannot wait for government to solve the problem. Its time for investors to act. Section 407 of the SarbanesOxley Act (SOX) requires a public company to disclose that it has at least one financial expert on its boards audit committee or otherwise disclose why it does not. In January 2003, the U.S. SEC released final rules defining a financial expert. More recently, the DoddFrank Wall Street Reform and Consumer Protection Act directs the Federal Reserve to ensure that bank holding companies with more than US$10 billion in assets
Risk Occurrence
the board level needs to be a priority. Boards are not operators. They are fiduciaries. They work for the shareholders, and thus, a companys management works for them. Boards may delegate authorities, but they cannot relegate responsibilities. This principle holds for investment boards (e.g., mutual funds and pension funds) as well as corporate and foundation boards. Ultimately, the board shoulders the heavy load of overall accountability for results and understanding the risks incurred to achieve those results. Usually, governance comes under scrutiny only after a negative event occurs, when risks thought to be under control by someone or some group turn
Stress-Event Occurrence: Catastrophic Force
Stress-Event Occurrence: Gathering Storm
LIKELIHOOD
ACCELERATION
ACCELERATION
Source: Paul L. Walker, William G. Shenkir, and Thomas C. Barton, Enterprise Risk Management: Pulling It All Together (The Institute of Internal Auditors Research Foundation, 2002).
have a risk committee that includes at least one risk management expert. (Federal Reserve Board Regulation YY, soon to be implemented, will impose these requirements.) Why not extend the requirement beyond financial institutions? The growth of enterprise risk management programs among corporations signifies that risk is a process all companies must consider. Mutual fund companies are launching funds based on alternative investments, some of which entail a high degree of risk. Why shouldnt certain independent fund directors possess quantitative and risk expertise? Making risk management a core competency at
out not to be. Recently, in the mutual fund industry, the SEC has brought enforcement actions that revolve around valuation issues and risk disclosure. Fund managers must describe risks accurately and monitor the valuation implications, particularly when derivatives and structured securities are involved. In some cases, fund boards have been cited as deficient in their oversight duties. These instances arose from alleged failures stemming from Level 2 and Level 3 asset valuation procedures. Cases involving risk management for corporate boards have also surfaced. For example, the review committee for the board of directors at
JPMorgan Chase & Co. recently stated, The mandate of the Risk Policy Committee has historically not been as welldefined as the mandates of other committees of the Board of Directors. Such cases raise a basic question: Why wait for a triggering event to put risk experts on boards? Typically, boards focus on objective data provided by management. Data are only objective components of risk, and even data can be tortured to make a false confession. The current frameworkfor all boards, not only those of financial institutionslacks sub jective components. Three key questions should be considered: (1) Does the board have a risk committee to enhance its strategic focus? (2) How much relevant risk experience do its members have? (3) Do committee members understand the potential for risk acceleration, and do they possess the necessary skills to advance the boards collective understanding? Put simply, if we assume that a financial institutions board actually has a risk committee (soon to be mandated by Fed Regulation YY), are the committee members skills sufficiently germane to their task? Do they understand how risks accelerate to a materiality threshold and how to communicate those risks to the rest of the board in plain English so that board members can fulfill their fiduciary responsibilities? Acceleration of risk is an important concept for risk committee members. Understanding how low-level theoretical risks can turn into significant actual losses prompts several serious questions: First, are board committees composed of individuals who can ask the right questions? For example, regarding the JP Morgan London Whale case, did anyone on the board really understand how US$50 million in value at risk could become a multibillion-dollar loss? Second, what are
IMPACT
MASS
MASS
the tradeoffs between acceptance of risk and expected corporate profits? Finally, what are the nonfinancial risks, and what are the procedures for escalating information about such risks to the board level? We in the investment profession can and should go beyond the minimum and support best practices for risk management by boards. For example, when we vote proxies, evaluating risk and governance can be part of our review process. Corporations listen to institutional investors. Perhaps such investors and some companies could collaborate to outline basic corporate governance risk metrics at the strategic level. Those in the industry who work on behalf of individual investors also have a duty to
ensure that boards are examining risks and that board members have the necessary expertise to analyze and understand risk information. As asset managers and financial experts, we understand the concept of risk-adjusted returns. We know our objective is not minimizing risk but optimizing the riskreturn tradeoff. Whether the risks are a function of financial assets (such as the thickness of an institutions exposure in a given credit default swap index) or operational in nature (such as event-driven interruptions of a supply chain), a board has a fiduciary duty not only to ensure that appropriate risk policies are implemented and measured but also to ask questions and challenge assumptions.
In other words, a board should not simply accept company managements assurances that its all under control. For boards to function effectively, risk needs to be incorporated into all aspects of the board governance process, and boards need to consist of the right people asking the right questions.
Mark Garbin, CFA, is managing principal of Coherent Capital Management LLC and chairman of the valuation committee for Two Roads Shared Trust, a mutual fund series trust. Rick Funston is the founder and managing partner of Funston Advisory Services LLC, formerly national practice leader for governance and risk oversight services at Deloitte & Touche, and author of Surviving and Thriving in Uncertainty: Creating the Risk Intelligent Enterprise (John Wiley & Sons, 2010).
LETTERS
May the ERP Be with You

I enjoyed reading An Opening of Minds (March/April 2013) and appreciate Rob Arnotts views and his willingness to test conventional wisdom, particularly on the subject of the equity risk premium (ERP). But when I bumped into his methodological conclusion that ERP might reasonably have been characterized as negative during some time horizon, I thought Id step back for a moment, reflect on the implications, and offer an alternative perspective. Regardless of the method used to derive ERP in particular, the primary application of an equity risk premium in the analyst community is the estimation of the price of bearing ex-ante equity risk for the purposes of valuing equity securities. In some contexts, an ex-ante equity risk premium may manifest discretely and formulaically through models dovetailed with ERP, such as the capital asset pricing model or build-up. In other cases (venture capital or angel investing, for example), an initial ex-ante equity risk premium may not require any formula at all. The common thread among all types of equity investments, though, is that the concept of an equity risk premium is intended to address the incremental return requirement that stems from perceived future uncertainty (or relative volatility or probability of loss/shortfall) in the equity cash flow projection relative to some virtually risk-free alternative. In fact, defining ex-ante equity risk and its associated premium in this way would seem to be foundational to age-old economic principles of risk and return. Therefore, for all intents and purposes, it seems reasonable to assume that ERP (again, when used to assess ex-ante equity risk) is always positive, which leads one to reasonably and respectfully question the robustness of paradigms that suggest otherwise. The fact that the analyst community regularly wrestles with research to gain an actionable understanding of future cash flows to equity, which includes accounting for many
behavioral finance theories and observations that may also be impacting stock values at any point in time, provides evidence of the opportunities that exist for investigating and opining on the culprit of perceived mispricings in equity markets whether those mispricings be perceived as absolute or relative. In cases of apparent overvaluation of equity securities, it would seem analytically appropriate to explore and wrestle with other potential explanations before concluding that the foundational concept of ERP has gone to the dark side.
Jim Kelley, CFA Fort Worth, Texas, USA
Writing without a Pencil

The latest cover story (Solving Financial Illiteracy, May/ June 2013) reminded me of what must be the best defense of quant methods ever offered: A computer does not substitute for judgment any more than a pencil substitutes for literacy. But writing without a pencil is no particular advantage. The words are Robert McNamaras, not when he was the illfated secretary of defense during the Vietnam War but when he was the wunderkind president of Ford Motor Company.
Ted Aronson, CFA Philadelphia, Pennsylvania, USA
Correction
The article Solving Financial Illiteracy in the May/June issue included an incorrect address for the blog of the Investor Education effort at CFA Institute. The blog can be found at insideinvesting.org. The editor welcomes the views and opinions of readers. Please e-mail comments to roger.mitchell@cfainstitute.org.
PORTFOLIO PERFORMANCE
Property Investing for Non-Property Investors

With risk appetites growing, should European real estate be on the menu?
By Maha Khan Phillips
Uncertainty over the fate of the eurozone has dominated European markets over the past three years, and the real estate sector has been no exception. Investors pulled their money out of riskier property assets and opted, in large part, to make allocations to core real estate only in prime markets. Deal flow in southern Europe slowed dramatically. Opportunistic funds struggled to raise cash. Now, however, the situation is changing. Investors are considering different sectors and strategies, motivated largely by lack of yield opportunities (and liability-matching assets) elsewhere. Our experience has been that more people are coming into property for non-property reasons. Before the crash, you had people coming and they would go into an openended fund that would track Investment allocations an index. Since the crash, to European real estate weve had people look at are expected to increase funds with long-term inflabecause the yield spread tion-linked income, such between real estate and as property debt, explains government bonds has Paul Richards, principal at never been higher. global investment consulWhile investors remain tancy Mercer. focused on core markets, The year 2012 recorded peripheral real estate secunexpected interregional tors may offer values that flows of capital into Europe, are being overlooked. according to research from global real estate services European retail and indusfirm Jones Lang LaSalle. This trial sectors appear martrend has continued in 2013, ginally underpriced and are despite continued anxiety projected to outperform. over the euros future. Net The perception of how the investment was up 18% in eurozone is coping with the first quarter of the year, its difficulties will signifand the firm believes capital icantly affect real estate will continue to flood into the performance. region throughout 2013. At the same time, a report compiled by the European Association for Investors in Non-Listed Real Estate Vehicles (INREV) revealed that investors appetite for risk is growing for the first time since the financial crisis. INREV surveyed 65 institutional investors, 73 fund managers, and 17 fund-of-funds managers globally, and most of those investors expect to increase the share of real estate in their overall multi-asset portfolios.
Core Strength, Peripheral Vision

In part, allocation is expected to increase because in many markets, the yield spread between real estate and gilts has
never been wider. Government bond yields are so low that, with the exception of Italy and Spain, potential investors are looking for income anywhere they can get it. And property has high income, says Richards. He believes that clients want a real asset portfolio and that they find making a tangible investment reassuring. In the U.K., property provided an annual return of 6.9% over the 10 years through the end of 2011. During the same period, equities returned 4.8% and 5- to 15-year gilts returned 7%. Across Europe for the year ending 31 December 2012, propertys performance varied. The IPD Global Annual Property Index, which measures the combined performance of real estate markets in 25 countries (the figures are based on euro conversions), reported the following returns by country: Sweden (10.4%), France (6.3%), Finland (6%), U.K. (5.8%), Switzerland (4.4%), Spain (2.1%), Italy (1.5%), and Portugal (0.8%). Given such numbers, it is hardly surprising that investors are still wary of Italy, Spain, and Portugal, let alone Greece. But analysts say that within northern Europe, there is plenty of interest in terms of both core markets and, more recently, riskier ones. The big trend is one of bifurcation, explains Paul Jayasingha, senior investment consultant at consulting firm Towers Watson. There are extremes in terms of what people are seeing in the market and how they are investing. The attractive strategies range from the very safe to the very risky in terms of where the biggest opportunities are. With respect to the safest assets, investors have been adopting a defensive strategy, looking to protect their capital from the effects of inflation and capital loss, according to Deutsche Asset & Wealth Management. Jayasingha points out that long-lease buildings offer good value: Clients look at property and look at the additional return they can get relative to bonds, assuming rents stay in place, so they are looking at secure income strategies. So you can get a 25-year lease with your rent linked to inflation over time. As long as you can be confident that your tenant is reasonably stable and your underlying real estate is reasonably well located, these types of strategies become really attractive on a risk-adjusted basis. Because investors are still interested primarily in core allocations, they are overlooking other markets with value. Investor focus is still on a very narrow definition of core, prime assets in the best locations with excellent covenants and unexpired lease terms. These risk-averse investors are generally punishing secondary locations regardless of individual fundamental strengths, says Simon Durkin, head of research and strategy for Europe at Deutsche Asset & Wealth Management. In this market, we would advocate
Key Points
a strategy that takes a very selective approach, leveraging deep market knowledge on a regional or micro level to consider assets that might exhibit one additional notch of risk. That risk might be one of location, vacancy, or building quality, but in a market with solid long-term fundamentals currently being shunned by investors. Such markets do not include southern Europeat least not yet. Stefan Wundrak, head of property research for Henderson Global Investors, says that investors are still studying and analyzing the implications of investing in the south. He anticipates no increasing inflows into the market because demand will remain in the core space for the next few years, and thus, more and more investors are being priced out of markets they were previously targeting. The markets that are affordable are often in the periphery of Europe, such as Italy, Spain, and Portugal, and investors are often quite cautious about [those markets], says Wundrak. If they invest, they demand really high yields.
from AXA Real Estate. The fund manager anticipates further growth this year of 14% in the U.K., 13% in Germany, and 22% in France. AXA also estimates that online spending will capture 90% of total growth in retail sales in these countries (worth approximately 91.5 billion to 101.2 billion) by 2016. This shift is highly significant for property markets. Retail outlets have warned that change is on the horizon. Analysts expect that from 150 to 300 shops owned by the Arcadia Group, the British multinational retailing company that accounts for several of the U.K.s best-known clothing brands, will shut down when leases expire in three to five years. Another U.K. retailer, Aurora, has already announced plans to spin off some of its key brands during the next 12 months, and management expects that it will not be requiring as much retail space. In fact, around 20% of current U.K. retail space will become surplus to requirements, according to the British Council of Shopping Centres.
Debt Funds
On the other end of the spectrum, interest in the debt space is growing, driven by restrictive lending conditions. In the past year, several lenders, including Eurohypo, Socit Gnral, NORD/LB, and Landesbank Berlin, withdrew from part or all of the real estate market, according to a report on emerging trends in real estate from consultancy PricewaterhouseCoopers. That report suggests that the trend will continue, with more banks either retreating to domestic lending or cutting property loose. According to INREV, in the past three years, at least 19 real estate debt funds have launched, primarily focusing on senior debt and (lately) in the subordinated space, and 31.8% of investors expect to invest in real estate debt and/or mortgage products in 2013. Fund managers and insurance companies are all getting involved in this space in some way, says Kiran Patel, chief investment officer of international property investment manager Cordea Savills.
A New Type of High Street

Henderson Global Investors predicts that in the future, brick and mortar stores might become showrooms for internet businesses or even collection points for goods ordered online. A Henderson report states, This begs the questioneven for landlords with the best assets on their booksof how we will calculate rent affordability. While most retailers will tell you the presence of the store strongly supports their online trade, when the transaction happens somewhere in cyberspace how do you prove your role as the landlord in helping that tenant grow its business? The challenge extends well beyond the U.K. market. In France, supermarket chain Carrefour has seen its online sales grow to 1 billion. In Norway, a third of shopping centers experienced falling sales. Fund managers say they are positioned defensively. Investors are attracted to supermarket companies because their stores can serve as both a physical outlet and a distribution center where groceries can be delivered or collected. As supermarkets push their retail network to expand into non-food goods (an increasing trend across Europe), the role of supermarkets becomes even more significant for investors. Analysts also say that prime regional shopping centers in popular locations will remain strong investments, as will leisure outlets, such as restaurants or cinemas. But such assets are hard to come by, particularly in key markets. In contrast, as online deliveries increase, warehouses, distribution centers, and logistics companies will post a lot of growth. I think the most interesting market is the logistics market, says Wundrak. It has only really developed in the U.K. as an institutional market. In the rest of Europe, it started before the financial crisis hit, and now it is starting to come back.
Structural Changes
In the current market environment, fund managers agree that asset allocation is critical. For example, on a sector level, the European retail and industrial sectors are marginally underpriced and projected to outperform the more volatile office sector during the next five years, according to analysis from Henderson Global Investors. Germany and the Nordics (Denmark, Finland, Iceland, Norway, and Sweden) are forecast to outperform on a five-year basis, whereas in the short term, capital values in southern Europe are expected to continue declining, driven by negative investor sentiment, a shortage of bank financing, and weak economic growth. Some sectors are undertaking a massive structural change that will affect the future. Retail properties, for example, have been hard hit by online shopping, which affects the warehouse, distribution, and logistics market. In contrast, these markets will benefit from the trend to shop online. In 2011, online sales accounted for 165 billion of the 1.5 trillion in retail sales in the three largest European online markets (the U.K., Germany, and France), according to research
Markets with Potential

Given core markets popularity, investors must consider casting their nets further afield. The U.K. is the largest institutional real estate market in Europe, followed by Germany, and many pension funds say they have considered investing
PORTFOLIO PERFORMANCE
in the U.K. residential sector. According to property and finance firm The Mills Group, which surveyed 27 major U.K. institutions, investors like the fact that the residential market has a low correlation with other asset classes. It also has attractive yields and stable growth in key locations. But the market itself is challenging. According to a 2011 report from Resolution Foundation, in a significant number of European countries, 10% to 15% of institutions overall investment in real estate lies in residential property. In the Netherlands and Switzerland, this figure has grown to more than half of all real estate investment. Consider the contrast with the U.K., where less than 1% of institutional money in real estate is in the residential sector. This trend has occurred despite the fact that U.K. residential assets outperformed commercial property in the first half of last year, with a return of 3.1% for residential versus 1.2% for commercial, according to IPD. There is a limited supply of existing, good-quality residential assets available for institutional investment in the
U.K. market, explains Laure Duhot, director, strategic capital markets for U.K. property fund manager Grainger. She believes that the biggest challenge to the market will be the delivery of purpose-designed, professionally managed private rental sector units, which are large new residential schemes currently being considered by the government. It would be a missed opportunityif the delivery of these schemes is slowed downto rely entirely on sales to private owner occupiers, at a time when there is strong demand from institutional investors, warns Duhot. In January, the 325 billion Dutch pension asset manager APG entered the U.K. market by acquiring part of a 350 million portfolio alongside Grainger, which will coinvest 59 million. APG made an investment of 158 million in GRIP, a U.K. market-rented residential property fund run by Grainger. Such deals are rare. Unlike the rest of Europe, the U.K. residential property market is very fragmented and dominated by small landlords. Scale is also an issue, with institutions
Listed Real Estate Has Its Own Challenges

