CFA Mag Nov-Dec 2011

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 Door
Will the renminbi emerge as an
international reserve currency?
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COLUMNS
6 In Focus
Back to the Basics
BY JOHN ROGERS, CFA
50 EMEA Voice
A New Era for Inter-
national Accounting
Standards
BY VINCENT PAPA, CFA
VIEWPOINT
11 China: Unhedged Risk in
Your Portfolio?
In light of how heavily invested
the world is in Chinas continued
growth, can you afford not to
be hedged?
BY JOEL HIRSH, CFA
13 Public Policy and Pension Promises
If the proposed changes ultimately
influence public policy, municipal
bond investors will be better off.
BY OLU SONOLA, CFA
15 Climate Change Disclosures:
Should Analysts Care?
What specifically might investors
and analysts examine regarding
GHG [greenhouse gas] emissions
as a valuation factor?
BY PAUL GRIFFIN
COVER STORY
36 A Half-Open Door
Is the renminbi on the way to becoming
an international reserve currency?
BY CHRIS WRIGHT
47 Adaptive Asset Allocation
In an award-winning article, William Sharpe rethinks asset
allocation and proposes an approach that downplays contrarian
behavior by setting asset weights relative to the market
BY SUSAN TRAMMELL, CFA
44
44 The Second
Great Contraction
The onset of the global financial
crisis and its aftermath caught
many by surprise, but to Kenneth
Rogoff, the trajectory of events
has been entirely predictable
BY JONATHAN BARNES
40 The Worlds
Best-Educated
Bubble
Is U.S. student debt a financial
shock waiting to happen?
BY JOHN RUBINO
53 Americas Outlook
Planting Seeds
BY ROBERT JOHNSON, CFA
54 AsiaPacific Focus
Commitment to
Lifelong Learning
BY JOEY CHAN, CFA
36
DEPARTMENTS
4 In Summary
Ode on a Grecian Downturn
7 Letters
Howto Think about the Unthinkable
50 Briefs
CFA Institute, member, and
society news
56 Chapter 10
Of Laundry and Lavish
Compensation
BY RALPH WANGER, CFA
Ethics
FORUM
24 Pensions and the
Duty of Loyalty
BY DOROTHY KELLY, CFA
Market
INTEGRITY
20 The Value of Our Industry
CFA Institute tackled the rather
provocative subject matter of
whether investment professionals
are delivering value for their
clients.
BY KURT SCHACHT, CFA
21 GIPS Standards Taking Root in
Latin America
A number of factors are likely
driving this sudden surge of
interest in the GIPS standards.
BY JONATHAN BOERSMA, CFA
22 Is Global Say on Pay Here to Stay?
While shareowners around the
world appear to be warming to a
say-on-pay standard, the details
of what say on pay actually means
vary from market to market.
BY MATTHEW ORSAGH, CFA, CIPM
Professional
PRACTICE
28 Portfolio Performance
Return of the life-settlement
market
BY RHEA WESSEL
31 Analyst Agenda
Project management and
shareholder value
BY SHERREE DECOVNY
34 Private Client Corner
The complexity of the
domicile decision
BY ED MCCARTHY
56
32 Decision makers of investment and
research firms should consider using
the expertise of project managers
in the industry to
understand how this
soft skill can help
develop realistic
future valuations.
51
The CFA Institute September 11 Memorial
Scholarship fund continues to help students
directly affected by 9/11 attacks
C F A MA G A Z I N E / N O V D E C 2 0 1 1 3
CFA INSTITUTE PRESIDENT & CEO
John Rogers, CFA
john.rogers@cfainstitute.org
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Roger Mitchell
roger.mitchell@cfainstitute.org
ONLINE PRODUCTION COORDINATOR
Kara Hite
ADVERTISING MANAGER
Tom Sours
tom.sours@cfainstitute.org
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Bashir Ahmed, CFA
Jim Allen, CFA
Jonathan Boersma, CFA
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William Espey, CFA
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November/December 2011 VOL. 22, NO. 6
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COVER PHOTOGRAPHY
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Heard melodies are sweet, but those unheard
Are sweeter; therefore, ye soft pipes, play on;
Not to the sensual ear, but, more endeard,
Pipe to the spirit ditties of no tune.
John Keats, Ode on a Grecian Urn
John Keats classic meditation on finitude depends on
mysterious paradoxesthe eloquence of a mute object
and the sweetness of unheard melodies, among others.
On the surface, the poem describes
how the images decorating the silent
form of an ancient Greek urn can
express a flowery tale more sweetly
than our rhyme. But the real silent
form at work in the poem is the
marriage of truth and beauty.
Beauty is truth, truth beauty
as Keats famously put it. To be mortal
is to experience a beauty (the wonder
of self-conscious existence) that is intensified by the
knowledge that all is fleeting, transient. In that respect,
financial markets might have provided Keats with another
apt metaphor. The valiant never taste of death but once
investors die many times before their deaths.
Economic history cycles through periods in which
markets temporarily appear to defy the second law of ther-
modynamics. Some investors begin to act as if their port-
folios are immortal. The zeitgeist proclaims, This time is
different! The phrase was used ironically as the title of
a recent book about the history of financial crises. Accord-
ing to the books co-author, Kenneth Rogoff, The broad
parameters of what happens in the aftermath of a crisis
(in terms of macroeconomic variables) are surprisingly
consistent across time, place, historical circumstances,
legal institutions, and political systems. So, if the patterns
are so predictable, what will happen next? Rogoff answers
that question in this issues feature interview (The Second
Great Contraction, p. 44).
With discontinuity comes opportunity. Could the con-
traction clear the way for a fundamental reconsideration
of standard methods? Take asset allocation, for example.
The field has been relatively fallow for some time, but an
award-winning article by William Sharpe has proposed
a new approach. The idea is to develop an asset allocation
policy that would readjust asset class weightings not in
relation to constant, predetermined proportionsthe
traditional asset allocation approachbut relative to their
proportion of total market value (Adaptive Asset Allo-
cation, p. 47).
In his ode, Keats envies a fair youth who is depicted
on the urn sitting under a tree and piping a tune. The lad
seems to exist in a state of timeless potential forever
Ode on a Grecian Downturn
piping songs forever new. Oddly, the Chinese renminbi
(RMB) comes to mind. Over the past decade, Chinese
monetary policy has definitely changed its tune, going
from a strictly domestic currency tightly controlled by the
central bank to a peculiar state between restriction and
openness, with the current account open and the capital
account closed. Unlike the urns happy melodist, how-
ever, the currency cant remain poised in the threshold
between potential and actual forever. Could a confluence
of circumstances enable the RMB to emerge as an interna-
tional reserve currency (A Half-Open Door, p. 36)?
The unheard melodies of investing (say, undetected
market signals or opportunities missed as a result of
inaccurate valuations) could be bitter or sweet, depending
on the outcome. Do they go unheard because investors
need to listen more attentively? Although effective project
management is essential to the fortunes of many compa-
nies, many analysts havent opened their ears to what
this important value driver can tell them (Analyst Agenda,
p. 31). Investors are increasingly vocal about say on pay
issues, but their calls for reform have not been fully
heeded (Market Integrity, p. 22). A different kind of deaf-
ness may result from humming the same tune along with
everyone else. If your belief about a company is the
same as the market opinion, there is no point in spending
much time on this company, writes Ralph Wanger, CFA
(Chapter 10, p. 56).
Sadly, the vivid intensity of Keats poetry, notably
the recurring themes of mortality, owed much to his early
death fromtuberculosis at 26. Had a life-settlement market
existed at the time, he might have been a participant.
Life settlement became highly attractive to some investors
when annual returns as high as 20 percent appeared
achievable, but these instruments later suffered from a
variety of ailments (declining returns, scandals, high fees).
Could institutional investors find an opportunity in what
may have become a buyers market (Portfolio Perform-
ance, p. 28)?
Keats final stanza addresses the urn directly: When
old age shall this generation waste, / Thou shalt remain in
midst of other woe / Than ours, a friend The urns
friendly message of consolation is the truthbeauty for-
mula. If that seems like cold comfort, Keats might agree
with you. Cold Pastoral! he exclaims. Why then should
the urn console us? The spirit listens for ditties beyond
the range of sensual ears. If truth really is beauty, a disso-
nant truth must have beautiful overtones, even if the
sweetness of the melody remains unheard. There is a word
for this: hope.
