cfa magazine jan - feb

January/February 2012

“How Wall Street has gone astray”

Career moves in the current market

Hindsight: “an insidious cognitive error”?

Goals-based reporting and client metrics

Overhauling Europe’s securities markets

Trading mechanics and hidden shorting costs

TIPSyAfter a decade of outperformance,have inflation-linked bondsreached a tipping point?

COLUMNS

7 In Focus

The Echoes of“Occupy”BY JOHN ROGERS, CFA

51 Asia–Pacific Focus

CFA Institute Moveswith the TimesBY ASHVIN VIBHAKAR, CFA

53 EMEA Voice

Streams of Professional EducationBY USMAN HAYAT, CFA


COVER STORY

34 TIPSyAfter a decade of outperformance, have inflation linked bonds reached a tipping point?BY ED MCCARTHY

38 On a MissionAnalyst Mike Mayo, CFA, explains “how Wall Street has gone astray.”BY JONATHAN BARNES

38

34

46 A PioneeringSpirit“Where you have prob-lems to solve, you haveinvestment opportuni-ties”—Renée Blasky, CFA,on why she’s “very posi-tive” on East AfricaBY JONATHAN BARNES

46VIEWPOINT

8 The Leadership Gap

“The investment community will bewell served to develop more rigor-ous analytical tools to determinethe quality of leadership within po-tential investment opportunities.”BY DAVE ULRICH, NORM SMALLWOOD, AND

MICHAEL ULRICH

10 Encouraging a Behavioral Shift

“We need to find not only new answers but new ways of findingthese answers.”BY PHILIPPE SARASIN, CFA

11 Goal-Based Reporting and Traditional Metrics

Empowering investors “means cre-ating goals-based reporting toolsthat resonate both objectively andsubjectively.”BY CHARLES M. OPINCAR

42 You Must Remember ThisIs hindsight “an insidious cognitive error” that willprevent us from learning the right lessons about theglobal financial crisis?BY MAHA KHAN PHILLIPS

DEPARTMENTS

3 In Summary

Finding What You’re Not Looking For

4 Letters

Demanding Full Disclosure from Congress

50 Briefs

CFA Institute, member, and society news

55 Chapter 10

How Do You Know When You’re Done?BY RALPH WANGER, CFA

EthicsFORUM

20 An Inside Look at the Disciplinary Process

“The basic process hasn’t changedmuch over the years, but how we execute it has changed quite a bit.”BY DOROTHY KELLY, CFA

MarketINTEGRITY

13 MF Global: Another Ethics and Regulatory Blunder?

“What has changed since similarlyrisky behavior brought the global financial system to the brink of collapse?”BY KURT SCHACHT, CFA

14 Overhauling Europe’s Securities Markets

“After nearly a year in the making,the legislative package puts trans-parency at the forefront with ambi-tious proposals to shed light ontrading in practically all financial instruments.”BY RHODRI PREECE, CFA

15 Have UCITS Grown Too Complex for Retailer Investors?

“Even though we are concernedabout the protection of investors, it seems to us that prohibiting thesale of structured UCITS outright to retail investors may not be theright answer.”BY AGNÉS LE THIEC, CFA


ProfessionalPRACTICE

24 Career Connection

The voice of experience: making career moves in the current marketBY LORI PIZZANI

28 Trading Tactics

Trading mechanics and the hidden costs of shortingBY DENNIS DICK, CFA

30 Private Client Corner

How advisers are using social media to get an edgeBY ED MCCARTHY

32 Standards in Practice

Will the SEC’s new enforcementregime work?BY LORI PIZZANI

55

24 “Sometimes people sit back too much.Don’t be afraid to stretch yourself. But be prepared for a lot of work. Transition is a lot of work, and thereare always new challenges.”CAREER CONNECTION

P O I N T – C O U N T E R P O I N T

56 Agree or Disagree:The Chinese renminbi (RMB) will

emerge as an international reservecurrency sooner rather than later.

53

C F A M A G A Z I N E / J A N – F E B 2 0 1 2 3

IN SUMMARY

“Janna soon found that people don’t see what they don’t look for.”—Hilda van Stockum, The Borrowed House

The Borrowed House is about Janna, a 12-year-old Germangirl during the Second World War who moves to Amster-dam to live with her parents (an actor and actress enter-taining the occupation force). Janna gradually pieces to-gether disturbing clues about the Dutch family who owned

the house before being forcibly evict-ed. She later makes an even more star-tling discovery—a member of the un-derground resistance, a young Jewishman named Sef, is living in a secret recess within the house.

When she discovers Sef, Janna hasalready begun to unravel the lies shehas been told about the war. She de-cides to keep Sef’s secret but suffers

great anxiety. The Dutch maid has been secretly supplyingSef with food and other assistance. Surely people will no-tice discrepancies. Then she stumbles on another discov-ery, this one about human nature: “people don’t see whatthey don’t look for.”

This principle has applications for investing. In fact,given the complexity involved, even when you know whatyou’re looking for, a sure solution can be hard to find. Forexample, take the outlook for inflation-linked bonds (orTIPS). “As an asset allocation shop, we think there’s a goodchance that inflation will pick up at some point,” says MarkWilloughby, CFA, “but we have no idea by how much andwhen” (“TIPSy,” p. 34).

Similar uncertainty haunts Janna: How much will she be asked to do and when? Fortuitous events can opendoors—literally for Janna on more than one occasion andfiguratively for professional life. “When you’re least likelyto be looking, the opportunity comes along,” says one CFAcharterholder of his recent experience with a career move.Yes, but to what degree can savvy planning help profes-sionals take advantage of career opportunities? To help answer such questions, this issue features the first install-ment of a regular section (Career Connection, p. 24).

Hiding an enemy from her own parents tests Janna’sconscience. In a different context, analyst Mike Mayo, CFA,faced his own ethical challenge when contemplating an un-popular decision to downgrade a bank. “There’s soul search-ing at a time like this,” he says (“On a Mission, p. 38). The theme of what Mayo calls “competing loyalties” runsthrough von Stockum’s novel—loyalty to family, friends,country, truth, human dignity. Janna’s Dutch tutor Hugo isloyal to a cause greater than himself. Begging his neighbors

Finding What You’re Not Looking Forto allow him to help them escape persecution, he asks,“What’s my life worth? … why can’t I risk it for you?”

Mayo also found himself asking existential questions: “Do I matter? Does my job matter?” Finally, he reasoned,“Either I would do the job in the way that is described inthe Standards of Practice Handbook, or the CFA charter iscompletely irrelevant.” CFA Institute shares his conviction,and fostering the influence of the Code of Ethics and Stan-dards of Professional Conduct is a key motivation for theCFA Program scholarships (Briefs, p. 52).

A recurring problem is the tendency of the humanconscience to insulate itself with self-assurance. When Jan-na raises troubling questions about the war and occupa-tion, her father explains that their side is just and humane.He allows war propaganda to deceive him into believingconvenient distortions of reality. In trying to draw the rightconclusions about our own historical circumstances, suchas learning lessons from the financial crisis, how vulnera-ble are we to “insidious” cognitive errors? “What I wouldsay to people is that you need to be particularly careful toinvestigate things that you don’t want to think about,” saysDavid Tuckett, discussing problems associated with finan-cial memory. “If you sense within yourself any kind of feel-ing of not wanting to examine something, then that’s ex-actly what you should start thinking about.” (“You MustRemember This,” p. 42).

Motivating clients to examine something—their own finances—is one aim of goals-based reporting. Tradi-tional reporting metrics are insufficient, writes CharlesOpincar, because they are strictly quantitative and fail toprovide “life signals” (Viewpoint, p. 11). Ralph Wanger,CFA, has found this behavioral principle to hold true dur-ing his long career: “Numeric tools provide nothing butnumbers, and it is hard to get people to act on numbersalone,” he argues (Chapter 10, p. 55).

Janna initially struggles to decipher the “life signals”of her own situation, which is essentially human. We allfind ourselves thrust into historical conditions beyond ourdirect control, yet by making courageous choices in our per-sonal sphere, we can have a profound influence on others.And ethical action goes beyond legality. Too often, as Jan-na’s friend Sef observes, “People confuse law with virtue.”On a larger scale, we may look to regulation and politicalreform (Market Integrity, p. 13). These have a place, butPatrick Guthrie, CFA, points out that laws can have criticalblind spots, even where insider trading by policymakers isconcerned (Letters, p. 4). “We must rise up,” he believes,“when the opportunity presents itself to do what is right.”

Janna, Sef, and Hugo would agree.

ROGER MITCHELLManaging Editor ([email protected])

“My point is not to say that members of congress are like bankers

(despite similar approval ratings) but that the rest of us should be vocal

in standing up and denouncing this type of outrageous behavior.”

C F A M A G A Z I N E / J A N – F E B 2 0 1 24

CFA INSTITUTE PRESIDENT & CEOJohn Rogers, [email protected]

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LETTERS

Demanding Full Disclosure from Congress

Scoundrels—this was the first word that came to my mind.In mid-September 2008, congressman Spencer Bachus,

an Alabama Republican, purchased options to short themarket after having closed-door meetings with TreasurySecretary Henry Paulson and Federal Reserve ChairmanBen Bernake. When the markets subsequently fell, Bachus’options went up in value, and he appeared to be acting inhis own self-interest and not acting in the best interest ofthe American people. Such an act by a member of Con-gress would seem reprehensible and despicable. However,according to a report on the CBS News program “60 Min-utes” (“Congress: Trading Stock On Inside Information?”broadcast on 13 November 2011), which was based on research in Peter Schweizer’s book Throw Them All Out,this type of behavior is neither uncommon nor unlawful.

Moreover, Bachus is currently chairman of the HouseFinancial Services Committee.

As an analyst actively engaged in the dealings of thecapital markets—and more fundamentally, as an Americancitizen—I strongly condemn this type of behavior. The in-tegrity of the markets and its participants is essential to thecontinued growth and prosperity of all in our society. Whena few individuals decide that they do not have to play bythe rules, they put cracks in the foundation of free marketsthat lead to greater suffering for everyone else. For example,

several years ago, a number of bankers did not follow therules when they manipulated loan documents to approvemortgage loans. The surge of bad loans was a catalyst for thefinancial meltdown of 2008 and the resulting high unem-ployment we have today. My point is not to say that mem-bers of congress are like bankers (despite similar approvalratings) but that the rest of us should be vocal in standingup and denouncing this type of outrageous behavior.

CFA Institute encourages members to practice theircraft according to the highest ethical standards. Accordingto the CFA Institute Code of Ethics, CFA charterholdersshould promote the integrity of the capital markets. Con-gress is in the process of drafting legislation to limit insidertrading by its members, but there is concern that the legis-


Corrections

Chip Dillon, CFA, should have been listed in the Septem-ber/October 2011 CFA Institute brief “CFA CharterholdersRecognized in Wall Street Journal.” Dillon was profiled as a top industry analyst for two general industries sectorpicks while working for Credit Suisse.

The cover story in the September/October issue (“Emerg-ing Threat Funds?” by John Rubino) incorrectly stated that the first exchange-traded fund was Standard & Poor’sDepositary Receipts (SPDR or “spider”), introduced in1993. It was actually the second. The first ETF was Toronto35 Index Participation Units (TIPS), which began trading in 1990 on the Toronto Stock Exchange. Thanks to BruceThompson, CFA, of Toronto for pointing out the error.

lation may have loopholes or that the U.S. Securities andExchange Commission would not actively pursue an inves-tigation against a sitting member for fear of congressionalretribution. The court of public opinion may provide morejustice than any investigation. What we must demand fromcongress is full disclosure of all market transactions on apublic database that is updated regularly. Only then can weidentify which members of congress are acting inappropri-ately and act accordingly in stopping such behavior. Wehave a duty to secure the integrity of the markets, and wemust rise up when the opportunity presents itself to dowhat is right.

Patrick Guthrie, CFALutherville, Maryland

Bridging the Gap between Goals and Operations

Regarding Sherree DeCovny’s article about the financialimpact of project management [Analyst Agenda: “An

Overlooked Value Driver?” (November/December 2011)],I feel there is another point that the article did not men-tion—critical thinking/solution finding. To me, a projectmanager is like a leader that helps bridge the communica-tion gap between the firm’s desired goals and its operationspeople. Thus, a project manager needs to have certainleadership qualities.

The first quality is observation, which means having a holistic view at the firm level, including the firm’s prob-lems and the market condition of the industry. How obser-vant a project manager is could be measured by the amountof continuing education the manager engages in. The sec-ond quality is comprehension, which means understandingeach department’s role within the firm, the specific purposeof each department’s function, and how each departmentinteracts with other departments within the organization.There are different ways to measure this skill, such as hav-ing face-to-face interviews with employees responsible forthe functions, but I feel the best way to obtain this knowl-edge is to have working experiences.

In certain industries, maybe all a project manager needsare the points stated in the article and no more. In a moredynamic business or a business undergoing a paradigmshift, such as asset management, I would argue that a proj-ect manager will need critical thinking skills as well. In aconstantly changing business environment in which solu-tions probably are rarely available in textbooks or over theinternet, firms need to develop their own creative solutions.Firms can benefit greatly from project managers who lookinside and outside of the box continuously and try to findcreative solutions.

Tony Chan, CIPMQueens, New York

Thinking Outside the Quantitative Box

Better risk management tools sound great in theory butseem to backfire in practice [see Viewpoint: “Long LiveQuantitative Models” (July/August 2011) and Letters: “Howto Think about the Unthinkable” (November/December2011)]. Banks and others may have gained a temporary advantage as they began incorporating better risk manage-ment techniques than their competitors. But their growingconfidence in their use only justified taking on more risk.And as more institutions copied these successful firms,they succeeded in creating systemic risk—the exact oppo-site of what they were attempting to do. Sometimes a greatnotion isn’t so great. Let’s just hope that more people thinkoutside of the quantitative box.

John Barber, CFASan Diego

The editor welcomes the views and opinions of readers.Please e-mail comments to [email protected].

LETTERS

November/December 2011

Now playing: Great Contraction 2

Unhedged China risk in your portfolio?

Climate change disclosures and valuation

Project management: analyst blind spot?

Adaptive asset allocation and performance

10 years on: 9/11 memorial scholarship fund

A Half-Open DoorWill the renminbi emerge as an

international reserve currency?

The Third Annual Middle East Investment Conference25–26 MARCH 2012 GRAND HYATT HOTEL

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In Focus

BY JOHN ROGERS, CFA

am not ashamed to call myself a capitalist, and Iwould venture to speak on behalf of most CFA Insti-tute members as believing in capitalism as well. Capi-talism is an ideology and economic system that does a

decent job of allocating resources according to merit whileproviding sufficient tax revenues for governments to fundsocial services and defense.

That doesn’t mean we don’t pay at-tention when the system has run amok,as many people worldwide (capitalists ornot) have noticed. The Occupy WallStreet movement captured global atten-tion with surprising speed, despite criti-cism that it lacks leadership and is takingon too wide a range of issues. In fact, ithas gone viral so fast that Chinese au-thorities have banished the search keyword “occupy” fromtheir internet in the hope of preventing similar protests.

The movement claims inspiration from the Arab Springof this past year and is fueled with populist anger overtough economic times and rolling financial crises. As win-ter arrives in the northern hemisphere, the physical occu-pation may be winding down, but the echoes of the pro-testers claims continue. Now is a good time to ask whetherwe’ve learned anything from the “Occupy” movement.

First, it is clear that the financial industry needs amakeover. More than three-quarters of people respondingto a recent CNN poll said financiers are greedy and over-paid, and two-thirds said they’re dishonest. A Global Mar-ket Sentiment Survey conducted by CFA Institute and re-leased in December (visit cfainstitute.org) makes clear thatour own members recognize the serious ethical challengesfacing our industry. There’s no need to rehash the newsstories of the past few years, but financial firms have beenin the crosshairs of the media and finance professionalshave been soft targets for criticism far too often for mycomfort. While it may be unfair to paint our industry witha single broad brush, particularly for those of us who abideby high ethical standards and put investors’ interests first,the reality is that our image has been tarnished by thosewho placed the business of finance or personal interestsabove the profession.

Another lesson from the “Occupy” movement is thatmisconduct imposes a set of expensive but largely unseencosts on financial markets. The biggest of these is the priceof mistrust. When both parties in any transaction feel rea-sonably informed and bound by some level of trust (or atleast accountability), markets function fairly well. Whenthis equation gets out of balance, when the seller knows a lot more than the buyer, when one party’s incentives are

IThe Echoes of “Occupy”

masked, then markets quickly become unbalanced—to the detriment of all participants. These are moments whenprofessionalism comes to the fore. The medical field is anexample of information asymmetry. The physician knowsmuch more than the patient, but this is more than offset by the professional standards of those providing the service.In finance, sadly, trust has been broken too many times,and we see the current fashion of “risk on–risk off” mas-querading as an investment strategy.

Regardless of how we might feel about the OccupyWall Street movement, it presents an opportunity for all ofus. This window of opportunity has in fact been open since2008, and now is the time to put a laser focus on our mis-sion of promoting ethics, education, and professional ex-cellence. The CFA Institute Board of Governors recentlyconducted strategic planning for the coming decade and,in the process, endorsed a renewed and sharpened focuson leadership in this arena. It’s critical for us to be the lead-ing voice on behalf of investors, educated professionals,and ethical practices in the investment industry. Our annu-al member surveys support this mission, with more than90 percent of respondents saying that advocating effective-ly for members for ethical markets is important.

As one example of our work, the regulatory communi-ty continues to take the opportunity to seek our advice andcounsel, which has magnified our reach and ability to posi-tively impact the profession on behalf of our members. Werecently served on the Private Sector Taskforce to the G-20,which has published a set of recommendations on regula-tory convergence in our industry.

There is likewise a window of opportunity for partici-pation by all CFA Institute members in our promotion of ethics and trust. For those of you who live by the CFAInstitute Code and Standards, I encourage you to advocatefor adoption of the CFA Institute Asset Manager Code of Professional Conduct. If you are a trustee or work withtrustees, please consider adopting of the CFA InstitutePension Fund Trustee Code.

To be clear, I believe that the vast majority of financeprofessionals are ethical and hard working and want thebest for their clients. But to paraphrase Charley Ellis, CFA,(formerly a chair of this organization’s governing board),the business of finance has overshadowed the finance pro-fession. The Occupy Wall Street movement protesters maywell pack up their tents and placards for the winter, yet it’sour duty to continue to hold ourselves and those aroundus to the highest possible standards of professionalism.

John Rogers, CFA, is president and CEO of CFA Institute.



Viewpoint

BY DAVE ULRICH, NORM SMALLWOOD, AND MICHAEL ULRICH

hy do active, long-term investors prefer toinvest in some companies over others? Thissimple question is important because under-standing investor logic and emotions can

help company leaders better position their company to gaininvestor confidence. Ultimately, investors make decisionsbased on information that they believe can improve theirperformance and mitigate their risk. If leaders know whatinvestors are looking for when making investment choices,they can share better information with those targetedinvestors.

To answer the question about why investors invest, weinterviewed about 30 senior investors and reviewed paperson the topic. From this preliminary work, we defined threebroad domains of information most important to investors:(1) industry favorableness, (2) company performance, and(3) quality of leadership.

Industry favorableness refers to the characteristics of theindustry, such as its growth potential, barriers to entry,competitiveness (or rivalry), social trends, customer oppor-tunity, regulatory opportunities, and so forth. Industriesmay be more or less favorable (e.g., demographics favorelderly care and technological changes and are less favor-able to traditional printing).

Firm performance refers to consistency of financial re-sults as indicated by a variety of metrics (e.g., working cap-ital, economic value added, operating margin, return oncapital, and so forth). Firm performance also refers to theintangibles related to strategy, technological advantage, andorganization capabilities (e.g., speed to market, degree ofinnovation, ability to collaborate, customer service, socialresponsibility, and so forth).

Quality of leadership refers to the confidence investorshave in the leadership capability of the company. Investorsare more likely to invest in companies with leaders whohave a strong record and have proven ability to set and exe-cute strategy, to manage current and future talent, and todevelop future leaders.

Next, we determined the relative weight of each ofthese three domains for investor decisions. Additionally, wewanted to find out how much confidence investors have intheir ability to assess each of the three domains. Thus, wedesigned a survey (available from the authors) to answertwo relevant questions: (1) What is the relative weight ofeach of the three domains on investment decisions? (2)How much confidence do investors have in their ability toassess each domain?

We used a “snowball” sampling technique that identi-fied investors who could complete the survey based on ourpersonal contact with them, their attendance at investorconferences, individuals with whom we conducted pilotinterviews on the topic, and lists of registered investors.1

Investors were asked to complete the survey and recommendothers to complete it. In total, we received 430 responsesfrom portfolio managers, institutional investors, mutual/hedge fund managers, private equity investors, and venturecapitalists. These 430 investors averaged more than 15years of professional investment experience.

Table 1 reports the relative importance of each domainand investors’ confidence in their ability to assess each area.

TABLE 1

RELATIVE IMPORTANCE TO INVESTORS ANDINVESTOR CONFIDENCE TO ASSESS

Importance Confidence to Assess(standard (standard

Domain deviation) deviation)

Performance 38.5% (15) 4.47 (0.58)

Industry favorableness 33.1 (16) 4.33 (0.66)

Quality of leadership 28.4 (14) 3.75 (0.96)

Note: To rank importance, survey participants were asked to divide 100 pointsbased on how important each domain is for investment decisions. To evaluateconfidence in ability to assess, they were asked to rate themselves on a scaleof 1 to 5 (highest) for each domain.

Investors consider company performance the most impor-tant domain for making investment decisions (38 percent)and also have the highest confidence in their ability to as-sess it (4.47). The standard deviation of 0.58 is the lowestof any domain. The written comments on company perform-ance include the following:

• “Firm performance is the most important ingredient to asuccessful investment. The firm must execute to a certainlevel to create value for its investors.”

The Leadership GapAssessing company leadership is investors’ most glaring weakness when making investment decisions

W

1 We used our personal contacts to invite investors to participate in this study.These contacts included contacting academic colleagues who had publishedabout investment criteria, colleagues who served as board members or in ex-ecutive positions, and investors with whom we had worked. We were able toinvite investors who attended BYU’s “Investment Professionals Conference,”who included professionals in private equity, venture capital, investmentbanking/capital markets, and asset management/hedge funds. In our pilotinterviews, we interviewed 30 active investors—venture capitalists, invest-ment advisors, asset managers, and sovereign wealth fund managers—whowere able to recommend their investor colleagues. A list of registered in-vestors from Harvard Business School library out of the Thompson OneBanker Database was used.


(2) if high quality of leadership is required for an invest-ment to succeed, then there may be other investments outthere (favorable industry, performing firm) with fewerhurdles to success. There is a Warren Buffett quote alongthe lines of preferring to invest in businesses that even amonkey could run because at some point, one will. Thisis the most important factor to us. At the end of the day, italways comes down to people.”

• “We care a LOT about this. This is what drives a firm tocapture opportunity. Nearly all the pathologies of leader-ship are easy to find if you know where to look. Too manyCEOs are such great toadies (some seem to be sociopaths)that you can’t depend on just meeting them—they willcharm you, and they’ll figure out what you want to hear.So, you have to get out into their operations and walkaround. If you know what real leadership is and what realintegrity is, you will find it or the absence of it out on thefront lines where products and services are being forgedand delivered to customers.”

• “Much rises and falls on leadership, so this is key, thoughwe are always looking for ways to make companies better,and we are willing to recruit leaders to lead.”

• “Leadership is one of the most important considerationsthat our fund makes when considering a potential invest-ment. If we are not comfortable with the managementteam, we will usually not invest until changes are made.”

• “This is a leading, non-financial indicator, yet all informa-tion systems and research services are designed to providefinancial metrics. Quality of leadership, culture, and rela-tionships with core stakeholders are critical to understandbut are also difficult to gauge. We’ve spent four years try-ing to get better in this area.”

Clearly, leadership matters to investors but is difficult todefine, measure, or track. Investors vary more on how muchconfidence they have in their ability to assess leadership. Forexample, one investor who managed a sizeable portfolio saidthat his firm starts with choosing to invest in a growth

• “Firm performance is quantifiable and measurable [and]thus given more weight.”

• “We look at a company’s long-term history in an effort toassess its future earnings power. Understanding firm per-formance relative to peers is very important—an under-earner is a more attractive investment than a companyearning more than its peers, all else equal and assumingthese are comparable businesses with no structural reasonfor marginal differences.”

Not surprisingly, company performance gains most investorattention because financial and strategic performance ismore objectively measurable, comparable across firms, andconsistent with most investor training.

Industry favorableness also matters (33 percent) toinvestors, and they have high and consistent confidence intheir ability to track it (average score of 4.33 with a standarddeviation of 0.66). Several survey comments are illustrative:

• “The better the industry structure and prospects, thehigher the potential for strong, stable returns.”

• “Industry favorableness makes investing a lot easier.A rising tide lifts all boats—as long as the company doesnot make mistakes it should benefit.”

• “It is quite possible to find great investment opportunitiesin industries with mediocre prospects. However, it is diffi-cult to find outstanding opportunities in industries withvery poor characteristics, especially in industries with in-tense price competition or those in a secular decline. Nev-ertheless, industry characteristics can be outweighed byfirm characteristics and by valuation.”

• “I want the industry to provide a tailwind.”