In the listed market, real estate securities have outperformed local equities in nearly every country between January and August 2012, according to data compiled by U.S. real estate manager Cohen & Steers. In Germany, real estate securities returned a massive 26.9% during that period. Listed real estate remains a small proportion of the overall real estate market in Europe, however, with estimates ranging from 5% to 10% of total market share. For many investors, listed securities are too highly correlated with the equity market, and volatility is always a concern. Core market prices have recovered in the direct market, but managers in the market argue that listed securities are still trading at discounts to underlying asset value, making these investments an attractive proposition. Others question the extent of correlation. Fraser Hughes, director of research, indices, and outreach at the European Public Real Estate Association, believes markets are not correlated in the long term. We have looked at correlations of our market versus the underlying market and the performance over the long term, and that tells us that in the short term, less than 24 months, the listed market does behave more like the equities market, he says. However, the longer you hold the listed securities, the more they perform like underlying direct real estate. Listed securities are a proxy for direct property performance over the medium to long term. announcement, Simon Property executed funding for the deal through US$1.3 billion of common stock priced at US$137 per share and US$1.75 billion of unsecured debt. The transaction could not have happened so quickly in Europe. European companies seeking to raise capital must first approach existing shareholders via a rights issue, a timely and (some argue) uncompetitive approach. Despite concerns about competitiveness, European pension funds and other European investors believe voting rights should remain as they are. They see a risk that their shares will be diluted and contend that it should be up to equity owners to decide on equity issuance. Not everyone sees it this way. Pre-emptive rights limit the company and managements flexibility to raise capital in the most efficient way. [Because] rights issues raise the cost of capital to issue shares and grow the business, I dont understand why shareholders believe they should have these rights. Each shareholder makes up its mind about whether it owns the company or doesnt own the company; the capital market is a free market that should regulate itself, and there are better ways to protect retail investors against dilution, argues Rogier Quirijns, portfolio manager and senior analyst for Europe at Cohen & Steers. He adds, From a shareholder value-creating perspective, I dont know why an institutional shareholder needs to be protected after it chooses to own shares in the company. The rights issue structure could even be value destructive [because] there is a risk that management is wrongly incentivized to make the best capital allocation decisions as existing shareholders are forced to participate, given the large discounted nature of the rights issue.
Europe and Preemptive Voting Rights

The listed market comes with its own challenges. Last year, U.S. commercial real estate company Simon Property Group announced that it was acquiring a 28.7% stake in Klpierre, a US$21 billion pan-European shopping center company. Within 24 hours of this
finding it difficult to locate the number of properties they even though the probability of a eurozone breakup has been need in order to build a cohesive portfolio. Still, dynam- reduced, a risk remains. Moreover, according to Deutsche ics are changing in favor of U.K. residential. The govern- Asset & Wealth Management, The result of a eurozone ment plans to give a guarantee of up to 10 billion for new breakup will depend upon the ability of policymakers to homes and 40 billion for infrastructure projects and is manage the transition. A best-case scenario would be a also looking at proposals to convert office space into res- managed and unforced exit of Greece, supported by tranidential space. Fund managers say that the market is ripe sitional financing. Koen Straetmans, real estate and commodities senior for change and full of potential. One part of the market, the offshoot student housing strategist at ING Investment Management, believes that the sector, is doing well already, providing investors with steady perception of what is happening with the eurozone crisis rental incomes of 3% to 4% annually, according to analysts. will significantly affect real estate performance. What you Players such as The Carlyle Group (which raised 125 mil- did see is that last year when [the European Central Bank] lion in bank debt to develop three London sites) and Sin- announced measures with respect to the OMT [outright monetary transactions], the pergapore sovereign wealth fund subception of systematic risk reduced. sidiary GIC Real Estate (which is in Keep Going This prompted positive inflows in partnership with UNITE Group to February for the first time in more invest up to 530 million on stuHome Truths: Global House Prices, summarized in CFA Digest (March 2013) [www.cfapubs.org] than a year. dent housing) are looking to take But Straetmans is still neutral advantage of the sector. Risk Management and Risk Budgeting in Real Estate and Other Illiquid Asset Classes, on Europe: I am inclined to take CFA Institute Conference Proceedings Quarterly a more positive view, but it is difMacro Environment (March 2013) [www.cfapubs.org] ficult at this time. Ultimately, the macroeconomic Searching the World for Growth: Opportunities in environment will have the greatEmerging Markets Real Estate and Infrastructure, Maha Khan Phillips is a financial journalist est impact on the future of EuroCFA Institute webcast [www.cfawebcasts.org] based in London and author of the novel Beautiful from This Angle. pean real estate. Deutsche Asset & Wealth Management argues that
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Analyst Agenda
Aye, Robot
Can machine learning systems replace human analysts and investment roles?
By Sherree DeCovny
Some computers are sophisticated enough to process and learn from datasets and make predictions about future data derived from a similar source. Machine learning is deployed by many companiesincluding Netflix, Amazon, and Googleto predict demand, generate revenue, and translate text. In the financial markets, machine learning systems are increasingly being used to select and execute trading strategies. One advantage machines have over humans is they do not succumb to biases that can negatively affect decision making. Machines bypass human According to Spencer biases because they Greenberg, a machine learncannot experience emoing expert and CEO of Rebeltion, rationalize, or merely lion Research in New York repeat past behavior. City, several types of human Building machine learnbiases can come into play ing systems that work well when mak ing f inancial for different tasks involves and other decisions. One more than picking a databias, known as the recency set and feeding it into the effect, is that people will algorithm. likely remember the most recent experiences best. This Process is important when bias may drive an investor using machine-learning to withdraw money from a based systems and mutual fund after one year human-based systems. of bad performance even though it has an excellent 10-year track record. Once humans act in a certain way, they are more likely to repeat similar behavior in the future. They tend to remember positive things about the choices they make and negative things about the choices they reject. This behavior is called the commitment effect. In a financial context, when humans put money in investments, it significantly increases the chance that they will make similar investments in the future. Additionally, humans do not like giving up things they own, so they have a tendency to hold investments today simply because they held them yesterday. They get decision fatigue and have difficulty reconsidering every investment daily. Moreover, the more choices they have, the more likely they are to stick with the default option. These biases are known as the endowment effect and the status quo effect, respectively.
of data and can work far more hours. Machines never experience anxiety or any other emotion. They do not have the ability to rationalize, nor do they have self-perception. They will not continue to repeat behavior merely because they performed the behavior in the past. An algorithm makes decisions based on input data and logic. They can be written to rebuild the decision-making process over a certain period (perhaps daily or hourly), reanalyze all new information, make fresh predictions, and reconstruct a portfolio accordingly. As Greenberg says, Its easy for the algorithm to redo its analysis from scratch in a systematic way so that it doesnt just assume that yesterdays decision was a good decision. Machine learning systems may even capitalize on human biases. When market participants hear bad news about a company, the stock price often declines too much and then bounces back. Machine learning systems can exploit this overreaction. Machine learning systems, however, do have their own biases. They may find certain models simpler than others, or they may be optimized for a particular metric. Additionally, they may rely on criteria that are too narrow. For example, a machine learning system may not incorporate information about a regulatory change, such as a transaction surcharge.
Key Points
Ability to Adapt and Learn

One way machine learning algorithms learn is by parameter fitting. An analyst or quant specifies the inputs to a particular model. Lets say he decides a companys stock price is determined by its market share, free cash flow, brand value, and recent price momentum. Given these inputs, the machine searches all possible models and picks the one that performed best over a particular time period. Then the model is tested on more recent data, and if it performs well, it is selected. Another way machine learning algorithms learn is for the analyst to select some inputs that might be relevant along with some metrics for judging a strategy. The machine searches through parameter spacethe set of all possible combinations of values for all the different parameters in a mathematical model. It also searches through strategies and models of the universe that best describe the data provided. In this case, the machine takes on more of the role of the human quant rather than being simply the equation solver. To develop an adaptive algorithm, one should have a clear understanding of the underlying machine learning model, says Vadim Mazalov, research and development specialist at Cyborg Trading Systems in Ontario. Some models are not
No Bias, Anxiety, or Emotion

Compared with humans, machines have a vastly greater capacity to memorize and correctly process large amounts
adaptive by design and require new training when a new set of training data is available. These models can still be used in a semicontinuous fashion, given that relearning is performed periodically with relevant training samples. The fresh parameters can be applied to the production framework with minimal interruption of the workflow. Other models allow incremental learning by adjusting the parameters with each input sample that can be gathered in a supervised or unsupervised manner. These models are naturally polymorphic (i.e., they exist in several forms) and gradually adapt to changing conditions, making them highly suitable for deployment in volatile online environments.
Limitations
Building machine learning systems that work well for different tasks involves more than just picking a dataset and feeding it to the algorithm. Most of the mathematical theory Capturing Synergies behind machine learning is based on having a fixed process, There are many things that computers do not do well yet. which enables the algorithm to learn from data and make For example, humans are still better at extracting meaning predictions about data that the process will generate in the from semantic content and acting intelligently. Humans can future. But the process itself does not change over time. also adapt and learn more quickly than machines. Machine learning algorithms learn automatically from Yet, there are synergies between humans and machine data, but they have to be built carefully, warns Greenberg. learning algorithms; specifically, human weaknesses can Its extremely important that you help the algorithm by be delegated to a machine and vice versa. Repetitive tasks making sure that the data it processes is relevant for what that follow a template, or those that can be described by a youre trying to predict and is structured so that the algo - model, should be executed by a computer. Humans should rithm can handle it. intervene when the environment behaves in an unusual Information can become irrelevant quickly, so program- way that is not reflected in the model. An activity that conmers need to make the algorithms understand information tains a creative component should be executed mostly by decay. Doing so prevents machine learning algorithms from a human, whereas machine learning can be used to genlearning patterns that once were true, based on historical erate informative indicators so that the human can make data, but no longer apply. In addition, programmers need to well-grounded decisions. avoid over-fitting, or creating highly complex models based Process is incredibly important regardless of whether on insufficient data. In such cases, the machine makes gen- youre using machine-learning-based systems or humaneralizations that may or may not be true in the future, and based systems, Andre points out. Algorithms need the in many cases, such generalizations are not true. right checks and balances to ensure they truly generate At Cerebellum Capital, we feed our systems random data alpha, not just spurious correlations. They also need to be and measure how often they find things that look good, even well managed from a risk perspective. though we know they cant possibly be good, says David Today, many companies deploy machine learning algoAndre, CEO of Cerebellum Capital, which is based in San rithms for an array of uses. As datasets get bigger and comFrancisco. We use that information to help us judge when puter processors become more powerful, machine learning weve really found something and when weve just found systems will assume even bigger challenges. Machine learnsomething that got lucky. ing is a multidisciplinary subject that spans practice and Another potential pitfall is inadvertent time traveling theory. On the practical side, new techniques and observawhen looking at old data. Lets say an analyst builds an tions of the environment being modeled will be continuously algorithm that trades between Apple and gold. Both assets introduced to the system. From the theoretical perspective, have risen spectacularly in the last the evolution of machine learning decade, and if they were combined depends on academic progress in Keep Going into a weighted portfolio, it would statistical and probabilistic models, probably perform well. But the anaapproximation theory, programHigh Frequency Trading, Algorithmic Buy-Side Execution, and Linguistic Syntax, CFA Institute lyst would not have known that 10 ming languages, and high-perforwebcast [www.cfawebcasts.org] years ago. mance computing. No doubt finanThe Physics of Wall Street: A Brief History of A common failing is survivor cial market participants will try to Predicting the Unpredictable (a review), CFA Book bias, when the model is tested on capture the opportunity. Reviews (January 2013) [www.cfapubs.org] a dataset that excludes the comSherree DeCovny is a freelance journalist Next-Generation Analytics, CFA Institute panies that did not survive. This specializing in finance and technology. Magazine (July/August 2012) [www.cfapubs.org] behavior can lead to returns that look great in theory but do not
materialize in practice. At times, analysts simplify assumptions to make it possible to describe complicated real world environments in terms of a machine learning model. But the model can behave unpredictably when one or more of the assump tions become invalid because of some unusual activity in the environment. More mature systems constantly scan the environment to ensure that the assumptions are satisfied, and once assumptions are no longer true, the process stops the system. The theory of machine learning or computer science in general is not even close to an adequate simulation of a human brain in its full complexity, says Mazalov. What we can do, however, is teach a machine to process data in a certain format and make decisions in a fixed environment.
Private Client Corner
Too Much or Not Enough?

Striking the right balance with risk metrics is a challenge for advisers
By Ed McCarthy
Institutional investors frequently use a gamut of sophisticated portfolio risk measurements, but institutions differ from private clients in significant ways. Those differences raise several questions: Which of the available metrics are best-suited for use with private clients? Given private clients general lack of training in portfolio analytics, how can advisers communicate risk metrics effectively? And can advisers do a better job than they currently do at risk measurement for private clients?
SIMILARITIES AND DIFFERENCES

From a high-level perspective, private clients are similar to defined-benefit plans, says Greg Kasten, MD, chief executive officer of Unified Trust in Lexington, Kentucky. Like pension plans, clients have Private clients focus more financial goals that translate on absolute returns and to future liabilities; the advisthe risk of loss versus ers job is to create a portbenchmark tracking error and dont understand what folio with sufficient funds more sophisticated risk for those costs. We live in a metrics can do. world where somebody says, Im going to do these three Clients understanding of things, and this one happens portfolio analytics should in 2015, this one happens in influence the amount 2020, this one happens in and format of risk metric 2030, says Kasten. They information presented by have a present cost today of advisers. $4 million, and I have these Some advisory firms are assets. How can I make sure delivering customized that the assets are going to risk analysis, but indusmatch up to the liability I try observers believe that face with the greatest degree the inability of most cliof certainty? Now, in that ents to demand more context, I would say that is advanced risk metrics from very similar to the definedtheir advisers holds back benefit world. It really is an progress. asset/liability kind of financial planning and downside risk management. Of course, clients have finite lives, and that condition creates a human capital life cycle. At the beginning of clients careers, their human capital (the present value of future earnings) is high, whereas their financial capital is usually low. Over the span of a career, human capital decreases while financial capital increases. Traditional risk metrics dont consider the human capital exposure, says Ron diBartolomeo, president of Northfield Information Services in Boston. He cites the example of real estate developers who
earn their wealth from property development and continue to hold much of that wealth in real estate. The problem is, of course, that from a portfolio diversification perspective, if theyre still active in the real estate activity, thats probably the worst thing they can do, he says. You want to take them away from their human capital and diversify into other things because if the real estate market goes sour, then both the investment portfolio and their livelihood are in jeopardy. Another difference is how the investor measures portfolio success. Institutional asset managers tend to focus on benchmark tracking-error measures because theyre hired and fired on the basis of relative performance. Thats not as important to private clients, according to diBartolomeo. To a private client, whether I did better or worse than the S&P 500 is kind of interesting, but I dont pay my bills with benchmark-relative money, he says. I pay my bills with actual wealth. And while there may be some concern in family offices about real returns net of inflation, in general, theres a lot more emphasis in the private client worldor there should beon absolute risk and absolute return as opposed to benchmark- or index-relative behaviors and the risk of underperforming the index.
Key Points
DIFFERENT FOCUS, DIFFERENT MEASURES