ROGER MITCHELL
Managing Editor (roger.mitchell@cfainstitute.org)
IN SUMMARY
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In Focus
BY JOHN ROGERS, CFA
ver the course of the past 18 months, we have
been evaluating the issues affecting markets,
consulting with our members, and discussing
educational and standard-raising concepts with
employers and regulators. A common theme has emerged
that the investment industry would benefit from a global
introductory-level program designed for
people who work in the investment
industry but who may not be directly
involved with investment analysis or
decision making. I am therefore excited
to give you an update on a new initiative
CFA Institute is undertaking to raise the
standards of ethics, education, and excel-
lence throughout our profession.
Based on helpful guidance, particu-
larly through CFA Institute members, we have identified
an opportunity to support the investment industry by
creating a new educational certificate. This program will
embrace those involved in our industry who fall outside
our traditional membership and will target those who
need a fundamental level of understanding about invest-
ments and the investment industry. This program will
directly target people working in roles such as compliance,
legal, client service, information technology, human
resources, marketing, and sales, thereby acting as a natural
complement to the many varied roles at work in the
investment industry.
This program fills an unmet demand in the industry
for a widely accessible, globally consistent, and ethics-
based study program. By drawing on our core educational
strength and directly contributing to the mission of CFA
Institute to raise standards globally, the program also
could provide development opportunities for CFA Insti-
tute member societies.
This program is specifically designed to target an
audience distinct from that of the CFA Program, which
remains the gold standard of the investment industry. The
fundamentals certificate will expand the educational reach
of CFA Institute beyond the CFA and CIPM Programs.
The program will be aimed at individuals with no formal
training in finance or investments, including industry
participants who do not wish to pursue or are at least
several years fromstarting the CFA Program. The level of
difficulty is also substantially different from other CFA
Institute programs, and we currently estimate it will require
approximately 50100 hours of study and successful com-
pletion of a 2-hour computer-based exam. Upon comple-
tion, successful individuals will receive a certificate of
knowledge from CFA Institute. The program will represent
O
Back to the Basics
an essential understanding of investment fundamentals
and how the industry works. There will be no connection
between the program and CFA Institute membership or
the CFA designation, and certificate recipients will not be
entitled to a designation or letters after their names.
To measure demand for entry-level education, we
asked CFA Institute members some key questions through
our annual member survey. The results were clear: 68
percent of respondents believe that its important for
employees not directly involved in the investment deci-
sion-making process to increase their knowledge of the
fundamentals of investments. In addition, more than half
of respondents would be likely to recommend a CFA Insti-
tute fundamentals program to their colleagues, and 75
percent of respondents told us that staff throughout their
organizations could benefit from investment-related edu-
cational development at the fundamentals level.
This new program is scheduled to launch in 2013.
The examination is expected to be delivered as a computer-
based multiple-choice test and be made available on
demand at test centers around the world. The examina-
tion initially will be delivered in English, but there are
plans to expand to other languages in the coming years.
The program and all supporting elements are currently
under development.
This is an exciting time for us at CFA Institute. We
anticipate that this new program will serve our members
by increasing professional excellence at many levels
within their firms. As we continue to work on finalizing
the details of the new program, we will be working with
many of you to develop the product, introduce it to the
industry, and launch it in 2013. As always, thank you for
your continued commitment to professional excellence
and support.
John Rogers, CFA, is president and CEO of CFA Institute.
The investment industry would bene-
fit from a global introductory-level pro-
gram designed for people who work
in the investment industry but who may
not be directly involved with invest-
ment analysis or decision making.
How to Think about the Unthinkable
In 1997, I had my first contact with quant models. The
project was to develop risk controls for a large insurance
company. Six months later, we were able to compute
weekly a daily value at risk (VaR) for a portfolio com-
posed of about 25 funds.
Today, we can compute the same daily VaR for, say,
400 funds in a couple of minutes. Great! Other things also
became better, like risk-control usage, but unfortunately,
not risk-control understanding.
I strongly agree with Mark Kritzman (Viewpoint,
Long Live Quantitative Models, July/August) that we
should not reject quantitative models. What we should
really do is better understand them. But when Kritzman
says VaR models failed spectacularly and suggests a new
approach (new from 1999), I must disagree.
According to Kritzmans analysis, an expected VaR
with 99 percent confidence showed a 9.9 percent risk.
The real world recently showed us a 35.5 percent drop!
I would say that is not a failure but a misconception! VaR
does not mean a maximum loss. VaR also does not mean
a number to be observed but a number to be interpreted.
It is not a loss limitation with 100 percent probability but
only with 99 percent. Remember, that 1 percent remain-
ing is for distribution tails and goes from 9 percent to
100 percent (if possible) loss! My conclusion: Real results
just showed us that 99 percent confidence alone was
not enough for that scenario.
What did risk controllers do wrong or what could
they do differently? Should they increase it to 99.9 per-
cent confidence? Of course not. It is very difficult to match
the right confidence interval. I would say that 99 percent
is far enough. Should they use more sophisticated models?
Perhaps, but we need should fully understand what
actually went wrong.
The main concern is correlations, as Kritzman
explains. Regular VaR models are parametric, which means
they use the past to infer about the future. Correlations
in the past could not be the same in the future. I would
like to add distribution tails to the problem too.
Risk managers should notice that VaR models are not
enough to build a risk profile, even with an extremely
high confidence level. Risk controls must be comple-
mented by other pillars that deal with correlations and
tails. The old-fashioned stress-test is my personal favorite.
It is difficult to build a stress scenario due to absence of
metrics. Percentiles, quartiles, and other iles may help,
but stress scenario levels are, in the end, based on the
historical experience of risk controllers. Why use them?
Because stress-tests (being empirical) break the correla-
tions rules. Because stress-tests go to tails. Because
stress-tests force risk managers to think about the
unthinkable. That is risk control.
The Euros Critical Weakness: Hubris?
Bruno Colmant, CFA, in his article The Euros Existen-
tial Challenge (Viewpoint, July/August), made several
unsubstantiated claims. As background, I should explain
that I have always been pro-European in the sense that I
would have liked to see the people of the various Euro-
pean nations ultimately choose to have a common govern-
ment. This project would have taken decades and would
have led to common monetary and fiscal policies if the
people so chose. Thereafter, a common currency could
have been introduced. None of this happened.
Virtually all of the governments of the euro countries
refused to allow their people to vote on this loss of sover-
eignty (which, to repeat, I would have supported eventu-
ally), and indeed, if the rhetoric is reexamined, it can be
seen that the various parliaments were told that the estab-
lishment of the new currency would in no way under-
mine their various existing sovereignties. Colmants claim
that economists who understood the consequences that
such a choice (viz. membership of the euro) would bring
about were rare is made without any evidence and in my
experience is the opposite of the truth.
More importantly, Colmants assertions that the
choice of a common currency was an excellent one and
the socioeconomic models of the member states cannot
simply be stowaways on board a monetary godsend are
self-contradictory and anti-democratic. If the people of
France, Germany, Belgium, etc., had been told that
LETTERS
The example shows that this particular
quantitative model, which most
assume failed spectacularly, would
have worked fine had we implemented
it with just a bit more rigor and a
slight nod toward realism.
MARK KRITZMAN, CFA
Long Live Quantitative Models!
CFA Magazine (July/August 2011)
I cannot say that a well-done stress-test would have
predicted a 35.5 percent drop. I can say that it would
have turned the yellow light on for a drop larger than
9.9 percent, and that would make asset managers think
twice about the future.
I also advocate for quantitative models. I really do!
But there is no efficiency in risk control without stress-
tests. Long live quantitative modelsand stress-tests!
Luiz Veiga, CFA
So Paulo, Brazil
LETTERS
control of their socio-economic systems would be trans-
ferred to Brussels and had voted for this, so be it. The fact
is, however, that they were not asked this question and
were predominately told that they would not lose socio-
economic self-government. Instead, the political elite
decided to push through this monetary union with the
intention of creating an environment in which fiscal and
monetary union would occur without asking their people.
This hubristic and profoundly anti-democratic approach
has now met its inevitable nemesis.
If the correct democraticbut much slower
approach had been followed, a viable euro could have
been achieved without the current absurd pain.
Geoffrey Lindey, FSIP
London
A Matter of Due Diligence
In the article A Matter of Trust: Regulatory call risk and
trust preferred securities (Analyst Agenda, July/August),
author Dennis Dick, CFA, highlights the risk of investing
in this type of hybrid callable security. Regardless of the
type of fixed-income security, investors should always
carefully review the prospectus/indenture for a particular
issue. As the article points out, what appeared to be black
and white in print at the time of original issue may later
become a shade of gray for contractual interpretation.