Although ranked lower among the three domains, qualityof leadership clearly matters to investors (28.4 percent) in aconsistent way (standard deviation of 14). But investorshave much less confidence in their ability to assess qualityof leadership (3.75) and they sense a much higher risk(standard deviation of 0.96) associated with their evalua-tions. Their comments reflect these findings:

• “Quality of leadership is important but I offer two obser-vations: (1) this domain may be difficult to assess and

Leadership matters to investors

but is difficult to define, measure,

or track. Investors vary more on how

much confidence they have in their

ability to assess leadership.

The investment community will be

well served to develop more rigorous

analytical tools to determine the

quality of leadership within potential

investment opportunities.

Viewpoint


industry. Next, they focus on the four or five highest per-forming firms in their selected industry based on a set offinancial criteria. Their final choice about how much toinvest in each firm comes after they meet for a day with theCEO of these targeted firms. In that day, they would meetnot only with the CEO but try to get outside the CEO’scomfort zone by going sailing. He felt that a lot could belearned about the CEO as a leader in this setting.

This story was consistent with our finding that compa-ny performance, industry favorableness, and leadershipmatter, but it also demonstrates that investors have a longway to go in determining quality of leadership. Neither com-fort in sailing nor strong interpersonal skills equate to lead-ership success. Additionally, looking at one leader—eventhe CEO—does not ensure leadership depth within a firm.

Conclusions

Our preliminary study captures broad trends with clear andchallenging implications. Investors tend to focus on com-pany performance and industry favorableness and have rel-atively high confidence in the assessments they make in

these areas, but they also pay attention to quality of leader-ship, despite having much less confidence in how to meas-ure it. So, how can investors better judge quality of leader-ship? We propose that the investment community will bewell served to develop more rigorous analytical tools to de-termine the quality of leadership within potential invest-ment opportunities.

If investors had better information about the quality ofleadership within a company, they would reduce their risk,increase their confidence, and make more informed deci-sions. Likewise, if regulators doing stress-tests on companieswithin an industry (e.g., financial services) could stress-testthe quality of leadership as well as financial ratios (e.g., liq-uidity), they could make more informed decisions.

Dave Ulrich is a professor at the Ross School of Business of theUniversity of Michigan and a partner with The RBL Group inProvo, Utah. Norm Smallwood is a partner with The RBLGroup. Michael Ulrich is a doctoral student at the Universityof South Carolina.

Encouraging a Behavioral Shift“We need to find not only new answers but new ways of finding these answers”

BY PHILIPPE SARASIN, CFA

Excerpted from remarks made in accepting the Alfred C.“Pete” Morley Distinguished Service Award

hat is it about CFA Institute that brings thebest out of individuals? Why do volunteersput aside personal or corporate interests andgive so much time, intelligence, and experi-

ence to set higher standards for the industry?Is there something specific about the CFA Institute

model that motivates successful men and women (whohave demonstrated their ability to climb to the top of thepyramid for their own benefit) to seek action in the collec-tive best interest?

At a time when so many questions are being asked, so many changes occurring and brewing, and when money,power, and old-boys’ networks are becoming suspect, weneed to find not only new answers but new ways of findingthese answers.

What is different today? Complexity? No, complexityhas always been rising with the directionality of time. Ris-ing complexity is a biological characteristic of life itself.What is new in today’s world is that we are about to reachlimits we thought were nonexistent or still far away. Demo-graphic expansion will come to an end sooner than we anticipate. We are approaching “singularity,” the momentwhen computers become more intelligent than humans.

And we have the limits imposed by climate change, popu-lation density, and scarcity of resources that will lead tochallenging mass migrations.

Just think of the implications of increased complexitycombined with these new limits—the potential impact oneconomic theory, valuation models, public policy, and for-eign relations (to mention only a few).

Not only does the task of addressing these challengesoffer an amazing opportunity for forward thinking and cre-ative research, but we need to move from the primal indi-vidual predatory survival instinct “mode” imbedded in rawcapitalism to a higher functioning mode of collective intel-ligence.

And this is where the CFA Institute higher sense ofpurpose and the behavioral shift witnessed in volunteerleaders come to mind. Could this combination be an inspi-ration for other professions or other areas of corporate andpublic life?

If only leaders from all walks of life could use their positions of power to serve a notion of higher purpose andgreater good and seek to encourage the kind of behavioralshift from predator to team player, our society would be a better place and would offer more of what the youngergeneration badly needs: goals and purposes of a natureworth fighting for.

Philippe Sarasin, CFA, is a former chair of the CFA InstituteBoard of Governors.

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Goals-Based Reporting and Traditional Performance MetricsBY CHARLES M. OPINCAR

principal preoccupation of traditional perform-ance reporting is calculating a portfolio’s rate ofreturn either in absolute or relative terms, withthe emphasis on relative comparisons: measur-

ing returns against some generally accepted benchmark,peer group, or risk-adjusted return.

Consequently, the performance metric for the individ-ual investor is the portfolio’s return relative to an index or median manager’s performance in a similar investmentstyle. A major goal of the investor and designated invest-ment manager is to create alpha or excess return of theportfolio relative to the benchmark, with success definedas beating the benchmark.

Although investors generally focus on portfolio rela-tive returns, the advent of behavioral finance suggests thata larger spectrum of investor behavior should be embraced.Rather than the narrow focus of portfolio allocation basedon risk–return calculation, there is the ongoing realizationthat investors have more experiential, real-world goals thanthose accommodated by standard risk–return models.

For example, a highly desirable goal for a retired ornear-retirement demographic is to have a spending streamor target spend rate that keeps intact the principal of theinvestment portfolio and that, at the same time, affords arealistic spending stream of income in the retirement years.An important concern of goals-based reporting is avoidingthe twin fears of exhausting retirement income premature-ly or not leaving a financial legacy to family members.

The standard metric used by traditional performancereporting is incomplete in measuring the attainment ofsuch goals. This is not to say that the retired investor is totally indifferent to their portfolio’s return relative to abenchmark. Rather, a complementary performance metricis required in assessing the achievement of a retiree’s goal.

Goals-based reporting is the missing element in theperformance story and represents a true understanding of an investor’s experiential preoccupations, worries anddreams. For that reason, the industry should move togoals-based performance metrics and reporting, which enables investment managers to produce performance reports that reflect the true aspirations of each investor.

Life Metrics

Disciplined spending and its associated depletion of accu-mulated assets in retirement can be a challenge. As JamesTobin, a Noble Prize–winning economist, noted in the con-text of endowment spending, there is a trade-off betweencurrent spending and the growth of the endowment’s principal. This trade-off applies to the retiree’s situation as well. By spending in excess of some targeted spend rate,

the retiree runs the risk of depleting assets and reducingthe intergenerational wealth transfer to family members.Investors must therefore be sensitive to their spendinghabits and establish an asset structure or asset allocationthat permits the realistic possibility of maintaining orgrowing portfolio value.

The purpose of traditional performance metrics is as-sessing the growth of the portfolio and the success of theinvestment manager. Knowing your small-cap managerbeat the Russell 2000 by 150 bps is reassuring. In addition,a Sharpe ratio higher than the median manager in a peer-group ranking reduces fears of unacceptable risk for this150 bps alpha return. All of these traditional metrics servea very useful and informative purpose. I do not suggestdiscarding these performance tools. Instead, they are indis-pensible complements to goals-based performance report-ing. But a different metric is required to monitor behaviorand ensure that current spending habits do not exceed thepre-defined targeted spend rate.

Consistent with Tobin’s suggestion, an optimal spend-ing rule or targeted spend rate is one that combines stableelements with market elements. Specifically, the stableterm is a percentage of the previous year’s spending plusan adjustment for inflation. In addition, the spending ruleincorporates a market term for a long-run sustainable rateof distribution multiplied by the market value of the port-folio. By varying the proportions between the two terms,investors can influence how sensitive their spending is tomarket variation. For example, more risk-tolerant retireescould select a higher proportion for the market term inthe spending rule, which would make current spendingmore sensitive to market fluctuations. Overweighting themarket term might be enjoyed during bull markets butcould lead to an anxiety-inducing and belt-tightening sce-nario in bear markets.

Layering: Assets and Spending Habits

Spending requires cash, and a targeted spend rate requiresa predefined amount of available cash. Without adequatecash, a steady spending stream as mandated by a spendingrule is impossible.

In addition to cash, goals-based reporting can have additional layers or asset classes, such as stable and growthassets differentiated by their liquidity properties and vari-ability of returns. Because cash and cash equivalents havezero or minimal variation, they occupy the foundation ofthe asset layering. Stable and growth assets are less liquidand experience varying degrees of return variability. Con-sequently, they account for a smaller proportion in the lay-ering of assets.

The spending rule in general (and the weights associ-ated with the stable and market terms in particular)

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determine the amount of cash and cash equivalents re-quired for the investor’s targeted spending. The remainingstable and growth assets are determined by a client’s riskexposure. The stable assets would “sit above” the founda-tional layer of cash and usually account for a large share ofportfolio value.

Finally, growth assets would add the top the layer and usually would constitute the minority of the asset mix.Notice that the asset mix is viewed from the perspective ofliquidity and the requirements for a stable spending streamas opposed to traditional view of asset allocation (namelyrisk diversification).

Cash does not fall from the sky but must be raised byselling other assets. Moreover, knowing when to sell assetsrequires some forethought and rule generation. This raisesthe challenge of the optimal, market-timing trading rules torefill the cash bucket and to maintain the targeted spend-ing rate. Trading rules are developed to satisfy the varioustypes of markets (i.e., range bound, rising, and falling). Forexample, it is better to replenish the cash bucket in a bonafide bull market than to sell assets at distressed prices in a raging bear market.

A minimum floor of cash (e.g., three months of cash tosatisfy targeted spending) is established and automaticallyreplenished when it falls below the minimum regardless ofmarket conditions. For other amounts of cash, using tech-nical trading indicators (i.e., moving averages, mid- tolong-term trend analysis, etc.), sell signals are triggered inorder to refill the cash bucket. In turn, the “freed up” cashflows to spending in alignment with the targeted spendrate. Hence, the foundational layer of the asset model (thatis, cash) supports the spending habits of retirees and pro-vides a very different depiction of portfolio allocation thantypical variance of return model. In a behavioral sense, assets are chosen not necessarily for their expected returnrelative to their risk but rather as a conduit of cash flow tosupport distribution and spending behavior.

Life-Metric Signals

The spending rule and ensuing spending behavior are sen-sitive, by varying degrees, to a market term. Statistical meth-ods can be used to estimate the impact of the market termon spending. Monte Carlo simulation is used to producestatistical estimation of various market scenarios and theirimpact on spending. Specifically, for various parametricvalues of the stable and market terms within the spendingrule, Monte Carlo simulation can estimate the portfolio returns and spending scenarios and can provide a measure-ment of important life-metric signals, such as the numberof years the current spending stream can continue beforean investor’s assets are exhausted.

A more immediate and compelling performance metricis the comparison of a historical current spend rate withthe theoretical target spend rate. The current spend ratecan be a moving average of historical spending or a pro-jected spend rate based on current spending behavior. By

developing and including additional rules that affect thefunctional interplay between the current and target spendrate, it is possible to provide investors with advisory sig-nals when their spending exceeds the target spend rate.

These life signals are not intended to replace the tradi-tional performance metrics of portfolio analysis. Clearly,investors should be concerned about the upper tiers oftheir asset mix. As noted, the market term of the spendingrule can have an important and decisive impact on a spend-ing stream depending on an investor’s risk tolerance. In-vestors need to know if their portfolio or investment man-ager achieves excess return relative to some benchmark.Not surprisingly, when investors open a monthly or quarter-ly investment statement, they appreciate the plethora of tra-ditional performance metrics: alpha, Sharpe ratios, Treynorratios, time- and money-weighted returns, and attributionanalysis. Performance life metrics will experientially res-onate with the investor in a different way than the tradi-tional tool set of performance metrics.

Putting the Investor First

An effective way of putting the investor first is to empowerthem. This means creating goals-based reporting tools thatresonate both objectively and subjectively with the in-vestor. In addition, these tools should promote proactiveinvestor behavior. Reviewing a monthly or quarterly in-vestment statement and noticing a “spend-limit violation”—the penalty of which is facing the retirement years withquickly dwindling financial resources—is sufficient reasonto reassess one’s spending habits and to initiate a portfolioreview with the investment manager.

Such a review should encompass both personal spend-ing behavior as well as noting excess returns relative tobenchmarks as a result of the choice of asset buckets or in-vestment manager selection. This approach is a win–winfor the investor and investment manager. Combining thisclient-centric focus with traditional and goals-based per-formance metrics can truly optimize an investor’s reportingexperience.

Charles M. Opincar is a senior reporting analyst at Fiserv in Jersey City, New Jersey.

Viewpoint

An effective way of putting the

investor first is to empower them.

This means creating goals-based

reporting tools that resonate

both objectively and subjectively

with the investor.

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MF Global: Another Ethics and Regulatory Blunder?institutions were other goals. Now it appears they weremere pipe dreams of the regulatory improvement effort.

It all begs the question, What has changed since simi-larly risky behavior brought the global financial system to the brink of collapse?

I think you know the answer. Although MF Globalwasn’t deemed systemically important, and perhaps hadless oversight as a result, this “small fry” by Wall Streetstandards is still the eighth-largest bankruptcy ever andhas become a new poster child for U.S. regulatory failure,not success. In fact, we are left to wonder whether Dodd–Frank rules and current regulatory oversight capabilitiesare adequate in any circumstance, much less a larger fail-ure—something along the lines of Lehman Brothers. Ourregulatory capabilities seem particularly hard pressed toeven recognize, much less prevent, industry firms fromgetting into similar trouble in the first place.

Even amid greater emphasis on financial institutionsfollowing the 2008 financial crisis, the fall of MF Globalunderscores that it’s still relatively easy for a major WallStreet player to flaunt the rules and disregard customerinterests. The fact that MF Global did not take down thesystem is hardly grounds for patting ourselves on the backand saying regulation works.

In the end, I and many others are hoping this situa-tion will all be sorted out, with customers made wholeand wrongdoers held accountable. Unfortunately, there issomething all too familiar about these problems. Despitethe harsh lessons from the 2008 crisis—which has left ashadow we’re still trying to escape—one has to wonderwhether our industry has learned anything at all.

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

BY KURT SCHACHT, CFA

My MF Global odyssey continues. A disgruntled accountholder, I’m looking for both answers and a check for theproceeds of my account—neither of which has been forth-coming. I am angry not just about the money but alsoabout what this situation reveals aboutour industry and efforts to improvetrust and ethics. Let me explain.

Despite many well-intentionedproposals to curb excessive risk takingon Wall Street, we’ve witnessed thecollapse of another securities firm,this time under the weight of hugeand risky bets on European debt.Although this is one of the biggestinvestment industry failures of alltime, several insiders have been saying that this is anexample of industry regulation working the way it is sup-posed to work. No government bailouts here—make surethey are not too systemic, let ’em fail, and move on. Butwhat about those 50,000 account holders?

Although the recent bankruptcy filing by MF Globaldidn’t send shockwaves across the global financial marketslike the fall of Lehman Brothers, to be sure, it’s furtherproof of just how little things have changed on Wall Street.

MF Global’s demise comes at a time when regulatorsare stalled on any meaningful Dodd–Frank reforms in theU.S., including how stringently to implement the contro-versial Volcker Rule—which sets out to segregate propri-etary trading from customer deposits. Stricter rules andoversight of the use of leverage by regulated entities, betterrecord keeping and risk management practices at such enti-ties, and assessing the systemic risk of non-bank financial

CFA Institute Announces New Appointments to Capital Markets Policy CouncilCFA Institute has announced the appointment of two newmembers to the Capital Markets Policy Council (CMPC) to provide expertise and perspective on critical issues relat-ing to the capital markets. Tony Tan Boon Leng, CFA, andNicola Ralston, FSIP, were appointed to one-year terms, renewable up to six years.

The CMPC is composed of a diverse group of invest-ment professionals who provide a global watch on marketissues and events. Their practitioner expertise and analysison such issues as regulatory proposals and structuresenables CFA Institute to provide ethics-based responsesthat are sound from a practical perspective.

Tony Tan Boon Leng is CEO of Governance & Treas -ury Advisory Services in Singapore and has significant

experience in corporate governance, capital markets, cor-porate finance, and risk management. He previously heldpositions with VTB Bank Europe, Tokai Capital Markets,BP Asia Pacific, and Overseas Union Bank. He is the CFASingapore Advocacy Committee co-chair as well as chairof the society’s Senior Members Committee.

Nicola Ralston is a director of PiRho InvestmentConsulting in London, with more than 30 years of invest-ment experience as an analyst, portfolio manager, andinvestment consultant. She previously managed the U.K.institutional business for Schroders and was head of globalinvestment consulting at Hewitt Associates. Ralston, whois a fellow and former chair of CFA Society of the UK, was a governor of CFA Institute between 2003 and 2009.

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Overhauling Europe’s Securities Markets

C F A M A G A Z I N E J A N – F E B 2 0 1 214

BY RHODRI PREECE, CFA

Recently, the European Commission commenced its over-haul of securities markets regulation in Europe with thepublication of legislative proposals for the revised Marketsin Financial Instruments Directive, dubbed “MiFID 2.” After nearly a year in the making, the legislative packageputs transparency at the forefront with ambitious proposalsto shed light on trading in practically all financial instru-ments—from equities to bonds, derivatives, and evenemissions allowances.

The transparency agenda stemsfrom the European Commission’s desire to implement the Group of 20(G–20) mandate to make financialmarkets safer and more resilient bypushing trading onto regulated, trans-parent electronic trading venueswherever appropriate.

CFA Institute has contributed tothe transparency debate with the pub-lication of a recently released report, “An Examination ofTransparency in European Bond Markets.”* The report, au-thored by Heidi Learner, CFA, examines the existing stateof transparency in bond markets, drawing from the experi-ences of Italy—Europe’s largest bond market and one ofonly a few to have already mandated public reporting offixed-income transactions—and the United States, whichhas required public post-trade transparency in the bondmarket since 2002 via the TRACE (Trade Reporting andCompliance Engine) system. The report broadly concludesthat careful implementation of post-trade transparency re-quirements in European bond markets can benefit investorsby improving access to pricing information, thereby bridg-ing the information gap between investors and dealers, and increasing competition among liquidity providers.

Consolidated Tape

On the issue of transparency, another welcome develop-ment under MiFID 2 is the requirement for a consolidatedtape for equity markets, an issue supported by CFA Insti-tute members and advocated for consistently by our organ-ization over the past two years. Given the fragmented nature of Europe’s equity markets, a consolidated tape isessential to provide investors with the transparency theyneed to compare prices and evaluate best execution acrossmultiple markets.

Rather than mandating a single entity to establish theconsolidated tape, MiFID 2 provides for the creation ofconsolidated tape providers (CTPs) that must meet thesame minimum standards and register with regulatory

authorities. CTPs will have to consolidate post-trade datainto a continuous electronic stream, to be made availableas close to real time as possible. It is hoped that competi-tion among providers will lead to high-quality, innovativeconsolidated data offerings.

The approach prescribed by the European Commis-sion seems appropriate at this stage, given current industry initiatives, expertise, and infrastructure. However, if thecommercially driven approach fails to meet the prescribedstandards, lower costs, or live up to investors’ needs, thenthe European Commission should look at other approach-es, including establishing a single public utility to run theconsolidated tape.

New Trading Venue Classification

A new aspect of MiFID 2 is the establishment of a tradingvenue category called the “organised trading facility”(OTF), which is essentially any type of electronic tradingplatform that matches orders multilaterally amongst usersof the platform but where there is some discretion over theway in which orders are executed. Ostensibly, the OTF category has been created as a means to ensure that all sys-tematized trading is captured under the MiFID framework,in an attempt to minimize regulatory arbitrage. For exam-ple, the OTF category will include certain broker crossingsystems, often referred to as “dark pools” operated bybanks. Such broker crossing systems would not be able tocombine the crossing of client orders with bilateral execu-tion against the broker’s own account under the OTFframework. This should lead to a more consistent ap-proach for the operation and regulation of dark pools.

Moreover, the OTF concept also applies to the tradingof derivatives. In essence, it is a broadly equivalent con-struct to the “swap execution facility” (SEF) trading venueestablished in the United States under the Dodd–Frank Act.

Whilst MiFID 2 addresses the trading of financial instruments up to the point of execution, post-trading issues, such as clearing and settlement, are covered underthe European Market Infrastructure Regulation (EMIR),which is nearing the end of the legislative process in theEuro pean Parliament. Like Dodd–Frank, EMIR requirescertain standardised, sufficiently liquid derivatives con-tracts to be cleared via central counterparty clearinghouses.

High-Frequency Trading

Another key development under MiFID 2 is the regulationof algorithmic trading firms, including high-frequency trad-ing (HFT) firms. Recognizing that HFT accounts for more

*Members can access “An Examination of Transparency in European BondMarkets” at bit.ly/bondmarket.

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than one-third of total trading volume in European equitymarkets and the potential systemic risks associated with it,MiFID 2 requires HFT firms to register with local regulatorsand imposes additional constraints on the way they operate.

Among other things, there will be a cap on the ratio of orders to transactions in an attempt to limit some of thecosts associated with the voluminous message traffic exert-ed on the market ecosystem, where currently more than 90percent of orders end up being cancelled. Whilst this hassome appeal, a risk of pricing inefficiencies across relatedmarkets and instruments remains if HFT firms engaging instatistical arbitrage are constrained from adjusting theirquotes in response to changing market conditions. MiFID2 also effectively requires HFT firms to provide liquidityon a continuous basis through the trading day, regardlessof market conditions. The view of CFA Institute on this is-sue is that if HFT firms benefit from certain privileges notavailable to other investors, such as faster data access toexchange servers or an advanced look at the order book,then they should be bound by such requirements as pro-viding continuous liquidity like traditional market makers.

Another risk associated with HFT is the potential foran erroneous algorithm to create market instability andpropagate systemic risk across markets. Whilst this wasn’tthe cause of the flash crash in the United States in 2010,HFT was considered to have amplified the transmission of instability from the futures markets to the cash markets

and beyond. To avoid any such occurrences in Europe, MiFID 2 contains a number of provisions related to riskcontrols for both firms, broker/dealers who provide directelectronic access, and exchanges. These measures are wel-come and should help protect the integrity and efficientfunctioning of the market.

HFT is also addressed under the revised Market AbuseDirective, published by the European Commission at thesame time as MiFID 2. New provisions under this directiveclarify which HFT strategies constitute prohibited marketmanipulation, such as submitting orders without an inten-tion to trade but to disrupt a trading system, known as“quote stuffing.” This is another welcome development toprotect market integrity in today’s technology-driven mar-ketplace.

MiFID 2 contains more proposals, such as strength-ened conduct of business requirements for investmentfirms. Indeed, yet more directives lay in store for 2012.Most of these provisions are a step in the right direction,but as with all legislation, the devil will be in the details.These will be worked out at a later stage in conjunctionwith technical advice from the European Securities andMarkets Authority. Ultimately, only time will tell if MiFID2 serves the best interests of all investors.

Rhodri Preece, CFA, is director of capital markets policy for CFA Institute.

BY AGNÉS LE THIEC, CFA

UCITS: A European Success Story

With Greece on the brink of default, solidarity betweenEuropean Union (EU) member states tested by deep finan-cial and economic imbalances, and the future of the euro-zone endangered, to say that Europe is not a particularlyhot asset at the moment would be an understatement.

However, Europe can still claimsome success stories, including in the financial sector. One of them isUCITS (Undertakings for CollectiveInvestment in Transferable Securi -ties). The UCITS story is a major andlasting testament to the vision of asingle European market. With a com-pound annual growth rate of morethan 11 percent over the last 20 years, UCITS assets nowexceed €5 trillion, and the UCITS “brand” has graduallybecome a global marque representing well-regulated andrisk-diversified investment funds that can be marketed toretail investors.

The UCITS phenomenon started in 1985 with the firstUCITS Directive, which established a framework for col-lective investment schemes across the EU and took the

Have UCITS Grown Too Complex for Retail Investors?first steps toward creating a single European market andregulatory framework for investment funds. It enabledUCITS to benefit from a “passport” that allowed them,subject to notification, to be offered to retail investors inany jurisdiction of the EU once registered in one EUmember state. UCITS I particularly aimed at facilitatingcross-border offerings of investment funds for retailinvestors, but it also aimed at enhancing investor protec-tion, notably through strict investment limits and capital,organizational, and disclosure requirements.

The Evolving Story of UCITS

The UCITS framework has evolved greatly since 1985. The first directive allowed UCITS to invest only in trans-ferrable securities, such as equities and bonds. UCITS fundswere permitted to use derivative instruments only in strict-ly defined instances, effectively limiting their use. This restriction led UCITS funds to be traditionally regarded as“plain-vanilla” investment funds. However, the UCITS IIIDirective of 2001 and the Eligible Assets Direc tive of 2007introduced great flexibility for UCITS managers by broad-ening their investment scope. Under the UCITS III Direc-tive, more and more funds today are using a wider range oftechniques and instruments and pursuing strategies thatwere previously more common in the alternative investmentfund sector. Indeed, a growing number of funds are

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using derivatives to gain both long and short synthetic ex-posures as well as to implement complex macro, arbitrage,and commodity investment strategies. Some funds havealso increasingly been using leverage. Acknowledging thepotential increased risks associated with this broadened investment scope, the EU regulator, in turn, asked forstrengthened risk management processes.