Private clients focus on absolute return and the risk of loss led Kasten to add multiple downside risk metrics to his firms portfolio analyses. The process starts with the traditional meanvariance optimization, he explains. That analysis is supplemented by an additional set of downside risk metrics, such as downside deviation risk and the active Sortino ratio, among others. He believes the combination of traditional meanvariance and downside risk measures benefits clients. We use the downside risk metrics to better understand the risk that the client is really being exposed to, he says. Then we look at how we can manage that risk better and make sure theyre not exposed to more risk than is needed for them to meet their goals. The less predictable nature of private client consumption also requires a metric that accounts for volatility over time, not just at terminal dates, as diBartolomeo observes. He cites an example of a client who has $1 million today and wants to know the likelihood that this amount will be less than $800,000 in five years. The arithmetic to answer that question is easy, but unpredictable consumption timing requires a different model. What people really care about is the probability that, at any one moment in time between now and five years from now, their wealth will be below $800,000, he says. Thats a very different question. Its not
just the end point; its a continuous problem. Most advisers dont know that math, so they cant really describe the likelihood that a particular set of investments with an expected return and a certain volatility is going to breach a floor value at any one moment.
EFFECTIVE COMMUNICATION
The quantitative background among professional investors is much higher than among the general public. Just consider the example of the CFA Program. According to Jerry Pinto, CFA, director of curriculum projects for CFA Institute, the curriculum covers dispersion measures (variance, standard deviation, mean absolute deviation, and tracking risk), systematic risk measures (beta and factor betas), downside risk measures (semivariance, target semivariance, etc.), drawdown measures (average drawdown, maximum drawdown, ROOM FOR IMPROVEMENT? etc.), and tail-risk measures (value at risk, or VaR, and con- United Trust and Athena Capital Advisors have customized ditional tail expectation). their private client risk metrics. But a survey conducted in Consequently, explaining portfolio risk metrics to clients 2010 by the Spaulding Group in Somerset, New Jersey, found requires a different approach. But it can be done effectively. that the tried-and-true measures are still the most widely Kasten reports that it has been much easier to explain down- used. The survey participants included investment advisers, side risk to clients since the 2008 correction. This is a very banks and trust companies, mutual funds, insurance comeasy conversation to have today, he says. Everybody says, panies, and others. The respondents most frequently cited I remember 2008 and how unusual that was. Really, theyd risk measures included standard deviation (92.9%), trackalmost be surprised if you didnt say something about 2008 ing error (83.0%), beta (78.6%), VaR (53.6%), and downbecause theyll typically bring it up. So, the downside risk side deviation (40.2%). The survey did not break down part of it now is a very easy conversation to have. Its not responses by private client versus institution. really abstract for these people. That result doesnt surprise Steven Greiner, author of Investment managers at Athena Capital Advisors in Lin- Investment Risk and Uncertainty: Advanced Risk Awarecoln, Massachusetts, generate in-depth risk metrics. David ness Techniques for the Intelligent Investor. He believes that Berns, vice president of risk management at Athena, says more progressive advisory firms are adopting additional the firm focuses on six risk factors: equity, duration, credit, metrics but the typical advisory institution is not. Based cash, real asset, and currency risks. The firms portfolio on his experience, Greiner has found that more people are management process revolves around understanding how talking about portfolio risk but not necessarily acting on much exposure clients have to those six risks. acquiring more technology or spending time learning about The factors are part of Athena Capitals QPA (quantita- newer methods. Where I see applications going is for large tive portfolio analysis) discipline, which serves as the center pensions, sovereign wealth funds, superannuation, and big of the firms portfolio and risk management software. The asset managers, he says.There may be trickle down to QPA was designed in-house, Berns explains, using SQL (a the small private client providers in the future, but I dont database software tool) and MathWorks MATLAB (a data see it there yet. analysis software tool), with an Excel front-end. The system One reason behind the slow adoption of additional risk also incorporates several additional risk models. The QPA metrics is a lack of demand from non-institutional invesallows portfolio advisers and the risk management team to tors, according to diBartolomeo. He maintains that most pull up the balance sheet of any client or account and see private clients, unlike their institutional counterparts, dont the risk profile. You can also propose trades in this soft- know whats possible with risk metrics. Consequently, he ware, and you can see how the risk profile will change if believes they dont demand more sophisticated risk manyou make certain moves in the portfolio, he says. And agement. They dont pressure the asset managers and the thats the basic construction of it. trust banks and so on to do it, which is really a shame, he The QPA generates an extensive risk analysismore than says. I think if clients were more sophisticated in the priclients could absorb, says Lisette Cooper, CFA, the firms CEO vate client world, there would be more pressure put on the and CIO. Initially, the firm tried to apply to private clients an financial services providers to do a better job, and I think analysis similar to a Barra framework that included many that would be good for everybody. factors, but it was too much detail. Ed McCarthy is a freelance financial writer The firm subsequently decided to in Pascoag, Rhode Island. Keep Going pare the amount of analytic results they share. We have many pages Risk Management: A Review, Research Foundation of CFA Institute (www.cfapubs.org). [of analytics] for internal consumption by the portfolio managers,
she says. Most commonly, we boil that down to a single page of information for the clientsthe risk statistics on their portfolio. Berns says the report shared with clients begins with a total portfolio view of the six risk factors and the geo graphic exposures, which are divided into five groups. The next section isolates the asset classes. For example, the fixed-income section includes credit quality, yield, sectors, and duration. The equity position analysis includes marketcap distribution in small-, medium-, and large-cap stocks, among other details. Its basically a one-pager that goes through the things that we find most useful in the portfolio manager process and what we think clients can most easily understand about their portfolio, says Berns.
CAREER CONNECTION
Side Tracked
To change career track, consider running on the inside lane
By Lori Pizzani
Many security analysts build their careers at research companies, asset managers, or other investment firms, deftly peering inside the financial statements, businesses, and management teams of multiple publicly traded companies. That career track can be a fully rewarding one for many, but some analysts have chosen to take the inside track literally. Leaving the broader world of analyzing several companies at one time, they honed their focus much more narrowly to a single company: their new employer. The investment profes sionals who shared their experiences for this article Investment skills and found that their skills and experiences can be leverabilities (especially what they aged for a career switch learned through the CFA Proto investor relations. gram) allowed them to make Versatility is a valuable a successful transition from asset for those seeking being on the outside looking to make a successful in. But once they were on the transition. inside looking out, they had to adjust their lenses a bit. For analysts, industry
knowledge can lead to employment opportunities.
Stepping Inside
Chris Jakubik, CFA, has been the head of investor relations at Kraft Foods Group in Northfield, Illinois, for more than seven years now. Previously, he transitioned from a position as an outside analyst and took a position working inside a public company, Gillette, which he joined in 2001. It was not a career path I had previously considered, he says. He had been called directly by the then-CEO of Gillette, a man he had known from his days as an outside securities analyst when the man had worked as the CEO of Kraft and Nabisco, two companies Jakubik had covered. It was career changing, he says. It gave me the opportunity to go and see a turnaround from the inside and made me a better investor all around. He made a lateral move to a position at Kraft when Gillette was acquired by multinational manufacturer Procter & Gamble in 2005. Theres a bit of an adjustment from outside to inside because there are fewer personalities to deal with, but it was the right move, he says. Like any other job on the sell side or managing money, the investor relations role has a lot to do with people, but now I work with the CEO, CFO, and the board of directors. For Steve Somers, CFA, the transition was easy. I hit the ground running, says the vice president of corporate development, investor relations, and treasury at Rosetta Stone, a public company headquartered in Arlington, Virginia, that
teaches people to speak different languages through the use of technology. Previously, Somers had worked at other firms, including a New York City-based sell-side firm and hedge funds. I liked all of the analysis but not the focus on risk reduction, he says. As a fundamental analyst, he was paired with an options trader to seek out investment opportunities. But after the tech bubble burst, the hedge fund he had worked at shuttered its doors. I looked at areas where I could leverage my skills and experience, but people on the corporate side didnt understand the value of my CFA charter or Wall Street experience. One day, an acquaintance asked if hed ever looked at an investor relations job, spurring him on by reminding him that he knew what the sell-side wanted, understood what the buy-side wanted, and had experience working with investment bankers. Once on the inside, after accepting a job with a wireless telephone company, he found that his CFA credential gave him instant credibility with external analysts on both the buy side and sell side. It provided me with an instant in; they could come to me and didnt need to automatically go to this companys CFO or CEO, Somers says. Leveraging investment skills was also key for Karen Sansot, CFA. I personally think a background in investment management and a CFA charter translate very well to investor relations, she says of her role as an investor relations executive at LeapFrog, provider of educational entertainment for children and headquartered in Emeryville, California. Sansot transitioned to working for the firm in February 2009. Earlier in her career, she had worked at an investment bank and had also provided security analysis of consumer companies (specifically lodging and gaming companies) at a firm in California. Since the [investor relations] role is essentially to manage investor communications, its helpful to be able to think like an investor, says Sansot, who also believes that training and finance skills from the CFA Program gave her instant credibility with investors. Its different on the inside, she acknowledges. I leverage the same skills, but I also provide insight to management. Working as an analyst provided a direct connection for Dean Morrison, CFA. After following Vermilion Energy, an international oil and gas exploration and production company headquartered in Calgary, Alberta, Canada, the company came to him with an offer. They reached out to me with the opportunity to align with a team that had created great value, says Morrison, who accepted a position as Vermillions director of investor relations in early 2010. Having worked at a private equity firm for more than three
Key Points
years, he saw the contrast very clearly. With private equity, you are trading on the value created by others. Its always rewarding if you make a good call, but you are relying on the management team [at that company]. Although the private equity side can be financially rewarding, he found the behind-the-scenes experience of contributing to value creation and building something was more appealing. Being involved and influencing strategy and tactics, is what Jakubik likes best about his investor relations role at Kraft Foods Group. I support management and senior decision making. If tactical decisions are made, management wants to know about the impressions of the investor base. Great companies dont always make great stocks, but being tied to a company whose stock improves can be attractive, especially if you have had an influence, he says. For Sansot at educational products provider LeapFrog, Its fun to be inside a company and helping children. I can really make a difference. Also, she notes, Being inside, you are allowed to go deeper. CFA charterholders on the inside, get to be viewed as an influencer, a contributor because of their broad-based CFA training and experience, says Somers. I like the ability to influence and have an impact on the company. Its exciting and interesting being able to make a difference.
company messaging. I really like talking to investors. I love being able to take finance issues and communicate complex concepts to others, she says. Another important difference for some is the impact on life outside work hours. IR is a great role if you have a family because there is predictable travel, such as during earnings season or at year end, says Sansot, a mother of two who appreciates the family-friendly situation. Such a predictable travel schedule differs from her experience working at an investment bank.
What It Takes
The insiders contacted for this article offered some tips and good advice for CFA Institute members and charterholders considering an insiders role at a corporation. Morrison suggests that individuals try to get the broadest base of knowledge versus being a specialist. Also, to excel in investor relations, one needs to understand both sides. Many portfolio managers never really get what it takes to manage a business or a workforce, he says. Those that have a broader perspective do better. Sansot recommends allowing natural enthusiasm and interest to lead the way. Find a company where you are really passionate about their products or services, she says. Then, be intellectually curious and be eager to do well. Someone who is already familiar with the companys broader Changing Perspective When investment professionals work for the buy side or the industry will have a leg up. Potentially negative aspects or limitations should be consell side, they tend to be singularly focused. But on the corporate side, says Somers, there are multiple groups to sidered as well. You can get tied to just one story, says take into consideration and manage. Moving to an inside Morrison. Personally, you have to go all in, and that is difrole at a company, such as investor relations, often provides ferent. Moreover, says Jakubik, working for one company a birds-eye view of that companys entire business from a can limit your ability to invest in other companies, including direct or indirect competitors, although not all compalevel that simply cant be accessed as an outsider. No other role sees all. I see the full operations, finan- nies formally impose such rules. In such cases, you cannot cials and more, says Morrison of his position with Vermil- act upon the expertise youve developed, he says. Another drawback can be the relative lack of time and ion Energy. I am the direct liaison on portfolio managers and guys on the buy side. Every day, Morrison has four or resources at the corporation for investor relations profesfive roles to fulfill at his middle executive level, and he likes sionals wearing multiple hats. Sometimes, call volume is so high that I cant spend as much time as I would like with the variety, a sentiment echoed by others. You become a Swiss army knife, says Somers about the investors, Sansot says. Being on the inside of a corporation can also change your versatility needed for the everyday job. On a typical day, I sit at the nexus for a lot of different things: strategic, posi- perspective, especially when it comes to discussing earntioning, key parts of the business, operations and more. ings or corporate goals and initiatives. Analysts and investors tend to lose sight and be shortHis responsibilities include taking on an M&A role to scout potential acquisition targets for his company, managing the term focused, says Somers. I think it would be great to move corporate coffers cash position and related relationships toward a longer-term focus and focus less on the short term. Despite the drawbacks that are inherent in any job, you with banks, funneling information in and out and up and down the organization, and communicating with top execu- can draw from your personal strengths to find your place in the corporate world. As Morritives as well as those outside of his son sums it up, Align yourself with company. In addition, Somers also Keep Going good people and a good business has to monitor what is happening and do the right things, and you from the Wall Street perspective. Competing for Capital: Investor Relations in a Dynamic World (a review), CFA Book Reviews will be rewarded. Sansots investor relations job (2006) [www.cfapubs.org] also includes varied tasks, such Lori Pizzani is an independent financial and Using Investor Relations to Maximize Equity as providing feedback to managebusiness journalist based in Brewster, New Valuation (a review), CFA Book Reviews (2006) York. ment, conducting morning calls and [www.cfapubs.org] meetings with investors, engaging in special analyses, and developing
Northern Exposure
Should investors be early movers in North Africa?
By Chris Wright
North Africa sounds like a term that should bind a homogenous group of nations. Egypt, Tunisia, Libya, Algeria, and Morocco are all Arabic nations, predominantly Muslim, with similar languages, cultures, topography, and climate. Among these nations can be found the heartbeat of the Arab Spring, in which ordinary people rose up to depose long-entrenched autocrats and dictators and so brought popular democracy to their countries.
But thats what you might call the view from 30,000 feet. The reality is that North Africa includes considerable diversity of political, social, and economic circumstances. Two of the five countries didnt have revolutions at all: Morocco (because it already had offered many freedoms) and Algeria (arguably because the country endured more repression than its peers). The three countries that did have revolutions emerged in differing circumstances. Tunisia has struggled valiantly and apparently successfully toward a workable model. Egypt appears to have replaced one inflexible figurehead with another and might yet see another revolution to depose the new leader. Libya has been left with a vacuum of leadership so uncertain that the United Nations still wont unfreeze the countrys oil wealth. For the investor, the region requires a nuanced look before going anywhere near it, but the patient buyer may find opportunities.
Morocco: A Balancing Act

To start at the most positive end of the spectrum, Morocco is about as far removed from the popular image of North African revolution as it can be. Any discussion with business leaders or bankers in Casablanca or Rabat might touch on Libya or Egypt as a matter of regional curiosity, but the conversation swiftly turns to Europe, which is where Moroccos key trading partners are. There have been security issues across the region; it keeps people on their guard, says Walter Siouffi, managing director for Morocco at Citibank Maghreb in Casablanca. But in terms of how it affects us, Moroccos trade is predominantly with Europe, with FDI [foreign direct investment] coming from Asia and the West. So, whats happening across North Africa doesnt have a big impact here. The main reason Morocco looks very unlike its regional peers is that it didnt have a revolution because reform had already been under way for some time. Morocco is a monarchy but one with a fair amount of power ceded to parliamentand a young democracy. When Mohamed VI became king following the death of his father, Hassan II, in 1999, an era of slow and modest but tangible reform began. In June 2011, as the Arab Spring gathered pace elsewhere in the region, Morocco had the sense to get ahead of any mood of unrest, and King Mohamed VI announced a referendum on constitutional
Illustration by Robert Meganck
reform. The referendum was held the following month, and political reforms were enacted, strengthening democratic institutions and protecting individual rights while leaving some powers with the king. The clearest example of the international investment community drawing a distinction between Morocco and other North African states came when the country set out to sell a debut international dollar bond issue in December. Morocco raised US$1.5 billion in 10-year and 30-year dollar funding and attracted US$7.9 billion of orders from 475 accounts. To a first-time issuer in a politically difficult region, this commitment of world investors to 30-year fundingvery long term, even for a sovereignsent a message about how Morocco was viewed. Bookrunners were delighted, if perhaps surprised. I have racked my brains, and I cant think of another issuer printing 30 years straight out of the gate, says Nick Darrant, head of the CEEMEA (Central and Eastern Europe, Middle East, and Africa) syndicate at BNP Paribas. Its hard to see how the deal could have gone better, says Charlie Berman, head of public sector global finance for the EMEA region at Barclays. In fact, investors in the deal had many questions, but the questions werent about Middle East politics or the Arab Spring overspill. Instead, investors wanted to know what Morocco was going to do about its fiscal position. Moroccos deficit stood at 7.2% of GDP in 2012, subsidies connected to fuel and agriculture are equivalent to 6% of GDP, and falling foreign exchange reserves and a widening current account deficit have pushed external funding needs to about 10% of GDP. All these numbers have been getting worse, and none are healthy. Moroccan Minister of Economy and Finance Nizar Baraka, interviewed in Rabat, is adamant that the problems can be fixed.1 Baraka admits that 7.2% is a huge deficit. He aims to reduce it to 4.8% in 2013 and 3% in 2016. He says the deficit was badly affected by matters out of the countrys controlnamely, movements in exchange rates and commodity prices. Both effects are undeniably true. Moreover, he notes, a boost was necessary for investment in 2011, further pushing up deficits. As for subsidies, he plans to reduce their level from 6% to 4.2% of GDP while improving the efficiency and management of the budget and subsidies. If this were accomplished, could Morocco meet its targets? Yes. We have to, he says. We know what we have to do, and we are doing it. Clearly, the bond investors believe that statement. But not everyone is convinced. Its interesting, for example, just how widely the opinions of the rating agencies about Morocco diverge. Standard & Poors puts it at investment grade BBB; Moodys Investors Service has it at below investment grade, at Ba1, and lowered this rating to negative from stable in February because of the deterioration in the governments fiscal metrics. Timely implementation of these measures (on subsidies and the deficit) will be needed if
1 As part of the authors travels in the region, he conducted an extensive interview with Baraka. The complete interview was published in the May 2013 issue of Euromoney.
the countrys public finances are to get back on a sustainable path and avoid a further rise in the public debt ratio. Morocco must achieve a balancing act: Reduce subsidies to improve the national finances and avoid causing social upheaval by doing so. But if it can manage the feat, there is a lot to recommend investment in Morocco, as demonstrated by a growing number of FDI partners. Recent examples include Bombardier, Kraft Foods, Groupe Danone, and numerous Persian Gulf institutions. With a public debt-toGDP ratio below 55%, compared with European economies, as well as the IMFs optimistic forecasts for 2013, Morocco offers promising prospects for development, says Brahim Benjelloun-Touimi, economist and banker at BMCE Bank in Casablanca. Relative to GDP, he continues, investments represented an average of 35% over the past six years, a figure encountered only in East Asian economies. For investors, Morocco is a market that has captured more attention on the debt side than the equity side, partly because it has a relatively small and illiquid stock market. David Mcilroy, chief investment officer and portfolio manager at Alquity Investment Management, which runs an African equity fund, says his fund holds only some selective positionsin Attijariwafa Bank and in Maroc Telecom. On the plus side, the equity market is not volatile. Ive been dealing with emerging markets for 20 years, and in that time, Morocco has been one of the lowest beta markets, he says. On the negative side, though, Morocco may well soon lose its place in the MSCI Emerging Markets Index, in which it occupies barely 0.2%. Still, Moroccos stability is something its neighbors can only dream of. They have other things to worry about.
Egypt: Too Big to Fail?