Furthermore, the U.S. Federal Reserve makes banking
rules and provides clarification about those rules through
its supervisory notices, but it does not seek to be the
arbiter of contract law for securities indentures! There are
several characteristics of trust preferred securities (TruPS)
that need to be understood before investing in these
hybrid securities.
First, almost all TruPS issued by bank holding com-
panies fall into two core categories: regular TruPS and
enhanced TruPS (commonly referred to as E-TruPS). All
TruPS were issued with early call trigger mechanisms for
potential changes in capital treatment, tax laws, and
rating agency views of the securities. The E-TruPS are a
second generation of trust preferred securities that were
issued by bank holding companies, mostly in the years
leading up to the 2008 financial crisis, and tend to have
higher coupons and longer final maturities than the older,
original TruPS. These E-TruPS have a few other unique
features that regular TruPS do not have. The author
rightly points out the ambiguity and potential for call risk
from a capital treatment event created by the Dodd
Frank Act on 21 July 2010. The early call risk potential
of E-TruPS is the primary concern, however, because quite
a few of these issues are still one to two years away from
their regular call dates. (TruPS typically have a five-year
non-call from the issue date.) Most regular TruPS are
already well past their initial call dates, so a regulatory
event is a nonevent. Therefore, investors should check
the prospectus on a particular issue to determine whether
it is a regular TruPS or an E-TruPS.
Second, almost all E-TruPS have a replacement capi-
tal covenant (RCC) feature that requires the bank holding
company to issue new Tier 1 capital (with a six-month
lookback option) to initiate any call. Regardless of the
capital treatment event date that would be used to trigger
an early call, new Tier 1 capital would have to be issued
by the company. Third, many E-TruPS require that the
early call election be made within 90 days of the regulatory
capital treatment event. This characteristic, together with
the replacement capital covenant, tends to place additional
constraints on a potential call. A few companies, most
notably Comerica and City National Bank, chose to use the
DoddFrank Act date last year to early call their securities
within the 90-day period. Both companies had previously
issued common equity within the six-month lookback
period to satisfy the Tier 1 replacement capital covenant.
Still, even if an investor understands these important
differences and features of TruPS and other economic
considerations of the issuer that might not be outwardly
transparent, exceptions to the expected rules can occur
sometimes. For instance, as the author points out, Fifth
Third Bank called its FTB-C (an E-TruPS) earlier in
2011well after 90 days from the signing of the Dodd
Frank Act. While using the DoddFrank Act as the basis
for a capital treatment event might be debatable, in this
case, the indenture language did not contain the 90-day
window. More recently, in early September 2011, Wells
Fargo early called one of its E-TruPS (the WCO). The
capital treatment event language in the prospectus might
be considered on the gray side of black and white, but
this E-TruPS issue had neither the replacement capital
covenant nor the 90-day window language that might
July/August 2011
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The investment industry is not equipped
to understand the impact of global political instability,
says one expert on political risk.
What can investors do?
LETTERS
otherwise have limited the companys ability to call the
security. Even with this language found in most other E-
TruPS, investors should take nothing for granted. It is
possible for an issuer to pay to eliminate certain restric-
tive features, such as the replacement capital covenant
through a consent solicitation offer to other more
senior securities holders. In fact, PNC Bank did a consent
solicitation in November 2010 for a series of E-TruPS
(National City A, B & C), although the company has not
yet called these securities.
With many tens of billions of dollars worth of TruPS
still outstanding, the pool will steadily dwindle because
changes in banking regulation directed by the Dodd
Frank Act have shortened the economic life of TruPS. A
legal skirmish may yet emerge over the timing and inter-
pretation of capital treatment event before the sunset
begins on TruPS in January 2013. Regardless, investors
always need to read a prospectus carefully rather than
assume that certain protections will always protect. By
doing so, perhaps they can build in a bit more of a yield
buffer when buying these securities.
Eric Grubelich, CFA
New York City
Is Clean Tech Cost Competitive?
The article Sol Survivors (Analyst Agenda, July/August)
was interesting but misleading. The first line about clean
technologies having a dirty little secret and not being cost
competitive is just the sort of thing which climate-change
deniers like to latch on to. The reason nuclear power is
cheap is that national governments funded a lot of the
start-up costs. And what would have happened had the
recent disaster in Japan been worse? Taxpayers would
have been asked to fund the clean up.
Likewise coal it appears to be cheap energy, but
the health costs associated with illnesses caused by air
pollution are being met by the public, largely through
increased health insurance premiums.
So, by all means, point out the subsidies to solar and
wind power, but please compare like with like and look at
the overall costs of the alternatives.
Andrew Doble
Bermuda
The Benefits and Importance of Public Service
I would like to thank you for publishing the article on
public service in the January/February 2011 issue (At
Your (Public) Service). I applaud the efforts to highlight
this important sector of the economy where our profes-
sion makes a valuable contri-
bution. I also left the comforts
of private industry for the
opportunities and challenges
of public service during this
historic period of change in
financial services. As a bank
examiner for the FDIC (Fed-
eral Deposit Insurance Com-
pany), I have encountered
experiences more diverse
than I would have ever seen
with a single firm or even
with a consulting company.
My decisions have a significant
impact on the future of an institution, and I often con-
duct critical discussions with boards and executive man-
agement. The ability to present well-supported conclu-
sions, as promulgated by the CFA Institute principles and
standards, has enabled me to maintain productive com-
munication even in the face of negative circumstances.
Public service can be beneficial at any phase of ones
career. For young professionals, its a great way to acceler-
ate career development. I have valued assets ranging from
mainstream securities to portable toilets (no kidding).
Resources are always stretched in government agencies,
which means youll have the opportunity to assume
responsibilities years before you would be allowed to in
the private industry. The lower prevalence of CFA charter-
holders also translates to a higher value and demand for
our unique skills. As one progresses up the ranks in the
corporate world, opportunities decrease and competition
increases. Often, people find themselves plateauing at
points in their career when they still have ambition but
their organization may no longer provide the same poten-
tial for growth. Transitioning to public service can be a
great way to reenergize your career and find a renewed
purpose in your work. A stint in public service can also
be a great sunset role when one has achieved a full career
in the private sector. Senior professionals have the oppor-
tunity to use their experience to achieve goals of public
policy in addition to profitable enterprise. While compen-
sation in general is relatively lower than the private sector,
one can still earn a good living in public service. Depend-
ing on how one values the quality of life that public service
allows, the total return of benefits for your time invested
on the job may be no different for private industry.
Like earning the CFA credential, public service adds
a new dimension of experience that increases your total Source: Yahoo! Finance
First Solar
(share price in US$)
2008 2007
350
300
250
200
150
100
50
0
C
ALL IT PUBLIC SERVICE, civil service, or working for the Fed. Does it sound like the last place you would look for a job? Maybe it is, because the last place you look for something is where you find it.
(Read the last sentence twice. It does make sense.)
If you need to broaden your job search, you might set your sights on one of the U.S. federal agencies linked
to the regulation of the capital markets.
Although opportunities abound in Washington, DC, for job candidates with financial services and investment industry experience, moving to the nations capital isnt necessary for most positions. The vast
majority (85 percent) of civil service employees do not
work in Washington.
That may not be the only surprise. Although the
public sector pay scale for investment professionals has
not kept pace by and large with private sector salaries,
many people willingly take a pay cut to enter government
ranks. They do so out of a spirit of serving their country.
Or they may seek to improve the quality of their lives,
cutting back their workweek from 80 hours in the private
sector to 40 or 50 hours on the governments payroll. A
strongly shared sense of mission, job security, and attrac-
tive employee benefits can be an appealing alternative to
the pressure-cooker environment of a Street firm. Moreover,
federal agency jobs can be intellectually challenging and
introduce new hires to an interesting group of people.
I think people from Wall Street would be impressed
with some of the talent they would meet at the Treasury
Department, the SEC (U.S. Securities and Exchange
Commission), and some of the other financial organiza-
tions, says Charles Ingersoll, senior client partner of
executive recruiter Korn/Ferry and head of its government
sector practice. Unfortunately, in the past the govern-
ment hasnt done a good job of selling the opportunities. Adjusting the Language The mentality of post a job and they will come is
gradually passing. Consider the leads of these two job
summaries that were posted on the SECs website. The
first advertises for a program analyst and the second seeks
an attorneyadviser. Both positions pay around US$68,000.