Concerns for Investor Protection

As a result of these changes in investment strategies andthe use of sophisticated financial instruments, referencesare now being made to the so-called Newcits phenomenon.With more than 200 Newcits on the market, and with moreevery week, the so-called retailization of UCITS-complianthedge funds has caused concerns among regulators.

Another recent worry expressed by regulators world-wide is the rapid development of exchange-traded funds(ETFs) and the move away from tradi-tional ETFs into synthetic and morecomplex structures. Both the FinancialStability Board (FSB) and the Bank forInternational Settlements (BIS) pub-lished reports in April 2011 on theassociated potential impacts forinvestor protection and financial sta-bility. These concerns led the newlyestablished European Securities andMarkets Authority (ESMA) to conducta consultation on the subject. Theobjective of the consultation, which closed in September2011 and to which CFA Institute responded, was to helpESMA develop guidelines applicable to UCITS ETFs andstructured UCITS.

In our view, the two main risks to investors in syntheticETFs and structured UCITs are as follows:

• Counterparty risk: when the fund enters into a deriva-tive transaction with a counterparty(ies)

• Collateral risk: when, through the use of a derivative,the collateral held by the fund is possibly of lower qual-ity and liquidity than the securities held in the trackedindex, for example, and when access to the collateral is potentially cumbersome

Even though we are concerned about the protection ofinvestors, it seems to us that prohibiting the sale of struc-tured UCITS outright to retail investors may not be theright answer because it would deprive retail investors ofthe benefits associated with these products. For example,when compared with plain-vanilla ETFs using physicalreplication (i.e., directly investing in stocks or bonds thatreplicate an index), synthetic ETFs—which replicate thereturn of an index through the use of derivatives—providesignificant advantages to investors. First, they widen theinvestment spectrum. Second, they offer lower costs and,

therefore, potentially higher returns. And finally, they tendto offer lower tracking errors in the case of index-trackingETFs. Therefore, the best way to protect investors’ inter-ests in this instance would be to significantly improve disclosures to investors on the characteristics and risks of structured UCITS—a move that would benefit retailand professional investors alike.

Future Regulation May Qualify Structured UCITS as “Complex”

Another point of contention is the fact that UCITS prod-ucts, by definition, are currently deemed “non-complex”products under MiFID (the Markets in Financial Instru-ments Directive). Qualifying as a “non-complex” productunder MiFID allows the product to be sold to retail in-vestors on an “execution-only” basis, meaning that theproduct can be sold without a prior “appropriateness test.”

The purpose of this test is to preventcomplex products from being sold toretail investors who would not have theexperience and/or knowledge to under-stand the risk of such products. Thissituation is likely to change because theEuropean Commission (EC), in its pro-posed revised MiFID text published inOctober, would now qualify structuredUCITS as complex instruments. Forc-ing investment advisers to go throughthis appropriateness test before selling

a structured UCITS is, in our view, not the only conse-quence of such a rule change. We believe that this require-ment could also have a significant impact on professionalinvestors, who are, in fact, the main buyers of structuredUCITS (about 80 percent of the money invested in Euro-pean ETFs comes from institutional investors). Qualifyingstructured UCITS as “complex” under MiFID is likely toincrease the due diligence obligations of a large number ofprofessional investors and to possibly somewhat limit theirdesire to invest in these products.

This isn’t likely to be the end of the story, however,because the revised MiFID text proposed by the EC mustbe approved by the European Parliament and the Councilof the EU and would not come into force before the end of2014. Then, the main challenge will be to define “struc-tured UCITS” and what would qualify them as “complex”—meaning that their suitability for retail investors andtheir risk profiles would have to be checked by the invest-ment adviser prior to sale.

Stay tuned for the continuing story.

Agnés Le Thiec, CFA, is director of capital markets policy for CFA Institute.

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The main challenge will be to define

“structured UCITS” andwhat would qualifythem as “complex.”

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With The Spaulding Group you get

Verified, but are you really compliant?

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A leading global organization working to promote goodcorporate governance practices recently recommendedthat asset holders ask investment firms to comply withthe requirements of the CFA Institute Asset ManagerCode of Professional Conduct. The InternationalCorporate Governance Network (ICGN), in its “ICGNModel Mandate Initiative: Model Contract Terms betweenAsset Owners and Their Fund Managers,” suggests com-pliance with Asset Manager Code provisions as part of its model contract terms relating to a manager’s adherenceto standards.

The ICGN is a global membership organization com-posed of more than 500 entities in 50 countries represent-ing over $18 trillion in institutional assets under manage-ment. The specific reference to the Asset Manager Codein its model contract recommendations demonstratesgrowing recognition among leading industry practitionersof the value and importance the Code has for investorsseeking a commitment to ethical investment practicesfrom their investment managers.

The Asset Manager Code enhances investor protectionby encouraging investment firms to voluntarily adhere toa strict set of ethical standards. Nearly 600 firms in morethan a dozen countries now claim compliance with theCode, which CFA Institute last updated in 2009.

The ICGN Model Mandate Initiative was approved at the organization’s annual general meeting in Septemberafter consultation over the course of the year with itsmembers, its committees, and the ICGN board. The docu-ment is subject to further ratification by IGCN members,and the final version will be published in March 2012.

For more information on the Asset Manager Code ofProfessional Conduct, visit www.cfainstitute.org/assetcode.

Asset Manager Code Recognized asBest Practice by International CorporateGovernance Network

Claire Fargeot Appointed Head ofStandards and Financial MarketIntegrity, EMEAClaire Fargeot has been named head of the CFA InstituteStandards and Financial Market Integrity division for theEurope, Middle East, and Africa (EMEA) region. She isresponsible for leading CFA Institute efforts in advocacy,policy development, and regulatory outreach in EMEA,including the development of policy papers, research

projects, and regulatory consulta-tions to help position CFA Instituteas a thought leader in the areas ofmarket integrity, investor protection,and ethical practice within the finan-cial services industry.

Before joining CFA Institute,Fargeot was head of the investorrelations practice at BuchananCommunications, one of the leadingfinancial communications advisers inthe United Kingdom. Prior to joiningBuchanan, she was responsible for

setting up and running the investor relations advisorydepartment of Fins bury, a financial, regulatory, and politi-cal communications agency. Fargeot previously set up andran the strategic communications management businessin Europe for PricewaterhouseCoopers, overseeing globalshareholder value projects, and was a top-rated analystand trader at HSBC Investment Bank. She currently servesas a member of the London Stock Exchange’s PrimaryMarkets Group Advisory Panel, which sets standards andpolicies for the U.K. regulated markets and associatedproducts.

She holds a bachelor of arts degree in bilingual Euro -pean business studies.

CFA Institute Seeks Volunteers for Advisory CommitteesCFA Institute is seeking volunteers to serve on advisorycommittees that address critical issues relating to the capitalmarkets, financial reporting, and investment performance:

• The Corporate Disclosure Policy Council (CDPC),which addresses issues affecting the quality of financial reporting and disclosure worldwide.

• The Capital Markets Policy Council (CMPC), whichprovides expertise and perspective on critical issuesrelating to the capital markets.

• The GIPS Executive Committee, which serves as thedecision-making authority for the development, inter-pretation, and promotion of the GIPS standards. TheGIPS Executive Committee is seeking nominees toserve as chair of the Verification/PractitionerSubcommittee that serves as a forum for discussingissues pertinent to verification from various aspects ofthe investment industry.

If you’re interested in these or other opportunities, pleasevisit the “Collaborate & Network” section of My CFA tolearn how you can get involved—and register—as a CFAInstitute volunteer.

Claire Fargeot

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CFA Institute Helps Influence G–20 Financial Reform AgendaWhile Europe’s debt crisis dominated the recent Group of20 (G–20) sum mit in the French city of Cannes, financialmarket reform and investor protection were high on theagenda. Indeed, several of the strategic priorities of a cross-industry task force in which CFA Institute participatedwere highlighted in the official announcements followingthe summit, including better regulation of derivatives trad-ing and monitoring of systemic risk.

The Private Sector Taskforce of Regulated Professionsand Industries—formed in May 2011 at the invitation ofthen French finance minister Christine Lagarde on behalfof the presidency of the G–20—was charged with makingrecommendations to harmonize financial regulatory stan-dards worldwide. The accounting, auditing, banking, andinsurance industries were represented in addition to CFAInstitute.

The final report, presented to the G–20 deputies inOctober, is consistent with many of the key positions andrecommendations of the U.S. and European Investors’Working Groups formed by CFA Institute during the crisis.

Need for Global Systemic Risk Oversight Framework

Despite some progress in identifying information gaps andexamining strategies for identifying and managing systemicrisk, the lack of a global systemic risk oversight frameworkleaves us vulnerable to a new crisis, the report states. To fillgaps in global regulatory tracking and response capabilitiesfor systemic risk, the task force recommends that the G–20enhance the mandate of the Financial Stability Board (FSB),or set up a specialized body under the FSB, to monitor sys-temic risks to the global financial system. This body wouldpromote macroprudential coordination, identify emerginginternational risks to stability, make recommendations forstandardization of data, and recommend responses.

Both Europe and the United States have set up theirown systemic risk regulators. However, the report statesthat it’s not clear how the European Systemic Risk Board(ESRB) will coordinate with national systemic risk boardsin Europe, and the U.S. Financial Services Oversight Coun -cil mandated by the Dodd–Frank Act has not fully staffedits investigative arm (the Office of Financial Research).

“We must cast a wide net because, as the last crisis illustrated, systemic risk episodes can have catastrophicconsequences on an increasingly interdependent and inter-connected world,” says Kurt N. Schacht, JD, CFA, head of the Standards and Financial Market Integrity Division of CFA Institute.

Gaps in the Regulation of OTC Derivatives

The task force recommends that the International Organi-zation of Securi ties Commissions continue to work towardconvergence of national regulation and oversight of capitalmarkets, including the establishment of cross-border mu-tual regulation recognition and enhanced coordination andconsistent regulation of OTC derivatives. This recommen-

dation echoes the U.S. Investors’ Working Group’s recom-mendation that OTC derivatives be subject to enhanceddisclosure requirements and be exchange traded and cen-trally cleared wherever possible.

The report notes that current differences in the way inwhich derivatives and end users are treated under pro-posed U.S. and European Union rules could hinder globalcoordination efforts.

Several years after the market meltdown, CFA Institutemembers still express strong concerns about the potentialfor derivatives to cause serious harm to the world’s finan-cial markets. In the 2011 CFA Institute Financial MarketIntegrity Outlook Survey, derivatives ranked as the mostcritical issue facing global financial markets in the comingyear, with respondents ranking it as the area needing the most urgent regulatory attention in order to enhancemarket integrity.

Resources for Regulators

The report laments the gaps in the enforcement capabilitiesof many jurisdictions in the regulation and supervision of financial institutions, stating that “virtually all enforce-ment bodies are significantly resource constrained. Failureto enforce existing rules and regulations contributed inpart to the global financial crisis.”

In the United States, both the Securities and ExchangeCommission and the Commodities and Futures TradingCommission (CFTC) are subject to “flat” legislative budgetallocations despite being charged with implementing sweep-ing new financial regulations demanded by Dodd–Frank.

Meanwhile, in Europe, common regulatory standardsare subject to different enforcement regimes among EUmember nations, with the potential to create disparitiesand confuse investors and threaten the integrity of capitalmarkets.

“The need for regulators to effectively pursue theirmissions and responsibilities, as well as keep pace with in-novations in the financial industry, is critical to the stabili-ty of our financial markets,” Schacht notes.

Impact of the Report

Based on the contents of the communiqué issued followingthe Cannes Summit, G–20 leaders responded positively to several of the task force’s recommendations. Indeed, thestatement stresses the importance of regulation and over-sight of financial markets as well as the need to improvethe capacity of the FSB to coordinate and monitor financialregulation.

In the “Final Declaration,” G–20 leaders discussed reform of the OTC derivatives markets, stressing that allstandardized OTC derivatives contracts should be tradedon exchanges or electronic trading platforms, where appro-priate, and centrally cleared by the end of 2012.

Access the task force report at bit.ly/G20report.


BY DOROTHY KELLY, CFA

David Stevens, CFA, chair of the Disciplinary Review Com-mittee (DRC), and Christine Koppel, CFA, the DesignatedOfficer responsible for overseeing the CFA Institute Profes-sional Conduct Program (PCP), sat down to discuss theCFA Institute disciplinary process, the work of the PCP andthe DRC, and how each process has adapted over time.

How do you describe the CFA Institute disciplinary processto members and other individuals?

Koppel: Our disciplinary process is a multilevel peer reviewprocess.

How would you explain peer review to those who areunfamiliar with the concept?

Stevens: In a peer review process, a group of professionalsin a given field is charged with reviewing or evaluating acolleague’s performance or work to ensure it meets the stan-dards of the profession. Peer review is a way for a professionto exercise self-regulation, maintain standards, and enhancethe profession and its credibility in society. Many professions(including academia, health care, software development,and the legal profession) use the concept of peer review touphold standards in their specific fields. For example, inacademia or software development peers evaluate the workof a fellow member to ensure the work meets certain stan-dards. CFA Institute applies the concept of peer review indisciplinary matters to determine whether certain conductmeets the CFA Institute Code of Ethics and Standards ofProfessional Conduct.

So members and candidates are judged by their peers?

Koppel: In the concept of peer review, peer refers to a quali-fied member of the profession, someone who is of the sameor higher ranking in the profession. At CFA Institute, thepeers are CFA charterholders.

What makes it a multilevel process?

Stevens: The Designated Officer conducts an initial peer re-view; in certain cases, the DRC contributes additional levelsof peer review. The multilevel aspect provides a process ofchecks and balances to ensure fairness and consistency.

Koppel: It’s similar to the checks and balances built into theCFA Institute grading process. Each June, CFA charterhold-ers grade all of the Level III essay answers. When that’s com-pleted, a second set of graders review exams that fall with-in a range of scores to ensure that the scores are appropriateand consistent. Consistency is important for both the CFAProgram and the disciplinary process.

An Inside Look at the Disciplinary Process

EthicsFORUM

How does the DRC contribute to the checks and balances?

Stevens: Members of the DRC serve on disciplinary panelsthat hear all contested disciplinary cases—matters wherethe member or candidate rejected the Designated Officer’sfindings and/or recommended sanction. In addition, DRCmembers serve on disciplinary panels to review matters inwhich the member and Designated Officer have agreed to asanction of censure, timed suspension, or revocation. Dur-ing the first three quarters of 2011, members of the DRCserved on 103 disciplinary panels.

Koppel: During that same period, the PCP staff concludedan additional 728 professional conduct matters. It’s a lotof cases, but they represent a very small percentage of CFAInstitute candidates and members.

Has the disciplinary process changed much over the years?

Koppel: The basic process hasn’t changed much over theyears, but how we execute it has changed quite a bit. Thegrowth in the CFA Program means that our jurisdiction nowincludes 111,000 members and more than 200,000 candi-dates in at least 90 countries. So both CFA Institute staff andthe DRC have adapted to deal with the increased volumeand the geographic and cultural diversity.

“We’ve added staff to handle the increased volume,and we now categorize disciplinary matters as either exam-related, or non-exam-related—also known as industry cas-es. Industry cases are generally associated with practitionerissues and currently represent about one-third of the case-load. We divide the cases among exam investigators andindustry investigators because the knowledge, skills, andabilities needed for the two types of cases are quite different.

Stevens: On the DRC side, we changed how we conductexam-related disciplinary proceedings. Exam-related pro-ceedings are now based entirely on written submissions.Eliminating verbal testimony from exam-related proceed-ings means that candidates for whom English is a secondlanguage need not be concerned about how well they com-municate verbally.

Koppel: We adopted an electronic case management systemand eliminated a lot of the paper associated with discipli-nary proceedings. Investigations and disciplinary proceed-ings can be extremely paper intensive. In the past, each ofthe five panel members would receive a copy of the writtensubmissions and documentary evidence submitted for a giv-en hearing. Panelists would often receive four-inch binders—sometimes more than one—to review prior to a discipli-nary proceeding. Now all these documents are distributedto panelists electronically and they download the materialsonto electronic tablets. We’re saving trees, staff resources,paper costs, and shipping costs.


Has the changing geographic and cultural diversity of themembership and candidate base had an impact on the dis-ciplinary process?

Koppel: Yes and no. CFA Institute is a global organization,and the rules and the Code and Standards are applied glob-ally. Every member and candidate is required to abide by thesame rules and the Code and Standards. Nonetheless, we’vemade a conscious decision to be more culturally aware inall of our activities and communications.

Stevens: Two years ago, DRC members worked with stafffrom the PCP and the office of general counsel to revise theRules of Procedure for Professional Conduct to providegreater clarity—particularly for those involved in the disci-plinary process. The overarching goal was to make theprocess more transparent and, as a result, increase fairness,but a major consideration was the cultural diversity and lan-guage abilities of our global membership and candidate base.We wanted to make the document understandable for mem-bers and candidates for whom English is a second language.Before I joined the DRC in 2006, the committee had about adozen members, many of whom were from North America.To tap into and reflect the broad diversity of our member-ship at the time, the CFA Institute Board of Governors ex-panded the DRC by about 50 percent and appointed mem-bers from around the globe. At the same time, the Board ofGovernors created the hearing panel pool from which wecould draw other volunteer members to serve alongsideDRC members on disciplinary panels. The creation of thehearing panel pool was based on the belief that members andcandidates facing disciplinary charges should be judged bypanels that resemble the broad membership. It makes sensegiven that our process is based on the concept of peer re-view. We have a globally diverse membership and candidatebase, so the disciplinary panels should reflect that diversity.

Koppel: More than 150 members from around the globevolunteered to serve in the hearing panel pool. It’s a testa-ment to the commitment and volunteer spirit of our member-ship that so many members stepped forward to contributeto the effort.

Stevens: In the end, we found that training such a large poolof volunteers on a continual basis was a significant challenge,so the Board of Governors made the decision to disband thepool and further expand the DRC.

What is the current composition of the DRC?

Stevens: We now have 30 CFA charterholders from 11 coun-tries serving on the DRC. Many of the committee membershave lived, studied, and/or worked internationally, so theglobal diversity is actually a bit higher than what is reflectedin those numbers. The committee is also professionally di-verse—we have academics, asset managers, analysts, regula-tors, and consultants serving side by side. The geographic,cultural, and professional diversity in the committee reflectsthe diversity of our membership and candidate base andensures a global perspective.

And they receive ongoing training?

Stevens: Yes, and the training has become more rigorous.We’ve had training in the past, but committee membersnow receive live training regularly, with more intensity, andthrough a variety of methods. Training topics include ques-tioning skills, how to lead a disciplinary panel, and properglobal etiquette and decorum. Additionally, this year weoffered a “boot camp” event for new DRC members. Theycame to Charlottesville, Virginia, and received two days oftraining. The first day staff provided training on the discipli-nary process; the second day members participated in amock disciplinary hearing.

How else have you adapted?

Stevens: After we expanded the DRC to 30 members, we cre-ated an executive team, which includes a deputy chair posi-tion, to provide additional leadership. At least one executiveteam member is assigned to each disciplinary panel. Theexecutive team also works on policy review and contributesto member evaluations, which we use to determine whethera member needs additional training or coaching. The deputychair serves as liaison to the Code and Standards of PracticeCouncil and leads meetings when the chair is absent.

Koppel: We have become more transparent with regard tothe disciplinary process as well as the sanctions imposed.Notices of disciplinary action include more detailed descrip-tions of the misconduct and are published both in CFA Mag-azine and on the CFA Institute website. Our website alsoincludes a list of individuals who are currently under sanc-tion by CFA Institute.

Why does CFA Institute do all of this?

Koppel: Our job is to protect the integrity of the CFA mem-bership, designation, and examination, so while fewer than1 percent of our members and candidates are involved in thepeer review disciplinary process, our work affects everymember and candidate.

Stevens: On a personal level, I enjoy the opportunity towork with other charterholders who are passionate aboutethics and fairness. It has been an honor to be a part of thisprocess.

Dorothy Kelly, CFA, is director of training and outreach forthe CFA Institute Professional Conduct Program.

For more information on how to volunteer for the DRC, see p.50.

For guidance in applying the Code and Standards, contact [email protected].

To report misconduct by a member or candidate, contact [email protected].

EthicsFORUM


DISCIPLINARY NOTICES

Summary Suspensions

On 3 August 2011, CFA Institute imposed a Summary Suspensionon O. Sam Folin (U.S.), a charterholder member, automaticallysuspending his CFA Institute membership and right to use the CFAdesignation. Folin was suspended after the U.S. SEC permanentlybarred him from association with any broker, dealer, or investmentadviser on 29 July 2011.

The SEC found that Folin misappropriated approximatelyUS$8.7 million from advisory clients, friends, and family throughmaterial misrepresentations and omissions. According to the SEC,Folin offered and sold securities promising investors that theirfunds would be invested in “socially responsible” companies, buthe then diverted a portion of the investors’ funds to pay previousinvestors, the expenses of his affiliated companies, and his ownsalary. In addition to the permanent bar, Folin was ordered to dis-gorge more than US$10 million in ill-gotten gains and to pay a civilpenalty of US$150,000.

On 25 March 2011, CFA Institute imposed a Summary Suspensionon Benjamin Chui (U.S.), automatically suspending both his mem-bership and right to use the CFA designation. This action resultedfrom an order issued by the U.S. SEC on 21 December 2010 barringhim from association with any investment adviser and with theright to reapply after five years. The SEC determined that Chui, theformer CEO of two registered investment advisers—American Pe-gasus and American Pegasus Investment Management—engagedin improper self-dealing, misused client assets, and failed to dis-close conflicts of interest.

Without notifying investors, Chui used more than US$18 mil-lion in loans and advances from his American Pegasus Auto LoanFund to acquire the fund’s sole supplier of subprime auto loans.According to the SEC, this created a “pervasive conflict of interest”as Chui had a duty to maximize the fund’s performance while atthe same time generating profits for the loan supplier he secretlyowned. The SEC also determined that Chui borrowed millions ofdollars from the Auto Loan Fund to support other funds he man-aged. At one point, 40 percent of the Auto Loan Fund’s assets con-sisted of loans to Chui-related businesses—with fund investorsbeing charged fees based on these undisclosed related-partytransactions.

Timed Suspensions

On 12 August 2011, a Hearing Panel imposed a Two-Year Suspen-sion of CFA Institute membership and the right to use the CFA des-ignation on John Phillip Watts (Canada), a charterholder member.The Hearing Panel found that Watts violated Standards I(A)—Knowledge of the Law, I(D)—Misconduct, IV(A)—Loyalty, V(A)—Diligence and Reasonable Basis, and V(B)—Communication withClients and Prospective Clients of the CFA Institute Code of Ethicsand Standards of Professional Conduct (2005).

The Hearing Panel found that between November 2006 andApril 2007, Watts provided research, recommendations, and sales

materials to clients without the prior knowledge or approval ofBerkshire Securities, his employer firm. Several of Watts’ communi-cations to clients contained unsupported price predictions, failedto distinguish fact from opinion, and failed to discuss the potentialrisks associated with the recommended investments. Watts alsosent new account forms to clients and asked that they be signedand returned in blank so that he could complete them later, in vio-lation of his firm’s internal policies and the rules of the InvestmentDealers Association of Canada (the IDA, now known as the IIROC).As a result of the foregoing misconduct, the IDA found that Wattsviolated its bylaws (29.1 and 29.7), and it imposed a C$10,000 fine,ordered him to pay C$10,000 in costs, and required that he passan examination on the IDA’s Conduct and Practices Handbook.

The Hearing Panel also determined that in April 2007 Wattsdeliberately misrepresented to his firm’s compliance departmentthat he had not disseminated to his clients an unapproved re-search report he had prepared when, in fact, he had already dis-tributed the report. The Hearing Panel concluded that Watts’ state-ment was dishonest, disloyal, and reflected adversely on his pro-fessional reputation and integ rity, in violation of CFA InstituteStandards I(D)—Misconduct and IV(A)—Loyalty.

On 3 June 2011, a Hearing Panel imposed a One-Year Suspensionof membership and the right to use the CFA designation on DavidM. Garrity (U.S.), a charterholder member. The Hearing Panelfound that Garrity violated Standards I(A)—Fundamental Respon-sibilities and IV(B.7)—Disclosure of Conflicts to Clients and Pros -pects of the CFA Institute Code of Ethics and Standards of Profes-sional Conduct (1999). This result was subsequently reviewed andaffirmed by an Appeal Panel on 12 October 2011.

The NASD (now known as FINRA) found that on nine occa-sions between 7 July 2004 and 23 May 2005, Garrity purchasedand/or sold securities in violation of NASD Rule 2711’s restrictedperiod. On 8 July 2004 and 23 May 2005, Garrity also publishedresearch reports that failed to disclose his financial interests in thesecurities that were the subject of his reports. According to theNASD, Garrity’s failure to make this disclosure violated Rule 2711’srequirement that a research analyst state in a research reportwhether he or she has a financial interest in the securities of thecompany that is the subject of the analyst’s report and the natureof that financial interest.