When Hosni Mubarak was deposed as Egypts leader, ordinary Egyptians possessed an enormous sense of hope and possibility about how their country might now be governed. Its fair to say a lot of that optimism has dissipated. As one fund manager puts it, I think theyre going to need another revolution. One can argue that things are improving in Egypt but off a low base. According to Bank Audi, real GDP grew by 2% in 2012, which was better than 2011, and inflation dropped to 8.7% after five years of double-digit growth in the countrys consumer price index. But despite those improvements, the economic situation is not particularly healthy. As Bank Audi reports, The economy [has] remained pressured by a multitude of economic and social challenges in addition to an acute political divide across the country on key national issues. There are some promising signs: Tourism, the lifeblood of the Egyptian economy, was up 17% in terms of number of arrivals in 2012 and 13% by revenues, but these rises were, again, off a low base. Far more signs are dire. Unemployment was 12.6% by the end of fiscal year 2012, compared with 9% before the revolution. From foreign currency reserves of US$36 billion before the revolution, Egypts reserves plunged to US$13.5 billion by the end of February 2012, equivalent to
just three months of imports (and imports are absolutely vital in a country that buys most of its food and fuel from overseas). And the budget deficit was 11.1% for the 201112 period, with debt to GDP now more than 80%. Investment has gone with it: Bank Audi estimates that implemented investments in crude oil projects declined nearly 45% in fiscal year 2012 and by a further 25.1% year on year in the first three months of fiscal 2013. In addition, there is the nagging sense that the new government, which is led by Mohamed Morsi and dominated by the Muslim Brotherhood, is suppressing dissent and opposition in much the same way as the old government did.
We still like Egypt longer term very much, but we are recommending that investors wait until some tough decisions are made first and the legal environment is clearer before entering the market.
Is there a positive case? The sense is that Egypt is still falling and that some inflection point is needed before investors will consider coming back into the Egyptian market in earnest. Is there any sign of that moment? Not yettechnically, says Angus Blair, president of Signet Institute, a regional think tank. There is still too much current and expected political noise for non-hydrocarbon FDI to rise sharply. With no clear, creative, or brave economic plan from the government, which has a fear of rising prices, the economic and political risk has risen, he says. We still like Egypt longer term very much, but we are recommending that investors wait until some tough decisions are made first and the legal environment is clearer before entering the market. Mcilroy at Alquity Investment Management says his fund has reduced its holding in Egypt from 12% at the beginning of 2012, when it was the funds third biggest country in terms of holdings, to 9% today. In contrast, Kenya has gone from 9% to 17% of the funds holdings over the same period. The inflection point needs to come when the Egyptian government makes the structural reforms that are required, he says. A key point is a planned US$4.8 billion loan from the IMF, which Mcilroy says will then unlock as much as US$10 billion from other sources, such as the African Development Bank and the European Union. Before granting the loan, the IMF wants to see such reforms as subsidy reduction, revised tax policy, and a more businessfriendly environment. If these reforms occur and the loan is granted, things could start to improve. Geopolitically in the international
community, Egypt is seen as a market thats too big to fail: Its the largest Arab democracy, and the U.S. doesnt want to see it fall over, Mcilroy says. As long as it makes moves towards the structural reforms the IMF is looking for, the chances are it will get the money. But he doesnt expect to see this before the fourth quarter, and he agrees with Blair: At the moment, the government is not speaking with one voice. That said, there are already signs of investors prepared to take the long-term view. Characteristically, these investors are chiefly from the Gulf area. In addition to seeing a business case for investing, they have a sense of obligation to help stabilize other parts of the MENA (Middle East and North Africa) region. Qatar National Bank is buying Socit Gnrales Egyptian operations; Emirates NDB is buying the Egyptian unit of BNP Paribas. Even Bill Gates has become involved, joining with other U.S. investors to put US$1 billion into the fertilizer and construction group OCI. Unfortunately, OCI is moving from Cairo to Amsterdam, with rather negative consequences for Egypts stock exchange because OCI accounts for about 20% of the index. And some regional brokers are already selectively recommending particular stocks in Egypt. Investment bank EFG-Hermes has suggested that Talaat Moustafa Group, Egypts biggest listed real estate developer, offers a good play on expectations of inflation and currency devaluation. When confidence does return, Cairos stock market will be a good place to express it: It is one of the oldest and deepest markets in the MENA region.
Libya: Institutional Knowledge Matters

In Libya, the challenges are different again, for this country was somewhat frozen in time, from an economic perspective, during the long years when Muammar Gaddafi held power. In 42 years of Gaddafi, the worst thing he destroyed was integrity, says one Libyan banker. Corruption was a way of life, but it wasnt corruption. It was survival. Perhaps the challenge facing Libya is best illustrated by the situation of its key asset, its crown jewel: the Libyan Investment Authority (LIA). This is where the oil surpluses have been invested since 2007, with the ideamodeled on other sovereign wealth funds in the region, such as the Abu Dhabi Investment Authoritythat it would help diversify hydrocarbon wealth and make sure that funds are available for the countrys future when the oil eventually runs out. The LIA has about US$60 billion in assets. In February 2011, Libyans in Benghazi took to the streets in protest against Gaddafi and over the bloody months that followed, they eventually removed him. After Libyans had wrested control of the government, an early priority was to work out exactly where all the LIAs assets had gone and to manage them prudently for the national good. The man appointed to do this was Mohsen Derregia, a Libyan who had been in academia in the U.K. for the previous 11 years but who was persuaded to return to Libya to become chairman of the LIA in April 2012 and CEO the following month. I remember the prime minister calling me, he says. He said: Its down to you. We cant all walk away.
Somebody has got to do this in the new Libya. It was no surprise to find that the LIA had in many respects been mismanaged. Some highly skilled people had worked at the LIA through the years, and some renowned international consultantsincluding Mercer, Ernst & Young, and KPMGhad been involved in recommending investments. However, Saif al-Islam Gaddafi, Gaddafis second son and the man most closely linked to setting up the LIA in the first place, was involved in investment decisions. Many of the LIAs assets had found their way into opaque subsidiaries, such as the Libya African Investment Portfolio, among the most obscure and least understood of all sovereign entities. It was a big, big problem, says Derregia. And fixing the problem is not something you are going to do in one or two years. This situation was not really a surprise, but the challenges Derregia faced in trying to do anything about it illustrate the problems for post-revolutionary countries. His first priority was to identify assets and establish their worth (Deloitte was brought in to help), starting with bonds and shares, then major assets, and then on to smaller positions. He also tried to set up a board, which is where problems began. There were several delays, but these were due to internal politics rather than anything else, he says. Unfortunately, the idea of conflict of interest, and selecting a board that was conflict free, was not really well understood. People in conflicted positions would try to delay decisions. Some of the decisions we have to take involve liquidating or merging some investments, and invariably, some people, as an individual, will lose because of that, but the Libyan people will gain. These people would resist very hard, in unimaginable ways. Further challenges arose with getting assets unfrozen, and Derregia spent much of his first year on the job in various Italian courts trying to get assets back into the stewardship of the people who rightfully owned them. On top of that, the UN had frozen almost all LIA assets (though it missed some of the subsidiaries). At first, Derregia welcomed this freeze and even asked for an extension of it. I initially asked the government to keep the sanctions until I took stock of at least the fairly liquid assets to make sure we knew where they were, he says. He then asked for the sanctions to be removed in July 2012, but theyre still in effect. And perhaps its not such a bad thing that they are. Earlier this year, Derregia noticed a distinct frostiness in his relationship with Prime Minister Ali Zeidan and began to hear whispers of his own demise at the LIA. A letter was sent to Derregia on February 10 informing him of his removal, to be replaced by Ali Mohamed Salem Hibri, deputy governor of the Central Bank of Libya. Derregia is challenging his removal in court. I want the government to understand that in the new Libya, even if you have the power, you must act within the boundary of law, of rules and regulations, he says. I dont understand what basis there is for wanting to change what happened in the last year. This is going to be lost effortnot to me, but to the LIA and to Libya. So whats left? The LIAs head count today is about 90. The institutional knowledge is enormously reduced from
For potential investors in North Africa, the biggest challenge is going to be all about timing: capturing the moment at which confidence returns to Egypt or finding the moment of best value in Morocco.
previous years, according to Derregia, so it is back to square one, which is what a lot of post-revolutionary North Africa is going through.
Regional Outlook
Less is written about investment opportunity in Algeria than anywhere else because its the least accessible country; the militant attack on the BP- and Statoil-linked Tigantourine gas facility in the desert, with the resulting death of at least 39 foreign hostages, underlines the challenges of doing business there. But what of Tunisia, where the Arab Spring began? Times are hard there. Unemployment stands at 17%, higher than in Egypt. And in the first two months of 2013, FDI and portfolio investment declined 9.6% year over year from 2012, according to Tunisias Foreign Investment Promotion Agency. The picture of the MENA region looks bleak and turbulent, but some funds are finding opportunities there. The Franklin Templeton MENA fund, for example, had 12.4% of its assets in Egypt and 1.95% in Morocco when investments were last disclosed on 31 March 2013. The Schroders ISF Middle East fund, in its last published update at the end of February, held a neutral position in Egypt; the fund managers said that valuations are cheap but political uncertainty has increased. It had no exposure to Tunisia or Morocco but for different reasons. Tunisias market is illiquid and the growth outlook is poor, while Morocco remains expensively valued relative to its peers. Analysts believe that in the longer term, Egypt will provide attractive investment opportunities in consumer goods, Algeria and Libya in oil and gas, Egypt and Algeria in technology and telecommunications, and Tunisia in healthcare. For potential investors in North Africa, the biggest challenge is going to be all about timing: capturing the moment at which confidence returns to Egypt or finding the moment of best value in Morocco. For fund managers looking at Libya, the challenge will be understanding the politics in Libyas sovereign fund and positioning themselves for the time when assets are unfrozen and allocated afresh. As always at a time of great change, somebody will make a fortune out of these circumstances, and plenty more will lose just as much.
Chris Wright is a freelance business journalist based in London.
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Frontiers
By Jonathan Barnes
Investors ignore key trends in frontier markets at their own peril, says economist Dambisa Moyo
Chinese commodity investment and trade are reshaping frontier markets and emerging economies, but many investors are overlooking an even bigger story, according to Zambian-born economist Dambisa Moyo, author of Winner Take All: Chinas Race for Resources and What It Means for the World. Although China is a major theme in the story, its contribution is less significant than the growth of domestic demand in these markets. Investors who focus only on the commodity aspect stand to miss out on opportunities for alpha generation. Moreover, a structural schism is forming between developed and emerging markets, with profound implications for investors.
In this interview with CFA Institute Magazine, Moyo, who recently spoke at the 66th CFA Institute Annual Conference in May, discusses key developments and trends in frontier markets. As she explains, common misconceptions can lead investors into trouble, including the tendency to conflate the idea of risk and uncertainty when they talk about emerging economies and the misinformed notion that developing markets are highly illiquid. Moyo also highlights the danger of escalating conflicts over natural resources.
public markets, because I think thats where there is a blind spot for most investors. Thats where I think there is significant opportunity, and weve already started to see that some of the savviest investors are really putting money to work in these markets. There is a lot of opportunity to invest and generate superior, uncorrelated returns in a broader global portfolio. Many frontier marketsjust looking at the macroeconomic themehave a solid capital base in terms of debt and deficits, strong labor dynamics (in terms of a young population), and a really compelling story around productivity. Those are three key ingredients that drive economic growth: capital, labor, and productivity. What Im suggesting is that in the public markets, trading of equities and fixed income is rapidly increasing. I think the returns in the macro story are reasonably well known, but where I see real change in the thinking is around risk management and liquidity. Those are the two key things.
What is changing in regard to risk management?

I think people traditionally conflate the idea of risk and uncertainty when they talk about emerging economies and frontier economies in particular. What were seeing with savvy investors is that there is a much clearer delineation between risk (which is measurable, which you can manage and hedge against) and uncertainty (which is obviously what is immeasurablethe whole idea of tail risk, of not being
What story are you seeing in developing markets?

A lot of people are quite focused on private equity when thinking about emerging or frontier markets. But the most interesting story is really the
countries face as they go from largely state-owned countries to market-driven economies that are more democratic. Investors who have the underground contactswhich is just good business in terms of risk managementwill do better than those who dont. You could ask, Is that the new risk management? No, its not. Thats how people do risk. They want to touch and feel, to look into the eyes of the people theyre doing business with. That is really where I think there have been leaps and bounds. People now feel comfortable to travel to these places and spend time with the business owners and the business managers and get a better handle on what is going on. That traditionally was not the case, because these countries and these places were viewed as far too risky, far too uncertain, a we dont go there kind of thing because its too worrisome. That story has changed quite considerably. Also, to the extent that youre getting much more market data, much more information and pricing information, then traditional model analysis, technical analysis, and fundamental analysis also become much more applicable.
How has Chinese investment impacted developing regions?

There are few countries that have not benefitted from Chinas campaigneveryone from the United States to countries across Africa and South America have all benefitted from the Chinese campaign, whether its through investment in debt (as in the case of the U.S.) or investment in infrastructure. But theres an impact also in some of the tradable markets. For instance, Chinas Industrial and Commercial Bank of China (ICBC) bought 20% of South Africas Standard Bank, one of the largest banks in Africa, in 2007. I think you would be hard pressed to come up with a country that has not benefitted from China. able to measure these outcomes). What has happened is that there has been a move away from this idea of uncertainty and toward the idea of there being significant opportunities in risk management and, therefore, the ability to put money to work in these markets.
Are there other examples?

My book Winner Take All is littered with examples of Chinese investment in commodities. I talk about the purchase of Mount Toromocho in Peru, which is basically a copper investment that the Chinese made in 2007. I talk about the deals that have been struck in Brazil, with the Chinese investing in agriculture there, and in places like Africa. I also talk about swaps that the Chinese put on in Russia and Pakistan in return for access to oil and uranium, respectively, which are very specific investments that could be very helpful. Having said that, is China a key piece of the story? Yes, it is. Is it the only piece? No, its not, because many of these economies are also very quickly seeing an increase in domestic demand. Their own local populations are actually now getting a foothold on the economic ladder. A lot of the change were seeing is due to China, but more significant is the domestic-demand theme.
And with regard to liquidity?

In regard to liquidity, people have tended to think these are highly illiquid markets, where there is really no opportunity to write big checks or the opportunity to go both long and short. Actually, weve seen a significant increase in the ability to trade large-ticket items. So, for example, it is not unheard of to be able to put US$10 million or US$20 million to work in a single name, in places like Nigeria or Kenya or the Philippines or Sri Lanka. Also, you can go short as well as long in these markets. Theres not much in terms of a developed knowledge base [of these areas]. Its just something that people who are in the know are doing much more.
Are investors using new techniques to measure risk?

Its actually age-old techniques being applied more thoroughly. If youre going to invest in these markets, you need to have very good underground contactsa network that can help you understand some of the evolutionary challenges these
How compelling are uncorrelated returns in frontier markets?

One of the main stories is this whole idea of superior, uncorrelated returns that you can garner by investing in the emerging markets. If you were to characterize the situation in developed markets right nowusing the lens of capital
and productivitywe know that they are struggling under significant debts and deficits. Theyve got serious aging-population concerns, not just in terms of the quantity of labor but also the quality of labor. If you look at the OECD statistics, you can see that the quality of labor is deteriorating in many developed markets. Then theres the issue of productivity. You have countries like Britain, where in the past decade theyve seen a decline in productivity in every single sector. If you look at the emerging market or frontier economy, the story is quite different. You see strong, solid dynamics, a very credible, positive upswing in labor, both in quality and quantity and in productivity. The democratic processes are including more transparency, less corruption, and countries are importing technology that can help them. So that in and of itself is a schism. The correlation between the developed markets returns and the bigger emerging market returns is around 0.9 by some measures. The return correlation between developed markets and frontier markets is closer to 0.7, which obviously is still significant but its relatively small and obviously makes a compelling story from the diversification of a portfolio point of view.
markets have been back-footed. But the hope is that if they were to remedy their problems, then they also would be part of this investment and trade story.
Whats the likelihood of China becoming a monopsony in commodities markets?