(1) As a Program Analyst in the Office of International Affairs, you will provide program management, research,
and logistical coordination associated with the administration of the technical
assistance function. You will also assist with the regulatory policy, comparative law and regulation, and enforcement functions as needed. Relocation expenses
will not be paid by the hiring agency. (2) Do you want to perform challenging work in a collegial environment,
while enjoying quality of life and a com-
petitive compensation package? Invest
in your career at the U.S. Securities and Exchange Com -
mission! The SEC has retained Futurestep, a Korn/Ferry
company, to provide strategic talent acquisition solutions
to help the agency address its continuing talent needs.
The second pitch obviously has more punch, and
Futurestep is the reason why. Futurestep works as an out-
sourced recruiting department for public and private
clients, installing its own employees on site. The size of
the team expands and contracts with the volume of hiring
assignments, so the clients investment in permanent
human resource headcount is held in check. Futurestep
first proved its mettle with the SEC during the commis-
sions hiring surge following the passage of the Sarbanes
Oxley Act of 2002. It stepped into its latest SEC assign-
ment after winning a competitive bid. A small team of
Futurestep employees is embedded at the SEC in
Washington, DC, assisted by colleagues at the companys
Houston headquarters. I see ourselves as an enhancement to the SECs
recruiting efforts, says Cynthia Gervais, Futuresteps
program manager at the SEC. The markets are moving
very quickly, and if the regulators want to keep up, there
is a need to add more expertise. Our task is to assist the
SEC in recruiting and to reach out to pools that the
SEC has not reached before. [See interview with Dwayne
Boyd, chief recruiter for the SEC, on page 44.]
Gervais, acknowledging the upbeat tone of SEC job
postings ghost-written by Futurestep, explains, When
youre talking to a different audience, you need to adjust
the language.
C F A MA G A Z I N E / J A N F E B 2 0 1 1
42
Looking for a new employer?
For some investment professionals, the federal
government
may be the answer

AT YC\KPUBLIC~!K\!C!
LETTERS
professional value and career options. Its nice to know
that I can continue in a rewarding line of work or perhaps
return to the private sector some day with a broader skill
set that will set me apart from other candidates. Much
like military service during a major war, the value of
public service today comes from participating in a his-
toric event. While the new regulatory regime may still be
under construction, one thing is for suretheres going
be more of it. Understanding and knowing how to navi-
gate the system will be valuable to many organizations.
I believe CFA Institute can still do more to promote
the benefits and importance of public service. We should
want professionals of the highest caliber managing public
funds. If the people fully understood the high standards
expected of CFA charterholders in all areas of skill and
ethics, I believe the CFA charter would become one of the
fundamental credentials expected of anyone with respon-
sibility as a public fiduciary.
Brian Bunn, CFA
Raleigh, North Carolina
Shaking the Foundations
[Several articles in recent issues (e.g., The Great Rebalanc-
ing in July/August and The Tower of Bobble in May/June)
examined potential implications for investment models built
on assumptions about a risk-free rate of return. One reader
addressed these concerns in light of the recent political dis-
pute about the U.S. debt ceiling.]
For nearly five decades, the concept of a risk-free
rate of return has served as one of the key elements for
modern financial economics. Most notably, the capital
asset pricing model (CAPM) developed by WilliamSharpe,
John Lintner, and Jan Mossin (circa 1964) has incorpo-
rated this concept into its groundbreaking benchmark
model to price most financial assets around the world. It
is widely used today to price many securities and to aid
in the management of portfolios around the world. In
modern financial theory, CAPMestablishes the relationship
of the riskiness of assets with its expected rate of return.
CAPM prices risk on a rational basis. Since the inception
of CAPM, U.S. Treasury securities by definition have been
synonymous with the risk-free rate of return. Now, with
Standard & Poors decision to downgrade, this key proxy
is being called into question and could shake the founda-
tions of how securities are priced around the world.
What proxy could be used to price securities in the
financial markets? Would the financial markets have to
turn to Canada or Australia for a new proxy for risk-free
securities? Currently, Hong Kong has a AAA rating
(under Standard & Poors). Would that enable China to
reshape Hong Kong as a new safe-haven securities market
for the world? And what about the need for liquidity in
markets other than the U.S.?
For decades, U.S. Treasury securities were by defini-
tion risk free and have collectively served as the global
benchmarks in the establishment of risk premiums,
another key component of CAPM. Generally, risk premi-
ums are intended to compensate investors for taking
risks in securities other than U.S. Treasury securities.
Now that U.S. Treasuries could lose their risk free stan-
dard of excellence, what would be the appropriate risk
premium benchmark? Could investors turn to the credit
default swaps (CDS) market for a proxy for risk premi-
ums? Perhaps we can create a new risk-free rate of
return by subtracting the CDS premium from the appro-
priate U.S. Treasury rate. If that were the case, would we
really have a true proxy for a risk-free rate of return?
Does one even exist in todays world?
This financial concept is now being thrown into tur-
moil and could be the source of continued uncertainty and
volatility in the global financial markets. Unfortunately,
U.S. leaders (President Obama and Congress) must begin
to face this issue quickly by
addressing our national
debt level and fiscal spend-
ing policies. Otherwise, the
financial world as we know
it today will be very differ-
ent tomorrow. Imagine a
world for which there is no
consistent proxy measure to
price financial assets. Our
401(k) retirement plans will
be the least of our problems.
George Koo, CFA
Dix Hills, New York
Overly Bullish on Africa?
Thank you for the article on Africa (Viewpoint, Into Africa,
September/October). I suspect, however, that there may
be various factual inaccuracies in the table on page 9.
I am of the view that the population of AAEMNS
(Algeria, Angola, Egypt, Morocco, Nigeria, and South
Africa) would have been closer to 372 million in 2009
rather than 224.4 million, as the table suggests. The com-
bined populations of Nigeria with 155 million and Egypt
with 83 million amounted to 238 million as of that date.
Furthermore, the table has the total AAEMNS number
deteriorating to 206.2 million by 2015, which I suspect is
unlikely given demographic trends within the six nations.
Also, the 2015 AAEMNS GDP is estimated at
US$20,537.6 billion, up from an estimated US$1,459 bil-
lion in 2013. Such growth over a two-year period seems
in my view a bit overly bullish.
Tongai Kunorubwe, CFA
London
C F A MA G A Z I N E / J U L Y A U G 2 0 1 1
32
How the outlook for low returns
and high volatility could change
the future of asset allocation
BY ABE DE RAMOS
I l l u s t r a t i o n : R o b e r t M e g a n c k
Champions). As such, when the Chinese government
suggests its goal is for 8 percent GDP growth, it has direct
levers at its disposal to influence the result.
This dynamic was readily apparent over the past sev-
eral years. During the financial panic, China, unlike most
other economies in the world, did not experience a reces-
sion. In fact, the Chinese economy grew at 9.6 percent
in 2008 and 9.2 percent in 2009 largely as a result of an
unprecedented monetary expansion. During a 24-month
period, Chinese banks, acting in accordance with central
government instructions, lent US$2.7 trillion to Chinese
borrowers. Amazingly, this level of lending was roughly
equivalent to the lending surge that fueled the U.S. housing
China: Unhedged Risk in Your Portfolio?
Given the worlds heavy investment in Chinas continued growth, can investors afford to not be hedged?
BY JOEL HIRSH, CFA
he markets recent gyrations are in many ways a
referendum on the political ineptitude displayed
on both sides of the Atlantic. While our leaders
place their political priorities ahead of averting a
1937 redux, the market is left with only one leg to stand
on: China. At present, China is essentially the only game
in town in terms of expected global growth. If Chinas
economy slows or even falls into recession, nearly all
global equity markets would surely be impacted. Should
investors be hedged?
By way of background, China has achieved tremen-
dous accomplishments over the last 30 years, with GDP
increasing sixteenfold. China has displaced Germany as
the worlds largest exporter and Japan as the worlds
second largest economy. Moreover, Chinas growth has
been achieved through a steady march upward, and the
perceived sustainability of Chinas growth has led to a
widely held belief in the Chinese miracle. At present, it
is only a minor exaggeration to suggest that nearly every
investor is currently long China. Many are outright
invested in Chinese equities, but many more are implic-
itly long the China growth story through investments in
commodities, commodity-linked equities, Australian
equities, Brazilian equities, additional allocations to
emerging markets as an asset class, energy stocks, indus-
trial companies tied to Chinese growth, and global multi-
nationals. On top of this, most of these investors are very
happy to be long China, as it is generally agreed that
Chinas growth is likely to continue on a smooth trajec-
tory upward, carrying the low- to no-growth developed
world along for the ride. Given the overwhelming abun-
dance of anecdotal evidence in conjunction with the valu-
ations attached to Chinese-linked equities, it is fair to say
a hard landing for Chinas economy is considered a very
low-probability event. Investors may not have an opinion
on the next 100 years of Chinese growth, but they should
have an opinion on the probability of a hard landing
and it is not negligible.