The NASD also found that Garrity violated NASD Rules3050(c) and 2110 when he failed to notify two firms by which hewas employed, promptly and in writing, that he held three accountsat other NASD member firms. He also failed to notify properly thefirms at which he maintained these outside accounts that he wasemployed by another broker/dealer. Based on these violations,the NASD fined Garrity US$10,000 and suspended him from asso-ciating with any NASD member in any capacity for 45 days.

The Hearing Panel determined that by failing to disclose hisfinancial interests in securities that were the subject of his re-search report, Garrity failed to disclose to clients and potentialclients all actual and potential conflicts of interest that could rea-sonably be expected to impair the independence and objectivity of


his research reports. Thus, Garrity violated Standard IV(B.7). Final-ly, the Hearing Panel determined that by violating NASD rules andCFA Institute Standard IV(B.7), Garrity failed to maintain knowl-edge of and comply with applicable requirements governing hisprofessional conduct in violation of Standard I.

Censures

On 7 September 2011, a Hearing Panel imposed a Censure onDavid Travis Weitz (U.S.), a charterholder member. The HearingPanel determined that Weitz violated Standards I—FundamentalResponsibilities, IV(B.2)—Portfolio Investment Recommenda-tions and Actions, and IV(B.7)—Disclosure of Conflicts to Clientsand Prospects (1999), I(A)—Knowledge of the Law, V(B.1)—Com-munication with Clients and Prospective Clients, and VI(A)—Dis-closure of Conflicts of the CFA Institute Code of Ethics and Stan-dards of Professional Conduct (2005).

Starting in late 2001 and continuing through early 2007,Weitz co-authored a quarterly investment newsletter called TheGeorgia Small Cap Stock Monitor. The newletter was distributed toapproximately 2,000 individuals, including clients and potentialclients of his firm. Each edition of the newsletter included a “StockPick” section that provided a brief analysis of a featured company,a recommendation to buy, and a specific price target.

In June 2009, FINRA accepted a Letter of Acceptance, Waiver,and Consent (AWC) submitted by Weitz to settle the self-regulato-ry organization’s allegations of misconduct. While neither admit-ting nor denying the allegations, Weitz consented to the entry offindings that he violated Rules 2110, 2711(c)(2), 2711(g)(2),2711(h)(1)(A), 2711(h)(7), 2210(d)(1)(A), and 501(A) of SEC Regula-tion Analyst Certification.

Specifically, FINRA found that (1) Weitz improperly shared adraft research report he had prepared with the CFO of a coveredcompany, (2) he failed to disclose that he personally owned asmall number of shares in three of the companies he featured asstock picks, (3) on at least four occasions Weitz purchased stocksfor his own account, or accounts he controlled, within 30 days pri-or to when he featured the companies as stock picks, (4) he failedto disclose the valuation methods he used in determining pricetargets for eight of his stock picks, and (5) in seven stock picks hefailed to include the required analyst certifications confirming thatthe reports accurately reflected his personal opinions of the sub-ject securities and that he had not received any compensation thatmight have improperly influenced his opinions. As a result of theforegoing misconduct, FINRA suspended Weitz for 30 days in allcapacities and fined him US$10,000.

Private Reprimands

On 21 September 2011, CFA Institute imposed a Private Reprimandon a Charterholder Member. CFA Institute found that the Memberviolated Standard III(B)—Duty to Employer of the CFA InstituteCode of Ethics and Standards of Professional Conduct (1999).

In 2005, while arranging to move to a new firm, the Memberparticipated in removing copies of his employer’s client lists, newaccount forms, account statements, and other documents and in-formation to be used to solicit the employer’s customers to movetheir business to the new firm. In mitigation, the Member promptlyreturned the documents when asked to do so.

On 21 September 2011, CFA Institute imposed a Private Reprimandon a Charterholder Member. CFA Institute found that the Memberviolated the CFA Institute Bylaws Articles 2.17 and 11.3, and Stan-dards I(A)—Knowledge of the Law, I(C)—Misrepresentation, I(D)—Misconduct, and VII(A)—Conduct as Members and Candidatesin the CFA Program of the CFA Institute Code of Ethics and Stan-dards of Professional Conduct (2005).

Between November 2007 and October 2010, the Member wasa party in a lawsuit in which his professional conduct was at issue.But, in his 2008 and 2009 Professional Conduct Statements, theMember denied that he was a subject or defendant in any litiga-tion in which his professional conduct was at issue. The omissionsoccurred because the Member improperly delegated his reportingobligations to a subordinate, and there was no evidence that theMember’s actions were taken intentionally to avoid or put off in-quiry by the Professional Conduct Program.

On 21 September 2011, CFA Institute imposed a Private Reprimandon a Charterholder Member. CFA Institute found that the Memberviolated Standards IV(A)—Loyalty and V(A)—Diligence and Rea-sonable Basis of the CFA Institute Code of Ethics and Standards ofProfessional Conduct (2005).

In August 2008, the Member forwarded to several acquain-tances in the investment community an e-mail description, pre-pared by an unidentified attendee, of a public company’s presen-tation to financial analysts. The Member noted in the cover line for-warding the report that there were rumors that this company was“committing accounting fraud” and could “go bust.” This e-mailwas written and disseminated in such a way that it appeared to bea research opinion, unsupported by reasonable analysis, of theMember’s employer. The public company’s stock price declined.In mitigation, no nonpublic information was involved, and therewas no indication that the Member intended to make a stock rec-ommendation or manipulate the market when he imprudentlyforwarded the e-mail.

On 21 September 2011 CFA Institute imposed a Private Reprimandon a Charterholder Member. CFA Institute found that the Memberviolated Standards I(A)—Knowledge of the Law, I(C)—Misrepre-sentation, IV(A)—Loyalty, and IV(B)—Additional CompensationArrangements of the CFA Institute Code of Ethics and Standardsof Professional Conduct (2005).

In 2007 and 2008, the Member had an unauthorized oralagreement with an estate-planning specialist associated with hisfirm, pursuant to which the Member would refer clients to the spe-cialist without actually talking to the clients before making thereferral. This arrangement caused insurance companies to be in-formed, incorrectly, that the Member was servicing those clientsand allowed the Member to receive additional compensation fromthe specialist for making the referrals. The Member did not securewritten authorization from his firm for the arrangement, which vio-lated technical aspects of firm policy. The Member’s truthfulnessand cooperation with the PCP were exemplary during inquiries,and there was no evidence of any actual damage to clients, theemployer, or the insurance companies.

KEY POI NTS

• When considering a career move, begin by evaluatingstrengths, weaknesses, values, and both professional and personal goals.

• Having a plan helps, but in the current market, job seekersshould be open to different directions and opportunities.

• Personal contacts can open doors. Networking remains avery powerful tool.

• Social media can help, but many succeed without it.

• Recruiting can still play an important role.

Career

In TransitionNine charterholders share advice on career moves

BY LORI PIZZANI

ooking for a new job or new career challenge?Considering sliding over to work for a firm affili-ated with your present employer? Wonderingwhat does and doesn’t work in the current job

market? To answer these and related questions, CFA Mag-azine spoke to several CFA charterholders who recentlychanged jobs and asked them to share their experiences,including their tips for a successful transition.

Tired of Retirement

For all intents and purposes, John Manley,CFA, was retired. He had held several in-creasingly responsible positions at SmithBarney in New York City and then UBSover his nearly 30-year career. He had wonaccolades for being a seven-time memberof the Institutional Investor All-America Re-search Team as well as being voted multi-ple times as the “most popular analyst” in a Smith BarneyFinancial Advisor poll. But when his boss at UBS decidedto retire, he declined to follow. “There were tool sheds tobe fixed and DVD collections to be put in order,” he quipsabout taking the plunge into retirement.

Several months later, boredom hit and he launched adesultory campaign to find a job. A friend told him that aWells Fargo’s mutual funds unit had posted a job onlinebut the application deadline loomed. He applied online atthe 11th hour. Several interviews followed, and he washired as the fund group’s chief equity strategist, based inNew York City.

“Keep your résumé as current as possible,” he says.Doing so paid off when he was able to apply for aserendipitous job opportunity with lightning speed.

Manley openly admits that he used social media plat-form LinkedIn, which provides the right amount of accessto connect with many people in order to stay in touchwith colleagues and friends. [For more on how advisersare using social media, see Private Client Corner on p. 30.]But one-on-one networking was useful as well. “Theycalled it networking even before there was a ‘net,’” hesays. He learned from his early years as a stockbroker that,

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ultimately, the more people you speak to, the more clientsyou attract. The same is true of networking for a job. “Itdepends on how badly you want the job,” Manley says.

Looking back, he says he used his brief retirement asan opportunity for reflection. “I had a few months when Iwas retired to walk, think, and consider what my strengthsand skills are.” His new job allows him to leverage thoseprecise skills.

In his view, the key to securing a new job, especiallyfor someone who may be discouraged and feel unable todo it one minute longer, is to not give up, exude self-confi-dence, and sell yourself. “Don’t think about what you wantbut what the other person needs,” he says. “You have tosell yourself and see yourself in that job.” In addition, jobseekers need to be able to accept rejections on the road tofinding that next job.

Getting to Know You

Michael Swinney, CFA, wasn’t actively looking for a newposition when a friend, also a CFA charterholder, intro-duced him to someone at San Francisco–based investmentconsulting firm Callan Associates. At the time, he was con-tent and doing well working as an investment consultantwith Hewitt EnnisKnupp. An informal lunch with a Callan

manager followed. He subsequently metwith others in the Atlanta office and wasintrigued by what Callan was doing. “Thethought of joining a private, best-in-classinvestment consulting firm became attrac-tive to me,” he says. But the key was forthem to get to know him and for Swinneyto get to know them.

At the time, Swinney says that he real-ly didn’t look to other Atlanta investment

consulting firms he knew were hiring, but he had consid-ered looking. The more he spoke to the folks at Callan, themore he turned his attention solely to that firm.

Conversations progressed and Swinney, whose casualfirst meeting had taken place in February 2011, went towork for Callan’s Atlanta office in August as a vice presi-dent in Callan’s Fund Sponsor Consulting group. “Thework I am doing hasn’t really changed,” he says.

Although he did not use Facebook or LinkedIn as networking tools, he reached out to a core group of six to


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Career Connection is a new column that will appear in each issue of CFA Mag-azine. Want to ask a career-related question or suggest a topic for us to explore? Please contact Lori Pizzani at [email protected].

Manley

Swinney


eight investment management contacts to network with, tobounce ideas off them, and to seek their independent opin-ions about his potential new employer. “They all said,‘Great culture, you’d be a good fit,’” he says. That positivefeedback gave him the confidence to continue having dis-cussions. Since joining Callan, Swinney says that a lot ofpeople have been reaching out to him via LinkedIn.

“I think you’ve just got to assess the personality andcultural fit as much as the technical capabilities youbring,” Swinney says. “Be yourself and let your profession-al capabilities come through.”

The Right Opportunity at the Right Time

Sometimes the right new opportunity finds you.Case in point: Andy Walker, CFA, who joined the San

Francisco–based investment management company RS In-vestments in September 2011 as an equity analyst coveringindustrial and power companies as part of the “hard assets”group. He had previously worked for a decade at Colorado-based Janus Capital and before that at Goldman Sachs.

“I wasn’t looking to move on, but thisopportunity came along and was a goodfit,” Walker says. He had personal connec-tions with people at RS Investments, in-cluding one peer he had gone to schoolwith. When he learned through a contactthat the firm was looking for an analyst,he spoke to people socially and inter-viewed with the firm to learn more aboutits corporate philosophy and goals. The

insight piqued his interest.“A personal and stylistic fit was an impetus for the job

as well as knowing some of the people I had worked with,”he says. From first contact to being hired took about threemonths, and he relocated from Denver.

Walker did not use Facebook or LinkedIn but admitsthat he might have used the social media platforms had hebeen actively looking for a new job. He believes maintain-ing personal connections, as well as continuing social in-teractions, is vital. “At the end of the day, this job cameabout through a personal connection. You have to have thebasis for talking to people, even if you’re not looking for anew job now but may be down the line,” he says.

“Make sure that the place you are going to is a goodfit,” he says. Is there a personality fit, and do you know thepeople from previous jobs that you can work closely andcollaboratively with?” He also suggests looking at the newcompany’s approach to investing: “Does it fit into your val-ue system?” he asks.

Doors Wide Open

The formal job transition of Paul Hamilos, CFA, took ninemonths, although he admits that the cogs were set in motionmore than two years earlier when he learned about the firm.He was also recently hired by RS Investments and joinedits value team as a financial institutions analyst. He waspreviously a vice president and analyst at Macquarie Group.

Hamilos had helped a former colleague with a searchthat landed a position at RS Investments. “When he took the

job, I kept in touch. I left doors open and lethim know that I’d be interested if anythingcame up,” he says. When he later traveledto San Francisco to visit his friend, he wasintroduced to people at the firm, but at thattime there were no jobs available.

“Expect the process to be lengthy.Keep your options open even if you are notlooking,” Hamilos says. “It’s worth takingthe time for the introspection and to fig-

ure out what career you want, then pursue that. I reallymade sure I was pursuing the position I had an interest inlong term and that it would be a good career move.”

Carpe Diem

Greg Tornga, CFA, head of fixed income and a portfoliomanager at Edge Asset Management in Seattle since July2011, seized a job opportunity he saw posted on the CFAInstitute career website as well as the website of parentcompany Principal Financial Group.1 His job transitiontook about six months, and he relocated from his previousjob as a senior vice president (head of investment-gradecredit) at Payden & Rygel in Los Angeles.

Quality of life played into his decisionto move for the new job opportunity. “Youhave to enjoy where you live, what youdo, and the people you work with,” hesays. “If you hate it, it can grind on you.”

He says he didn’t use social media be-cause, given his role, he didn’t feel com-fortable doing that. But he did researchthe new company online. “Now that I’vechanged jobs, I do see that there is a lot more informationon LinkedIn about jobs, but that was not so a year ago.”

The key, according to Tornga, is to be patient and pre-pared for an opportunity. If you’re going to look for new em-ployment, you need to be ready and not give it a half effortbecause it shows. “Obviously, with what’s going on in thejob market, there are fits and starts,” he says. “When you’releast likely to be looking, the opportunity comes along.”

In the current buyer’s market, job seekers have to setrealistic expectations for compensation, the people, the jobcycle, and your expected longevity. “There is no one-size-fits-all and different people in their careers want differentthings,” he says.

Opportunity Calls

Despite independent job search efforts, recruiting is farfrom dead.

Duncan McKeen, CFA, who joined Lockwood Finan-cial of Montreal in September as a senior mining companyanalyst after working at Macquarie Capital Markets

1 CFA Institute members can access the CFA Institute Career Centre athttp://careercentre.cfainstitute.org.

Walker

Hamilos

Tornga

R E C O M M E N D E D R E S O U R C E S

“Career Conversations: Getting the Recruiter Perspective”CFA Institute podcast with Deon Brenner, CFA(www.cfawebcasts.org)

“The Role Social Media Can Play in Managing Your Career” CFA Institute webcast featuring Matthew Youngquist(www.cfawebcasts.org)

Canada, was initially called by a recruitingfirm. At the time of the call, McKeen sayshe had already been seeking other oppor-tunities, specifically an ambitious youngcompany looking to grow. The entire job-changing process took about six monthsand included a bit of courting. “Since theteam at Lockwood is small and tight-knit,we both wanted to make sure that it was agood fit, so we spent a lot of time getting to know eachother before we signed a contract,” he says.

How did he know it was time to change positions? “I had worked for small, entrepreneurial companies in thepast and was looking to relive that experience again,” hesays. Small companies “have the ability to make decisionsand adapt very quickly, often having ad hoc meetings inperson or on the phone and we avoid heavy e-mail use andcalendar scheduling. This keeps the environment dynamic,efficient, and fun,” McKeen adds.

His best tip? “Speak or meet with people you alreadyknow and use that as a starting point to build a network,”he says. People who are hiring often start by consideringcandidates they know and those who have been recom-mended by friends and colleagues. By the time the employ-er has progressed to external posting, the competition hasincreased considerably,” McKeen adds.

Resetting Your Mindset

“The right attitude is to be confident and say, ‘I’m not surethis is the job for me, but I am going to get out there andshow my best,’” says Daniel Kern, CFA, who in August2011 became the president of Advisor Partners, an invest-ment advisory firm in Lafayette, California. Previously amanaging director and portfolio manager at Charles SchwabInvestment Management, Kern decided it was time to leave

after having 16 different bosses over aneight-year period. “All of the bosses whoknew of my successes were gone,” he says.

Kern admitted that he drifted for awhile before drawing up the blueprint tofind a new job. “I spent lots of time plan-ning to plan a job search,” he says. He wasdiscouraged and initially had a very differ-ent type of job in mind. When friends toldhim he was setting his sights too low and

suggested he pump up the job level based on his skill set, hereworked his resume and reset his expectations. “It camefrom people who knew me well professionally. Having thatkind of feedback allowed me to interview better,” he says.

Kern’s best advice for those seeking new jobs is to be asprepared as possible. “Candidates win or lose not on talk-ing about their career and background but by having donethoughtful research on a [potential] company and askinginsightful questions.”

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A New Role

This past August, Ken Schiebel, CFA,moved to head up the newly formed Port-folio Strategies Group, a spin off fromPFM Asset Management in Harrisburg,Pennsylvania. He had been a managing di-rector and 15-year veteran of the firm. Thenew position offered him a bigger, betterrole. The transition began with a review,begun earlier in the year, about how thefirm provided services to clients. Execu-tives elected to reorganize and create a new group thatwould focus on the firm’s fixed-income portfolio manage-ment and marketing along with research, analysis, and cus-tomized solutions for clients.

A broader perspective can often be a step toward real-izing opportunities. “It may make sense to step back andlook at the bigger picture and future needs of the organiza-tion and the way to effect positive change,” Schiebel adds.

Expect Surprises

Christopher Sheldon, CFA, had been working in variousfunctions for BNY Mellon Asset Management since 1995.He had most recently been president of the BNY Mellon

Funds and had been the chief investmentstrategist of the bank’s wealth manage-ment division. The firm decided to com-bine wealth management and asset man-agement into one division, which includ-ed bringing the Dreyfus Corporation intothe fold. In April 2011, the former chiefinvestment officer at Dreyfus announcedhis retirement. After considering severalcandidates, Sheldon was chosen and as-

sumed the new position in November. He had not beenseeking a new position externally.

“I’ve been at the other group for 16 years. I had an im-pact. I felt that I was gaining something, not losing some-thing,” he says of the transition.

“Sometimes people sit back too much. Don’t be afraidto stretch yourself,” he counsels. “But be prepared for a lotof work. Transition is a lot of work, and there are alwaysnew challenges.”

Lori Pizzani is an independent financial services journalistbased in Brewster, New York.


Kern

Sheldon

Schiebel

McKeen

Career CONNECTION

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KEY POI NTS

• Whether long or short, investors need to understand theimpact of trading mechanics.

• Borrowing fees and other costs (as well as the threat of abuy-in) can make short positions cost prohibitive.

• In some cases, borrowing rates can lead to toxic securityprices and a no-win situation for both the buyer and the seller.Short It and Forget It?

The trading mechanics of shorting can be costly

BY DENNIS DICK, CFA

he recent Groupon IPO has garnered a lot of ana-lyst attention. Some analysts have said the stockisn’t worth the $15 billion market cap and is a no-brainer for shorting. Groupon’s business has few

barriers to entry, and the stock is even-tually going to fall as competition in-tensifies—or so goes the argument.Well, Groupon might be overvalued,but the case is not as simple as short itand forget it.

A lot of factors must be consid-ered when shorting a stock. Can thestock even be shorted? Is the stockeasily borrowable? If not, how much isthe borrowing rate to short the stock? How great is the riskof a possible buy-in if the stock becomes hard to borrowafter I have shorted it? All of these questions need to beanswered before initiating a new short position.

Take a closer look at the mechanics behind shorting astock like Groupon. The first step is to find out whetherthe stock can actually be shorted. In order to short a stock,the stock has to be borrowed from an investor who is long.Many stocks that are highly traded can be shorted easily ifthe customer’s broker has ample inventory. Other stocks are“hard to borrow,” and the trader must call the broker’s secu-rity lending desk to obtain a “locate” on these shares. Thebroker will charge the trader a fee for lending these shares.For less-liquid stocks, such as Groupon, the broker’s lend-ing desk may have no inventory, and the trader may haveto go outside of the brokerage to locate the stock.

This situation is where a company such as Locate-stock.com can get involved. Locatestock.com operates anelectronic platform that brings lenders of stocks and shortsellers together and specializes in locating hard-to-borrowstocks for traders.

“Large institutions who would like to lend their stockpopulate our inventory and advertise a rate that they wouldlike to be paid on the stock they lend,” says John Tobacco,CEO and founder of Locatestock.com, explaining the me-chanics behind his business. “We then advertise that rateto traders who would like to short the stock. We charge a transaction processing fee to the trader for facilitating the transaction.”

The rate that lenders demand for borrowing their stockis a factor of supply and demand. If ample supply exists

Tand the demand is relatively low, the rate may be as low asa fraction of a percent. But in the case of a stock like Groupon,the demand is very high (because many investors feel thestock is overvalued). The supply is also limited because the float is small. In addition, underwriters of new IPOsare restricted from lending their shares for the first 30 daysof trading, which limits the supply further. In such cases,an institution holding the stock long will demand morecompensation for loaning its shares.

In the case of Groupon, three days after the IPO, thedaily borrowing rate at Locatestock.com was 9 cents a share.Keep in mind that this rate changes continuously, so therate may fall later as the stock becomes easier to locate andthe demand to short the security drops. But if Grouponstayed at this borrowing rate for over a year and a traderheld the stock short the entire time, the trader would pay atotal of US$32.85 a share ($0.09 x 365). With Groupon cur-rently trading at US$24 a share, the stock could potentiallyfall to zero and the short trader would still lose money.

In other words, the short trader has a considerableamount of risk. For short-term traders, this fee is feasible be-cause Groupon can have excessive intraday moves. But fortraders that want to short the stock for longer time periods,this fee would make that short position cost prohibitive.

In some extreme cases, these borrowing rates can actu-ally lead to toxic security prices that cause both the buyerand the seller of the security to lose.

For example, Ford Motor Company has an exchange-traded debt note (“Ford Motor Co., 7.50% Notes” tradingunder ticker symbol F.PRA on the NYSE) that pays quarterlydistributions of US$0.46875 a share. The next distributionwas due on 15 December. The security traded on 15 Novem-ber for a price of US$27.00 when the security was callable

In some extreme cases, these

borrowing rates can actually lead

to toxic security prices that cause

both the buyer and the seller of

the security to lose.

Trading TACTICS


“Short Arbitrage, Return Asymmetry, and the Accrual Anomaly”Summarized in CFA Digest (November 2011)(www.cfapubs.org)


at the issuer’s option at a price of US$25.00. Considering thehigh rate of the coupon (7.5 percent per annum) and thefact that Ford recently called in a similar security back inMarch, Ford logically might have called this security early, amove that would have made the price of US$27.00 looklike an attractive short because a trader could have bankedUS$2 if the security was called the next day.

But significant fees were associated with shorting thissecurity. The borrowing fee on 15 November was 7.1 per-cent per annum at Interactive Brokers (a retail brokeragefirm). Thus, an investor shorting this security would havepaid US$1.917 per annum in borrowing fees to stay shortthe security (assuming the borrowing rate remained thesame throughout the year). The investor also would havebeen required to pay the distributions of $1.875 per annum.The total annual cost would have been US$3.972—or$0.010389 a day.

If the short trader was banking on the security beingcalled, the call would need to have happened in the next192 days for the short trader to make money (US$2 poten-tial gain divided by daily cost of $0.010389). In otherwords, for the short to be profitable, Ford would have tocall the security by 26 May 2012. If it was called after thisdate, the short trader would lose.

Now take a look at the other side of this trade—theinvestor buying the security. The investor can currently buythe security at US$27. Considering the US$27 purchaseprice and the potential callable price of $25, a long investorwould stand to lose US$2 if the security was called thenext day. But the investor would continue to receive quar-terly distributions of $0.46857 each quarter if the securitywas not called. The next quarterly payment was due on 15December 2011. The interest would continue to accumu-late on this security after this date at the rate of $0.46857each quarter. The investor would need to receive a mini-mum of four more quarterly distributions plus an addition-al 24 days of interest in order to make money at the US$27purchase price. The breakeven date for this would be 9 October 2012. If the security was called before this date,the investor going long would lose on the investment.

Therefore, if the security was called between 26 May2012 and 9 October 2012, the current price of the securitywould be toxic—because both the investor going long andthe investor going short would lose. As can be seen, theseborrowing costs are a very important consideration whenshorting a security.

Not only should investors consider the borrowing costswhen initiating a short position, but they also need to con-sider the possibility of a potential buy-in, especially if illiq-uid issues are being shorted. If the brokerage’s clearing firmis unable to locate a previously shorted stock, that shortposition may become subject to buy-in so the brokerage canstay in compliance with restrictions on naked short selling.

Typically, a notification is sent to the trader who isshort, stating that the security has become hard to borrow,and if new shares cannot be located, the security may bebought-in. Buy-ins usually occur on less-liquid securities,

which often have a very small float. The lack of liquidity inthese securities can pose some substantial risks to traderswho are short.

