In anticipation of the upcoming 68th CFA Institute Annual Conference, we are delighted to share some thoughts published in CFA Institute’s Conference Proceedings Quarterly by speakers at some of our recent events.
“The dollar is our currency, but it’s your problem,” John B. Connally, Nixon’s former US Secretary of State famously told the world more than forty years ago. But as the impact of today’s soaring US dollar ripples out across the globe, the greenback’s position as the international reserve currency is a recurrent concern. “The end was touted back in the early 1990s,” Jeffrey Heisler, CFA, said during the recent Future of Finance Financial Market History Roundtable in Boston, “when the yen was going to become the reserve currency as Japan Inc. took over the world. We all know how that turned out. We are heavily indebted, so everyone accepts dollars; 80% of world trade is conducted in US dollars. The transition from the dollar to another currency potentially would be unpleasant because we would have to live within our means.” Heisler is not alone in worrying about debt. Mis-scaled national debts consistently vex commentators at CFA Institute conferences.
“The central economic problem of the post-crisis period is that the world is struggling with a huge debt overhang,” Lord Adair Turner, Fellow of the Institute for New Economic Thinking, said at the recent CFA Institute European Investment Conference. “The most important reason why demand has been depressed is not that the financial system has been impaired and is unable to provide new credit supply but that overleveraged households and companies do not want to borrow.” Turner proposes a radical alternative solution: “Constraints on excessive credit creation — in particular against real estate — should be viewed not as the unfortunate or unintended consequence of macro-prudential policy but as the overt aim.”
Mirroring Connally’s insight about the US dollar, today many local problems are simultaneously the problems of the whole world. At the 68th CFA Institute Annual Conference, Philippa Malmgren and Ian Bremmer will each be discussing how these global interconnections have have shaped geopolitics and what it means for global investors.
Several speakers link themes such as national demographics and entitlements to long term global investment drivers. “Demography tends to move very slowly. It is like a river with a powerful current. If you wade in around the edges of the river, you do not really notice how powerful the current is, but it is strong,” Robert D. Arnott, chairman and CEO at Research Affiliates said at the Fixed-Income Management Conference. “Essentially, the natural real yield right now should be at its lowest level ever in the G–8 because of the large roster of mature workers in those countries who are scrambling to accumulate enough reserves to retire.” And once entitlements are added to national debt, its true size seems disproportionate to the GDP and population. “The debt burden must be addressed. The choices are pay the debt, abrogate the liabilities, or reflate. In the United States, the official debt level is 100% of GDP, but it increases to 650% when entitlements are included,” says Arnott.
Amlan Roy of Credit Suisse, spoke recently on Why Global Demographics Matter: GDP, Debt, Inflation, and Asset Prices. He concluded with a slightly different emphasis to others that “Demographics is about consumers and workers; they change behavior over time.” An insight which certainly strikes an intuitive chord.
Disentangling Component Risks
“Asset allocation drives risk and return. Studies suggest anything from 80% to 100% of variability of risk and returns is a function of asset allocation. The asset allocation decision drives the portfolio, but most institutions spend very little time on asset allocation.” said Jeffrey C Scott, CFA at last year’s Annual Conference in Seattle. Explaining his own approach, driven through a dozen risk lenses, he first described the diversification of beta exposures starting with five basic risk factors: interest rate risk, credit risk, equity risk, inflation risk, and currency risk. Alongside that, he considered the risk premium of alternative assets, factors (value, size and momentum) and alpha strategies including active tail risk management. Such risks, not just nominal asset classes, must be rebalanced regularly.
“What next for bond yields?” asks Stephen Major, CFA of HSBC. “There seems to be some disconnect between the evolution of sovereign spreads across the eurozone and the actual progress by governments to reform their economies.” In the markets, what seems to have been missed by mainstream thinking, Major said, “is that it was relatively easy for the Fed to buy bonds and create reserves to enter into this unconventional policy. But we will see what happens when the Fed tries to reverse the process, if it can be reversed without too much disruption.”
Right now, portfolio managers face some of the most irksome challenges of their careers. In particular, challenges from themselves, their own human biases and (mis)interpretations which lead directly to departures from the prevailing theoretical models. At last year’s annual conference, Clifford S Asness, Founder and CIO of AQR pointed out that discount rates that are too low are not rational. Casting doubt on overly doctrinaire interpretations of efficient markets, Asness said, “An equilibrium model that depends on the idea that people just had a taste for owning tech stocks will not save market efficiency. This approach just sneaks inefficiency into the model. So, I want to add one word to the debate: reasonable. A test of market efficiency should be a joint test of market efficiency and a reasonable model of market equilibrium that assumes some kind of rational investor.”
At the 68th CFA Institute Annual Conference delegates will be treated to several sessions which may help investors apply informative insights from the world of neuroscience to their own investment practice including Roland Ullrich, CFA and a plenary session by John Coates.
“Even if there is disagreement about what makes the market work best,” Asness said, “investment managers have to accept that the markets are in the middle of two extremes: behavioral and the EMH.” Walking this delicate tightrope places even greater reliance on robust market structures and regulatory systems, the subject of what is likely to be a fascinating discussion at the Annual Conference. Haim Bodek, Irene Aldridge, and James H. Freis, Jr., CFA will discuss Financial Innovation, Market Structure, and the Implications for Investors on a panel moderated by Gemma Godfrey.
- Financial Market History Roundtable, Boston. At a roundtable held in Boston at the MIT Sloan School of Management on 26 February 2014, a panel of high-profile investment industry participants were asked to address the questions, What are the lessons of financial market history, and how can investors make money from those lessons?
- Managing Credit Creation—Beyond Inflation Targeting by Adair Turner. Bank capital and derivatives regulation are not sufficient to avert another global financial crisis, primarily because of a buildup of excessive bank lending in real estate. Future policies must prevent the buildup of real economy debt and leverage to excessive levels.
- Whither Bonds, After the Demographic Dividend? by Robert Arnott. Deficits, levels of debt, and demographics are deeply interrelated. Demographics have a major impact on GDP growth as well as on investment returns. The long-term headwind that can be expected in the 21st century compared with the demographic dividend, or tailwind, of the 20th century has serious implications for bond investing. But there are still investment opportunities that can be found today.
- Why Global Demographics Matter: GDP, Debt, Inflation, and Asset Prices by Amlan Roy. To move forward in today’s investment industry, practitioners need to rethink their understanding of demographics and avoid some common but costly mistakes. Aging populations, youth unemployment, and the lasting effects of the 2008–09 financial crisis are reshaping the investment landscape.
- Optimization, Valuation, Diversification, and Risk in Constructing Global Portfolios by Jeffrey C. Scott, CFA. Current institutional portfolios have many challenges. An investment framework of value considers diversification, the true meaning of assets in a portfolio, and risk rebalancing—not rebalancing capital each quarter but rebalancing risk. Finally, tail risk management must be managed opportunistically.
- What Is Next for Bond Yields? by Steven Major, CFA. The Fed is planning a lift-off of rates that, because of the unprecedented circumstances, it does not know how to do. At this difficult juncture, with the Bank of Japan and European Central Bank running accommodative policies, forecasting bond yields requires more than analysis of cyclical data.
- 21st Century Asset Management: Facing the Great Divide by Clifford S. Asness. The “great divide” in financial economics is where investment managers stand on market efficiency. On one side are those who believe the markets are inefficient and subject to behavioral biases, and on the other side are those who believe the markets are efficient. The reality is most likely somewhere in between the two extremes.
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