The issues currently facing Chinas economy begin
with Goodharts law, which states that when an economic
statistic becomes a stated policy goal, the statistic itself
loses its informational value. In China, the stated goal is
8 percent annual GDP growth. This goal was chosen
because the Chinese government believes a minimum of
8 percent annual growth is needed to prevent social unrest.
Keep in mind that Chinas national government owns
(as opposed to regulates) the banking system as well as
the largest businesses in most industries (National
T
Viewpoint
At present, China is essentially the
only game in town in terms of
expected global growth. If Chinas
economy slows or even falls into
recession, nearly all global equity
markets would surely be impacted.
Should investors be hedged?
bubble during the middle of the past decadedespite
the fact that Chinas economy was roughly only 35 percent
the size of the U.S. economy in 2009.
Further, a large portion of this lending binge was
directed to local governments charged with finding stimu-
lus projects that would help China reach its goal of 8 per-
cent GDP growth. For local government officials in
charge of directing the new funds, careers were at stake
in the need to find projects. If the projects went bad, the
money was essentially free because the loan was from
a bank funded by a government that would not demand
repayment. Under this set of circumstances, it is not sur-
prising to read credible news reports of local Chinese
governments hiring construction crews to dynamite
working roads and bridges so they could then be rebuilt.
Of course, hiring construction crews for both the demoli-
tion and rebuilding projects added to GDP growth!
With this sort of lending-spurred growth, future
returns on those investments are unlikely to be impressive.
In fact, recent Chinese government agency estimates
suggest China has accumulated bad loans to local
governments totaling more than 15 percent of GDP. Some
estimates are significantly higher. Additionally, taken
together, Chinese central government statements, rating
agency reports, as well as third-party analysis suggest
Chinas banking system is in a highly precarious position,
with a reasonable probability of being insolvent.
While this line of research suggests shorting Chinese
bank stocks as a prudent means to hedge the portfolio,
China is not the U.S. It was very telling that Chinese
banks did not follow other Chinese industries on an
international acquisition binge during the recent crisis.
The reason is simple: Chinas banking system is a closed
system. The banks are largely funded and controlled by
the government, and their accounting is not open to
external scrutiny. As a result, when a bank needs to be
recapitalized (China has spent more than US$315 billion
bailing out its financial
system since 1997), loans
that are unlikely to be
paid are often moved to
newly created asset man-
agement companies that
buy the loans from the
banks using proceeds
from bonds sold to the
very same banks! As a
result, the banks remove
the bad loans from their
balance sheets but replace
them with a bond issued
by a newly created asset
management company. Of course, the ability of the asset
management company to repay the loan is wholly
dependent on the repayment of the bad loans. Tellingly, in
the 10 years following the creation of China Cinda Asset
Management, not a single loss was taken on any bad loan.
At present, two of Chinas four largest banks hold more
than 50 percent of their equity in bonds backed by asset
management companies. This sort of accounting could
never happen if Chinas banking system was forced to
operate under the same scrutiny applied to Western
banks. As such, while Chinas banks may very well be
insolvent, they may remain that way with little repercus-
sion to equityholders barring a change of heart by the
Chinese government. Given the governments majority
ownership position in the very same banks, I am not
holding my breath.
Although the Chinese banking system may be able
to skirt many of the issues that would impact banks oper-
ating in a Western-style, open system, the outcome is not
likely to be a free lunch. As China has lent unprecedented
levels of money, it has done so at almost no cost. In fact,
real interest rates in China are negative. As such, Chinese
investors have rationally invested in low-return projects
because a low return is still higher than the cost of
the funds. With the mountains of money chasing poor
projects, inflation has cropped up as the primary threat
against continued uninterrupted 8 percent annual growth.
Current Chinese government reports suggest inflation
running in the 6 percent range. Given that the Chinese
premier-in-waiting has publicly ridiculed the stated infla-
tion figures and two of the largest inflation inputs (food
and real estate) are growing at 11 percent and 20 percent,
respectively, the reality of double-digit inflation could
be more credible than stated government statistics.
So perhaps it makes sense that the Chinese govern-
ment has repeatedly stated that taming inflation is a top
priority and has begun to raise interest rates while order-
ing a dramatic reduction in bank lending. Unfortunately,
slowing bank lending is a difficult proposition for the
Chinese economy, because fixed investment (such as con-
struction spending funded by a bank loan) represents 60
percent of annual GDP.
This level of investment-
fueled growth has never
been successfully sus-
tained. If reduced invest-
ment is necessary to con-
trol inflation, 8 percent
annual growth will be
difficult to achieve.
The most effective
way to hedge the threat of
a Chinese slowdown is
through the external link
to Chinas economy
imported commodities.
If Chinas economy has a hard landing, undercapitalized
Chinese banks may be able to shift the liabilities off their
balance sheet as they have done historically, but the slow-
down in purchased commodities will not be able to be
hidden. Given Chinas impact on commodity prices, a
Chinese economic slowdown would dramatically impact
commodity markets and commodity-linked equities
priced for continued Chinese growth.
I am not calling for a Chinese meltdown. I do mean
to point out that, although valuations imply the probabil-
ity of a Chinese hard landing is remote, the actual proba-
bility is substantially higher. As a result of this mismatch,
the pricing of this hedge may be attractive relative to
many other investment opportunities indirectly depend-
ent on continued Chinese growth. In light of how heavily
invested the world is in Chinas continued growth, can
you afford not to be hedged?
Joel Hirsh, CFA, is a portfolio manager at Kovitz Invest -
ment Group in Chicago and a member of the CFA Society
of Chicago.
The most effective way to
hedge the threat of a Chinese
slowdown is through the external
link to Chinas economy
imported commodities.
State and local governments have also accumulated
significant estimated pension liabilities. Estimates vary
widely depending on the discount rate applied to the pro-
jected benefits payments to pensioners over many decades.
There are a wide range of choices in calculating key pen-
sion variables, and the discount rate is perhaps the most
important and by far the most controversial (see Figure 1).
Why the Discount Rate Matters
Consider this disclosure by the state of New York in its
2010 annual report to the controller on actuarial assump-
tions: a reduction from the current assumption of 8 per-
cent to 5 percent, all things being equal, would increase
FY 2011 employer contributions from more than US$3
billion to about US$14 billion, close to a 300 percent
increase.
Without question, increased employer contributions
force governments to reevaluate pension benefits and the
burdens they place on budgets. GASBs proposal includes
a caveat that the changes affect how public pensions are
reported, rather than funded. Still, as a result, realistic
accounting improvements are likely to drive future fund-
ing decisions if the proposal is implemented, which is
precisely why the accounting rules issued by GASB may
ultimately affect public policy.
Currently, public pension plans can discount future
pension benefits using an assumed expected return on
Public Policy and Pension Promises
Can accounting reforms influence public policy and help municipal bond investors?
BY OLU SONOLA, CFA
ouis Brandeis, a U.S. Supreme Court judge in the
early 20th century, once noted that sunlight is
the best disinfectant. And if any area of account-
ing needs a good dose of sustained sunlight, it is
the accounting and financial reporting of state and local
government pensions in the U.S.
U.S. public pensions are fundamentally complex,
reflecting each states unique institutional, constitutional,
and statutory environment. Various demographic and
actuarial factors (coupled with the flexibility allowed
under current accounting standards for public pensions)
magnify the complexities even more.
Consequently, the ability of investors and various
public stakeholders to understand the magnitude of a
state or local governments pension obligation is limited.
Moreover, comparing the relative pension cost among
governments is challenging because pension obligations
can differ significantly based solely on which assumptions
and methods are used.
Thankfully, the Governmental Accounting Standards
Board (GASB), the organization responsible for accounting
standards used by state and local governments in the
U.S., has proposed changes that will significantly reduce
the choices available today and also shed more light on
the true cost of reported public sector pension obligations.
These proposed changes are long overdue. Although
some argue the reforms are not far reaching enough, they
certainly make a good step in the right direction. Ulti -
mately, what really matters is the impact the proposed
changes have on future government decisions. Whether
state and local governments take heed will be interesting
to watch.
Many state governments are taking action in reducing
pension benefits that may be unsustainable in an era of
limited revenue resources and reduced investment returns.
But the legality of some of the cuts is being contested in
courtrooms across the country, and these could drag on
for many years.
The Pensions Landscape
State and local governments have accumulated approxi-
mately US$3 trillion in assets (US$2 trillion of these
assets are invested in corporate equities and mutual funds
and about US$800 billion in a broad spectrum of fixed-
income investments). The pension plans cover 20 million
current and former employees and pay out an excess of
US$200 billion in benefits.