“It is dangerous to short an illiquid stock because atanytime the clearing firm can buy you in,” says Jeff Gold-man, managing partner at JC Trading Group. “Sometimes,they give you a warning that you have so much time tocover the position, but other times, they give little or nonotification at all. They just buy-in the position. If the se-curity has little liquidity on the sell side, these buy-inprices can get pretty ugly.”

To compound problems for the short traders, stocksoften become difficult to locate in multiple brokerages si-multaneously. Other shorts may be subject to buy-in at theexact same time, putting a further demand on sell-side liq-uidity, which can press the buy-in prices even higher.

In any event, it is important for traders looking to ini-tiate a new short position, to analyze the costs of puttingthat position on as well as the costs and risks in holdingthat short position for longer periods of time.

But understanding these costs and risks can be valu-able information for long-only traders as well. Excessiveborrowing rates and potential buy-in risks are two seriousdeterrents in shorting illiquid securities. With fewer shortsto keep the prices in check, these deterrents could possiblylead to over-inflated prices. A stock such as Groupon couldremain at lofty prices for quite sometime, even if the funda-mentals of the company are hurt by increasing competition.

Whether you’re a long trader or short trader, it is im-portant to consider the overall trading mechanics whenmaking an investment decision. Being right on the funda-mentals can still result in being wrong in the P&L.

Dennis Dick, CFA, is a proprietary trader at Bright Tradingin Detroit and a member of CFA Detroit.

Not only should investors

consider the borrowing costs

when initiating a short position,

but they also need to

consider the possibility of

a potential buy-in.

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30

Private KEY POI NTS

• Financial advisers increasingly are using social media as acommunications channel.

• Advisers face the challenge of making their messages standout from the online noise while meeting compliance regula-tions.

• Different strategies have proven successful for advisers andfinancial professionals in varying capacities. The key is adapting effectively to your own circumstances.


BY ED MCCARTHY

ocial media have gone from leading edge to every-day use within a few short years and continue togrow. The latest social media forum, Google+, hasmore than 25 million users already. At times, it

seems everyone is tweeting, blogging, and participating onnetworks such as Facebook, Twitter, LinkedIn, and others.And financial advisers are no exception.

Participating in these technologies can pay off. RickFerri, CFA, founder of Portfolio Solutions in Troy, Michi-gan, estimates that 95 percent of his leads for prospectiveclients come from the internet. He’s an active publisher ofonline content and user of social media, and these tech-nologies drive his marketing plan: “We hit a billion dollarsin assets, and so the question is, “How do you get to threebillion? And the answer is you get to more people. How doyou get to more people? Well, through the internet.”

Although social media have become standard commu-nication tools, they pose several challenges for financialadvisers. Compliance is frequently cited as a deterrent.How can advisers reach their target audiences without vio-lating the rules? The second challenge is making messagesstand out in an environment where many advisers pursuesimilar messaging strategies. We asked several advisers andindustry consultants who have been successful with socialmedia for their insights on participating effectively whileavoiding regulatory problems. Without exception, they be-lieve these media can benefit advisers who are willing tospend the time required.

A Virtual Network

Ferri started using the internet to build his business about12 years ago. He began by writing articles for his websiteand publicizing those articles in investment chat roomsand online message boards. He also put the chapters of hisfirst book, Serious Money, into PDF format and allowedreaders to download them. Subsequent books (he has pub-lished six) led to more online writing opportunities, in-cluding a column for Forbes.com on index investing.

As the volume of Ferri’s writing grew, he decided tocentralize it on a new site, RickFerri.com, which serves ashis online publishing hub. He uses multiple social mediaplatforms to publicize his writing and to engage readerswith cross-links among the media that create a virtual net-work to leverage his online presence. “There are links onForbes’ website back to my website, and there are links on

Social GracesAdvisers are using social media to get an edge

S

CLIENT CORNER

the Morningstar website and links on the Bogleheads.orgwebsite that link back to my website,” he says. “When Iwrite something that I think is worthy of telling other ad-visers about, I put a post on LinkedIn [that there] is a newarticle or a new interview I just did, a new video that Ithink has interest to the adviser community.”

The writing and social media marketing take signifi-cant time. Ferri recently hired a director of interactive mar-keting to oversee the firm’s online marketing efforts. InFerri’s mind, marketing with social media is no longer op-tional. “It’s not easy—it really isn’t,” he says. “You’ve got to do a lot of work, but if you don’t do the work, you may not survive.”

Dealing with Constraints

Advisers’ communications, including social media, are sub-ject to regulatory constraints. Mike Langford, senior socialbusiness strategist with Socialware, a social media softwarefirm in Austin, Texas, says following the general guidelinesof recognizing what constitutes advertising and what con-stitutes advice can help avoid regulatory problems. “Ifyou’re on a social network, consider it to be akin to beingon a television interview or a radio interview,” he says.“What type of information would you share there versuswhat would you share in a client situation?”

Advisers affiliated with broker/dealers usually operateunder more constraints than their registered investmentadviser (RIA) counterparts. Bill Winterberg, owner of FP-Pad.com in Dallas consults on technology and practicemanagement with independent financial advisers. Hepoints out that registered reps affiliated with FINRA-regu-lated broker/dealers typically operate in much more conser-vative compliance environments. Additionally, there is nocommon guidance among broker/dealers, and some firmsprohibit their reps from using social media altogether. U.S.SEC-registered advisers have more leeway, according toWinterberg. “I feel they [SEC-registered advisers] have abigger opportunity because the rules that the SEC has pro-vided are fairly general and fairly open as they pertain tosocial media,” he says. “So, certainly, independent adviserswill want to avoid testimonials, they want to avoid postingany performance information relative to the portfolios that they manage. But outside of those specific areas, Ithink that most topics are fair-game discussion on socialmedia sites.”


“Tweet Success”CFA Magazine (Nov/Dec 2010)(www.cfapubs.org)

“The Role Social Media Can Play in Managing Your Career” CFA Institute webcast featuring Matthew Youngquist(www.cfawebcasts.org)

“Stepping Out”CFA Magazine (Nov/Dec 2009)(www.cfapubs.org)

31C F A M A G A Z I N E J A N – F E B 2 0 1 2

Circumstances vary widely, however. Kerry Jordan,CFA, a managing director who handles development andcapital raising with Phalanx Capital Management in Chica-go faces an additional constraint with her social media ac-tivities because Phalanx is a hedge fund for private in-vestors. Consequently, she can’t discuss the firm’s productswith prospects until she has verified that they are accredit-ed investors. She can’t even link her LinkedIn profile toPhalanx’s site because that might be construed as an offerfor sale.

Nonetheless, Jordan maintains an active and success-ful social media presence within the restrictions. She par-ticipates on LinkedIn and sites such as Opalesque and Al-bourne Village that focus on alternative investments. Jordanbelieves her participation builds her credibility, which inturns leads to inquiries about Phalanx. As an example, shecites her activities on LinkedIn, where she belongs to rough-ly 17 focused groups. “Whenever I have a question—for

example if I am looking for someone’s best practices or if Iam going to be speaking at an event—I will post somethingon my LinkedIn site,” she says. “I will probably get 40–50people looking at my profile just as a result of that oneposting. Of those 40–50 hits on my profile, I generally willget six LinkedIn requests, people making inquiries of me.”

Her online participation doesn’t take much time or ef-fort, says Jordan. “It’s a marketing tool. It leads me to peo-ple that may be investors for the fund, so it’s a low-costway to market, to help me develop my business, and ittakes very little time. It takes three seconds to post that[announcement], and it’s all going on in the backgroundwhile I’m actively doing my job.”

Advisory firms can use social media for multiple pur-poses. Andy Zimmer, managing director with Vestor Capi-tal Partners in Chicago was seeking to hire financial advis-ers but wasn’t satisfied with the results professional re-cruiters were delivering. He decided to try contacting po-tential job applicants via LinkedIn. Once he identifiespotential hires, he sends them basic information about theposition he’s trying to fill and asks if anyone in their net-work meets the criteria. The contacts often express interestthemselves, he says: “You’re asking for the opportunity tospeak to people that they know, but on occasion, they raisetheir hand and indicate that they might have an interest ininterviewing for the position as well. So, it’s pretty effec-tive.” Using LinkedIn has led Vestor to offer positions toseveral advisers. Factor in the searches’ cost savings, Zim-mer adds, and his firm is very happy with the results.

Get Creative

As more financial advisers adopt social media, it becomesmore difficult for messages to be heard above the onlinenoise. Overcoming that problem is possible but requires acreative approach to using the media. Consider the follow-ing suggestions for improving your social media businessdevelopment efforts:

Focus your network. You don’t need a massive networkwith hundreds of participants to succeed, says Langford.Building a smaller network of qualified prospects and refer-ral sources of roughly 100 connections lets you tailor yourcontent and participation to that group’s interests.

Avoid the overcrowded networks. Langford cites the“Chamber of Commerce”-style meeting “in which there are18 financial advisers and three to five insurance agents andaccountants and so forth all circling around the one or twopeople in the room who don’t already have a financial ad-viser, an insurance agent, or what have you.” His advice isto look beyond the overcrowded forums and become activein groups based on the things that interest you. As an ex-ample, Langford cites his active participation with groupsthat enjoy the Red Sox, craft beers, and good food. Sharingthese personal interests with others online can help formthe personal bonds that lead to business.

Provide quality and not just quantity. A financial profes-sional needs to be a thought leader, and in order to beviewed as a thought leader online, you must publish con-tent, says Stephanie Sammons, founder of social mediaconsulting firm Wired Advisor in Dallas. That means pro-ducing quality articles, videos, podcasts, white papers, pre-sentations, and webinars that will interest your target mar-ket. “If you’re not publishing online, then you’re reallynothing online,” says Sammons. “And this content thatyou produce to position yourself as an authority in yourtarget markets can easily be syndicated out to your socialmedia communities and can also be a great way to positionyourself within your target markets as an expert.”

Participate. One-way conversations won’t build rela-tionships, says Winterberg. “What doesn’t work is peopleusing social media as their personal megaphone or theirpersonal bullhorn, and all they do is push and push andpush content. They fail to follow up with conversation anddon’t respond to inquiries or comments and feedback.”

Ed McCarthy is a freelance financial writer in Pascoag, Rhode Island.

“What doesn’t work is people usingsocial media as their personal mega-

phone or their personal bullhorn.”

BILL WINTERBERG

KEY POI NTS

• The U.S. SEC has now twice used new deferred-prosecutionagreements and non-prosecution agreements to compelcorporations to self-report federal securities law violations.

• The SEC hopes to obtain evidence earlier from people closeto misdeeds and develop more robust investigations.

• Companies—and investors—must consider the benefitsand drawbacks to these agreements.

BY LORI PIZZANI

his past May, Tenaris, the Luxembourg-head-quartered manufacturer of steel tubes andprovider of other services to the world’s energyindustries, became the first-ever corporation to

reach a deferred-prosecution agreement with the U.S. SECunder a new cooperative enforcement regime. Tenaris haddiscovered an internal bribery scheme that includedundisclosed payments of commissions to “agents” hired tohelp the firm win contract bids with an agency of the gov-ernment in Uzbekistan.

Under the terms, Tenaris agreed (1) to produce allnon-privileged information, documents, and materials nomatter the location, (2) to use best efforts to secure fulland truthful cooperation from current and former direc-tors, officers, employees, and agents responding to regula-tor’s inquiries, and (3) to have personnel testify at trials orproceedings over a two-year period.

The company paid US$5.4 million in disgorgementand interest to the SEC and agreed to enhance policiesand procedures, strengthen compliance, implement due-diligence requirements, and notify the SEC of subsequentinfractions.

The SEC’s new enforcement regime was first an-nounced in January 2010 and borrows heavily from theU.S. Department of Justice’s long-standing prosecutorialstructure. That’s not surprising. Robert Khuzami, theSEC’s director of the Division of Enforcement who was ap-pointed in February 2009, previously spent 11 years as afederal prosecutor with the U.S. Attorney’s Office in NewYork City, including three years as chief of the unit’s Secu-rities and Commodities Fraud Task Force.

Investigating from the Inside Out

The SEC’s new cooperative enforcement platform encour-ages both companies and individuals to offer greater coop-eration to the U.S. securities industry’s top regulator, whichengages in in-depth investigations and imposes enforce-ment sanctions for federal securities law violations.

The ultimate goal? “To build stronger investigationsand obtain evidence earlier,” says Lorin Reisner, formerdeputy director of enforcement at the SEC who left in ear-ly January 2012. “The purpose of cooperation agreementsis to help us bring stronger cases and obtain informationand evidence earlier from those with direct knowledge of

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unlawful conduct. That model has proven effective in theDepartment of Justice context.”

In return for that cooperation, the SEC has promisedto consider a lighter regulatory hand in the form of offer-ing companies (and their fully cooperative personnel) thepossibility of reduced sanctions, deferred-prosecutionagreements, and/or outright non-prosecution agreements.That is a significant departure from the SEC’s customaryfull-blown enforcement actions, which carry hefty finesand penalties, harsh sanctions, and reputational harm.

“When we launched this initiative, we had no gameplan as to when the first deferred-prosecution agreement ornon-prosecution agreement would be used. We take theseinvestigations as they come,” Reisner says. “We’ve beenvery pleased with the results of our 33 cooperation agree-ments to date, which involve many different types of cases.I think this has greatly enhanced our enforcement efforts.”

Not every infraction will be eligible for deferred prose-cution. The SEC will fully assess the seriousness and per-vasiveness of the misconduct and whether the case was anisolated incident, whether the misconduct involved a com-pany’s senior personnel, whether there was full and com-plete self-reporting to the SEC, whether the company sub-sequently engaged in exemplary conduct, and whether itquickly took full and appropriate remedial actions. Reisneradds that the model was designed to allow those less cul-pable to benefit from providing information concerningthose who engaged in more culpable conduct.

Test Cases

In the case of Tenaris, the SEC found that from April 2006 toMay 2007 regional sales personnel had bribed governmentofficials in Uzbekistan to gain access to confidential con-tract bids from competitors. According to the SEC, the com-pany used this information to revise its own bids and wingovernment contracts to the tune of US$5 million in profits.

But in March 2009 a third party revealed those illegalpayments, which violated the Foreign Corrupt PracticesAct. The audit committee of Tenaris’ board hired a law firmto investigate the matter. In June 2009, those paymentswere voluntarily brought to the attention of both the SECand the Department of Justice, which later, and in conjunc-tion with the SEC’s May 2011 profit disgorgement man-date, levied its own US$3.5 million criminal penalty andestablished its own non-prosecution agreement withTenaris. In uncovering the bribes, Tenaris quickly ordered

Enforced CooperationWill the SEC’s new enforcement regime yield better results?

T

StandardsIN PRACTICE



“Countering Market Abuse” (EMEA Voice)CFA Magazine (July/August 2011)(www.cfapubs.org)

“The Other CEO” (Standards in Practice)CFA Magazine (May/June 2011)(www.cfapubs.org)

an internal review of the compliance system and beefed upits anti-corruption policies and practices by strengtheningits code of conduct, business conduct policy, and processfor retaining and paying agents.

Immediate self-reporting, comprehensive internal in-vestigation, procedures enhancement, and cooperationwith the SEC all led to the regulator’s decision to grant thedeferred-prosecution agreement. The SEC, however, hasbeen stingy with deferred and non-prosecution agreements.Only two have been implemented since the program’s start,and none of the names of the corporations entering intocooperation agreements have been publicized.

While Tenaris was the first to hatch a deferred-prose-cution agreement with the SEC, Carter’s, the children’sclothing manufacturer based in Atlanta, was the very firstcompany to test the SEC’s cooperative policy. A few monthsbefore Tenaris, in December 2010, Carter’s became the firstto reach a full non-prosecution agreement with the SEC.The SEC agreed not to prosecute Carter’s in return for a listof concessions and full cooperation.

The agreement and investigation focused on the mis-conduct of a former Carter’s executive vice president ofsales who was found to have engaged in financial fraud andinsider trading from 2004 through 2009. The executivemanipulated the amount of discounts the firm granted onelarge department store that sold Carter’s clothing. Thosespecial “accommodations” were then erroneously mischar-acterized by Carter’s accounting personnel. The same exec-utive also exercised his stock options for a profit duringthis period while financial conditions were being overstat-ed. Carter’s discovered the misconduct in 2009 and subse-quently restated several years’ of financial statements.

In announcing the non-prosecution agreement withCarter’s, the SEC cited the “relatively isolated nature of the unlawful conduct” and praised the company’s promptand complete self-reporting of the misconduct, thoroughinternal investigation, and extensive cooperation with investigators.

No Huge Implications?

“In the Carter’s case, the company got out in front of theissue early on and fired the people maybe even before theissue came to light,” says Scott Krasik, CFA, senior researchanalyst with BB&T Capital Markets in New York City.“Carter’s did everything it should have done. There wereno huge implications.”

Since then, Krasik says, he has fielded investors’ ques-tions regarding the company’s credibility, but concerns weredispelled. “Once investors understand the level and scopeof what’s covered (in the non-prosecution agreement), aslong as it isn’t fraud which could come back to affect man-agement in the future, investors move on,” he says.

Such agreements can be beneficial to companies. But there are drawbacks.

“A company will enter into a deferred-prosecution ornon-prosecution agreement, pay a fine, be recognized forits cooperation, and its stock price will often go up,” says

Jacqueline Wolff, partner with the law firm of Manatt,Phelps & Phillips in New York City. But the case does notjust go away. Under a deferred-prosecution agreement, theSEC can bring the identical charges that it agreed not toprosecute if the company breaches the agreement duringthe two- or three-year term. In other words, she says, “Ifyou’re bad, they can prosecute later.” She also notes that acompany’s insurance policy would generally not cover thecost of a penalty or disgorgement.

Questions and concerns have recently surfaced, in-cluding whether the SEC’s new regime will translate intowatered-down investigations, given that insiders are help-ing investigators connect the dots.

“I don’t think the investigations (into Carter’s orTenaris) were any less vigorous,” says Ian Roffman, partnerin the Boston office of law firm Nutter McClennen & Fishand a former SEC prosecutor. “The SEC was finding theright balance between crediting good behavior and not let-ting bad behavior get a full pass.”

Just because the SEC said it will give companies abreak doesn’t mean a flood of companies will come forward.“If the SEC shows sensitivity toward trying to encouragecompanies to come forward, then it will be good,” says LisaNoller, partner in the Chicago office of Foley & Lardner.

But there is a risk. “If the SEC isn’t transparent in itsactions or uses a heavy hand, it won’t compel companies tocome forward,” warns Sam Winer, partner in the Washing-ton, DC, office of Foley & Lardner.

“There’s motivation on both sides, but cooperationagreements are not for every case,” says Keith Bishop, part-ner in the Irvine, California office of the law firm AllenMatkins. “When there’s an investigation into a corporation,that’s a pretty dark cloud that is following you around. Youjust want it to go away as soon as possible,” says Bishop.Companies must weigh the pros and cons, however, beforedeciding on an agreement. “I think you’ll see a lot moreself-reporting by companies and see more investigationsbut not all will result in deferred or non-prosecution agree-ments,” he predicts.

“Companies will have to decide whether they want tobuy peace early on,” says Robert Ray, partner with PryorCashman’s litigation group in New York City. “Are the in-centives great enough and is the downside risk low enoughto encourage companies to come in early, get this going,and secure the benefits?”

Lori Pizzani is an independent financial journalist based inBrewster, New York.



After a decade of outperformance,

have inflation-indexed bonds

reached the tipping point?

BY ED MCCARTHY

TIPSy

T


he past year was another good one for Treas-ury Inflation-Protected Securities (TIPS). TheBarclays Capital U.S. Government Inflation-Linked Bond Index, which includes TIPSwith one or more years remaining to maturitywith a total outstanding issue size of US$500

million or more, was up 14.65 percent (year to date)through 4 November. Longer-term bonds with maturitiesover 10 and 15 years were up 25 percent and 26 percent,respectively, for the same period (see Table 1).

Most of the gains came in the first half of the year (although the eurozone crisis moved prices higher in latefall), but the performance was no fluke. Figure 1 comparesreturns from TIPS and nominal intermediate-term Treasur-ies with inflation for the 1998–2011 period and illustratesTIPS’ outperformance for four of the past five years.

“This market generally has produced some prettystrong returns in recent years,” says John Hollyer, a princi-pal with the Vanguard Group and co-manager of the Van-guard Inflation-Protected Securities Fund in Valley Forge,Pennsylvania. “The general theme has been that interestrates have been falling a lot, and the nice thing about TIPSis that they have a pretty long average life, or duration, andthey are Treasury quality, so some of the credit issues thathave emerged in the past few years haven’t affected their val-ue at all. So falling rates and high quality have caused bondswith high quality and long duration to perform really well.”

TIPS and Inflation

TIPS’ short-term returns are volatile and may underper-form the trailing inflation rate. That’s because TIPS returnsare determined by the realized rate of trailing inflation(i.e., inflation adjustments to a bond’s principal) and themarket’s expectations of future inflation. “In the shortterm, declining or rising interest rates will cause TIPS

prices to move substantially, and so you could be in a ris-ing rate environment and have TIPS produce a negative total return over the course of 12 months,” Hollyer notes.“That’s true with any long-term bond investment.”

TIPS investors frequently focus on the breakeven inflation (BEI) rate as an indicator of anticipated inflationand a TIPS pricing guide.1 The BEI is the difference be-tween the nominal Treasury yield and the comparable ma-turity TIPS yield. For example, in early November 2011Bloomberg.com showed the 15 August 2011 10-year Treas-ury at a 2.03 percent yield and the 15 July 2011 TIPS bondat –0.10 for a BEI of 2.13 percent. (Bloomberg tracks theU.S. 10-year BEI under the U.S. 10-year breakeven rate[USGGBE10:IND].) The rule of thumb for evaluating TIPSprices compares the investor’s anticipated inflation rate withthe BEI. An investor who believes inflation will be higherthan the BEI will buy TIPS on the expectation that TIPS willoutperform comparable-maturity Treasuries. When the BEIis greater than the investor’s expected inflation rate, TIPSare considered overpriced and forecasted to underperformon a total-return basis (from that investor’s perspective).

The BEI can be volatile, as the second half of 2008showed. As concerns over tight monetary policy and a pos-sible global depression spread, 10-year Treasury yields fellto just above 2 percent, roughly the same level as 10-yearTIPS. On 1 July, the BEI was 2.55; by December 26 it hadfallen to 0.10. By June 2009, the BEI had moved backabove 2 percent. That volatility persists: the BEI droppedfrom 2.65 percent in early April 2011 to 1.7 percent in lateSeptember before bouncing back to 2.13 percent in earlyNovember.

1 For more details on the BEI, see Daniel C. Dektar, “ABCs of TIPs,” CFA Institute Conference Proceedings (2005).

TABLE 1

TIPS 2011 RETURNS (year to date through 4 November)

Index Return

U.S. government 14.65%

1–3 years 3.54

3–5 years 8.09

5–7 years 11.44

7–10 years 14.95

10+ years 25.18

15+ years 26.61

Source: Based on Barclays Capital data, cited with permission.

Source: Based on data from Vanguard, Barclays Capital Live, and the U.S. Bureau of Labor Statistics.

Note: Annual year-end returns are represented by the Barclays Capital U.S. Intermediate TreasuryIndex for nominal intermediate Treasuries and by the Barclays Capital U.S. Treasury Inflation-Protected Securities Index for TIPS. Inflation is represented by year-end over year-end results forthe Consumer Price Index for All Urban Consumers (CPI-U).

FIGURE 1

TIPS AND INFLATION

20%

15%

10%

5%

0%

–5% 1999 20092007200520032001Sept2011

Nominal Intermediate Treasuries

TIPS

Inflation

Despite the short-term volatility in the BEI, TIPS ap-pear to provide inflation protection over the long term. Re-searchers have found that holding TIPS for shorter periodsis not an effective method for hedging against short-termfluctuations in inflation.2

Longer-term investors do receive the expected benefitsbecause buying new issues and holding to maturity locksin a risk-free real rate of return. “Changes in the inflationrate based on the U.S. CPI-U are highly correlated with inflation rates based on other price indices over long peri-ods,” conclude the researchers “So, TIPS provide effectiveprotection against unanticipated changes in the average inflation rate over fairly long horizons. If TIPS had beenavailable during the 1970s and 1980s, they would havebeen a very effective means of locking in a real rate of re-turn. In contrast, long-term nominal Treasury issues pro-duced unexpectedly erratic rates of return.”

Going Negative

The falling interest rates that have increased prices of TIPSand other bonds to premium levels have also pushed short-er-term TIPS’ yields into negative territory. As of early No-vember 2011, the five-year TIPS yielded –1.12 percent andthe 10-year’s yield was –0.10 percent. Dan Dektar, chief in-vestment officer with Smith Breeden Associates in Durham,North Carolina, points to the Federal Reserve as driving thelow rates. “The Fed is holding real ratesnegative in order to transfer wealthfrom savers to borrowers,” he says.“That’s one way of looking at it, andanother is they want to make sure thatdeflation doesn’t take hold in the U.S.economy. The only tool that they reallyhave to be able to do that is to take thereal yield on short-term rates negative.”