The idea of a monopsony is about Chinas market power in publicly traded markets. Its not necessarily about their impact on a frontier economy. Are they able to influence (inadvertently, I would say) the market price of different commodities? The answer is yes for both copper and coal, for example. Many market traders would argue that, even today, the Chinese influence on the ability to be price setters is quite significant. I think that the ability to be a price setter and to have pricing power in the broader markets is a piece of the puzzle, but I dont think it has to do with Chinas engagement with frontier economies per se. Australia is the largest recipient of Chinese foreign direct investment. And as we speak today, the China National Offshore Oil Corporation (CNOOC) is about to close its largest transaction ever in the commodity space with a US$15.1 billion dollar purchase of Canadian oil producer Nexen. Those are both nonfrontier economies, but the activity obviously will have significant implications for the markets.
Has China set an example in how to engage frontier economies?

Of the worlds population, 90% live in the emerging market. In many of these countries, up to 70% of the population is under the age of 25. Its a very young population, and very, very impoverished. These countries need trade, they need investment, and they need job creation. The Chinese mode of engagementwhere they are interested in forging a relationship of investment and trade, creating jobs, and building out infrastructureis much more beneficial for longer-term development than an attitude or an approach that focuses much more on supporting these countries in the short-term through aid. I dont think it is rocket science. There is not a single country in the history of the world that has achieved economic growth and reduced poverty in a meaningful way by relying on aid to the extent that many emerging countries rely on aid today. So it is not a mystery to me that good trade and engagement, solid foreign direct investment, capital markets development, and so forth are key pillars of a strategy to create economic growth. That is really what many people are describing as Chinas approach for engagement.
What does the evolution of the BRIC markets tell us about the path for frontier markets?
One of the case studies I love is the story of Turkey. Turkey has quickly changed from what was arguably a frontier economy into a much more developed market economy. Within 710 years, Turkey went from an economy where the cost of funding to do a trade would be about 8% and the maximum size you could do in a transaction for one stock would be about US$5 million to one where the funding cost is about 0.5% or 1% and you can very easily write a ticket of up to US$200 million dollars to buy or sell into a particular stock in Turkey. That shows how much liquidity has become available. To me, that transition (from being a relatively niche market, quite small, to becoming a market where you can actually put on massive trades for reasonably aggressive funding) is exactly the sort of path that I expect we will see amongst the frontier economies in the years to come.
What about specific investments in frontier markets?

One of the big misunderstandings about many emerging economies, particularly in Africa, is that people think it is a big commodity trade. That is completely wrong. Over 85% of the stocks that trade in Africa (there are about 20 stock exchanges and over 1000 stocks) are non-commodities. There are stocks in banking, logistics, telecommunication, the retail sector, and consumer goods that have really captured the growth theme that weve talked about already. Thats my big pointyou miss out if you think its just a commodity story. The second point is I believe very strongly that you dont want to just be going long in these markets. You also want
Do you see Western countries following Chinas lead?

Yes, absolutely but obviously to a much lesser degree, because one key aspect of Chinas approach is that its got deep pockets. But if you go across the emerging world, it is pretty clear that India, Turkey, and others have adopted the approach to some degree. Across Africa, you see a lot of Turkish, Lebanese, and Russian investmentwhat you would call South South investment. It is a big piece of the economic development story thats going on across the emerging world. It is worth pointing out that the ongoing financial crisis in the U.S. and Europe means that many of the developed
Across Africa, you see a lot of Turkish, Lebanese, and Russian investmentwhat you would call SouthSouth investment. It is a big piece of the economic development story thats going on across the emerging world.
natural-resource conflicts is one thing that we need to be concerned about. The other things emanating from this demand-and-supply imbalance are increases in prices and also in price volatility. Finally, an under-discussed concern is the real risk of resource nationalization in a world where commodities have become scarcer.
What form would resource nationalization take?

It could be a whole range. In Australia, theyve increased the tax on mining and iron companies by over 30%. Nationalization could also be much more aggressive, as with expropriation, which youve seen in places like Argentina and Venezuela, where the government just takes full ownership of some assets. The discussion around natural-resource nationalization has become a big deal, everywhere from Mongolia to South Africa.
How do you see price volatility extrapolating in the future?

to be able to short. Some of the worst performers last year were Mongolia and the Ukraine (on the back of the difficulties that they both had in their political environment). The markets are now mature enough to be able to put on positions that reflect those negative outcomes. Fortunately, you now are able to short the market for many but not all of the frontier economies. I dont like to be a stock picker, but I will say that in virtually all of these frontier economies there are two sectors that I like in particular. One of them is banks, which are the foundation of economic development. There is real significant upside around banking and insurance. If you think about some of the Nigerian banks, you can see the theme being put to work as a practical example. The other area that I really like a lot is construction. Weather concerns, political volatility, and political actions also exacerbate commodity price pressure, but I think the real driver is going to be the structural fundamental demand-and-supply challenges that Ive already outlined. If you look at the IMF forecast or the forecast from the U.S. Energy Information Administration [EIA], you can see that this concern about commodity price increases (and therefore the impact on our living standards) is very real. Both these agencies forecast, for example, that oil prices could be as high as US$200 dollars a barrel over the next decade.
What else would you want investors to know about the frontier?
Mainly two things. In terms of equities were talking about more than US$1 trillion in market cap, with 8,000 stocks that trade in that frontier market space. About US$200 billion of it is a free float, and I really believe that in terms of diversification, there is a real story for investors going back to basics of picking stocks based on micro fundamentals instead of this whole risk-on/risk-off phase, which is what weve been in for the past three years. The fixed-income side is another place of real opportunity. Take Africa, for example. Today weve got almost 20 countries that have credit ratings. Just in the past eight months, we have seen at least four countries come to the marketTanzania, Angola, Zambia, and Morocco. [Editors note: For more on Morocco and other markets in North Africa, see the cover story Northern Exposure on page 30.] Theyve done big bond issues in the market, ranging from US$600 to US$750 million. Were talking about bond issues that were 10 or 15 times oversubscribed in some cases and very aggressively priced. They are pricing more aggressively than Spain, Portugal, or Italy. So it is a real solid story. These countries now have credit ratings, which they are using to issue debts, and the market loves that. For people who are interested in opportunities for alpha generation, who want to get off their benchmark hugging, I think these markets are ignored at their own peril.
Jonathan Barnes is a financial journalist in the San Francisco Bay area.
How prevalent are resource conflicts in these regions?

In the U.S., the National Security Agency (NSA) put out a report in February 2012, basically articulating concerns and real risks around commodity-based wars, particularly emanating from water scarcity. In Winner Take All, I have a couple of tables at the back [of the book] that look very specifically at which region and what countries are already engaged in skirmishes, civil wars, and so on around commodity scarcity. Since 1990, there have been over 20 wars around commodity scarcity. If you look at some of the work by Michael Klare [professor of peace and world security studies at Hampshire College and author of The Race for Whats Left: The Global Scramble for the Worlds Last Resources], there is a lot being done right now in forecasting where some of the big wars could come from in the years to come, borne out of scarcity of natural resources. Am I worried about this being a big piece of the puzzle? Yes, I am worried about increased conflicts. It is already happening today, and it could escalate. Demand pressures, such as population, increases in wealth, and urbanization, are just not matching with the supply of water, arable land, minerals, and energy. This type of concern around
THE Biological INVESTOR
Investment methods based on biological insights may not be cleared for takeoff but that doesnt mean investors cant benefit from flying lessons
By Cynthia Harrington, CFA
Investment professionals want to refine their understanding of risk and return, and research in neurology, psychology, biology, and other disciplines provides a range of insights. Much of this body of knowledge is new, however, and tools for applying it still need to be developed. The task presents multiple challenges. Although a vast amount of research has been published, even the experts dont agree on how to interpret the findings. Some say the component parts of the biological system, such as hormones and neurons, make up the answers. Others say decisions are formed by processes, such as emotion and memory.
This article is the fourth in a series called The Biological Investor. The first three parts, focusing on research into particular aspects of decision making, were published as follows: chemical messengers and neural processes (Part 1, The Biological Investor, January/February 2013), the influence of emotions (Part 2, Sentimental Journey, March/April 2013), and memory formation (Part 3, The Decision Code, May/June 2013).
To use this new information and learn from it, investors need some frameworks. First, a background on the different schools of thought can help investors evaluate the findings. Second, some method is needed to find and incorpo rate the growing number of variables necessary to build models that can apply the findings. Finally, developing a framework for managing the relationship between human and computer has become an important part of the study and application of this emerging body of knowledge.
A Matter of Perspective
The research promises to improve decisions and provide better support tools for decision makers. For example, some studies show that people who trust and use their feelings when making decisions make better predictions than people who try to avoid being influenced by feelings. Other
studies demonstrate that levels of serotonin and testosterone influence risk decisions. But to interpret such findings correctly, an understanding of the motivations and assumptions of the researchers is important. One basic question is critical: Does the researcher believe that the parts add up to a whole or, instead, that the whole creates the experience from the parts (in undetermined ways)? The articles in this Biological Investor series have included examples of both schools of thought. Consider the research of Michel Pham, a professor at Columbia Universitys Graduate School of Business, whose investigation of the predictive ability of feelings follows the whole creating the experience path. Part 2 of this series (Sentimental Journey, March/ April 2013) explains how Pham designed an experiment to test whether feelings influence the ability of test subjects to make predictions. His definition of feelings as subjective experience does not address any electrical signals, chemical messages, or neural activities. Contrast this approach with the research conducted by Camelia Kuhnen, associate professor of finance at Northwestern Universitys Kellogg School of Management. As described in Part 1 (The Biological Investor, January/ February 2013), her investigation measured subjects levels of serotonin, the length of serotonin receptor genes, and attitudes about risk. But Kuhnen didnt stop there. She also correlated the findings with personality measures. One study put subjects under the metaphorical
microscope from the perspectives of four different types of researchers: a chemist, a geneticist, a financier, and a personality psychologist. The distinction between these two schools of thought matters, at least given the current state of knowledge in this field, because researchers often reach different conclusions about whether the parts do add up to a whole. Researchers on the sum of the parts adds up to a whole side are finding increasing convergence among parts. But according to those in the construction of experience (or whole organism) camp, the experiments too often turn up differences. For non-biologists who seek to apply this research and build models, knowing where the scientist is coming from will help in evaluating the results. Sometimes, the tools used in the experiments define which camp the researcher is in. An experiment like Phams in which a subject is simply asked to do somethingwithout any observations of biological phenomena being involvedis a sure sign of a whole-organism experiment. In other studies, however, the presence of the ubiquitous fMRI (functional magnetic resonance imaging) machine does not always indicate a sum-of-parts researcher. Two researchers illustrate this point. Daphna Shohamy, who directs the Learning Lab at Columbia University, studies memory and learning and conducts research into brain location activity by measuring electrical signals and hormones. Our mantra is that you cant look at any one of these individually when it comes to understanding what the brain does, she says. Theres not one right method. Shohamys big question has been whether these individual elements add up to a whole picture. The excitement over the past several years into rewards and learning is high because there is convergence in findings, and it makes the community feel like we got it right, she says. The view is very different from Lisa Feldman Barretts Interdisciplinary Affective Science Laboratory at Northeastern University, where researchers study what emotions are and how they work. Barrett also uses multiple methods, including experiential, behavioral, psychophysiological, and brain-imaging techniques, but the findings of her team have not pointed to convergence. Once we started measuring multiple channels, we found they dont correlate, says Barrett. More than that, theyre not even consistent. Sometimes, the response is anger with a scowl, and other times, we get a smile. Sometimes, the heart rate goes up, and sometimes, down.
Models and Prescriptions

For an example of how an investment professional might use this framework to apply findings, consider the recommendation that researcher John Coates has proposed as an antidote for testosterone-driven risky trading behaviors (see Part 1, The Biological Investor, January/February 2013). Coates research in neuroscience and finance at the University of Cambridge is groundbreaking work for the investment world because the subjects in his study were actually investment professionals. Most research in the fields of behavioral and experimental finance and neuroeconomics uses 20-something college students with no particular background in finance. Considering what Pham found about the importance of domain knowledge in predicting outcomes, Coates findings from studying investment professionals gain credibility. But based on findings about the maturation of executive functioning, age also must be taken into account, according to the research of Armin Raznahan, who studies brain development at the National Institute of Mental Health (see Part 3, The Decision Code, May/June 2013). Can such findings be applied in a practical way? A simple thought experiment shows how complicated implementation might be. Suppose the risk manager at an investment firm wanted to inhibit risky trading behavior and prevent traders from degenerating into what Coates calls
Researchers often reach different conclusions about whether the parts add up to a whole.
Illustration by James Yang
Research currently available can be used to provide insights for improvements to our current models of decision making that omit the biological basis for behavior.
the wolf phase. Because research shows that high testosterone correlates with higher daily trading results, the risk manager will want to retain that advantage. To balance it, however, Coates suggests putting more women on the trading floor. The recommendation is backed up by some additional research. One of Coates collaborators, Aldo Rustichini also at the University of Cambridge, conducted trading experiments that used gender-specific universes of traders. The all-male and the all-female markets quickly degenerated into unstable conditions; the balanced gender markets stayed stable. Given these findings, the risk manager in our thought experiment might conclude that the biological wolf phenomenon can be balanced by rearranging a social setting and adding more women (traders with less testosterone). But theres a potential complication. Other studies show that the presence of an attractive female actually spikes testosterone production, followed by outrageous and riskier behavior although only for young, single men. Married and older men avoided the presence of the attractive female. (For one notable example of such research, see the study Uncommitted men match their risk taking to female preferences, while committed men do the opposite by Willem E. Frankenhuis and Johan C. Karremans in the January 2012 issue of the Journal of Experimental Social Psychology). With these findings in mind, our hypothetical risk manager might decide to put more women on the trading floor (but only if they were unattractive or secluded behind trading screens) and to keep a balance between young, single male traders and married men over the age of 30. In short, even if one had an accurate understanding of the range of variables that affect the many dimensions of biological influences on investment decision making, trying to find a workable solution that integrates insights from the research would be a very tricky task. And that doesnt even consider the problem that some efforts to apply scientifically valid findings might be deemed offensive by many people. While we wait for more definitive evidence, the breadth of research currently available in both the sum-of-parts and the construction-of-experience schools can be used to provide insights for improvements to our current models of decision making that omit the biological basis for behavior.
Computers, Investing, and Humans