L
Viewpoint
FIGURE 1
Aggregate State and Local Pension Liability
under Alternative Discount Rates as of 2010
$7
$6
$5
$4
$3
$2
$1
0
L
i
a
b
i
l
i
t
y

(
i
n

U
S
$

t
r
i
l
l
i
o
n
s
)
Discount Rate
Source: Based on Boston College Center for Retirement Research data.
8% 6% 5% 4%
their pension assets, and most plans assume returns
between 7 percent and 8.5 percent (see Figure 2).
These rates appeared justifiable in the era of robust
equity returns enjoyed by pension investments through
the equity boommarkets of the 1990s and 2000s, in which
market returns exceeded the discount rate assumptions
in all but a few years. In light of anemic equity market
returns over the past decade coupled with a very uncer-
tain economic outlook, these rates now seem optimistic.
Several observers have championed a much lower
discount rate linked to the rate of return on an index of
high-quality government bonds, similar to the methodol-
ogy used for corporate defined-benefit plans. A lower rate
reflects the likelihood that governments will have to pay
their obligations to retirees, given the contract protection
that pension benefits enjoy under many states laws.
Many actuaries and others argue that a higher rate
reflecting the expected return on public plan assets is
more appropriate because, over time, the investment
returns from plan assets will provide the majority of
resources used to make pension benefit outlays and that a
lower rate fails to consider the diversified nature of pen-
sions investment portfolios and the long-term nature of
governments and their tax bases. They also argue that a
consistent long-term return assumption (rather than a
variable rate based on an index of high-quality govern-
ment bonds) provides more stability in annual contribu-
tions and ultimately eases volatility in budgets.
GASBs proposal seeks a middle ground between the
two ends of the spectrum identified above. It proposes
changes to many key areas of public pension accounting
which would be more aligned to the way private corpora-
tions now account for their pension plans. However, the
proposal maintains fundamental differences on the deter-
mination of the discount rate.
Will the Proposal Change the Discount Rate?
In addition to proposing that state and local governments
recognize pension liabilities on their balance sheets
rather than disclosing them only in footnotes, GASB lays
the groundwork for a new way of determining the dis-
count rate.
The proposal introduces a complicated hybrid dis-
count rate that combines a municipal bond index rate
and the expected long-term investment return rate (the
rate currently used by all public pension plans).
To the extent that pension assets are projected to be
sufficient to meet future benefit payments, the expected
long-term investment rate of return will be the discount
rate. If plan assets are projected to be insufficient to cover
all future benefits, a high-quality municipal bond index
rate will be the discount rate for the unfunded portion of
the liabilities.
Actuaries roughly estimate that the proposed GASB
changes on discount rates, along with other changes,
could result in approximately a 1 percent decline in the
hybrid discount rate for the typical plan that is currently
80 percent funded. The result could be an estimated
increase of 10 percent to 12 percent in liabilities and
close to 40 percent to 50 percent in contributionsif the
states decide to fund their pension plans based on GASBs
new rules.
Although the proposed changes are an incremental
improvement, some observers still argue that they dont
go far enough. Changes pertaining to the discount rate
are limited, but GASBs other proposed changes will pro-
vide much improved additional disclosure, which should
help analysts and investors make analytical adjustments if
deemed necessary.
Will the Proposed Changes Matter?
State and local governments dominate the US$3 trillion
municipal securities market with approximately US$2.5
trillion bonds outstanding70 percent of which is held
by private households, mutual funds, and money market
funds. These investors should pay attention to GASBs
proposal and possibly make their opinion known over the
coming months of deliberation.
On balance, GASBs proposed changes should
enhance transparency and consistency on multiple fronts.
They should make it easier for investors to compare
public pension plans and also enhance their understand-
ing of the financial impact of pensions on government
participants. Furthermore, reforms likely will pressure
governments to give fuller consideration to the overall
burden pension liabilities place on the financial health of
state and local governments. If the proposed changes ulti-
mately influence public policy, municipal bond investors
will be better off.
Olu Sonola, CFA, is director of credit policy for Fitch Ratings
and a member of the New York Society of Security Analysts.
FIGURE 2
Public Pension Plan Investment
Return Assumptions (%)
Number of Plans
Note: Data as of most recent actuarial survey for 126 public pension plans.
Source: Based on Public Fund Survey data.
8.50
8.25
8.00
7.80
7.75
7.50
7.25
7.00
0 20 40 60
Climate Change Disclosures: Should Analysts Care?
BY PAUL GRIFFIN
Lights, cameras, full disclosure! Later this year, the
Environmental Protection Agency (EPA) will release data
on greenhouse gas (GHG) emissions. This information
results from the EPAs 40 CFR Part 98 rule mandating that
U.S. companies and other entities disclose their GHG
emissions. The rule applies to about 10,000 public and
private U.S. facilities (an EPA-defined term) whose
annual output of direct GHG emissions from manufactur-
ing exceeds 25,000 metric tons. Why and how might this
information have news value for investors and financial
analysts? To answer this question, we need to understand
the new GHG information and the link between green-
house gas emissions and stock prices,
why the new EPA data might offer
insights about riskreturn factors rel-
evant to company valuation, and how
investors and analysts might use the
new e-GGRT (electronic-Greenhouse
Gas Reporting Tool) information to
arrive at a better understanding of the
companies they follow.
The New e-GGRT Data
The EPA rules request detailed infor-
mation annually about two groups of
reporter facilities. The first group
comprises those companies and other
entities whose manufacturing pro -
cesses cause direct GHG emissions, such as in the produc-
tion of electricity, food, iron and steel, and ethanol. Those
companies will report the GHGs generated from six major
gas source categories (also known as the Kyoto six) used
in facilities manufacturing processesnamely, carbon
dioxide, methane, nitrous oxide, aerosols (chlorofluorocar-
bons), refrigerants (e.g., Freon), and sulfur hexafluoride
(a helium-like heavy gas used in the electric industry).
Direct emissions are also known as scope 1 emissions.
The second group comprises supplier or distributor
companies that supply mostly fuel (e.g., coal, natural gas,
petroleum, or fluorinated gas) to others, which will pro-
duce GHG emissions when released (combusted or oxi-
dized) by those who purchase the product. These compa-
nies will report both the volume of product and the GHG
emissions associated with their release. As part of the EPA
requirement, e-GGRT reporters will also document their
monitoring and quality assurance plans and submit signed
certification statements.
Though detailed, the new EPA rules are less than
comprehensive regarding companies overall carbon
footprint, especially in two important respects. First, the
rules do not require reporting of most indirect emissions
caused by a manufacturer, such as emissions from pur-
chased electricity or another energy source (also known
as scope 2 emissions) or indirect emissions caused by the
transportation of purchased materials, employee travel,
and solid waste (scope 3 emissions). This omission is
interesting because scope 2 emissions can be highly signif-
icant and can well exceed scope 1 emissions for many
companies. For example, in 2009, Gap produced an esti-
mated 527,722 metric tons of scope 2 emissions (mostly
from purchased electricity) but only 25,657 tons of scope
1 emissions. Only the EPAs version of the latter (scope 1
emissions) would be entered into the e-GGRT system.
Second, the EPA rules require
GHGs to be measured on a facility
basis rather than on the basis of the
consolidated entity. According to
the EPA, a facility means any tangi-
ble asset under common ownership
or common control of the entity
that emits or may emit GHGs cov-
ered by the 40 CFR Part 98 rule.
The upshot is that (in addition to
scope issues) the GHGs produced
within the economic or financial
boundaries of a reporting company
may not always marry with those
set by the EPAs narrower facility
definition. Thus, the EPA informa-
tion may lose some of its punch. From a strategic stand-
point, I would expect investors to be more interested in
how companies manage their worldwide carbon footprint
rather than how they comply with a federal reporting rule
that may or may not provide relevant information for
management decision making.
Guidance for Investors
What if investors and others already have some of the new
e-GGRT data on U.S. companies as a function of voluntary
reporting through surveys, such as the Carbon Disclosure
Project (CDP)?
1
Could some forthcoming e-GGRT infor-
mation be stale from an investor standpoint?
To understand how much GHG information is already
reflected in stock prices, my co-authors and I studied the
scope 1, 2, and 3 emissions reported to the CDP by the
Viewpoint
1 The Carbon Disclosure Project, an independent non-profit funded mostly by
large institutional investors, holds the worlds largest database on corporate
GHG and other climate change information. Other data registries with voluntary
reporting, such as The Climate Registry and the EPAs Climate Leaders, by com-
parison, list very few corporations in their databases.