Some advisers and bond fund man-agers believe that TIPS are still attrac-tive despite the negative yields. Holly-er cites a TIPS bond maturing on 15April 2013 with a 0.625 coupon as anexample. Although the bond’s price inlate October was US$102, producing ayield of –0.84 percent, he believes theinvestment is rational. “By paying aUS$102 price for that bond, you’repaying 2 percentage points above par,and you’re only going to get par at ma-turity,” he says. “You’re only going toget over the course of two years 0.625(interest) x 2 for two years, so you’regoing to get 1.25 percent back. But the

investor who buys that bond is expecting a positive totalreturn because he’s also going to get whatever inflationhappens over that two-year time frame.”

Other investors and advisers claim that TIPS are over-priced. Russ Koesterich, CFA, iShares global chief invest-ment strategist in Jersey City, New Jersey, believes that investors who are buying TIPS with negative yields are expressing an excessively pessimistic economic view. Heargues that these negative-yield investors are accepting sig-nificant duration risk and locking up their money for a period with zero real return. “Now, to my mind, this onlymakes sense under one scenario,” he says. “It only makessense if you believe the U.S. is about to enter a period ofJapanese-style deflation. Therefore, the breakeven numberson the TIPS—in other words, the implied inflation rate—are way too high, and we’re actually going into a deflation-ary period.”

Littman Gregory Asset Management in Larkspur, Cali-fornia, recently decided to sell TIPS from their conserva-tive tax-exempt portfolios. In early October, Jack Chee, asenior research analyst with the firm, published an articleon the firm’s AdvisorIntelligence.com website explainingthe decision. In short, the firm’s estimated returns for TIPShave fallen significantly below the average total return (in-come plus price change) of 7.1 percent from their intro-duction through July 2011.

EXHIBIT 1

TIPS PERFORMANCE UNDER DIFFERENT SCENARIOS

Real Economic Growth

Inflation Low High

High Easy Fed

Oil shock

Stagflation

Positive for safer currencies

Negative for financial assets (including equities)

Best TIPS scenario

Low General economic weakness

Economic or geopolitical “event”

“Debt deflation”

Positive for government bonds

Negative for commodities

TIPS Performance Mixed

Low Economic Activity

Source: Based on data from Daniel Dektar and Smith Breeden Associates.

36

Strong economic growth

Weak dollar/foreign capital withdrawal

Positive for cyclicals

Positive for commodities

Negative for government bonds

TIPS Performance Mixed

Aggressive, effective Fed

Lower oil prices

Productivity boom

Positive for real estate

Worst TIPS Scenario

High Economic Activity


2 Michelle L. Barnes et al., “A TIPS Scorecard: AreThey Accomplishing Their Objectives?” FinancialAnalysts Journal (September/October 2010).


TIPS protect against inflation but still share the inter-est rate risk of conventional bonds (among other similarrisks). And the firm anticipates higher interest rates. Chee’sanalysis:

“When interest rates rise, bond prices fall, and viceversa. From 1997 to July 2011, interest rates trend-ed lower, declining from close to 6 percent to 2percent, serving as a tailwind to bond prices. But,over the next five years our expectation is that in-terest rates will rise from current levels of less than2 percent to levels between 4 percent and 8 per-cent, depending on the scenario, and that therewill also be a rise in real rates, though the two rateswill not move uniformly. So, while we generally as-sume that inflation will persist over our investmenthorizon such that the principal value of TIPS willadjust higher, these income gains will be offset byprincipal losses in the form of lower TIPS priceswhen real rates rise.”3

TIPS and the Economy

Despite their premium prices, Dektar maintains that TIPScan still play a role in portfolios because they can performwell in an otherwise adverse macro scenario. He sees twodiametrically opposed schools of thought in the world.One is that economies are heading further into a debt de-flation cycle. “That’s what the central bankers and policy-makers are fighting against in Europe as we speak and theFederal Reserve as well,” he says. “So, there’s a good caseto be made for significant deflation. But, as much fuel asthey’re pouring on the fire here, certainly long-term infla-tion risk is there and that’s one of the possible escaperoutes from the debt problems we’re having. It’s not clearwhich way we’re going.”

If investors are worried about inflation, they need todistinguish between whether it’s going to be in a high-growth or low-growth scenario, according to Dektar. TIPSwill be the best performing asset in a low-growth, higher-inflation environment, and there isn’t much else in thatsector that will do well. When growth is low and inflationis high, TIPS are the best, as shown in Exhibit 1. In thehigh-growth, high-inflation scenario, commodities, equi-ties, and real estate, for example, will perform well.

TIPS in the Portfolio

Hollyer believes TIPS can play several different roles in aportfolio. The first is inflation insurance (i.e., an asset thatshould be responsive to unexpected changes in inflation).When inflation is as low as it is today, he notes, TIPS aresensitive to unexpected increases in inflation. The secondrole would be as a diversifier in a portfolio. “Because oftheir inflation-index nature, they don’t move exactly inlockstep with other bonds, especially when inflation ex-pectations are changing,” says Hollyer. “Any asset that has

a reasonable expected return but potentially somewhatlower correlation can be a diversification benefit in a port-folio. So I think those would be the two primary objectivesof TIPS in a portfolio.”

Mark Willoughby, CFA, a principal with ModeraWealth Management in Westwood, New Jersey, says hisfirm follows a strategic asset allocation approach and TIPSare a core holding for clients. Modera uses TIPS mutualfunds, and Willoughby estimates that the typical portfoliohas a TIPS allocation of 3 percent to 5 percent. This defen-sive strategy fits well with the firm’s approach. “As an assetallocation shop, we think there’s a good chance that infla-tion will pick up at some point but we have no idea byhow much and when,” says Willoughby. “When we allo-cate to TIPS, we’re trying to put a protection for our clientsin their portfolio against unanticipated inflation. We’reconcerned about unanticipated higher levels of inflation,and we want to have some protection in our clients’ portfo-lios for that eventuality if it ever occurs—because whenyou buy TIPS, there’s a breakeven inflation point.”

Dektar points to another strategy with TIPS. SmithBreeden’s portfolios can hold them with a short Treasuryposition that Dektar says essentially positions them forhigher or lower inflation. “When you talk to TIPS traders,they talk about holding them on a real-yield basis, which isunhedged, or holding them on a breakeven inflation basis,which is fully hedged with Treasuries or in lieu of Treasur-ies,” he says. “Then what you get for your capital gain orloss is the differential between the Treasury yield and theTIPS yield.”

The variety of TIPS investment options allows for ad-ditional strategies in addition to direct long and short posi-tions. Investors concerned with a near-term spike in infla-tion should consider short-term TIPS or PIMCO’s 1–5 Year U.S. TIPS Index Fund (symbol STPZ), according toLawrence Weinman, a financial adviser in Los Angeles,California, who described several strategies in a SeekingAl-pha.com article.4 Laddering TIPS maturities via exchange-traded funds is another option with STPZ on the short end,the iShares Barclays TIPS Bond Fund (TIP) for intermedi-ate coverage, and the PIMCO 15+ Year U.S. TIPS IndexFund (LTPZ) for the long end. To lock in the breakevenrate, Weinman suggests purchasing both the 10-year TIPSand the iPath U.S. Treasury 10-year Bear ETN (DTYS).With this strategy, he writes, if nominal Treasuries yield increases, the hedge will increase in value to offset changesin the TIPS’ value if those yields rise simultaneously.

Ed McCarthy is a freelance financial writer in Pascoag, Rhode Island.

3 Jack Chee, “TIPS Asset Class Review,” AdvisorIntellingence.com (7 October 2011).Reprinted with permission.

4 Lawrence Weinman, “Yes, You Should Buy TIPS; Here’s How and When,”SeekingAlpha.com (25 February 2011).


STANDING UP FOR THE RIGHT CALL, doing thejob “the way it’s supposed to be done”—that’s whatdrives Mike Mayo, CFA. A veteran analyst with a

reputation as a maverick, Mayo was named by Fortunemagazine as one of “8 Who Saw the Crisis Coming…” andtestified before the Financial Crisis Inquiry Commission in 2010 on the causes of the financial crisis. Now manag-ing director with Crédit Agricole Securities (which pro-vides services in the U.S. for CLSA, a global boutique brokerage firm), Mayo spoke with CFA Magazine about analyst independence, the events leading up to his 1999banking sector downgrade, and his subsequent terminationby the firm that employed him as well as how to improvecapitalism.

How has your view of ethics evolved?

I got my CFA charter in 1991. At the time, I found the ethicscomponent more annoying than anything. In some ways, italmost reminded me of the Ten Commandments. I felt likeit was a matter of checking the box more than something Iwould actually apply.

During the extreme stock market bullishness of the late1990s, there were almost no sell ratings. I wanted to down-grade the bank group and specific banks to a sell rating.That was a huge professional and personal risk. The CFAInstitute Code of Ethics and Standards of Profes sional Con-duct helped give me the backbone to make the most signifi-cant professional call of my life in May 1999, when I down-graded the bank group and put sell ratings on banks, in themidst of what is likely to have been the most bullish periodof our professional careers.

What specific conflicts were you facing?

There were competing loyalties. One loyalty was to thecompanies I covered. Some of these companies were quitenice to me. I went on the Gulfstream jet of Bank One withthe Bank One CEO who in 1992 was voted Banker of theYear by American Banker. It wasn’t lost on me that compa-nies had given me information and access.

A second loyalty was to my firm. Credit Suisse was getting many investment banking deals done. They allowedme to invite my wife and investors to fancy dinners on thehighest floors with celebrity chefs of the New York City

scene. And my boss—who had hired me—had given me ashot I could never have gotten several years earlier.

I had loyalty to my family. Wouldn’t not rocking the boatbe the best way for me to provide for my family? So, when Idecided to downgrade bank stocks to sell ratings in the late1990s, I knew doing so could be perceived as violating loyaltyto the companies that I covered, to the firm where I worked,and to my family, notwithstanding my desire to call it straightfor the investor.

It was one of the hardest decisions in my life becauseeveryone in the room is telling you to do it one way, andyou are thinking about doing something different. That is not a move to be taken lightly. In fact, one day, I was actually going to make the downgrade and I chickened out.I backed out.

How did you make the decision?

Ultimately, I realized that I was either supporting the CFAInstitute mission—either I had a purpose in what I was doing, a meaning in helping to make a better system—or Iwas neglecting my duties and just trying to make as muchmoney as possible. If I neglected the duties, then I wasn’treally seeing the job as adding value to the world. There’ssoul searching at a time like this. Do I matter? Does my jobmatter? There is no question about what the Code andStandards—specifically Standard III: Loyalty—have to sayabout situations such as mine. If I have a choice betweenloyalty to my company, loyalty to my firm, and loyalty to theinvestor, the Standards of Practice Handbook doesn’t mincewords. Client interests are paramount.

Either I would do the job in the way that is describedin the Standards of Practice Handbook, or the CFA charter iscompletely irrelevant. If you just go by the book, my callwas pretty easy and straightforward. In fact, when I told mywife, she said, “Well that’s your job—you say buy, you saysell. What’s the big deal?” She didn’t get it as far as the stepsI was taking. But the reality was that nobody used sell ratings.

The morning I made the downgrade, Joe Kernen ofCNBC said, “Who’s Mike Mayo, and do we know whetherhe was turned down for a car loan?” I went on CNBC in theafternoon, and the question was asked of me, “Do I trustthat there won’t be a big backlash against me?” My answerwas, “I trust that the banks will do the right thing and allowme to do the job the way it is supposed to be done.” In the

MISSIONIn his new book Exile on Wall Street,

analyst Mike Mayo, CFA, argues for integrity

BY JONATHAN BARNESONA


end, I made it until the merger of Credit Suisse and Donald-son, Lufkin & Jenrette in 2000.

What happened next?

I made this big call, and then I got fired as part of the merger.Prudential Securities wanted to make some noise about be-ing a true independent research firm and they hired me tohelp lead the way. I was featured in commercials that playedduring the Kentucky Derby and the NBA finals. Immediate-ly after the tech bubble crashed, there was a lot more atten-tion to the need for sell ratings. There were others beforeme and others after me. But I would say at that period oftime, I gave it renewed momentum.

What would your career be like if you hadn’t taken a stand?

I don’t think you would be talking to me right now. I couldhave lived a comfortable life. If I had given myself an outand not downgraded the group in 1999, chances are youwould see me today with a bunch of ratings, hold or above.I would say, “Well, my holds are really sells and my out-performs are really holds and my buys are really buys” orsomething like that.

Even today, I think that is how the majority of analystsoperate. Most investors kind of get it anyway, fortunately orunfortunately. But on the other hand, they don’t always getit. Hold ratings are a way to hedge as far as what you reallythink. Bottom line is, if I didn’t make that May 1999 call,then I would have simply been like themajority and blended in.

What could make it easier for analysts now?

One is simply the culture of a firm. Atmy current firm, there is a culture thatencourages independent research. Infact, we don’t even have hold ratings.We have buy, outperform, underper-form, and sell. There is no ability tosimply say hold. Talk about a cultureencouraging independent research—that says quite a lot.

Having more CFA charterholders isalways a good thing. In time, I wouldlike to see more CFA charterholder-onlyfirms.

Why can’t there be CFA charter-holder-only firms where every senioranalyst is a CFA charterholder? It istime to bring the CFA designation up to the next level. Thefirst CFA exam was in 1963, the year I was born. So theCFA Program is growing up. When the CFA Program turns50, can we start thinking about CFA charterholder-only firms?

In your book, you write about “a better version of capitalism.” What does that mean to you?

It means having improved transparency. The role of account-ing is to capture reality in numbers, and the goal of financialanalysis is to take those numbers and recreate reality. If the

numbers aren’t right and if the accountants aren’t getting itright, then the financial analysts can’t get it right either. Partof the solution is what I call ABC. “A” stands for accountingand, frankly, auditing too. We need some combination ofauditor rotation or auditor accountability (a person whosigns their name to an auditing report) and more informationthan the pass–fail approach in place now.

The “B” stands for bankruptcy. Let firms fail when theyshould fail. Let’s not go the route of the zombie companiesin Japan. If banks overextend themselves, the governmentshouldn’t step in and prop them up. Allow capitalism towork. There is a survival-of-the-fittest element in our versionof capitalism, and to support underperforming banks orcompanies is a gross resource misallocation.

The “C” stands for clout—reducing the clout of thelarge banks and other corporations. We need to give powerback to the shareholders as opposed to the sometimes en-trenched managers and boards. Shareholders should havemore avenues to speak up, and a company should be moreapt to listen—because in my experience looking at some ofthe largest banks, that has been anything but the case.

How can this be done practically?

The U.S. SEC could make it easier for shareholders to havea say on a range of topics. The Public Company AccountingOversight Board is looking at changes in auditing to givemore clarity in auditing statements. Regulation should en-

sure that the banks have less leverageand better transparency. But don’t micro-manage them either. Give the banksrules, and then allow them to function.

It’s important to have a tone fromthe top—not just for brokerage firmsbut really from the top of our country—that personal responsibility and ethicsmatter. Some combination of the chair-man of the Federal Reserve, the secretaryof the Treasury, and other leaders shouldset a tone to encourage ethical behaviorbased on transparency, long-term orien-tation, and accountability. Moral persua-sion can go a long way.

Everybody has an incentive to pur-sue their self-interest and make as muchmoney as possible, but not when there ismisleading information or people arecutting corners in their professional re-sponsibilities.

What do you think of the current banking environment?

Who knows what will happen by the end of 2011, but weare seeing two themes. One we are calling “Japan lite.” Nobody is saying that it will take 20 years for the U.S. to recover from the current situation, but to some degree, theU.S. is in the third year of what has been a 20-year cycle inJapan. The question is, how much longer?

For the banking industry, this is likely to be the worstrevenue-growth year since 1938. It is simply a function of

“Ultimately, I realized

that I was either

supporting the CFA

Institute mission—

either I had a purpose

in what I was doing, a

meaning in helping to

make a better system—

or I was neglecting my

duties and just trying

to make as much

money as possible.”


having overshot the loan growth in the past decade, and nowyou are likely to undershoot at the same time that growth isless. It is simply a matter of fewer loans, lower margins,lower capital market fees, and some additional regulatorycosts. It does not have to be the end of the world. Slowgrowth can be okay, as long as the companies recognize theirlimitations.

The second theme is crisis-lite, meaning that when Europe sneezes, the U.S. can catch cold. That can certainlyhave an impact on capital market revenues, which includestrading, investment banking, and stock market-sensitiverevenues. It can also cause a big risk-off trade and encourageinvestors to pull back on risk as well as companies and con-sumers and overall retrenchment. I am defining the currentperiod as both Japan lite and crisis-lite.

Do you have banks that you favor now?

No bank is immune to the pressures that I am talking about.I don’t know of one bank that ever thought that the 10-yearbond would be anywhere close to 2 percent. Even if it goesto 3 percent, that is still lower than people had expected,which further depresses revenues.

Is there still the pressure of backlash in your job?

I’ve established a habit of changing ratings on stocks regard-less of the pressures, but there are still pressures on WallStreet analysts. I am still aghast and amazed. I cannot believethat this still happens after everything that has gone wrong,from the analysts’ scandals to the banking crisis. We havehad enough—the real estate crisis in the early 1990s, thetech bubble, the blowups of Enron and WorldCom, and thehousing crisis.

Has being a Wall Street outsider helped you?

No question that being a Wall Street outsider has forced meto do better work and not to rely on management statementsas much. I’ve had to dig a little harderand kick a few more tires for the research.

You write that “the crisis didn’t occurbecause of something that banksdid… it was the natural consequenceof the way banks are, even today.”

The main idea is that the crisis didn’tstem from a single action that bankstook or even a set of actions. It wasn’t aone-time occurrence. It was basicallywhat you would expect to happen with a financial systemset up the way ours is. And the basic structure of our system,with all the flawed incentives and lack of market conse-quence, is still in place.

How can the system be re-incentivized?

At the top of the list is compensation. In many cases, execu-tive compensation still isn’t based on long-term incentives.Legitimate incentives, as well as stronger clawbacks (espe-cially for CEOs and top executives) are needed. They shouldhave more deferred compensation.

Compensation at the SEC could also be re-incentivized.The SEC staff that performed poorly during this crisis shouldbe fired. The SEC should hire back half as many but pay themtwice as much to reduce the incentive for them to move fromthe public to private sector. For regulators, clawbacks shouldbe based on the success of the entities they regulate. Thenumber of regulators that specifically examine large banksshould be increased.

At the rating agencies and accounting firms, ways shouldbe found so that accountants and rating agencies are moreaccountable to investors as opposed to the companies theyrate. This change may involve a new payment scheme be-cause the purpose is to benefit investors.

How would you like your book to be received?

I would like to say that, as a result of this book, positivechange developed in the financial system—auditing andaccounting rules were improved, bankruptcy was more accepted, and clout of big companies was moved in favor ofshareholders. To the extent that we get some wins, we canthink about effecting more change.

By writing Exile on Wall Street, I’m trying to bring aware-ness to the issues in plain English. I wrote this book foreverybody’s mother. Not only do I want CFA charterholdersto read the book, but I want them to give it to their motherand say, “This is what we are up against. This is what we dealwith, and this is how Wall Street has gone astray.” The issueisn’t that capitalism is bad but that we haven’t had capitalismfunctioning the way it should.

What kind of a role would you like to play?

Actually, somebody else asked me this recently. Do I intendto use this as a stepping stone to something else, like AndrewRoss Sorkin? Or do I intend for this to enhance my job? I’d like this to allow me to do my job better as an analyst, toallow me to make statements about companies without fac-

ing a potential backlash in all sorts ofsubtle ways.

There’s a phrase in Judaism, tikkunolam, which means “repairing the world.”It relates to the ultimate question ofwhat am I doing. What am I supposed tobe doing here? CFA Institute helps tomake the financial world better and thegoal is to actually make the world better;therefore, I should go ahead and do thejob the best that I can.

It just comes down to having meaning in my job. I feelthat money is an enormous motivator, but I think that missesthe point sometimes. The search for meaning is an evengreater motivator. Meaning for me is to have a sense thatmy job somehow connects to improving the world where Ilive.

Jonathan Barnes is a freelance journalist and author of thenovel Reunion.

“The issue isn’t that

capitalism is bad but

that we haven’t had

capitalism functioning

the way it should.”

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Because of flawed financial memories, confirmation bias,

and other behavioral factors, investors may not be able

to learn the right lessons from the global financial crisis

BY MAHA KHAN PHILLIPS

FINANCIAL MEMORY IS NOTORIOUSLY SHORT.“The world of finance hails the invention of the wheel overand over again, often in a slightly more unstable version,”observed the late economist John Kenneth Galbraith in A Short History of Financial Euphoria. More than 17 yearsafter the book’s publication, Galbraith’s comments havenever been more applicable to the world of finance. Marketsand investors seem to be suffering from a collective case of financial amnesia.

“People have forgotten whatever they did learn, if theylearned anything at all,” says James Montier, a member ofthe asset allocation committee at Boston-based fund man-ager GMO and author of several books on behavioral fi-nance. “It is amazing how short-term memories are andhow unwilling people are to learn from their mistakes. As a behavioralist, it constantly amuses and disappoints me.”

The causes of Montier’s frustration are easy to see. Inthe aftermath of the worst recession since the Great De-pression, one which has left most of the developed worldin dire fiscal straits, it is difficult to imagine why bankswould still be complacent about leverage. But complacentthey are.

Although some bank capital has been raised, substan-tial additional capital may be needed to support the recov-ery of credit and sustain economic growth under the antic-ipated new Basel III capital adequacy standards, accordingto the International Monetary Fund’s (IMF) most recent“Global Financial Stability Report.” The IMF has been giv-ing out the same warning since 2008 and still finds lever-age too high.

“The emperor has no clothes on,” says Montier. “It’sjust that people don’t really want to listen. You can rantand rave all you want but you never know what will trig-ger a collective awakening.”

Banks are leveraged 20 to 1 and are mostly investingin government bonds and mortgages, despite fears of an-other bubble in the banking sector. Eric Sprott, the Cana-dian money manager who predicted in 2008 that bankingstocks would plummet, recently argued that U.S. saverswill eventually withdraw funds from banks that remainoverleveraged.

For the past three years, investment banks have talkeda lot about the lessons learned and the importance of riskprofessionals. In some cases, however, risk managementhas clearly taken a backseat or the processes have simplyfailed.

The most glaring example came in September 2011when trader Kweku Adoboli was arrested for alleged fraud,and Swiss bank UBS was forced to admit that it had failedto detect unauthorized trading of index futures on the S&P500, DAX, and Euro Stoxx 50 during the previous threemonths. With losses amounting to US$2.3 billion, UBSchief executive Oswald Grüber claimed such abuses cannotbe prevented when “someone acts with criminal energy.”(Grüber later resigned.)

The Fundamental Things Apply

Why does the financial services industry have such diffi-culty heeding the lessons of the recent past? If the devel-oped world were to enter into a double-dip recession, nobody could argue that they didn’t see it coming.

Joachim Klement, chief investment officer at financialconsultancy Wellershoff & Partners in Zurich, believes human flaws in financial memory are to blame. Speaking atthe 2011 CFA Institute Annual Conference in Edinburgh,Scotland, Klement argued that memory plays tricks onpeople.1 We can be conditioned to think in a certain way,which affects how we perceive the markets.

For example, in the late 1990s, many investors wereconditioned to equate the term “dot-com” with a profitableinvestment. In 1999, the company Computer Literacychanged its name to fatbrain.com, and its stock went up 33 percent in one day. Similarly, between 2004 and 2007,companies that added the word “oil” or “petroleum” totheir name saw their stock price rally by 8 percent on aver-age. During the 2002–10 period, 90 companies in the U.S.,Europe, and Australia added the word “China” to theirname. In the four months around the name change, thestocks of these companies rallied 324 percent on average.

Seven flaws distort financial memory, according to Klement. Three involve our ability to forget information(transience, absent mindedness, and blocking), and threeconcern false memories (misattribution, suggestibility, andbiases). The final flaw, persistence, is a term used to ex-plain traumatic memories that are difficult to erase. Thesedefects may lead to flawed decisions or repeated invest-ment mistakes.

But experience is another critical variable. “Lack of experience of investors is the biggest part of why the crisishappened and why lessons weren’t learnt, going all the wayback to the 1960s,” says Klement. “It’s because there is anatural replacement of investors. At some point, the oldguys retire and the new guys haven’t learnt from the past.”

He cites research conducted by Robin Greenwood at Harvard Business School and Stefan Nagel at StanfordUniversity. In their 2007 paper “Inexperienced Investors

1 To view the webcast featuring Klement, go to www.cfainstitute.organd enter “the flaws of our financial memory” in the search bar.

You Must Remember This


and Bubbles,” Greenwood and Nagel argue that inexperi-enced investors play a role in the formation of asset pricebubbles. Looking at the performance of equity managersjust before and after the technology, media, and telecom-munications (TMT) bubble of 2001, they discovered thatyounger managers (those under the age of 30) outper-formed the market in the run up to the crash. In contrast,older managers (older than 45) fared better after the bub-ble burst and underperformed previously (see Table 1). At the peak of the bubble, mutual funds run by youngermanagers were more heavily invested in technology stocksrelative to their style benchmarks. Younger managers alsoexhibited trend-chasing behavior.

“You can go back to the year 2000 and then subtract,”says Klement. “If a fund manager in the year 2000 was 30years old, then his or her entire investment experience oc-curred in the 1980s and 1990s. Someone who was 50 yearsold, however, was more likely to have experienced the1970s—high inflation and the energy bubble.”