Much of the research in behavioral finance and neuroeconomics has tended to focus on documenting how humans err in their decisions. Over
the past three decades, an increasingly popular way of minimizing human error was to rely on computers, which can process more information and decide faster without human foibles. [For more on the machine learning challenge facing investors, see the Analyst Agenda article on page 24.] The biological basis of investment decisions is interrelated with the use of computers. We wouldnt have any of these research findings without computers that can process the kind of data generated by biological and behavioral studies. Increasingly, some researchers cant work without machines. For example, psychologist Michael Frank draws on his neurocomputational background to study the basal ganglia and better understand the neural components of choice and behavior. His work (described in Part 1, The Biological Investor, January/February 2013) has shown that highly emotional behaviors may correspond to mathematical signaling patterns in the human brain. From the perspective of the financial system and markets, the relationship between human and computer is important. The purely human investment decision-making process is described as being deliberative, a process of considering many factors and guarding against errors. Noted money manager Howard Marks, CFA, whose firm, Oaktree Capital Management, has more than US$90 billion in assets under management, has written clearly about the procedures and principles of his decision process. He explains the necessity of second-level thinking (or taking a second and more analytical look at a stock) and the importance of determining value, being contrarian, and pursuing patient opportunism. According to his July 2003 memo titled The Most Important Thing, he attributes Oaktrees successful performance to 16 principles for profitable investment decisions. The common theme among the items on Marks list is the advice to find principles to follow that temper ones animal spirits. [Editors note: Marks explained his views in an interview published in the September/October 2010 issue.] Computers were expected to temper our animal spirits, but increasingly, humans are being asked to cope with trading glitches and algorithmic errors that resemble errant animal behavior. Consider the flash crash on 6 May 2010 and the recent strangeness caused by what turned out to be a bug in Knight Capitals trading software. Both events sent prices gyrating. The task of accurately assessing the risk in the markets has been complicated by such computer errors. Yet, although computers have
changed the markets, the basic fundamentals of the markets are still intact, according to Peter Bossaerts, whose research at the Caltech Lab oratory for Experimental Finance is summarized in Part 1 (The Biological Investor, January/February 2013). There are times when the computer is necessary because humans get disoriented, as though flying through clouds, he says. But we do need to understand markets better in order for humans to assess the risks and to question what types of risks one might be facing. To underscore his point, Bossaerts points out that some professions are better at relying on intuition and experience than those in the investment management field. Firefighters and airline pilots find successful outcomesmore often than notby relying on intuition. He explains that these professionals have a smaller universe of usual outcomes and possible outliers to understand. Over time, they are more likely to be successful at adapting creatively in response to crises because they are more likely to have seen a similar pattern in the past. Even so, disasters can still occur. In June 2009, an Airbus A330 hit turbulent weather on a flight from Rio de Janeiro to Paris and crashed into the ocean from an altitude of 38,000 feet. Ice in tubes that monitored the planes velocity caused erroneous data to be fed into a computer, which shut down the autopilot. The aircrafts cockpit voice recorder captured one of the crew shouting, Je ne comprends rien! (I dont understand a thing!). Although highly experienced, the pilot could not react fast enough to find the computer error and thus could not respond correctly. Perhaps the anterior insula region of the pilots brain was overwhelmed. When reaction signals become contradictory, human error occurs. A similar pattern may develop when investors confront markets accelerated by algorithmic trading. Contrast this disastrous episode with the experience of US Airways Flight 1549, widely known as the Miracle on the Hudson. When a collision with birds took out one engine on the Airbus A320-214 aircraft, the pilot, Captain Chesley Sully Sullenberger, had to improvise a solution. At 3,200 feet, the plane shuddered and instruments indicated that both engines were losing thrust. Unlike the Paris flight, the captain and crew of the Hudson flight could still see the ground. They were oriented, which gave them the ability to take manual control from the automatic flight controls. Despite this difference from the Paris flight, they didnt know whether it was possible to manually fly a
bulky aircraft built to fly with the thrust of a jet engine. Everything would have to go smoothly. First, the slats and flaps on the wings had to be extended to slow the plane. Next, all openings that take in and let out air in the plane had to be sealed. Even if both of those things were executed perfectly, bulky airliners arent built to glide. The nose would have to be kept up with the wings perfectly level, which is not a task most big-plane pilots have the instincts for. By chance, not only was Sully experienced in commercial airliners, but he also happened to have the knowledge and instincts ingrained from his hobby piloting gliders. The end of the story is well known. The plane glided smoothly to a stop in the Hudson River. Reflecting on the Paris crash, Bossaerts concludes, What we need are improved methods of knowing when to take the controls and when to let the computer do its job. As we learn more about the details of biological behavior and decisions, we surely will be able to improve our outcomes. Knowing the risks of low serotonin or the process of cortical development can help us better define what is really happening behind certain behaviors. The causes of what we now call risk aversion or aggressiveness may be understood more accurately, which could lead to more nuancedand effectivesolutions. This emerging body of knowledge gets us closer to understanding how to operate in conditions outlined by Peter Bernstein in his book Against the Gods. Bernstein tells the story of how humans gradually moved away from acting on intuition and believing in fate and acquired a more disciplined approach to measuring risk, a process thats been unfolding over centuries. As civilization has pushed forward, Bernstein points out, natures vagaries have mattered less and the decisions of people have mattered more. The title of the books final chapter, Awaiting the Wildness, is an apt label for what is happening now with new insights and measures of risk emerging from the research into the biology of decision making.
Cynthia Harrington, CFA, is principal at Cynthia Harrington & Associates, a Los Angeles-based firm that provides executive coaching for investment professionals.
Computers were expected to temper our animal spirits, but increasingly, humans are being asked to cope with trading glitches and algorithmic errors that resemble errant animal behavior.
Translation
Nick French aims to bring Western and Eastern business cultures together
By Jonathan Barnes
Found in
Until youve actually lived and worked in Asia, its really difficult [for Westerners] to appreciate how Asians think and operate, says Nick French, director of Asianways, a Singapore-based training consultancy specializing in cross-cultural connectivity. Drawing on almost 20 years of business experience in Singapore and around Asia, French instructs Westerners on how to navigate Asian business culture (which may vary widely from China to Japan to Thailand) as well as Asians venturing to the West. A speaker at the 66th CFA Institute Annual Conference, held in Singapore this past May, he is the author of the eponymous culture guide Asian Ways. In an interview with CFA Institute Magazine, French discusses EastWest and WestEast employment strategies, the pitfalls of marketing investment products in Asia, the important Chinese networking concept of guanxi, and why seemingly harmless gestures can lead to misunderstandings that are essentially damaging to the relationship.
What is cross-cultural competency?

First of all, to be effective in cross-cultural encounters, you need to be open-minded and perceptive. One important element is just simple etiquetteunderstanding whats right from wrong in day-to-day issueswhether its going for a meal, giving a gift, or interpreting someones name. Using proper etiquette sends a message to the other party that you have taken some trouble to understand their culture. But this is just a very basic level that will only get you so far. The next level is what I call the execution of businessthe interaction between investment professionals, fund managers, and clients, for example. If youre dealing with a Japanese person, you should not be too loud or direct in the way you communicate with them, as we might amongst Westerners. In that way, they will respect you a lot more. You can save them face when imparting bad news or giving negative feedback through appropriate means of indirect communication.
It also means recognizing that Asian culture is not generic across the continent and that there are subtle differences across the region. Awareness of these differences will enable you to relate better to other culturesand so connect with them from their particular cultural position, rather than from your own.
the table or only with one hand. In Asia, gifts are presented with greater reverence. For example, you hand them over with both hands. Gift giving is more important than in some Western countries. If youre visiting an investment client, take them a local delicacy like cake or something that can be shared amongst the staff.
Groups and individuals play different roles in Asia and the West, correct?
Youll find that Asians often rate group identity above the individual. For instance, lets take a simple case in the workplacean employee wants to take leave. He or she will concern themselves with Whos going to take over their responsibilities during my absence? How much of a burden is it going to be on them? whereas a Westerner might be quite happy to go off for two or three weeks and whatever work there is, whoever has to handle it, thats their problem. When youre speaking with an Asian person, you should rather refer to we rather than I if youre representing your company, because it presents you as part of a group.
How might client relationships differ?

In the West, if you approach me offering a financial product, Im probably going to be looking more at the content of the product. How good is it? What are the returns like? Then Ill make a decision to invest with you or not. As we progress down the road, then we might develop a deeper personal relationship. Asians are the opposite. You may have a fantastic product, but the guy sitting across from you will be evaluating you and asking, How do I relate to you? Can I trust you? Yes, your product looks quite good, but I want to know a little more about you and feel comfortable with you. When youre doing business with a prospective Asian client, it may take longer to transact business because they are taking time to evaluate you, not only the product. In the Asian context, personal relationships may have to be developed first.
How would one market investment products in Asia?

If youre naming a financial product, be very careful because Western names, once interpreted may be highly offensive in that country. Use a name that appeals to the particular culture youre working with, even though it seems incongruous to you. For instance, a company that I used to work for is called Sasol. In China, if you said Sasol and you didnt pronounce the L properly such that it sounded like Saso, that would mean kill your father! Look at your brand and product names carefully. Have them translated into the local language. As some written languages, notably Chinese, are graphic, extra care should be exercised. Get a local expert to check your names and marketing literature very carefully. You should be aware of little quirks. For example, using the number 4 in Chinese environments is considered very unlucky because it is synonymous with death. Youd be better sticking to 8, which is a lucky number. For this reason, prices usually have 8s in them, $88 or $188, for example. The numbers 3 and 9 are also auspicious numbers. If youre marketing a product, a free giveaway or small free gift is always appreciated. Asians tend to be quite keen on that, especially in Singapore.
How does that translate practically?

When dealing with an Asian client or partner, more time has to be spent entertaining because they want to evaluate you in a different context. That may mean dinners, karaoke, and other forms of Asian entertainment. Usually, with an Asian person, its a good idea to couple a meeting with a meal. Arrange the business meeting whilst providing the opportunity to go for lunch or dinner afterwards.
Business stakeholders are valued differently in Japan than in the West. How so?
In the West, shareholders come first, followed by customers and then employees. In Japan, its the customer, then employees, followed by shareholders. In other words, business is directed at building lasting harmonious customer relationships and also looking after employees. Once you have those good relationships established, the Japanese believe that profitability and higher company value (or share price) will ensue. In Western companies, youll find that senior executives tend to manage the business for shorter-term profitability. Frequently they come in and make changes knowing their bonus is going to be determined by the share price. Decisions tend to be more short term, based on shareholder expectations
Some gifts should never be given in Asia. Which ones?

You wouldnt give a clock to somebody whos Chinese because this conveys a message that they are about to die. You dont give anything sharp like a knife, letter opener, or scissors because that means a severance of your relationship with them. The way you present the gift is important. It should be well wrapped and nicely presented. Westerners sometimes hand out promotional items by casually passing them across
What should investors know about doing business in China versus Hong Kong and Taiwan?
Most Taiwanese have had a foreign education, [typically] in Australia, New Zealand or the U.S. Hong Kong obviously
has enjoyed a long British influence, which to some extent is still prevalent today. Many students in Hong Kong also go to study in Canada or the U.S. The ability of Westerners to build relationships with Taiwanese and Hong Kongers is relatively easy because on average theyve experienced Western culture more than older China nationals in the PRC who havent had international exposure. However, with the easing of travel restrictions in China, more and more of their nationals are traveling and studying abroad. Youll find younger Chinese will be more westernized than older Chinese. If youre dealing with an older Chinese person, therefore, you should show them and their culture more respect. China is a very large country with many subcultures. For instance, in the South, they are quite business savvy theyve had exposure to Hong Kong. You might find that doing business in the south of China is going to be easier because theyre more business driven. The farther north you go, the more relationship driven theyre going to be. Particularly in Beijing, depending on who your client is, you may have to spend time educating them and supporting them and, perhaps, acceding to some rather strange requests.
How would a Western investment professional go about job-seeking in Asia?

The type of skill you have will determine how easily you get a job. If you have a particular skill that is in demand that the locals dont have, they welcome you. Maybe youre a portfolio manager or somebody whos got superb analytical skills or knows a market sector very well. First thing is to leverage your unique offering. Then seek those institutions in the region that might have a need for your particular advantage. Another way is to work for a global company in a major city, such as New York, and then make it known youre interested in working abroad in Asia and bank on a transfer. Thats a cheap and easy way of getting across.
What about Asians looking to work in the West?

Asians should understand how Westerners think. Obviously, directness is appreciated, more eye contact, understanding that Westerners need information presented clearly and openly. Its a bit of an attitude change, which may make Asians feel uncomfortable because theyre stepping out of their own frame of reference. When it comes to securing a job in the West, using a third party, such as an employment consultant, can help. But again, youd need to have a competitive advantage, such as a special skill or knowledge.
What kind of requests?

You may be asked for something that seems out of the norm. They may ask you for some additional education or support on a product that is not normally requested. Youll have to make a judgment call as to whether or not youre prepared to cooperate. My advice is if you accede to these strange requestsprovided its not unethicalits going to earn you tremendous amounts of what we call guanxi. Guanxi is played out to a very large degree in China. Its a typical case of you scratch my back and Ill scratch yours. Basically, it means if somebody asks you for a favor, theyre indebted to you. And it can be network driven. If I do something for you and I need some help in a particular area, you may not be able to help me directly but you might know somebody else who can. Because of your good relationship with that person, you can leverage this to help me with my particular problem.
For Asian investment professionals already in the West, what parts of social interaction can be tricky?
I remember Dale Carnegie saying that one of the ways you connect with people is to ask questions. Ask them questions about themselves and their interests. If you dont know much about Western sports, dont be afraid to ask questions. How does American football work? Why do you only play for two minutes at a time and have a break? Asking questions draws the other side out and communicates that youre interested. But dont rely on closed, weak questions like So, hows business? Have you been traveling lately? Where are you from? If youre working in a Western environment, when you go for your performance review, be more open than normal. My experience has been that Asians can be withdrawn when asked about their future plans. The message here is be direct, be open, be prepared to stand out, be prepared to challenge.
What else about business in China might be challenging?

Usually, the Chinese will take you to their restaurants and you may have to eat some [strange] things[for example] a delicacy thats still alive on the plate! If presented with such a dish, eat it and smile. You dont necessarily have to finish it, but if you object and say, In my country, we dont eat that, thats a tremendous loss of face to your host. You eat as much as you can and be seen to appreciate it. There is a protocol to the way you drink. If you have a glass of wine at your table, you dont usually sip it with the meal. You wait until somebody toasts you, and then you bottom it upand then youre expected to toast them back later on.
Whats the climate for female investment professionals in Asia?

Some countries, such as Japan and Korea, have male-dominated business societies, whereas in the past, foreign women found it difficult to succeed. Fortunately, its changing away from this, as evidenced by the recent election of a woman president in South Korea. Still, if you go to Japan and Korea, most of the time youre going to be dealing with men.
Youll have to make a judgment call as to whether or not youre prepared to cooperate. My advice is if you accede to these strange requestsprovided its not unethicalits going to earn you tremendous amounts of what we call guanxi.
If you are a woman dealing with men, its good to portray yourself as a very senior person. In these countries, seniority is highly respected and commands attention. How do you do that? If youre leader of a group and the others are men, make sure you sit in the leaders chair in the meeting roomwhich is at the center of the table, with the guys to either side of you. Simple acts such as this, coupled with others, will soon get the message across. In other countries, such as Thailand, you find that women are much more readily accepted in business and management positions and are well received from abroad. So, you wouldnt be faced with the same challenge. Nonetheless, women should be mindful of the fact that older men in some countries may be more reserved towards them and it may take longer to be accepted.
to a Muslim woman. If she offers her hand, then Ill shake itjust lightly, though. Another thing is mid-morning meetings on Fridays not a good idea. Friday midday is a very important time for Muslims to go to mosque and pray. Avoid organizing training sessions or a meeting around this time if Muslims are attending. If necessary, ensure that a mosque is close by and plan time for them to attend the midday prayer session.
How would a Western investment professional navigate workplace dynamics in Asia?

If youre a Western person in an Asian office, you have to control your emotions. You may have to be less ebullient, less outgoing. The last thing you want to do is show any kind of irritation openly, and Im not talking about shouting and losing your temper and thumping the table. Im talking about any minor display of irritation, such as raising your voice even slightly or an inappropriate facial expression of annoyance. You have to remain calm no matter how angry you feel; otherwise, you will lose respect from those around you. Never ever criticize somebody in public. If in a meeting somebody hasnt done their job properly, you wouldnt make a direct reference. You would have to be discreet in the message you give and say something like, Lets do a bit more work here. You might say to them, Could you go and investigate that for us? rather than openly criticizing them. If you are unhappy with their performance, mention it to them in private. If youre a manager, understand that youre not always going to get clear messages from your subordinates. They may not share everything immediately with you and may hold back bad news until they feel its appropriate to tell you. It may also take longer to build their trust in you. You have to walk the walk and be a good leader. If you can do that, they will have the utmost respect for you, probably far more than youll ever get from a Western subordinate.
Jonathan Barnes is a financial journalist in the San Francisco Bay area.
How would one behave in Asian countries with a strong Islamic influence?
Im talking [primarily] about Singapore, Malaysia, and Indonesia, where the Muslim faith abounds. But this could apply in any country around the world. If youre entertaining Muslims, the restaurant you take them to should be certified halal. In Singapore (and it may happen in some other countries), you have various degrees of Muslim catering. You can have what is termed no pork, no lard, and no alcohol. This technically is not sufficient. Its advisable to look for a place that is halal certified where the utensils are dedicated to the preparation, serving, and eating of halal food. For instance, if you go to a company cafeteria in Singapore, youll find that used halal eating implements and plates are handled on one side and non-halal on the other. The bottom line is to always make sure youve got certified halal food options. If youre bringing in food, finger lunch, or anything like that, ensure it is halal certified. If the service provider tells you no pork, no lard, thats not good enough. A man never initiates a handshake with a Muslim woman. Some Muslim women dont mind shaking hands, others do. If you extend your hand, theyre going to feel an obligation and may decline. Personally, I never offer my hand

Market Integrity and Advocacy
Is the Financial System Safer Today?