Investors value a
company less when
it has higher GHG
emissions, other
valuation factors
remaining the same.
S&P 500 and the Toronto Stock Exchange (TSE) 200 over
the 200509 period and found a negative relation between
stock price and GHG emissions per share.
2
In other words,
investors value a company less when it has higher GHG
emissions, other valuation factors remaining the same.
This relation holds because investors buy and sell deci-
sions about stocks are influenced by a perception that
companies with higher GHG emissions will likely experi-
ence more future cash flow drain in the form of higher
compliance, abatement, regulatory, and tax costs, which
are not already reflected in the markets assessments of
current earnings and common equity.
3
A negative relation
between GHG emissions and stock price also suggests that
higher GHG emissions impose additional business and
credit risks from enforcement uncertainty and environ-
mental litigation.
What is more, we found that this negative relation is
also more harmful for stock price when a company has
high GHG intensity. The most common measure of
GHG intensity deflates total emissions (usually scope 1
and 2) by sales revenue (in US$ millions). In fact, many
companies monitor GHG intensity closely and use it to
measure their progress in meeting GHG goals. Some com-
panies also like GHG intensity as a metric because it can
reflect a more favorable picture of environmental perform-
ance, in that the measure scales high absolute emissions
with high production or sales. For example, in its 2009
corporate responsibility report, U.S. computer manufac-
turer Dell reported a 2009 GHG intensity score of 6.65
(406,252 metric tons of scope 1 and 2 GHGs divided by
US$61.101 million net sales). While this score was a 6.6
percent drop compared with 2008, it still contributed to
Dells stated operational goal of a reduction in company-
wide GHG intensity of 15 percent by 2012, using 2008 as
the base year. How investors might have reacted to Dells
6.6 percent drop is unclear, but in the aggregate, our
research shows that high GHG intensity definitely matters
as a valuation driver.
Many companies do not report their GHG data to the
CDP or to other registries. For example, only about one-
half of the S&P 500 companies disclosed their GHG data
to the CDP in 2009, and GHG information for most other
U.S. companies is presently limited to voluntary reports
or other analyses. Nevertheless, an efficient market should
factor emissions information into stock prices from multi-
ple channels, not only from the CDP or other data reg-
istries. My co-authors and I estimated greenhouse gas
emissions for CDP non-GHG discloser companies based
on their industry and operating characteristics and pro-
duced the same findingsstock prices vary negatively
with estimated GHG emissions, and the negative relation
between GHGs and stock price strengthens for high
emission-intensive companies. Under the e-GGRT system,
investors and analysts will soon be able to track GHGs
and GHG intensities for thousands of companies (at least
for scope 1 emissions) without resorting to surveys or
estimates.
Nine Ways to Benefit from e-GGRT Data
What specifically might investors and analysts examine
regarding GHG emissions as a valuation factor? Nine
considerations top the list:
Compare and resolve differences in levels and year-to-year
changes between the EPA-reported GHGs and those reported
voluntarily to the CDP or other registries. One comparison
would focus on the characteristics of first-time GHG
reporters versus the others (the characteristics of compa-
nies that did not submit similar information on a volun-
tary basis to the CDP or other registries versus those that
did). Investors might respond most negatively to a high
GHG-intensity company that did not submit voluntary
information earlier, as the new EPA information now
reveals the company is a high GHG-intensity company,
which might have been the reason for nondisclosure in
the first place.
Focus on reconciling trends based on the new EPA data versus
the voluntary data. Such reconciliation would provide addi-
tional insight, especially if the trends have contradictory
implications. Although the EPA information should be of
higher quality, it may be less comprehensive regarding the
consolidated entity, particularly when there are interna-
tional operations. Moreover, the EPA does not require
companies to report scope 2 emissions, which could be
highly significant in amount and influential regarding
stock price.
Review and interpret companies 8-K, 10-Q, and 10-K climate-
change filings, and check for possible market reaction to the
new EPA disclosures. Also, with a considerable amount of
new and detailed information about GHGs from the e-
GGRT system as a backdrop, investors might see such SEC
disclosures in a new light. Further, some companies might
feel compelled to issue interpretive statements about the
e-GGRT disclosures via a news release or conference call.
Examine GHG disclosures for opportunistic behavior. Many
companies establish a base year for GHG emissions and
GHG intensity and track changes relative to that base year.
An overstatement of base-year emissions could create a
positive bias in GHG reduction and climate-change per-
formance. Some companies may change the base year
intentionally to improve performance.
Focus on non-S&P 500 companies with unexpectedly high or
low carbon intensity measures. Significant reductions in
GHG levels or intensity will generally signal positive news
2 Paul A. Griffin, David H. Lont, and Yuan Sun, The Relevance to Investors of
Greenhouse Gas Emission Disclosures, UC Davis Graduate School of
Management Research Paper No. 01-11 (available at ssrn.com).
3 Under present accounting rules, current earnings and common equity reflect
only the realized costs and benefits of companies climate change management
and reporting, not the expected net benefits.
to investors, but the stock market imposes greater scrutiny
on large companies in high absolute GHG industries, such
as utilities and oil companies. Hence, the new e-GGRT
measures of smaller companies are more likely to be news-
worthy for stock prices.
Pay attention to corporate green or sustainability rankings.
These are aggregate measures, and capital markets often
respond to rankings (or ranking changes) as summary
measures of complex information. Indeed, if history is a
guide, one should soon see a few key indicies emerge,
such as a company-specific GHG-intensity or intensity-
reduction index and/or a GHG disclosure score.
5
Be vigilant about confidential GHG disclosures. Under 40
CFR Part 98, certain information will be filed with the
EPA as confidential business information. The proprietary
nature of such information will enhance its appeal to
opportunistic market participants, which could lead to a
confidentiality breach, either from the company as a
strategic disclosure vis--vis a competitor or as privileged
information to insiders and other investors who might
trade to gain an unfair advantage.
Use the EPA disclosures to estimate the potential off-balance-
sheet cap-and-trade liability. U.S. federal cap-and-trade leg-
islation is on hold, and a judge has temporarily halted the
California cap-and-trade AB 32 law on grounds of unfair-
ness to low income earners.
6
Still, the e-GGRT disclosures
will allow investors and analysts to estimate companies
AB-32 cap-and-trade liability in the event the California
plan overcomes its legal challenges. A simple measure of
this liability would be to multiply reported e-GGRT emis-
sions by the price of one ton of GHG emission.
Keep apprised of new challenges for analysts. Just as the
SECs EDGAR database led to a wide variety of value-
added services, expect a similar private-sector response to
the new EPA data. Some service providers exist already
and will simply upgrade their existing offerings to incor-
porate the new e-GGRT information. Others will emerge,
offering proprietary valuation and analysis software. Now
is the time to prepare for what could be a treasure trove
of new company information about the effects of and
companies strategies regarding climate change.
Paul Griffin is professor of management at the Graduate
School of Management, University of CaliforniaDavis.
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Date: October 31, 2011
I certify that all information furnished on this form is true and complete. I understand that
anyone who furnishes false or misleading information on this form or who omits material or
information requested on the form may be subject to criminal sanctions (including nes and
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5 For example, U.K.-based Maplecroft uses an emission reduction factor as part
of its climate innovation index to rate 350 large U.S. companies. The index is
based on five climate-change factorsmanagement (12.5 percent), mitigation
(12.5 percent), emission reduction (12.5 percent), innovation (50 percent), and
adaptation (12.5 percent) (www.maplecroft.com).
6 See the Superior Court of California decision of 18 March 2011 in Association
of Irritated Residents, et. al v. California Air Resources Board.
Congratulations to our members who recently achieved signicant milestones in the
CFA Institute CE Program as of calendar year 2010. These members have voluntarily
committed to the lifelong pursuit of professional excellence in an ever-changing global
investment industry.
We also recognize our rst group of members to complete 25 years of participation, and
applaud their ongoing dedication to professional development!
25 YEARS
A Commitment TO Excellence
The CFA Institute Continuing Education (CE) Program
Engaging in lifelong learning demonstrates your dedication
to serving your clients and employer.
John H. Conley, CFA CFA Society of Nebraska
Joseph T. Dabney III, CFA, CIPM CFA Society of Houston
David G. Diercks, CFA CFA Society of Madison
Richard B. Dole, CFA CFA Hawaii
Donald L. Gher, CFA CFA Society of Seattle
Clayton L. Liscom, CFA
John G. Mebane Jr., CFA CFA North Carolina Society
George W. Noyes, CFA The Boston Security Analysts
Society, Inc.