Klement draws two conclusions: “If I was running aninvestment company, one of the things I would really lookout for is having a good mix of young and older people.You need young people because they have new ideas andare the risk takers. You also need older people who won’tbuy into the most expensive sentence in Wall Street: ‘Thistime it’s different.’”

Klement believes the industry would be well served by keeping investment diaries that record manager actions(buying or selling of shares, etc.), the rationale behindeach decision, and the possible risks attached with the de-cision. “This is something that I still recommend to fundmanagers,” he adds. “Investment diaries help with errorsof cognition but also of omission.”

Klement dismisses concerns that diaries are too timeconsuming. “I have the time. It doesn’t take long, actually,for my short-term trading ideas,” he says. Another sugges-tion is to use a checklist, just as pilots use checklists beforeevery flight to make sure they haven’t missed any safety aspects. Having a framework can prevent managers fromforgetting an important step.

A Miss Is Just a Mis(interpretation)

Others see the fundamental cause of flawed financial mem-ories as being a different phenomenon that requires differ-ent solutions. Meir Statman, the Glenn Klimek professor of finance at the Leavey School of Business at Santa ClaraUniversity, believes the problem is not financial amnesiabut misremembering situations. For example, people arequick to draw analogies between past episodes, believingthem to be the same as what they are currently goingthrough. “The problem goes back to the saying that historydoes not repeat itself but it rhymes,” explains Statman. “It is very convenient for us to think that episodes are thesame. We fall into the trap of making confirmation errors.”

With confirmation bias, investors look for evidencethat confirms their perceptions and overlook evidence thatdisconfirms them. People don’t forget the past; they misin-terpret it. Hindsight can be a misleading thing. “It is an in-sidious cognitive error,” says Statman. “Are we in a bubbleright now? Are prices now higher than what is the intrinsicvalue of the stocks? I don’t know. I will only know in threeyears time. But in three years time, it will be really tempt-ing to say, ‘I knew this all along.’”

He believes that investment professionals tend to beclinicians: “They would rather believe that three experi-ences that are lodged in their memory are the most impor-tant, and they form a world view based on that. Profession-als should know from systematic studies how difficult it is to beat the market. Yet they just walk around believing it is easy to do because they’ve had three prior successes.”

Montier disagrees. “Bubbles may have different details,but they have the same themes,” he says. “The reason wedidn’t spot this last bubble is because we are overly opti-mistic as a species. We don’t stop to think that things lookvaguely familiar.” Consider the 2008 crisis. “These [collat-eralized debt obligations] were exactly the same structureswe’d seen back in the late 1980s in the junk-bond boom;it’s just that they were called collateralized bond obliga-tions back then. Few people managed to spot the generalsimilarities.”

As Time Goes By

Market structure is a factor. Neil Dwayne, European chiefinvestment officer for Allianz Global Investors, believesthat investors have stopped investing for the long term. Instead, with markets experiencing heightened volatility,possibly driven in part by high-frequency traders, investors“rent” stocks. Rather than buying stocks and holdingthem, investors buy and sell rapidly. “This is renting ratherthan investing, and it is causing financial amnesia. It hasbecome more extreme in the 25 years since I’ve been inthis business,” he says.

As recently as 25 years ago, according to Dwayne, the fact that U.K. telephone company British Telecom sawits share price rise by 5 percent in a day would have beenheadline news. “Now, the big stocks are moving 10 percent,”he says. “Some of these moves are, frankly, ridiculous.”

TABLE 1

FUND MANAGER PERFORMANCEAll performance data in %

Age of Outperformance OutperformanceFund January 1998 – April 2000 –Manager March 2000 December 2002

25 – 30 8.16 –8.6431 – 35 3.6 –3.8436 – 45 1.68 –0.8446 – 55 –1.32 0.3656 – 65 –1.56 3.2466 – 90 –1.32 4.68

Source: Robin Greenwood and Stefan Nagel, “Inexperienced Investors and Bubbles,” Working Paper (2007).


Another chief investment officer, Bob Browne atNorthern Trust in Chicago, makes a related point aboutmarket structure with regard to the speed in which infor-mation is processed and disseminated. Browne draws ananalogy to the invention of the wheelbarrow. First inventedin ancient Greece 2,400 years ago, the device soon van-ished from Europe and was reinvented in China during theHan dynasty in the second century. The wheelbarrow sub-sequently disappeared for a thousand years and wasn’t seenagain until around the year 1170 in Europe. This slow historical process is almost unimaginable today, explainsBrowne, because “good information is immediately dissem-inated and acted upon.”

The focus on new information can distort the invest-ment decision-making process and lead to short-termism.Investors “are probably spending 70 percent or 80 percentof their time focusing on what’s happened in the last 30days and what will happen in the future 30 days,” saysBrowne. “That’s an irrelevant time horizon.” The challengeis to figure out what information has value and what canbe disregarded.

Hearts Full of Passion

The perceived opportunity costs of getting a decisionwrong also complicate matters. Colin McLean, FSIP, pointsout that in asset bubble cycles, managers can lose out byboth joining in and staying too late in a market or by notjoining in at all and missing the upside. Thus, managersare more likely to follow the consensus view.

A case in point would be Tony Dye, one of the U.K.’sbest-known fund managers in the 1990s. Dye, who waschief investment officer at asset management firm Phillips& Drew (which was subsequently subsumed into UBS),made the case that markets were too expensive as early as1995. By 1996, he was moving large amounts of clientmoney into cash and out of equities. With the subsequentequities boom, Dye came under immense pressure. Thefirm hemorrhaged assets and underperformed, and Dyewas fired before events proved him right. His story was anexception—a fund manager who stuck to his guns foryears despite the pressure he was under.

A more common attitude was articulated by CharlesPrince, the former Citigroup chief executive. Commentingon the leveraged buyout market, he famously remarked,“As long as the music is playing you’ve got to get up anddance.”

Rick di Mascio, chief executive of Inalytics, the Lon-don-based performance measurement firm, finds this kindof mindset ludicrous: “People suppress their common sensein the need to make a profit. You’ve got traders lookingpurely at their compensation and boards who just turned a blind eye to risks that institutions were taking becausethey all wanted to be a part of the game. It really is a greedand herd mentality.”

David Tuckett, a leading psychoanalyst and visitingprofessor at University College London, offers a different

take: “The basic starting point would be to say that the nature of finance is that you cannot know what is going tohappen in the future. That brings radical uncertainty. Thisengages with your emotions.” Individuals have two statesof mind, according to Tuckett, who is also a pioneer in thefield of emotional finance. They can be primarily integrat-ed or primarily divided. With an integrated state of mind,an individual may have many different feelings but he orshe is aware that they have the feelings. A divided personwill examine only those feelings that make him or hercomfortable.

“Many investors, particularly professional investors,say they try to keep their feelings out of investing. But abetter approach might be to realize that they have feelings,”says Tuckett. He believes the biggest financial problems occur when people are not able to feel anxious about whatthey are doing.

“What I would say to people is that you need to be par-ticularly careful to investigate things that you don’t want tothink about,” explains Tuckett. “If you sense within yourselfany kind of feeling of not wanting to examine something,then that’s exactly what you should start thinking about.”

Tuckett cites the example of George Soros, who fa-mously explained that he knew he needed to re-examinehis portfolio when he had a backache because it meantsomething wasn’t right.

It’s Still the Same Old Story

So where does all this leave the market? Regulators cannotexactly legislate for faulty memories. McLean believes thatmarket participants should be required to study financialhistory. “Even the regulators should be reading more histo-ry books,” he says.

Alan Brown, ASIP, chief investment officer of SchroderInvestment Management in London, wants to go deeper:“It wouldn’t even hurt to have this on the school curricu-lum either. Everyone is being asked to make their own futures, with the development of defined-benefit schemes.I remember when my eldest son came to me for advice. He was given an ungenerous pension plan [at work], andneither they nor the Independent Financial Advisor (IFA)gave him the information he really needed, which was that6 percent would never fund a proper pension fund. Ithought that was immoral.”

Amin Rajan, chief executive of the Centre for Researchin Employment and Technology in Europe (CREATE) inLondon, argues that behavioral biases should be taught inaddition to traditional financial history. “We teach [students]about the stock market and bonds and shares, but we don’tteach them about how people make mistakes,” he says.

And unless investors can learn to unlearn mistake-prone behaviors, the financial wheel will continue to bereinvented.

Maha Khan Phillips is a financial journalist based in Londonand author of the novel Beautiful from This Angle.

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W ith 19 years of investment and financial ex-perience in East Africa, Renée Blasky, CFA,clearly knows the region. As the founderand managing director of Vista Capital Limit-

ed, a financial consulting firm based in Nairobi, Kenya, Blaskyprovides advisory services and has at times helped link in-vestors to private equity. She also is chair of the East AfricanSociety of Investment Professionals, which hopes to becomethe next CFA member society in Africa. In 2006, she was a con-sultant for the Kenyan Capital Markets Authority in a survey oninvestors’ perceptions of the Kenyan markets. In this interviewwith CFA Magazine, Blasky discusses the challenges and op-portunities of investing in East Africa and future prospects forgrowth and returns.

What are investors’ perceptions of East Africa?

People ask me, “What is it like in Kenya?” I ask them toenvision living in California in the 1800s. You must havean entrepreneurial pioneering spirit. There are tremendousopportunities, but there are also a lot of areas you need tolook out for—in terms of what could go wrong. Your riskmanagement needs to be very strong, and you need to havea very long-term outlook.

If you’re a local investor or have been in the area a longtime, it’s much like investing anywhere—you know wherethe opportunities are, the players, the required procedures,

SpiritRenée Blasky, CFA, on investment prospects for East Africa

BY JONATHAN BARNES

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APIONEERING


and you know the local politics. However, for a foreign investor coming into the East African market for the firsttime, it can be an interesting experience.

What should foreign investors be aware of?

If you are a direct investor, there are a lot of proceduresand licensing. The East African governments are trying tomake the process more investor friendly in terms of reduc-ing the number of licenses and the time frame. But it canstill take a long time to close a deal, particularly if you areworking with the government as an investment partner. Iam working with a foreign investment group that is tryingto put a deal together in Kigali, Rwanda. The general part-ner had been very frustrated that after a year [the deal]hadn’t closed, and I was shocked that she thought that itwould have. Deals in this region can take two to three yearsto negotiate and close when governments are involved.

What is the Kenyan business culture like?

You have a different protocol than in more developed mar-kets. It is much more formal here in terms of introducingyourself and getting to know someone. When you talk tosomebody on the phone, you don’t start off immediatelywith what you want to talk about. You ask them how theyare, how their family is, and how work is going. Eventual-ly, you can get around to what you want. It is more likeJapan. Business here is much more centered on relation-ships than in the U.S. In the U.S., you meet somebody, youshake hands, and you get down to business pretty quickly.Not here. It’s about the person first.

What are some of the operational risks?

You have issues with electrical power and with telephones.You have issues with licensing and taxes. It is just not asstraightforward as in other markets. For instance, power inmy office goes off at least once a week—for a full day. Sup-posedly, it’s going off for maintenance, but it’s been likethis for the past six months. So you have to always have abackup plan in order to continue operating.

Sometimes it can be frustrating. One client had to deliver a document to a third party on deadline, and thecourier service got into a motorcycle accident. As a result,they didn’t meet the deadline. Traffic here is horrific and ahuge challenge. To get to a client’s office only 15 kilome-ters away could take me an hour and a half, depending onwhat time of day I leave my office.

How big of a story is the Nairobi Securities Exchange(NSE) demutualization?

Most financial people want to get it done. It’s an importantstep, as the markets have been stymied by being mutual-ized. It’s going to provide a lot more governance to themarket. The stock market in Nairobi has always been aboys’ club, but that is starting to change. The Capital Mar-kets Authority (CMA) has begun to implement risk-basedsupervisory rules to help with governance within the stock-broker and investment banking community. They’ve taken

away licenses recently from three or four firms because ofabuse of client funds or governance issues.

There was a notice in the paper the other day from astockbroker that had let 11 staff go in an investigation ofKSh10 million stolen from a client account. A public an-nouncement like that has never happened before. Thebroker would have kept it quiet. I take my hat off to them.The brokers have come a long way, and I look forward toeven further improvements.

What else is changing?

There are some big players coming into the market. Wehave Moscow-based Renaissance Capital in the market,and I believe HSBC is looking at coming in as well. I thinkJ.P. Morgan is looking around. That speaks volumes. Thesefirms are not going to come in to play a small role. Theyare going to come in to do major things. The FTSE isworking with the NSE to build indices. And Bloomberg iscoming in. The markets are going to be much more com-petitive, and I hope the commissions will come down.

More and more, the East African region is acting asone market. There was talk of a common currency—Idon’t see that [happening] for some time. But the commonmarket is really a game changer for attracting foreign in-vestment. You are effectively dealing with an entire region,not just five separate countries. Kenya has about 40 mil-lion people; Tanzania, more than 43 million; and Uganda,about 30 million people. Rwanda and Burundi combine foranother 20 million. Instead of targeting individual coun-tries, you can target the region as a whole—the likes of atleast 130 million people. That’s the type of market that canattract a manufacturing or consumer goods company, oreven a financial services company.

How large is consumer demand?

When I first got here 19 years ago, there was a very, verysmall middle class. Now the middle class is very active.When you go to the big shopping malls, you would neverknow that anybody is having an economic crisis in theworld. It is packed.

“Amazingly, I’m very positive long termfor the whole region. … In the shortterm, we are in a very uncertain periodbecause of political risk and economicchallenges.”


There are Apple stores here, and you have iPhones.Blackberry is very popular. There are close to 20 millionmobile phones. You see a lot of BMWs, Mercedes, LandRovers, and Range Rovers. It is a pretty mobile society. I believe there is a Marriott hotel coming in and also aRadisson. I saw statistics the other day that internet usagein Africa has grown almost 2,500 percent since 2000 (com-pared with 400 percent in the rest of the world). We arecoming from a lower base, sure, but the growth is huge.

How would you rate the political risks?

Very high, I am afraid, and I don’t think it’s declining in thenear future. We are still paying the price for the violencefollowing the last general election of 2007 in Kenya. Theeconomy was effectively shut down for two months. Wehad very high security risks. A lot of people were shutting down their businesses trying to safeguard theirbelongings. When I was at a client’s office, we would getphone calls saying, “Send your employees home becausethings are heating up.”

It was quite bad for a while—riots and demonstra-tions in the streets. People were killed and a lot of peoplewere displaced. And some of those victims are still dis-placed, living in tents basically. They haven’t been relocat-ed. With the new elections closing in, it’s not necessarilygoing as smoothly as I would like to see. Some of thethings that caused the political violence in the last electionhave yet to be resolved.

Could the situation repeat itself?

It could repeat itself. I have spoken to a lot of Kenyans,particularly younger Kenyans in Nairobi, to get a feelingabout what is going to happen in the upcoming election.They don’t think there will be violence. But in Nairobi, youhave a more politically sophisticated population. It is inthe rural areas where you have more tribal affiliations andtribal tensions. A lot of the population is still living belowthe poverty line. They have nothing to lose. They are theones who are potentially going to think, “Let’s go for it. Wehave everything to gain and nothing to lose.”

The next election is supposed to be in August 2012,but it may be pushed to 2013 as they haven’t worked outall the modalities of implementing the new constitution.This uncertainty is hard on business, because a lot of in-vestment decisions (particularly direct investment deci-sions) aren’t made until after elections. People are a littlehesitant to make a business decisions before an election,because if you have new parliamentarians and a new cabi-net, things can change.

Do you encounter a lot of corruption?

Corruption can be encountered in dealing with policemenall the way through to different government departments.I’m not sure if corruption is actually worse than before or if we are just hearing about it more because there is morefreedom of the press.

The government is aware of corruption. They know itis harmful for the country, but it is going to take some timebecause it is part of the culture of tribal affiliations. In the1970s, the governor of the Central Bank of Kenya effective-ly said it was OK for government employees to operatetheir own businesses on the side. That way, the govern-ment didn’t have to pay them as much of a salary. Becauseof that, you had a lot of government employees setting uplogistics companies and transportation services to sell theirservices/products to the government. I think that startedthe whole thing.

If you knew what policemen here were earning as awage, you would certainly understand why they are tryingto take bribes on a daily basis. They are just not paid aliving wage. They can’t send their kids to school, and theycan’t pay their rent.

How does corruption affect your work?

When you’re dealing with the private sector, you don’t facemuch corruption. When you’re dealing with the exchanges,you don’t have corruption. It is more when you are dealingwith big government projects—road contracts, power con-tracts, and telecommunications. Part of our traffic problemis because the roads aren’t built correctly. Some body gotmoney instead of buying bitumen. I don’t know what thespecs are, but let’s say that instead of building a six-inchfoundation, they built only a three-inch foundation andthe missing three inches is in somebody’s pocket.

The government, however, is reducing the amount oflicensing required in an attempt to reduce corruption andbureaucracy. If you don’t need a license and you don’t needto deal with all of the bureaucracy, there are fewer possibil-ities of corruption.

How are professional standards in the financial industry?

For the most part, Kenya has pretty high standards. It isimproving all of the time. Previously, some risk manage-ment issues were lacking, but again, the regulatory bodiesare beginning to implement risk-based supervision. I thinkthe CFA Program has done a lot to increase professionalstandards in the region. We now have between 500 and600 candidates registered for the exams every year. Theexam takes up a whole conference center.

How many charterholders work in the region?

Right now, I believe we have 35 charterholders in Kenyaand another 5–10 in other East African countries. To start aCFA member society, we need 50 regular members. Wehave enough now and just need to make sure they becomemembers of the East African Society of Investment Profes-sionals so we can make a formal application.

In the past, the biggest challenge to increasing ourCFA Institute member numbers has been that Kenyans gottheir charter and then left the country. They wanted to goto developed markets—such as New York, London, SouthAfrica, and Dubai—to gain experience. That was good, be-cause they gained a different perspective, but we wanted


them to come home afterward. Since 2008, the financialcrisis actually has benefited us in some ways because a lotof people are coming home.

What other investments are available—outside the NSE?

There are mutual funds. We call them collective invest-ment schemes or unit trusts. I don’t know the value of assetsunder management, but we have about 45 unit trusts oper-ated by 12 different service providers. It’s not as popular as I had hoped it would be. I think it’s partly because thefront-load is still too high—between 5 percent and 6 per-cent for an equity fund. In the downward market we arefacing now, that is just not viable.

Also, a number of private equity funds are coming intoplay. We have foreigners coming in for private equity aswell as locals. The president of Kenya is calling for pensionfunds to play a larger role in the funding of infrastructure.The Retirement Benefits Authority currently regulates thepercentage a pension fund can allocate to private equity oralternative investments. We don’t have any public–privatepartnership types of investment from the pension funds

So where does the money go?

A lot of it is going into government debt. New regulationsfor real estate investment trusts are expected shortly. Thisis highly awaited by the whole industry. The pension plansare really looking forward to the real estate investmenttrusts (REITs) because it will provide them with a propertyexposure—and a liquid one.

The government issued another 30-year infrastructurebond. They are also issuing a diaspora bond to try to get theKenyans who are living overseas to invest back into theircountry. It didn’t go as well as they had hoped, though. Itwas undersubscribed. I think the Kenyan diaspora have lessto invest as they are sending more home to their familiesfor basic upkeep with increasing food and electricity prices.

There are more opportunities outside the NSE than onit. If you want liquidity and a dividend yield, you go to thestock exchange. If you want long-term growth and you area risk-taking, venture-capitalist type, then you go privateequity.

What’s the state of the Kenyan shilling?

Our currency has depreciated against the U.S. dollar byabout 24 percent since the beginning of 2011. Inflation isrunning around 18 percent [annually]. So life is gettinghard. Costs are really increasing, and most of it is becausethe middle class wants imported goods. Commodity foodprices are skyrocketing. Electricity is going up because 80percent of our power is hydropower and we are in a drought.The reservoirs are low, and the power company is runningdiesel generators.

The government claims a lot of the banks are holdinghard currency and not turning it into Kenyan shillings,which is really putting pressure on the shilling. And withthe inflation, even government securities yielding 12–14percent can give a negative real return.

So what is your outlook?

Amazingly, I’m very positive long term for the wholeregion. You have a very young population. You have a well-trained, English-speaking, highly educated population.There are massive growth opportunities in transport andinfrastructure, health care, education, IT, telecommunica-tions, tourism, and the financial markets.

In the short term, we are in a very uncertain period because of political risk and economic challenges. The newconstitution is still in the infant stages. Provincial govern-ments are being introduced effectively for the first time, sothere are some teething problems. But overall, I think thelong term looks fabulous. Where you have problems tosolve, you have investment opportunities!

Jonathan Barnes is a freelance journalist and author of thenovel Reunion.

1 For more on the NSE and East Africa investing, see the CFA Magazine interviewwith Peter Mwangi, CFA (July/August 2011).

“Where you have problems to solve,you have investment opportunities!”

yet. But I think this is a huge opportunity for pensionfunds because they can match their long-term assets totheir long-term liabilities.

The NSE has stated it wants to grow to 100 listed companies by 2015.

That’s been the goal for years, decades it seems. The listednumbers have ranged between 52 and 56 companies foryears. Every CEO of the NSE has had the goal of increas-ing listings, but there are challenges to being publiclylisted. One of them is a tax issue. A lot of these family-runcompanies or even larger, private companies have not nec-essarily declared all of their revenue. As a result, they can’tvalue their company properly. They want a company tohave the highest value for their shareholders, but the fi-nancials don’t support it.

One of the things that the government is consideringis a tax amnesty. But until that issue gets resolved, I think[NSE CEO] Peter Mwangi, CFA, has a challenge on hishands.1 The NSE is trying to do a small and medium en-terprises (SMEs) exchange, but it also just goes back toone of our biggest problems, which is liquidity. You haveall of these investors—the pension funds in particularhave contributions coming in every single month—andthey have got to figure out where to put that money. Typi-cally speaking, the equity proportion of the asset alloca-tion for a Kenyan pension fund can be between 25 percentand 45 percent. That’s low when you consider the averageage of the pension member is probably in the low 40s andhas another 20 years in the work force.


CFA InstituteBRIEFS

Richard A. Allen, CFALACONIA, NEW HAMPSHIRE

William C. Allen, CFACENTENNIAL, COLORADO

Scott Robert Antill, CFASHAKER HEIGHTS, OHIO

Michael H. Biggs, CFAPLACERVILLE, CALIFORNIA

Benoit Carra, CFAQUEBEC CITY

William G. Christman, CFAWEST CALDWELL, NEW JERSEY

Volunteer with the DRCIf you have a strong interest in helpingto uphold ethical conduct in the invest-ment profession, are a CFA charter-holder with no pending professionalconduct issues, have a fair and impar-tial temperament, and have knowledgeof or a desire to learn more about theCFA Institute disciplinary process, theDisciplinary Review Committee (DRC)would like to hear from you.

The DRC, a committee of CFA Insti-tute member volunteers who help eval-uate and decide disciplinary cases, is accepting nominations for potentialnew members to begin serving in Sep-tember 2012. DRC members are a central component of the ProfessionalConduct Program, providing valuablepeer input to the disciplinary reviewprocess for members and candidatesfacing alleged violations of the Code ofEthics and Standards of ProfessionalConduct, including the rules and regu-lations of the CFA Program.

For further details about theProfessional Conduct Program, pleasevisit the “Ethics and Standards” sec-tion of www.cfainstitute.org and select“Professional Conduct Program.” Torequest a DRC nomination application,please e-mail DRC staff liaison JuliaBellis at [email protected].

15 Years of ServiceRobert Johnson, CFA, former CFA Institute senior man-aging director for the Americas region, left CFA Institutein October 2011 after more than 15 years of service.Johnson joined CFA Institute in September 1996 as vicepresident responsible for the CFA Program curriculumdevelopment process; he was promoted to senior vicepresident in December 1998. Since then, Johnson hasserved as senior managing director for CFA Institute andhas been responsible for several areas, including educa-tion, financial market advocacy, the professional conduct

program, and development of the organization’s Americas strategy. He served as the executive director of the Research Foundation of CFA Institute. He alsoserved on the advisory boards of the Journal of Portfolio Management and theJournal of Wealth Management and has been published in several finance andeconomic journals, including the Journal of Financial Economics, Journal of Finance, Financial Analysts Journal, and Journal of Portfolio Management.

“Bob Johnson has made many contributions throughout his 15 years ofservice to the organization, including significant enhancements to the CFA Pro-gram, the introduction of the CIPM Program for performance measurementprofessionals, and the launch of our Latin American strategy,” said John Rogers,CFA, president and CEO of CFA Institute. “All of us at CFA Institute thankhim for these contributions and are grateful for his legacy.”

Departure from the Board of GovernorsMark J.P. Anson, CFA, left his post with the CFA Institute Board of Governors as

of 31 December 2011. Anson did not fulfill the remainder of his second three-year

term due to time demands of his business activities as managing partner and

chief investment officer of Oak Hill Investments. The vacated Board of Governors

seat will be filled following the organization’s annual election in May 2012.