By Kurt N. Schacht, JD, CFA
I recently attended a panel discussion at New York Universitys Stern School of Business featuring former Federal Reserve Chairman Paul Volcker and British economist Sir John Vickers, who chaired the U.K. Independent Commission on Banking. No two individuals are more synonymous with the current debate over structural reforms of banksand more to the point, how to rein in excessive risk taking and to protect taxpayers. While Volcker supports an outright ban on proprietary trading, Vickers advocates ring-fencing the retail parts of banks from their investment businesses. The fact that were still debating the best path to reform some five years after we stood on the brink of a systemic meltdown only shows that the wounds are still freshor at least inflamed by recent scandals that serve to remind us of how vulnerable we still remain. Unfortunately, progress has been slow. In the U.S., we are eagerly waiting to see how regulators will define key aspects of the so-called Volcker Rule that would ban U.S. banks from proprietary trading. Calls for implementation have picked up momentum in recent weeks in the wake of a Senate investigative report on JPMorgans London Whale scandal, which concluded that reckless speculation led to the US$6.2 billion loss. The report also concludes that the final Volcker Rule should be issued Keep Going immediately. While we recFollow the Market Integrity Insights blog: http://blogs.cfainstitute.org/ ognize that the marketintegrity/ Volcker Rule (and Follow us on Twitter: @MarketIntegrity drawing a line bet ween leg itStay up to date on the Systemic Risk Council: www.systemicriskcouncil.org imate market making and speculative trading) is indeed ambitious, the JPMorgan episode clearly illustrates the need to move beyond the status quo. Of course, the issue of reining in risky bets that could destabilize a bank goes hand in hand with the problem of Too Big to Fail financial institutions. In its latest annual report, the Financial Stability Oversight Council (FSOC) recently cautioned that the largest U.S. banks may be encouraged to take excessive risks with the expectation of a government bailout. This is a particularly unsettling declaration because the problem of Too Big to Fail was supposed to have been solved three years ago with passage of the DoddFrank Act.
What does this all mean for investors? Plenty. To address that very issue, the Systemic Risk Council (SRC)co-sponsored by CFA Institute and Pew Charitable Trustsrecently held a roundtable discussion in New York on Too Big to Fail, soliciting the input of regulators as well as large financial services firms. We focused on the disclosure of living wills and resolution planning currently available to the public; the information needed to evaluate the risks and returns of large, complex financial institutions; and whether there are market-based solutions to rightsizing these institutions from both the regulator/policymaker and investor/analyst perspectives. Through the Systemic Risk Council, CFA Institute has helped create a high-profile platform to advocate for key regulatory and structural reforms to bolster systemic protections. Yet, as the Senate report on JPMorgan and the FSOC warnings about Too Big to Fail dramatically illustrate, systemic safety may still be an illusion.
Kurt N. Schacht, JD, CFA, is managing director of Standards and Financial Market Integrity at CFA Institute.
Raising awareness of the CFA Institute Asset Manager Code of Professional Conduct continues to be an important initiative to position CFA Institute as an ethics leader. Kurt Schacht, CFA, managing director of Standards and Financial Market Integrity, and Jan Squires, CFA, managing director of Strategic Products and Technology, recently recorded their thoughts on the value of a global standard of conduct for asset managers at Bloombergs New York studios. The recordings will be combined with similar reflections from CFA Institute President and CEO John Rogers to create a series of radio advertisements that Bloomberg Radio will broadcast and stream on its web app.
The Asset Manager Code in Asia Pacific

In the wake of the global financial crisisand calls for greater transparency and protecting client interestsCFA Institute updated the Asset Manager Code of Professional Conduct with new provisions that strengthen protections for investors. Since that time, the number of firms claiming compliance with the Asset Manager Code has increased significantly and now stands at nearly 900 firms in 29 countries. Although the majority of adopting firms are based in the United States, outreach activities are under way to promote the Code in the Asia-Pacific region, where financial scandalsincluding the pension-fund fraud at Tokyo-based AIJ Investment Advisors Co.have raised public, investor, and f inancia l i ndust r y awareness of unethical behavior in the investment industry. In the light of these ethical lapses, the climate for asset managers has changed completely, says Alexander Flatscher, CFA, director of CFA Institute codes and standards for the Asia-Pacific region. Pension funds in the Asia-Pacific region are waking up to the growing importance of making sure that the asset managers they entrust their beneficiaries funds with have a culture in place that demands high ethical standards. First released in 2005, the goal of the Asset Manager Code is to offer comprehensive protections for investors through a professional code of conduct for investment management firms they hire. It provides a framework for ethical standards of conduct that can be used as a guidepost for investors seeking managers that adhere to sound ethical practice. Since the Codes re-release in 2009, outreach efforts aimed at building awareness in the Asia-Pacific region have relied heavily on local society involvement. The CFA Society Japan was one of the first to take a prominent role in promoting the Asset Manager Code in the region. Activities include outreach to the Japanese Trade Union Confederation, which is pressuring Japans Government Pension Investment Fund to develop policies for responsible investment, and an ethics symposium to promote the Asset Manager Code to members of Japans Pension Fund Association and the Japanese Investment Advisers Association. Likewise, CFA Society Singapore is meeting with asset managers, pension funds, and local regulators to promote the Code. Elsewhere in the Asia-Pacific region, New Zealand recently saw its first firm claim compliance with the Asset Manager Code, owing to outreach by CFA Society New Zealand. Thanks to the strong commitment by local CFA societies in the Asia-Pacific region to promote higher ethical standards in the investment industry, CFA Institute has been able to increase awareness levels for the Asset Manager Code, Flatscher says, noting that the Code recently was translated into Korean by local volunteers, opening up the potential for wider recognition in the important Korean investment
industry. The Korean translation joins the Japanese and Chinese versions, which were also prepared with the aid of the Asia-Pacific CFA society network. Currently, Thai and Urdu translations are under development in collaboration with volunteers in Thailand and Pakistan. For his part, Flatscher recently presented to 170 delegates at the annual conference of the Fund Manager Association of the Philippines and visited several organizations in Thailand, including the Government Pension Fund and the Securities and Exchange Commission of Thailand. Similar activities are planned for other countries, including China, Korea, and India. Following the CFA Institute Annual Conference in Singapore, Flatscher and Michael Trotsky, CFA, chair of the Asset Manager Code Advisory Committee (the advisory body for the Asset Manager Code), were to attend several planned meetings with regulators, pension funds, and asset managers in Singapore and Tokyo. Those outreach activities included a meeting with Japans Government Pension Investment Fund (GPIF)the worlds largest pension fundand a media luncheon and investment industry seminar in Tokyo. As a result of promotion efforts, market participants are increasingly seeing the benefits of adopting a globally respected code of conduct, such as the Asset Manager Code, Flatscher says. Asset managers appreciate the strong impact it has on the reputation of a firm and its ability to retain and attract clients. By the same token, pension funds are increasingly interested in their managers complying with the Asset Manager Code because it advances proper due diligence. For more information on the Asset Manager Code of Professional Conduct and to view a list of registered firms, visit www.cfainstitute.org/assetcode.

Updating the Standards of Practice Handbook

The CFA Institute Code of Ethics and Standards of Professional Conduct continue to serve as the model for ethical behavior in the investment profession globally. Although they represent enduring ethical principles, periodic reviews are necessary to ensure these principles are keeping pace with changes in the investment management profession. In a recent interview, Glenn Doggett, CFA, director of standards of practice at CFA Institute, discussed related updates to the Standards of Practice Handbook, which provides guidance to the people who grapple with real ethical dilemmas in the investment profession on a daily basis. The proposed updates to the Handbook are being reviewed by the volunteer Standards of Practice Council (SPC). Glenn Doggett, CFA Proposed addition: Disclose to clients and prospective clients significant limitations and risks associated with the investment process.
The Standard for members and candidates who supervise or have authority over others within their firm was updated to lead to better actions in preventing illegal and unethical behavior. How is it different from the previous version?
With the proposed updates to Standard IV(C), the SPC wanted to stress that supervisors should be doing more than looking out for wrongdoingthey should be helping to prevent it. The new proposal stresses a broader expectation for effective compliance, which may include regular training of a supervisors direct reports on rules and regulations. Proposed update: Members and Candidates must use reasonable efforts to ensure that anyone subject to their supervision or authority complies with applicable laws, rules, regulations, and the Code and Standards.
Will CFA Institutes expanded mission of shaping an investment industry that serves the greater good be incorporated in the Handbook?
The current Code of Ethics contains many aspirational elements with the broader investment community in mind. Members and candidates must practice in a professional and ethical manner to reflect positively on the profession; they also strive to help other investment professionals improve. The SPC is recommending a modification to more closely align with CFA Institutes updated missionand the idea that as members work to promote and maintain the integrity of the markets, their actions are critical to maintaining the social contract with investors. Proposed update: Promote the integrity and viability of the global capital markets for the ultimate benefit of society.
As members work to promote and maintain the integrity of the markets, their actions are critical to maintaining the social contract with investors.
Increased use of social media is having a major impact on the industry. How will you address this industry trend in the Handbook?
The use of social media has potential implications for several of the Standards. But since social media was viewed as another form of communications, the SPC decided that creation of a new social mediafocused Standard was not required. Rather, members and candidates will notice a number of new sections of guidance that address such issuesfrom applying new regulatory guidance and requirements to avoiding the misrepresentation or disclosure of sensitive information. CFA Institute is seeking comments on the proposed changes. The public comment period opens in July and runs through 30 September 2013 with the goal of making the Handbook effective for members in summer 2014. To comment on the proposed changes or for more information on the Code & Standards, visit www.cfainstitute.org/ethics/codes/ethics (to comment, scroll down to Periodic Review of Code and Standards and click on the Learn More link).
The Standard for members and candidates regarding communications to clients was modified to include implicit disclosures of significant risks and limitations. What is expected with the updated version?
There are constantly new financial products and strategies that rely on more advanced investment models and processes. In updating Standard V(B), the SPC felt that members and candidates should clearly inform clients of any significant risks and limitations associated with a particular recommendation or strategy. The new principle and related guidance acknowledge that levels of disclosure will differ between products and services. Members and candidates, along with their firms, must determine the specific disclosures their clients should receive while ensuring appropriate transparency of the individual firms investment process.
Coordinating Global Accounting Standards

The newly formed Accounting Standards Advisory Forum (ASAF)a technical advisory body to the International Accounting Standards Board (IASB)recently met for the first time in London. The goal of the ASAF is to improve cooperation among financial reporting standard setters worldwide and to advise the IASB on the development of International Financial Reporting Standards (IFRS). In a recent interview with Vincent Papa, CFA, director of financial reporting policy at CFA Institute, Yael Almog, executive director of the IFRS Foundation (the oversight body of the IASB), discussed the 12-member ASAF and its role in the development of global accounting standards and whether investor interests will be represented.
What kind of impact does this groups formation have on the IASBs relationship with the Financial Accounting Standards Board (FASB), particularly as IFRS and U.S. GAAP convergence projects are close to being finalized?
Almog: We considered it to be crucial for the FASB to have
What motivated the IASB to form the ASAF?

Almog: Formal advisory bodies provide an important chan-
nel for the IASB, enabling it to engage directly with key stakeholders, such as preparers and users, as well as specific groups for individual technical projects.Until the establishment of the ASAF, however, the engagement with national standards setters had been conducted by way of numerous bilateral or ad-hoc arrangements. The ASAF enables the IASB to streamline and structure the relationship with national standard setters on a multilateral basis. One of the key points set out in the Trustees Strategy Review, completed in 2012, was the need for the IASB to strengthen its relationships with national standard setters around the world and, in particular, to consult with them as an integral part of the global standard-setting process. The ASAF will enable us to do this by giving national standard setters greater involvement in the standard-setting process at an earlier stage. The geographic balance of the group will also ensure that a wide range of perspectives are brought to the table.
a seat at the table. As we reach the conclusion of the convergence project, it has become clear that, while both the IASB and FASB may need to focus on their independent agendas, they must continue to communicate and coordinate their work. The ASAF represents a good way for both boards to communicate effectively to the international standard-setting community while remaining focused on their own constituents. With regard to the ASAFs contribution towards global standards, the IASBs mission, as set by the G20, is to achieve a single set of high-quality global standards. We recognize that in order to succeed in this endeavour, we will require international support. At the inaugural ASAF meeting, all participants signed a memorandum of understanding making a commitment to provide that support. Therefore, I think that the ASAF will be an important factor in helping us to make standards fit our global constituents and acceptable to many of them.
Is there a risk that the national standard setters, through the ASAF, may disproportionately influence the IASB without sufficiently eliciting investor input?
Almog: I dont think the ASAF will disproportionately influence the IASB at the expense of investors. First, were not giving up on the extensive investor outreach program we already have in place. We will always look to investors as an important independent reference point when creating standards. Furthermore, most national standard setters have a mandate to work in the service of the public good, including in the best interests of users and preparers in their jurisdictions. So, in that sense, investor needs should also be well represented at the ASAF.
Who makes up the ASAF?

Almog: The ASAF comprises 12 seats, which consist of national accounting standard setters and regional bodies with an interest in financial reporting. It is chaired by the IASB chair. In deciding the composition, the aim was to achieve a good geographic representation. We considered such factors as knowledge of and experience with IFRS and their application. We also looked to ensure a balance between IFRS users and non-IFRS users, who will offer a valuable external perspective. The involvement of non-IFRS users was almost universally supported in the feedback we received after publishing our initial proposals on the formation of the ASAF. The inclusion of regional bodies was also considered to be very important. Another factor was the scale of the capital markets represented at the table.
How will you assess the ASAFs effectiveness?

Almog: The IASB is committed to considering the views of
the ASAF in its standard-setting activities. IASB members have been present at ASAF meetings, so views expressed are already being fed directly into the standard-setting process. I think that this in itself is a success. In the long term, involvement of the ASAF will mean that we get the perspective of the international community early on in the standard-setting process. We hope that this will encourage greater ownership and buy-in of the standards, enhancing their quality, legitimacy, and acceptability around the world.

The GIPS Standards: Not Just for Asset Managers

The success of the Global Investment Performance Standards (GIPS) is largely due to the support of asset owners who demand compliance from asset managers. Oversight boards of pension plans and other asset owners, however, increasingly expect the performance of the asset owner to also be reported according to industry best practice and are looking to the GIPS standards for direction. In response, CFA Institute recently released draft guidance on applying the GIPS standards to pension funds, endowments, foundations, and other institutional asset owners. The GIPS standards can be adopted by any firm or entity that manages discretionary assets, notes Jonathan Boersma, CFA, executive director of the Global Investment Performance Standards at CFA Institute. In many cases, large asset owners look and operate just like asset managers. They have investment mandates, manage dis- Jonathan Boersma, CFA cretionary assets, and can be compensated based on performancethe difference is that they typically do not have external clients. But because the GIPS standards were written from the perspective of the asset managernot the asset owner applying the standards to an asset owner is not as obvious in some areas. A frequently asked question is why asset owners, who typically do not market their products and strategies, would want
Join the Global Conversation

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Reporting performance according to a globally recognized, ethicalbest-practice standard is simply good governance.
to comply with the GIPS standards. As Boersma explains, Although claiming compliance provides a distinct marketing and competitive advantage to asset managers, particularly when competing for institutional mandates, there are other benefits of compliancehaving a strong compliance framework and internal controls, robust policies and procedures, enhanced management information, and improved performance data for investment reportingthat are realized by both asset managers and asset owners when applying the GIPS standards. It is these benefits that are attracting asset owners to the standards. In addition, oversight boards increasingly expect the performance of the asset owner to be reported according to industry best practice, and compliance with the GIPS standards meets this need. In fact, several public pension funds, sovereign wealth funds, and social security funds already have adopted the GIPS standards. Reporting performance according to a globally recognized, ethical-best-practice standard is simply good governance, Boersma stresses. I believe this is an incredibly important step for the GIPS standards, for the industry, and ultimately for the benefit of asset owners and their beneficiaries. For more information, visit www.gipsstandards.org. Feedback and comments on the draft guidance are welcomed and can be directed to standards@cfainstitute.org.
Key Points
There are currently GIPS Country Sponsors in 37 countries, with the Philippines and Thailand as the latest to join the growing list. While the GIPS standards are focused on presenting performance to prospective clients, there has been very little guidance for ongoing reporting once a client hires an investment manager. The Investment Reporting Working Group is establishing a set of principles for ongoing investment reporting to existing clients. CFA Institute is also developing technical guidance for risk measurement and reporting, performance record portability, pooled funds and retail products, treatment of overlay strategies, and verifier independence as part of the GIPS standards.

PROFESSIONAL CONDUCT
Self-Disclosure, Fair Process, and Confidentiality

By Dorothy Kelly, CFA
Each year, in accordance with the CFA Institute Bylaws, members sign and submit Professional Conduct Statements (PCS) disclosing any investigations, litigations, arbitrations, complaints, disciplinary proceedings, and/or other matters relating to their professional conduct. As shown in the Cases Opened chart, more than 250 members self-disclosed professional conduct matters to CFA Institute last year, slightly more than in previous years. Members who self-disclose professional conduct matters on their annual Professional Conduct Statements can count on two things from the Professional Conduct Program (PCP): fair process and confidentiality of proceedings. CFA Institute is committed to providing members with a fair disciplinary processone that provides them the opportunity to be heard and presumes their innocence until it is proved otherwise. Thus, the Rules of Procedure for Professional Conduct (Rules of Procedure), which govern the disciplinary process, ensure that a member under investigation has the opportunity to present his or her case for peer review by members of the Disciplinary Review Committee. The Rules of Procedure also prohibit disclosing whether a member is under investigation (unless required by law, the member has waived confidentiality, or disclosure is necessary to conduct the investigation). With these safeguards in place, members who self-disclose matters can take comfort in knowing that they will receive fair treatment and that their confidentiality will be preserved throughout the disciplinary processand possibly longer. When a matter or complaint is disclosed on a Professional Conduct Statement, reported publicly, or submitted to CFA Institute, PCP staff members begin an investigation by requesting additional information and documentation from the member. Depending on the type of matter and the members response, the investigation phase may be very quick or it may take yearsas is often the case with matters that are under investigation by regulators or involved in litigation. Throughout this time, the members confidentiality is preserved in accordance with the Rules of Procedure. Following the investigation phase, PCP staff members evaluate all the evidence gathered to determine whether it is more likely than not that the member violated the Code of Ethics and Standards of Professional Conduct. For any matter with insufficient evidence of wrongdoing, PCP staff members close the case with no disciplinary sanction or further action. The entire matter remains confidential, and no disclosures about the allegations or investigation are made. Historically, following an investigation, PCP staff members have closed nearly 85% of industry-related cases with no action. Many of these cases involve lawsuits or complaints lodged against members following a period of market decline.
Cases Opened from Self-Disclosures (20002012)