J. Parker Hall III, CFAWINNETKA, ILLINOIS

David B. Healy, CFASIERRA VISTA, ARIZONA

Norman M. Johnson, CFANORTHFIELD, ILLINOIS

Richard D. Jennings, CFAWILSON, WYOMING

Michael A.J. Meuse, CFAONTARIO, CANADA

Bernard J. R. MignonTHE HAGUE, NETHERLANDS

Timothy W. Mikullitz, CFANEW YORK CITY

Laurie L. Mills, CFAONTARIO, CANADA

Stephen J. Mottus, CFAPIKESVILLE, MARYLAND

William A. Pincoe, CFANORTH CANTON, OHIO

Robert R. Roback, Sr., CFABALLSTON SPA, NEW YORK

Teo Corinne B.G., CFASINGAPORE

Patrick James Tomalin, CFATORONTO

In Memoriam


CFA Institute Moves with the TimesBY ASHVIN VIBHAKAR, CFA

The Asia-Pacific region represents more than 27percent of the world’s GDP, according to recentEconomist Intelligence Unit (EIU) data. China isforecast to account for 33 percent of the regional

subtotal, and India is expected to have a double-digitgrowth rate in the next five years. The region includes 60percent of the world’s population, and approximately 48percent of the region’s population is under 30 years of age.Of notable interest are Pakistan, thePhilippines, and Malaysia, where youthpercentages will be at 65 percent, 59percent, and 55 percent of the coun-tries’ total populations, respectively;these countries are estimated to havethe highest percentage of youth in theregion by 2015. With the right eco-nomic policies, the relatively youthfulpopulation in these countries can leadto more sustainable economic growth.

Across the region, the average annual growth rate ofboth CFA Institute members and candidates was 15 per-cent from 2001 to 2011. Currently, the region holds 43.3percent of global candidates; China and India account formore than 40,000 candidates. The CFA Program is offeredonly in English, which may create a challenge for individ-uals whose first language is not English, but this obstacledoes not stop candidates in the region from striving toattain the highly acclaimed CFA designation. Furthermore,new and seasoned charterholders in the region are quickto point out the benefits of earning the charter—industryrecognition, respect, and career development—as theycontinue their efforts to uphold the highest ethical stan-dards in the industry.

CFA Institute and its members recognize the need toeducate and develop more stewards to face challenges inthe world’s investment markets, especially within the Asia-Pacific region. We see professional excellence and ethics as the foundation for both regional and global economicsustainability. For this reason, CFA Institute continues toinvest in initiatives that promote understanding of the orga-nization’s mission through educational outreach, advocacy,and industry and society relations.

With professional excellence in mind, CFA Institutewill host its first Asia-Pacific Investment Conference inHong Kong in March 2012. The conference will focus onproviding a platform for industry experts across the regionto come together, connect, and learn from CFA charter-holders and each other. The conference aims to place CFAInstitute at the forefront of the minds of influential leadersacross the region and will pave the way for the CFA

Institute Annual Conference to be held in Singapore inMay 2013.

CFA Institute also advocates for strong ethics and professionalism in the region through collaboration withinfluential industry leaders. For example, the NationalInstitute of Securities Markets (NISM), established by theSecurities and Exchange Board of India, and the local CFAmember society, the Indian Association of Investment Pro -fessionals (IAIP), will hold the second India InvestmentManagement Conference on 13 January 2012.

Furthering our outreach beyond the industry andtoward the growing number of young adults in the region,the CFA Institute Research Challenge has been growing inpopularity. Last year, more than 600 students from 149universities participated. This year, more than 156 univer-sities from 18 countries have enrolled (30 of these univer-sities are CFA Program Partners). Local rounds of thisyear’s Research Challenge are already under way, and theregional final is scheduled for March 2012 in Hong Kong.The winning team will compete in the global final in April in New York City.

As the markets move, the role of CFA Institute contin-ues to evolve. Throughout the Asia-Pacific region, CFA Institute staff and volunteers are working in areas such asthe Global Investment Performance Standards (GIPS), pro-fessional standards, market integrity, and industry relationsto enhance the region’s understanding of how the CFA Institute mission can benefit the regional and global invest-ment industry.

Ashvin Vibhakar, CFA, is the CFA Institute managing directorfor the Asia-Pacific region.

T

Asia-PacificFOCUS

Global Advertising InitiativesAdvertising campaigns in China, India, and France werelaunched in December 2011 to promote the CFA Programand to increase awareness of the CFA designation amongyoung professionals. We currently have three campaignsin the market that are continuations of our FY2011 adver-tising efforts. The Global Employer and Asset ManagerCode of Professional Conduct campaigns are both global,digital-only campaigns; the Private Wealth Managementcampaign runs in North America and has both print andonline components. To find out more about these cam-paigns, go to www.cfainstitute.org, select “Pressroom”under the “About” tab, and go to “Advertising Initiatives.”


CFA Institute Scholarships: Awareness and Access

CFA InstituteBRIEFS

BY RAHUL KESHAP

CFA Institute has awarded CFA Program scholarships tocandidates for many years. In our most recent fiscal year,we awarded more than 3,800 scholarships to universitystudents, finance professors, employees of regulators, andworthy recipients selected by our global network of mem-ber societies. Over the years, thesescholarships have provided recipientswith a substantial discount on the priceof registration for the CFA Program.Despite the lasting impact of the schol-arships for those who use them to be-come CFA charterholders, many yearshad passed since CFA Institute had re-viewed its scholarship strategy. At therequest of the CFA Institute Board ofGovernors and our senior manage-ment, over the last year CFA Institute has reviewed all ofits existing scholarship categories and the rationale foreach of them to confirm a clear strategy for scholarships.Beyond reviewing the strategic plan, the internal discus-sion spurred excitement to expand the reach and effective-ness of our scholarships, and I’m delighted to share ourplans with you.

Our mission exhorts us to lead the investment profes-sion globally by setting the highest standards of ethics, education, and professional excellence. Scholarships con-tribute to the mission by promoting more widespreadawareness of CFA Institute certificate and designation pro-grams and by providing access to those programs for peo-ple who could not otherwise afford their full price. As aresult of our strategic review, we have crystallized thesedual objectives of awareness and access as the overarchingjustifications for offering scholarships.

The objective of awareness directs us to providescholarships to those key influencers who are well posi-tioned to spread knowledge of our programs throughword of mouth, such as the finance faculty of universities,government industry regulators, and perhaps even jour-nalists who report on the industry. By encouraging moreof these influencers to earn the CFA charter, the industryas a whole benefits, and the people they touch may them-selves learn about the benefits of the CFA Program. Theobjective of access dictates that we should make our pro-grams more broadly available to individuals who are un-able to afford the full price. By improving opportunity forpeople to register for the CFA Program regardless of theirability to pay, we demonstrate our good corporate citizen-ship and expand our reach to those who may be strug-gling to enter the industry but have a great deal of talentto contribute.

For awareness scholarships, we plan to make changesto reach key influencers more effectively and measure ourresults more accurately. University finance professors willcontinue to be a core focus for the scholarships, with allfull-time finance faculty members who wish to sit for theCFA or CIPM exams receiving a scholarship. We will con-tinue to work with our university relations team to im-prove the connection between academic institutions andCFA Institute scholarships by providing additional schol-arships for university students and instituting guidelinesfor promoting those scholarships within the universities.Finally, we also plan to expand our regulator outreach byentering into more relationships with selected industrybodies around the world.

In order to promote CFA Program access to thosewith financial need, we will be transitioning to a newscholarship program that continues to involve our mem-ber societies and leverages their local presence and knowl-edge. At the same time, we will implement a uniformglobal application process that simplifies the scholarshipsearch for prospective candidates. Society scholarships for2012 examinations will remain as they are. Beginning withthe June 2013 CFA examination, we will transition to thenew access scholarship program. Obtaining a scholarshipwill take some advance planning, much like financial aidapplications for students attending a university. Beginningin mid-January, applicants for 2013 scholarships will beable to go to our website and apply. In June 2012, we willshare the applications with our member societies, andwe’ll seek their guidance in distributing up to 2,500 accessscholarships for the 2013 calendar year. Successful appli-cants will learn of their scholarships in September and beable to register for the CFA Program with plenty of time to begin studying. They will each be expected to pay onlyUS$250, almost $800 less than the price of registrationand enrollment for a new candidate but still enough forthem to feel invested in the experience.

As a result of the newly articulated scholarship strate-gy, CFA Institute will be expanding its overall scholarshipnumbers from 3,800 in 2011 to more than 5,000 in 2013.Along the way, we’ll be focused on making those scholar-ships more effective at achieving our dual objectives ofawareness and access. We’ll also be looking for more ideasto improve the programs, and we welcome your ques-tions, comments, and suggestions. And don’t forget tospread the word about the new online application for ac-cess scholarships, coming soon to www.cfainstitute.org for2013 exams! For more information about CFA Institutescholarships, go to www.cfainstitute.org/scholarships.

Rahul Keshap is head of education special projects at CFAInstitute.


BY USMAN HAYAT, CFA

ducation and information technology are naturalfriends. The two help fuel and feed each other.Both are prominently featured in the CFA Insti-tute strategic objectives and help to further our

mission of leading the investment profession globally.To increase educational opportunities for our members,

we use a variety of tools, including producing podcasts, organizing audio webinars, and engaging members throughsocial media. Recently we added another tool to our port-folio—streaming.

Streaming an educational event enables viewers towatch it online as if they were present at the venue. In to-day’s world, where there is an abundance of free on-demandcontent, which can quickly become obsolete, streaming offers significant benefits. Most importantly, it widens ac-cess to educational content, which otherwise may be limit-ed to a small group of individuals. Streaming also makesthe viewers feel that they are part of a community of otherinterested professionals from around the globe and enablesthem to use such interactive features such as addressingquestions to the speaker—all of which are not available inrecorded multimedia.

Streaming is particularly attractive to CFA Institutegiven the global nature of our membership and frequenteducational events that we hold in different parts of theworld. Recently, we streamed two sessions from the fourthannual CFA Institute European Investment Conference inParis. Viewers from more than 22 countries joined us onlineto watch Simon Johnson from Massachusetts Institute ofTechnology (MIT) and Wolfgang Munchau from the Finan-cial Times share their views on the financial crisis.

CFA Institute has also worked collaboratively with societies in the Europe, Middle East, and Africa (EMEA)region to increase access to their educational events. In2011, we streamed a number of events hosted by the CFASociety of the UK, with the pilot stream attracting morethan 100 viewers.

Member societies in EMEA vary in size and resources.While it is possible for some larger societies to organizemany educational events, it is difficult for smaller societiesto do the same. Streaming an event hosted by a large socie-ty like CFA Society of the UK, therefore, enables membersof other societies to view the event wherever they are. Weare also experiencing strong support for streaming fromsome smaller societies.

Interestingly, some of the reasons which make stream-ing of live events attractive to CFA Institute also apply tosome of our societies. For example, a society’s membershipmay be spread across different cities and streaming canhelp avoid the need to hold the event in each city or require

Streams of Professional Education

E

members to undertake significant travel. Streaming is alsobeneficial for hosting events that are over-subscribed, al-lowing those who are unable to secure a spot access to thespeaker and the event.

The economics of streaming are also attractive. Whilethe cost of technology varies, depending on the hardwareand level of professional support needed, it is possible toacquire streaming capability with relatively low investment.The technology is meant to be mobile and it is possible toset up at a venue within a few hours. The advantages andcost efficiency of streaming have resulted in some societiesusing this technological tool. For instance, after receivingbasic training from the EMEA multimedia producer inJune 2011, CFA Spain has now started streaming its ownevents.

Given the large number of high quality educationalevents held by CFA Institute and regional societies, wehope to build steady streams of education and an onlinecommunity of regular viewers. You can view recordings ofsome of our recent streams at www.livestream.com/CFAI.If you would like to stay up to date on future streams fromEMEA and share your views, follow us on Facebook orTwitter (@CFAemea).

Usman Hayat, CFA, is director of Islamic finance and ESG investing.

EMEAVOICE

Streaming is particularly attractive to CFA Institute given the global nature

of our membership.

Sustainability @ CFA InstituteBY USMAN HAYAT, CFA, AND STEVE BOLTON

ow is CFA Institute educating investment pro-fessionals on environmental, social, and corpo-rate governance (ESG) considerations—suchas carbon emissions, community relations, and

executive compensation—that define sustainability in in-vesting? And is CFA Institute also pursuing a sustainabilityagenda that considers things such as energy consumption,environmentally responsible products, and physical wastemanagement? The answers to these questions begin withthe CFA Program. CFA Program candidates are introducedto ESG considerations in Level I in the context of individ-ual investors, and one reading is entirely devoted to corpo-rate governance issues. Similarly, candidates learn aboutrisks posed by ESG issues in Level II and about socially responsible investing in Level III.

If ESG issues are your area of specializa-tion, you will probably find the amount ofESG content in the CFA Program relativelylimited. The proportion of ESG content, likethat of any other topic, depends on the prac-tice of the investment profession. CFA Insti-tute regularly surveys investment professionalsaround the world to determine the knowledge,skills, and abilities that are relevant to thepractice. The findings of the CFA Programpractice analysis determine the body of knowl-edge that forms the basis of the CFA Program(i.e., the proportion of ESG content will likelyincrease when the practice analysis suggests that it should).

The ESG learning opportunities that CFA Institute offers for continuing professional development of invest-ment professionals are wider and deeper than the content inthe CFA Program curriculum. You can find detailed publica-tions like “Environmental, Social, and Governance Factorsat Listed Companies” and “The Social Responsibility of theInvestment Profession” on the CFA Institute website1 andmore than 40 pieces of multimedia content in our ESG se-ries.2 The CFA Institute website also includes content pub-lished by others, such as the November 2010 J.P. Morganreport on “Impact Investments: An Emerging Asset Class.”3

CFA Institute frequently has sessions on ESG issues atits conferences, and CFA Institute member societies holdevents specific to ESG investing. In September 2011, CFAInstitute worked with member societies in Switzerland,

Austria, and Germany to organize a traveling conferencedevoted to social and environmental considerations in theinvestment process.

CFA Institute is also pursuing sustainability as an or-ganization. To formalize those efforts, we established a sus-tainability task force of employee volunteers in 2009 thatexplored and began implementing more sustainable ways ofaccomplishing work and delivering products and services.

CFA Institute took a significant step forward in 2011by initiating the sustainability program through which weare charting organizational goals and strategies, developingmetrics to measure success, and mobilizing internal re-sources. The various measures we are implementing includechanging the default setting on office printers to two-sidedprinting and pursuing Leadership in Energy and Environ-mental Design (LEED) certification as a “green building”

for our new operations headquarters in Charlottesville, Virginia. There is keen interest in sustainability among employees, who have already generated 25 sustainability-related ideas as part of our internal innovation process.

If you would like to get involved in ESG education, familiarize yourself with existing CFA Institute ESG educa-tional content.4 Members are welcome to initiate or joinany ESG-related discussion in the practice analysis.5 Youcan also contact your local member society if you are inter-ested in a live event on ESG issues. Finally, if you comeacross ESG educational content that you would like to sharewith investment professionals, please let us know so thatwe can consider adding it to the CFA Institute website.

Usman Hayat, CFA, is director of Islamic finance and ESG investing, and Steve Bolton is the sustainability program man-ager at CFA Institute.


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CFA InstituteBRIEFS

1 Go to www.cfainstitute.org, and enter the article title in the search bar atthe top of the page.

2 Go to www.cfawebcasts.org, select “Series” under “Browse,” and choose“Environmental, Social, and Corporate Governance (ESG) Investing.”

3 Go to www.cfainstitute.org, and enter “Impact Investments: An EmergingAsset Class” in the search bar at the top of the page.

4 Go to feeds.feedburner.com/cfa_esg_fbf to subscribe to the ESG-relatedcontent feed.

5 Go to www.cfainstitute.org, select “Course of Study” under the “CFAProgram” tab, and go to “Learn more about practice analysis” under thepractice analysis section.

How Do You Know When You’re Done?BY RALPH WANGER, CFA

once knew a psychiatrist who belonged to the psychi-atric sect founded by Heinz Kohut and who asked meto read one of Dr. Kohut’s works. I opened the book tothe first chapter and was surprised by the title: “Termi-

nation of the Analysis.” The first sentence of the book stat-ed, “The question whether at the point of terminating ananalysis the analytic process has been completed, or termi-nation has been premature, confronts the analyst in a vari-ety of circumstances.”

This raised a couple of questions in my mind. Thefirst, which may have already occurred to you, was “Howam I going to get through a book that is written in such a dense and technical style?” The second question was“Why do you start with the finish?”

Dr. Kohut went on and on about this subject but final-ly stated the end was when the patient was “functionallyreliable.” The problem of terminating analysis is equallygermane to us as financial analysts. If you are looking at acompany for the first time, you may find that reading allthe company releases, U.S. SEC filings, and some other analyst reports provide a massive data dump, but how doyou get a coherent story out of all that stuff? What aresome practical ways to proceed?

In psychoanalysis, the doctor is paid by the hour andso has no financial interest in terminating the analysis.You, however, have many companies to follow and have to do your work in a time-efficient manner. There will betimes when you’re told to work on the company because of some new product that the research director read aboutthat might not have been fully reflected in the stock price,a negative story in the press, or a dramatic move in thestock price (probably down). In the last case, you reallymust cobble up some sort of response today or tomorrow atthe latest. The company does not require a lengthy programof analysis—the stock is already in crisis. Your opiniondoes not have to be exhaustively researched, but your buy–sell recommendation has to be clear and—above all—fast.

Say, for example, that the stock just dropped 15 per-cent. You have to figure out what is likely to have causedthe drop and whether that information is true or relevant,and whether the stock has overreacted. These are not easyjudgments to make. I have met portfolio managers whowill tell you that if they don’t own the crashing stock, thesudden drop may be a buying opportunity, but if the stockis already in the portfolio, then that company undoubtedly

I

has a fundamental problem and you should get out fast.Some academics may argue that this asymmetrical line of argument violates the capital asset pricing model. But sell-side analysts know Murphy’s Law, so you should simplydrop a company that has cratered. Anyway, terminate theanalysis as fast as you can.

But the base case is a normal first-time analytic projecton a company in an industry you follow. How do you pro-ceed? You can build spreadsheets and a dividend discountmodel as part of your process, and these tools are excellentguides to valuation. But these numeric tools provide noth-ing but numbers, and it is hard to get people to act onnumbers alone. In practice, I have found that quantitativevaluation models are less accurate than qualitative ones. Isuggest you work toward a “Reason to Own” for the stock.The “Reason to Own” should consist of two short sen-tences, one about the company and the other about thestock. The reasons should be falsifiable. For instance,“good management” is a hard criterion to disprove. Betterwould be “EBITDA margins will go to 14 percent by theend of 2013.” That will be true or false. If it is true, youshould have made good money on the stock. If it is false,that will be a strong argument to get out. In either case, bythe end of 2013, the “Reason to Own” will have expired,and you must invent a new one.

If you have found a “Reason to Own” and you havedone enough work to convince yourself that the reason issound, then you are done and may terminate the analysis.

Ralph Wanger, CFA, is a trustee of Columbia Acorn Trust andan adviser at Wanger Investment Management.

Chapter 10


Illus

tratio

n: R

ober

t Meg

anck

Point Counterpoint

DISAGREE: The RMB will emerge as an international reservecurrency only when it is fully convertible. This develop-ment is at least a decade away. Economic growth is one ofthe main tools for achieving the political objectives ofChinese leadership (in particular maintaining power). Theagricultural sector was partially relieved of public-sectordirection in the 1980s and public industries were first lib-eralized in the late 1980s and then privatized in the 1990s,but financial reform stopped in the mid-2000s. Massiveefforts to avoid a downturn included a historic stimulus in2009 and 2010, which might have created a major debtbubble. A bubble burst would be hugely damaging eco-nomically and politically for the governing party. Increasedpublic spending has been financed by borrowing fromgovernment-controlled banks, placing a burden on thefinancial system—both the official one and the shadowsystem. If the RMB were made fully convertible, not onlywould the exchange rate become more volatile (hurtingexporters and destroying jobs) but also the risk of capitaldeparting the country might increase. Currently, financialcompanies in China enjoy an oligopoly that would be inclear danger if capital flight were possible. Given the nega-tive real interest that depositors currently receive, this riskis very real. If the official figures regarding the strength ofthe financial system are accurate, making the RMB fullyconvertible would not pose a threat to the financialsystem. But if the financial system is much more fragilethan has been publicly disclosed and includes massiveamounts of hidden bad debt related to government-spon-sored infrastructure projects over the past three years, the danger of full convertibility will be enormous—withno obvious benefits from political leaders’ point of view.

Daniel Pasini, CFA, is chief investment officer for equitiesinvesting at ACPI Investments in London and a member of the CFA Society of the UK.

AGREE: Although the RMB doesn’t have full convertibilityyet, a lot of eastern Asian economies already have a highlevel of acceptance for it. People in these regions are ingeneral comfortable with owning RMB and consider it avery stable currency that will maintain its value. Currently,about 35 percent of China’s foreign trades are bilateraltrades with other Asian economies, and there are signsthat major Asian economies are moving toward acceptingeach other’s currency instead of the U.S. dollar as a settle-ment currency. At the recent Asian Development Bank’sannual meeting in Hanoi, Vietnam, the finance ministersof China, Japan, and South Korea agreed to consider settling trades in their own currencies. From a policy per-spective, the fact that the Chinese government is aiming to turn its economy from export driven to domestic-consumption driven increases the motivation to drive

the RMB internationalization process. The governmentalready made Hong Kong a very active offshore RMBcenter and recently took the first step of opening thedomestic bond market. Full convertibility is important,but I don’t see it as a prerequisite for the RMB to start theprocess toward attaining reserve-currency status.

Wei Shao, CFA, is assistant portfolio manager at AthertonLane Advisers in Menlo Park, California, and a member ofthe CFA Society of San Francisco.

DISAGREE: The RMB will join the global array of traded currencies, but the notion of a single reserve currency nolonger works and will be abandoned. Instead, the Interna -tional Monetary Fund and others will soon establish a currency basket to provide assurance that the politicalperils and fiscal irresponsibility of one nation (or currencybloc) will no longer threaten to disrupt the orderly pricingof global commodities. A currency basket will also reduceworld dependence on a few giant financial institutions.

J. Gregg Buckalew, CFA, is chief investment officer atFiduciaryVest in Atlanta and a member of the CFA Society of Atlanta.

AGREE: China is determined to increase trade settled inRMB (currently only 7 percent). Undoubtedly, the amountof RMB in circulation outside of China will increase as aresult. Just 12 months after the opening of the offshoredeliverable RMB market in Hong Kong (that is, CNH), the size of the RMB pool has increased almost tenfold toRMB600 billion. The process is forcing more liberalizationand market-oriented reform of the currency regime. Thewhole movement is also in line with the Chinese govern-ment’s goal of making the RMB fully convertible by 2015.

Patrick Law, CFA, is head of greater China trading atBarclays Capital in Hong Kong and a member of the HongKong Society of Financial Analysts.

DISAGREE: For the currency of a leading world economy to become a reserve currency seems natural, but it isunlikely to happen with the RMB. Opening the currencymarket would cause Chinese authorities to lose the mostimportant tool for assuring competitiveness globally andmaintaining social stability. For Chinese leaders, domesticsocial problems rank far ahead of full international recog-nition; they cannot risk a steep appreciation of their cur-rency, which would sink exports and depress growth inChina, thus driving unemployment up and exacerbatingsocial costs and disparities.

Dragos Cabat, CFA, is managing partner at Financial ViewConsulting in Bucharest, Romania, and is vice president ofCFA Romania.

Agree or Disagree: The Chinese renminbi (RMB) will emerge as an international reserve currency sooner rather than later.


Advances in Asset Allocation Seminar

State-of-the-art risk management and asset allocation processes for product innovation

San Francisco, 6-8 March 2012 New York, 12-14 June 2012

Bridging the gap between modern portfolio theory and practical portfolio construction to build stable models

Understanding enhanced index and optimal benchmark construction

Reviewing the fundamentals of ALM and assessing the inflation-hedging potential of alternative asset classes and strategies

Designing new investment solutions through the use of dynamic beta management, risk budgeting and dynamic core-satellite allocation

Discovering new risk management techniques

Optimising regulatory constraints using new LDI approaches

Information and registration: Joanne Finlay: +33 (0) 493 187 819

[email protected]

http://store.edhec-risk.comwww.cfainstitute.org

CFA Institute—EDHEC-Risk Institute

www.edhec-risk.com

Institute

Lionel Martellini, PhDScientific Director,EDHEC-Risk Institute

“ Dr. Martellini was an excellent presenter and entertained all input

of the participants.Michael Hall, CFA

Senior Vice President, Fidelity Security Life, USAPast participant

I found the theoretical content to be very intriguing and at the same time offering great practical opportunities. Professor Martellini’s considerable

research expertise is matched by his teaching expertise and obvious enthusiasm.Toby Tobleman, CFA

Principal In Charge, Rudd and Wisdom Inc., USAPast participant

A must for all portfolio managers and client advisors working on either asset allocation or LDI implementation. In this time of resource constraints, it is

critical to understand where to focus your research efforts and this seminar is instrumental in understanding how to take the advances in available technology

and improve upon portfolio construction and risk management.Anwiti Bahuguna, PhD

Director, Bank of America and Senior Portfolio Manager, Columbia Management, USAPast participant

cfa magazine jan - feb

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