300
200
100
0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
If the matter appears to be a violation of the Code and Standards, the disciplinary process may take much longer. When PCP staff members determine that it is more likely than not that there is sufficient evidence of a violation, they will send the member a Statement of Allegations explaining their findings and providing the member an opportunity to respond and present his or her position. The PCP staff members then conduct a final review of all the information and evidence gathered before submitting the matter for a first level of peer review. The Designated Officer, a regular member of CFA Institute, whose role and authority are described in the Rules of Procedure, provides the first level of peer review. If the first level of peer review indicates that it is more likely than not that a violation occurred, the member receives findings of fact, a conclusion as to the violation, and recommended sanction and has 30 days to respond. If the member rejects the findings, conclusion, or recommended sanction, the matter is referred to a Hearing Panel composed of five CFA charterholders from the Disciplinary Review Committee. According to the Rules of Procedure, hearings are held within 120 days of the referral and the decision is due within 30 days of the hearing. Thus, a disciplinary matter involving evidence of a violation could take six months to move through the hearing process. If the decision involves a suspension or revocation of membership and/or the right to use the designation, the member may appeal, adding another 90 days or so before an Appeal Panel issues a final decision and the matter is concluded. When a final decision to impose a sanction has been made, CFA Institute publishes a Notice of Disciplinary Action in a CFA Institute publication and/or on the CFA Institute website. If the member receives a sanction of censure, timed suspension, or revocation of membership or the right to use the designation, the notice may include the sanctioned partys name. These notices may be shared with regulators, member societies, and (upon request) third parties, such as prospective employers and clients. If the disciplinary panel concludes that no violation of the Standards occurred, the matter is closed with no action and the members confidentiality remains intact. Given CFA Institutes commitment to preserving the confidentiality of

PROFESSIONAL CONDUCT
members involved in the disciplinary process and the time required to complete the disciplinary process, those who report misconduct might misinterpret a lack of public information as inactivity. Lack of public information can be misleading, however. CFA Institute takes allegations of member misconduct seriously, and for all disciplinary caseseven high-profile matters in the presswe adhere to the Rules of Procedure, preserving member confidentiality and providing
a fair disciplinary process before making public disclosures. Self-disclosure is one way to help rebuild trust in the investment industry. Members should self-disclose matters relating to their professional conduct on their PCS confident in the knowledge that the Rules of Procedure assure them both fair process and confidentiality of proceedings.
Dorothy Kelly, CFA, is the director of training and outreach for the Professional Conduct Program at CFA Institute.
Disciplinary notices
REVOCATION On 13 March 2012, the CFA Institute Designated Officer imposed a Summary Suspension on David Rubin (U.S.), a charterholder member, automatically suspending his membership and right to use the CFA designation. Rubin requested a review of his summary suspension, as provided under Rule 10.3 of the Rules of Procedure (2010) but did not proceed with the Summary Suspension Hearing Panel once scheduled. Because there was no completed request for review within the time provided under the Rules of Procedure, the Summary Suspension automatically became a permanent Revocation of his membership and the right to use the CFA designation. On 30 December 2011, Rubin pleaded guilty in federal court to charges that he engaged in separate conspiracies to rig bids for investment agreements and to defraud municipal issuers. According to the U.S. Department of Justice, from approximately 1998 through 2006, Rubin was the owner of CDR Financial Products, a financial services firm based in Beverly Hills, California. State and local governments and agencies hired CDR to act as their broker and conduct a competitive bidding process for contracts to invest the proceeds of municipal bonds issued to pay for public projects. Rubin and others, however, decided in advance which providers would be the winning bidders for certain investment agreements, in return for kickbacks to CDR in the form of unearned or inflated fees. As part of their fraudulent scheme, Rubin and others also gave certain co-conspirator providers last look information about the prices and conditions in their competitors bids, which enabled the providers to win contracts at artificially determined price levels. In exchange, CDR received kickbacks and relied on the co-conspirator providers to submit intentionally losing bids when requested on other contracts. SUMMARY SUSPENSION On 28 November 2012, the CFA Institute Designated Officer imposed a Summary Suspension on a Candidate, automatically suspending his participation in the CFA Program. The Candidate subsequently requested a review of his summary suspension. A hearing was then conducted by telephone conference call on 11 April 2013. The Hearing Panel reviewed the matter and affirmed the Suspension, which then automatically became a permanent Prohibition of Participation in the CFA Program. In May 2011, while he was a candidate in the CFA Program, the individual entered the womens bathroom at a local university and photographed a woman without her consent. After his arrest, the Candidate admitted to legal authorities that he had secretly taken hundreds of indecent photographs and videos of multiple women in a pattern of conduct over several
months preceding his arrest. The Candidate pleaded guilty to the offense of loitering under circumstances that caused a person reasonably to be concerned for her safety or well-being. The offense carried a maximum sentence of two years imprisonment. On 22 February 2013, the Professional Conduct Program rescinded its Notice of Summary Suspension and reversed the Prohibition from Participation in the CFA Program previously imposed on Sheng Song (Peoples Republic of China) because he agreed to cooperate with the Professional Conduct Programs investigation. TIMED SUSPENSION On 25 February 2013, a Review Panel affirmed the CFA Designated Officers imposition of a Six-Month Suspension of membership and of the right to use the CFA designation on Darren A. Delage (Canada), a charterholder member. The Designated Officer found that Delage violated the following standards: the CFA Institute Bylaws (2005, 2006, and 2007); Standards IFundamental Responsibilities and II(B)Professional Misconduct (1999); and Standards I(A)Knowledge of the Law, I(C)Misrepresentation, I(D)Misconduct, and VII(A)Conduct as Members and Candidates in the CFA Program of the CFA Institute Code of Ethics and Standards of Professional Conduct (2005). Specifically, during June and July 2005, Delage, a trader for a hedge fund, entered into numerous end-of-day purchases of shares of a thinly-traded stock on the Canada Venture Exchange, when he knew or ought to have known that this pattern of trading would contribute to a misleading price in the shares, in violation of the Ontario Securities Act. As a result of this misconduct, the Ontario Securities Commission suspended Delage from registration and trading for four months, imposed two years of special supervision by a registered trader, and ordered him to complete a conduct and practices course and to pay $7,000 in costs. In addition, CFA Institute separately found that, although he knew that the Ontario Securities Commission began investigating him in July 2005, Delage falsely stated on his 2005, 2006, and 2007 Professional Conduct Statements that he was not subject to any investigation regarding his professional conduct. CENSURE On 12 April 2013, a Hearing Panel imposed a Censure on Amala B. Thakkar (U.S.), a charterholder member. The Hearing Panel determined that Thakkar violated Standards I(A)Knowledge of the Law; I(D)Misconduct, III(A)Loyalty, Prudence, and Care; and V(A) Diligence and Reasonable Basis of the CFA Institute Code of Ethics and Standards of Professional Conduct (2005).
Specifically, the Hearing Panel found that Thakkar learned that an advisory client wanted to buy put options for the purpose of protecting the value of certain shares she owned as a result of the acquisition of a large, publicly traded company that her family had founded. The clients son, who advised his mother on financial matters, told Thakkar that he had identified on the internet specific put options that he believed might serve this purpose. Thakkar then purchased the put options for her clients non-managed sub-account without performing any due diligence or giving proper consideration to whether the options made sense and were consistent with the clients stated purpose for buying them. Several months later, Thakkar again, without conducting any due diligence or considering whether the options made sense and were consistent with the clients stated investment purpose, purchased more of the same put options for her clients subaccount at essentially the same price, even though the market price of the underlying stock had declined significantly during the intervening period. The in-the-money put options that Thakkar purchased were originally issued by the company whose shares the client wanted to protect, but they had been adjusted subsequently by the Chicago Board Options Exchange to reflect the terms of the acquisition. As a result, the adjusted options required the payment of so much cash on exercise that they were worthless and provided no protection to the client. The adjusted put options had a price of less than $0.30 per share, when the intrinsic value of a put option at that strike price would have been more than $8.00 per share. In an earlier arbitration proceeding, that panel found that the disparities of the option premiums should have been immediately obvious to an experienced financial adviser like Thakkar and should have put her on notice to review the options carefully. The arbitration panel thus concluded that the bank that employed Thakkar had failed to exercise reasonable care and awarded her client more than $650,000 in actual damages and costs. Likewise, the CFA Institute Hearing Panel found that Thakkar engaged in conduct that reflected adversely on her professional reputation and competence, failed to act with reasonable care and in a prudent manner to avoid harm to her client, and failed to exercise diligence and thoroughness in twice buying the worthless put options. RESIGNATION Effective 18 December 2012, Christos Bagios Sommer (Switzerland), a charterholder member, permanently resigned his membership in CFA Institute and any member societies, as well as his right to use the CFA designation, in the course of an investigation of an industry-related matter by the Professional Conduct Program.
Chapter 10
The Revolving Revolution

What can old issues of Fortune magazine tell us about current trends?
By Ralph Wanger, CFA
Fortune helps the brave.Terence (185159 BCE) Being an older fellow and not enamored with current events, I thought there might be something of interest in dusty old issues of Fortune magazine. I went to the stacks at the Illinois Institute of Technology to look at their old copies of Fortune and found I did not have to compete with any other readers. Fortune had many good writers and access to all the business figures of the day, so it was not as boring as I had feared. For instance, when Alfred P. Sloan, founder of General Motors (and later a great philanthropist) wrote his memoirs in 1964, he published substantial excerpts from his book in three successive issues of the magazine. In the early 1960s, computers were being introduced widely but not yet universally. In 1964, an article announced with wonder that there were now 16,000 computers in the U.S. (The Boundless Age of the Computer, February 1964). The computers of the time were large mainframes housed in a glass-walled temple in the middle of company headquarters. They were expensive and just then being converted from vacuum tubes to semiconductor circuits, so their reliability was poor. IBM dominated the industry, but the article claimed that competitors were heavily armed with brains, ambition and money. The competitors mentioned included GE, RCA, Burroughs, and National Cash Register, all large electronics companies and household names. There was a second group (all based in the Minneapolis area): Sperry Rand-Univac division, Minneapolis-Honeywell, and Control Data. The great engineer Seymour Cray was designing a supercomputer for Control Data in a cabin in the woods near his hometown of Chippewa Falls, Wisconsin. (Chippewa Falls became famous for Cray Research, Leinenkugel beer, and Annies family home in the Woody Allen masterpiece Annie Hall. I have no evidence that Woody Allen ever saw Chippewa Falls, except perhaps flying over it at 38,000 feet going from Hollywood to New York City.) This cluster of computer and electronics companies in the Twin Cities area created a tech stock boom in Minnesota. I remember flying to Minneapolis in 1962 to visit a hopeful young electronics company called Magnetic Controls. I had been told to visit them to check out the story that they had invented the first automatic electric meter-reading system. The electronic meter-reading device turned out to be only a breadboard circuit. (A breadboard was a long sheet of plywood in which discreet electronic devicescapacitors, resistors, and transistorswere wired together. This was before integrated circuits and microprocessors.) It was so far from a finished product that it was of no interest. Since that time, Ive been exposed to lots of re-inventions of the
Illustrations by Robert Meganck
Chapter 10
new technology has been driving a revolution since the development of the transistor in the 1950s. Revolutions not only destroy the old regime but also the revolutionists of the previous revolution.
A.F. Ehrbar wrote Index Funds: An Idea Whose Time Is Coming in the June 1976 issue of Fortune and mentioned Wells Fargo, Batterymarch, Wilshire Associates, and American National Bank of Chicago. In June 1974, the article Gold Bugs Are on the March reported that gold had gone from US$36 an ounce in 1970 to US$165 an ounce in June 1974 and looked toppy. A key insight on the permanent derating of utility stocks was right on (For the Utilities, Its a Fight for Survival, May 1975). Up until 1972, electric utilities were the core of many portfolios, offering predictable growth, high dividends, and stability. After 1974, utilities forfeited these three delightful attributes. Finally, I came to June 1974. In the article The Heat Is on the Analyst, Fortune wondered if our predecessors were worth their pay. Analysts salaries ran from US$25,000 at banks to as much as US$45,000 at sell-side brokers. So, what did I learn from spending a leisurely afternoon in the library stacks? Four things. First, I am not allergic to dust. Second, Fortune has maintained its format and consistently good writing standards over the years. Unlike some of us, however, Fortune has lost weight over the decades. There are a lot fewer pages and, therefore, less advertising revenues. This is true for most newspapers and magazines. You may feel stronger than you used to 20 years ago, it took both hands to carry the Sunday New York Times. Now, you can easily tote it in one hand. You may be reading this essay on your computer or iPad. Third, knaves and fools are always with us. There is a reason stocks have a risk premium. Finally, new technology has been driving a revolution since the development of the transistor in the 1950s. Revolutions not only destroy the old regime but also the revolutionists of the previous revolution. I remember when all computers were called Univacs and every copier was a Xerox.
Ralph Wanger, CFA, is a trustee of Columbia Acorn Trust.
Continued from page 55
electronic meter reader, but for the next 40 years, none of them worked very well. Magnetic Controls stock was then trading at US$8 a share. I reported that it was worth perhaps US$2 a share, so our firm sold the small position it owned. A few weeks later, the stock rose to US$20 a share. All I could do was shrug; the early 1960s market in Minneapolis was a smaller predecessor of the Silicon Valley internet boom of 1999. A year later, Magnetic Controls collapsed to 45 cents a share, so my US$2 price target proved naively optimistic. Some Fortune articles were right on target and remain evergreen stories that could be reprinted today with minor edits. In July 1973, for example, they published Why the Postal Service Cant Deliver, complaining about the U.S. Postal Services terribly slow delivery and rude service. In May 1974, it was Amtrak Is about to Miss the Train, in which Richard Loving complained that Amtrak did not keep to its schedule, the cars were dirty, and the staff were rude. In December 1973, an article suggested Lets Reform Campaign-Financing But Lets Do It Right. Some articles were less prescient. An early piece about climate change quoted Hubert Lamb, a distinguished British meteorologist and climate expert at the University of East Anglia (An Ominous Change in the Weather, February 1974). This university had already started a major effort in climate research, and its preeminence continues today. Global temperatures since 1945 constitute, we believe, the longest unbroken trend downward in 100 years, said Lamb. Reid Bryson of the University of Wisconsin agreed that the climate was cooling, saying that although the carbon dioxide greenhouse effect existed, dust and aerosols in the atmosphere more than offset the effect, causing net cooling. It has been claimed that the social value of financial analysts has been to make weather forecasters look smart, but these climatologists clearly had it backwards. How did Fortune do with articles about investment? Often very well. In 1964, the shift to an institution-dominated buy side was noted. The article New Forces in the Stock Market pointed out that The new stock market is made by individuals selling to pension funds. At the time, institutions owned about 15% of all stocks and private pension funds owned more than US$40 billion in equities. Institutions still do not have the vote to control the market, the article stated, noting that they may have these votes in a decade or two. One of my contemporaries still remembers the Master of the Universe feeling in 1960 when he got an order to buy 100,000 shares of a US$28 stock at a fixed commission of $0.36 per share. His cut was probably 30% of $36,000, or $12,920 for the day. That would have been a decent yearly income for many people. Commission rates had to come down, and after May Day (when the U.S. SEC issued a mandate on 1 May 1975 to deregulate the brokerage industry), they did.
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CFA Magazine July Aug 2013

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July/August 2013

The Member Magazine for Investment Professionals

To learn more, call 877-76-iPath or scan the code.

CFA Institute News

8 EMEA Voice Seeking Greater Value from Auditors

9 APAC Focus Advancing Our Mission in China

12 Financial Analysis at Jungle Speed

18 Board Governance and Risk

Ethics and Standards

 Self-disclosure can help rebuild trust

The Time to Be Calm

July/August 2013 CFA Institute Magazine 3

Fitch 7city Learning Global financial services training experts

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July/August 2013 Vol. 24, No. 4

4 CFA Institute Magazine July/August 2013

gips standards annual conference

GIPS STAndArdS InTerACTIve WorkShoP

learn more about these special events: www.cfainstitute.org/events

CFA INSTITUTE NEWS

Visible and Tangible Steps

6 CFA Institute Magazine July/August 2013

July/August 2013 CFA Institute Magazine 7

CFA INSTITUTE NEWS

Investors Seek Greater Value from Auditors

CFA INSTITUTE NEWS

Advancing Our Mission in China

An Ethical Leader in the Industry

July/August 2013 CFA Institute Magazine 9

THANK YOU TO ALL THE 20122013 RESEARCH CHALLENGE HOSTS

We couldnt have done it without you.

CFA INSTITUTE NEWS

Financial Analysis at Jungle Speed

Members Help to Build a More Trustworthy Financial Industry

CFA INSTITUTE NEWS

Research Competition Helps Launch Career

What Made the Crisis So Severe?

July/August 2013 CFA Institute Magazine 15

Illustration by Jesse Lefkowitz

The Great Disparity

Lessons for Investors

Board Governance and Risk

Stress-Event Occurrence: Gathering Storm

May the ERP Be with You

Writing without a Pencil

July/August 2013 CFA Institute Magazine 19

Property Investing for Non-Property Investors

Core Strength, Peripheral Vision

A New Type of High Street

Markets with Potential

Listed Real Estate Has Its Own Challenges

Europe and Preemptive Voting Rights

Now available from The Research Foundation of CFA Institute:

A New Look at Currency Investing

July/August 2013 CFA Institute Magazine 23

Ability to Adapt and Learn

No Bias, Anxiety, or Emotion

Too Much or Not Enough?

SIMILARITIES AND DIFFERENCES

DIFFERENT FOCUS, DIFFERENT MEASURES

30 CFA Institute Magazine July/August 2013

Morocco: A Balancing Act

Illustration by Robert Meganck

Egypt: Too Big to Fail?

Self-disclosure can help rebuild trust