John D. Richardson, CFA Phoenix CFA Society
Robert H. Shaw, CFA CFA Society of Rochester
Robert W. Templeton, CFA CFA Society of Los Angeles
C. Thomas Tull, CFA CFA Society of Austin
Charles C. Walden, CFA
Ralph Collins Walter III, CFA CFA Society of Los Angeles
To learn more about the CFA Institute CE Program and to view
a list of colleagues who have achieved ve-year participation
milestones, please visit cfainstitute.org/learning.
20 YEARS
15 YEARS
10 YEARS
Gerald L. Fuller, CFA CFA Society of San Antonio
Clifford A. Gladson, CFA CFA Society of San Antonio
Kenneth L. Green, CFA
Hansen Burnett, CFA New York Society of Security
Analysts, Inc.
Tommy O. Huie, CFA CFA Society of Atlanta, CFA
Society of Milwaukee Inc
Todd Parker Lowe, CFA CFA Society of Louisville
Dennis W. McLeavey, CFA Providence Society of Financial
Analysts, New York Society of
Security Analysts, Inc.
Marguerite A. Boslaugh, CFA Hartford CFA Society
Jonathan M. Brodie, CFA CFA Society of Washington DC
John S. Clark, CFA CFA Vancouver
W. Kent Copa, CFA CFA Society of San Francisco
Thomas H. Dinsmore, CFA New York Society of Security
Analysts, Inc.
Bruce P. Eshbaugh, CFA The Boston Security Analysts
Society, Inc.
Martin Faucher, CFA Montreal CFA Society
James Kevin Flicker, CFA
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Sanjay Jagatsingh, CFA Society of Financial Analysts -
Mauritius
Geraldine M. James, CFA Toronto CFA Society
Priscilla Baker Jones CFA Society of Rochester
George S. Mellman, CFA, CIPM The Boston Security Analysts
Society, Inc.
John Mark Nussbaum, CFA
Trevor W. Nysetvold, CFA
Howard A. Pulker, CFA CFA Society of Orlando
Margaret Rubey Rust, CFA CFA Society of San Francisco
Mark H. Sinsheimer, CFA CFA France
Leif M. Sjoblom, CFA Swiss CFA Society
Mark C. Stevens, CFA CFA Vancouver
Peter C. Stimes, CFA CFA Society of Los Angeles
John D. Stowe, CFA CFA Society of Columbus
Eugene S.C. Wan, CFA
William R. Warnke, CFA CFA Society of Milwaukee Inc
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Krzysztof M. Ostaszewski, CFA CFA Society of Chicago
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Analysts, Inc.
Zoe L. Van Schyndel, CFA
Daniel W. Weber, CFA
Yu-Cheng Cheng
Kevin Michael Hodges, CFA CFA Society of Atlanta
John Henry Homier, CFA CFA Society of Houston
Darcy S. MacLaren, CFA CFA Society of Seattle
Mark C. Pocino, CFA CFA Society of Los Angeles
INTEGRITY
Market
The Value of Our Industry
Are investment professionals earning their fees?
Duncan commenced the conversation by citing
research statistics in which 85 percent of the equity man-
agers studied underperformed the market in nearly all
relevant time periods. Meanwhile, the amount of fees
extracted globally for this and other types of mediocre
financial-intermediation services is a staggering US$1.5
trillion annually.
The panel discussion included the following highlights:
Value proposition for investors: While panelists gener-
ally acknowledged poor relative investment performance
on a time-weighted basis along with high costs, industry
representative Haaga noted that time-weighted returns
are not the sole metric and that performance and deliv-
ery of value comes in many forms, including, most
importantly, dollar-weighted returns.
Challenges of educating investors: The vast majority of
people are ill prepared for saving and investing for
retirement, and despite mountains of available informa-
tion and educational tools, the ability to effectively close
the education gap is daunting. Even the investment
management industry, with its vested interests and all of
its resources, has been ineffective.
Fees and compensation in the investment management
industry: It is time for a more collective effort to define
and institute more credible, long-term-focused compen-
sation that rewards performance, not just asset accumu-
lation by managers.
Restoring trust, and how CFA Institute can contribute:
CFA Institute should support credible compensation
practices within the investment management business,
(along with regulators) hold industry practitioners
accountable, establish a culture of client-focused com-
pliance within the industry, and loudly and broadly pro-
claim its private commitment to market integrity. CFA
Institute has the brand, content, and resources to make
a difference, particularly when new industry scandals
are uncovered.
I hope youll take time to listen to this dynamic discussion,
and tune in for future installments in the Challenging
Industry Norms series. We invite your thoughts on future
Challenging Industry Norms topics as well as your feed-
back on the most recent discussion. Please contact us at
advocacy@cfainstitute.org.
To access podcasts from the Challenging Industry
Norms series, visit bit.ly/ChallengingIndustryNorms.
Kurt Schacht, CFA, is managing director of Standards
and Financial Market Integrity at CFA Institute.
BY KURT SCHACHT, CFA
If you have been following the Market Integrity section
over the past few years, along with our new Market
Integrity Insights blog (blogs.cfainstitute.org), you have
likely gained a better understanding of the policy issues
and standards on which CFA
Institute focuses. We are determined
to lead the investment profession
globally with the highest standards
for ethics, education, and profes-
sional conduct. But, as you might
expect, that aspiration is far more
challenging in practice. Believe it or
not, people around the world are not
necessarily clamoring for the next
ethical pronouncement from CFA
Institute (or from anyone else for that matter). Hence,
we saw the need to think outside the box in order to bring
both relevance and interest to the subject.
We think we are on the right track with our new
Challenging Industry Norms discussion series. The
virtues of acting ethically and with professional integrity
are best served warmor better yet, heated. To that end,
this new series examines long-held notions, even myths,
about the investment industry and how well it is serving
clients and society in general. There are countless oppor-
tunities in all directions as we aim to raise the tempera-
ture and build a robust debate around critical issues and
the complex challenges we face in restoring trust in the
investment management industry. Previous topics
included the ethics of financial reporting and the state of
ethical practice in the investment profession.
For the most recent discussion, CFA Institute tackled
the rather provocative subject matter of whether invest-
ment professionals are delivering value for their clients.
The discussion was held as part of the recent CFA
Institute Society Leadership Conference in Los Angeles. A
panel of experts discussed, among other things, whether
fee levels are appropriate and aligned with client interests,
whether these fees are contributing to distrust and a
growing restlessness with investment managers, and what
steps CFA Institute can take to improve investor trust.
Suzanne Duncan, global head of research for State
Street, moderated the panel discussion featuring Paul
Haaga, board chairman of Capital Research and
Management Company; Lynn Turner, former chief
accountant for the U.S. SEC; Rosalind Tyson, regional
director of the SEC; and Jason Zweig, Wall Street Journal
columnist and author.
C F A MA G A Z I N E N O V D E C 2 0 1 1 20
BY JONATHAN BOERSMA, CFA
As the global economy continues to expand, Latin Ameri -
can countries are playing a larger role. Consequently,
these developing capital markets are increasingly looking
to adopt global standards in order to improve their global
competitiveness.
Latin America is an area of strategic focus for CFA
Institute, and the Global Investment Performance Stan -
dards (GIPS) are a key tool for engaging industry partici-
pants. The GIPS standardsthe CFA Institute ethical
standards for the calculation and presentation of invest-
ment performance informationhave a broad geographic
reach through partner country sponsor organizations in
34 countries. These country sponsors have a formal role in
the development and governance of the GIPS standards and
are responsible for promoting the standards locally. Until
recently, however, no Latin American countries partici-
pated as country sponsors. But that is quickly changing.
On 23 September, Procapitales, a Peruvian organiza-
tion devoted to promoting good corporate governance
practices and attracting foreign investment in Peru, was
approved by the GIPS Executive Committee as the first
country sponsor in Latin America. This marks a signifi-
cant milestone not only for the GIPS standards but also
for the region. Industry organizations, regulators, and gov-
ernment officials in Argentina, Brazil, Chile, Colombia,
and Mexico all have expressed significant interest in
bringing the GIPS standards to their respective countries.
Whats Driving the Trend?
A number of factors are likely driving this sudden surge
of interest in the GIPS standards. The purpose of the stan-
dardsto allow fair comparisons of asset managers and
promote fair competitionis an obvious place to start.
Compliance with the GIPS standards creates a level play-
ing field on which asset managers from around the world
can compete. Firms in developing markets can compete
on the same basis as those in developed markets.
Another factor driving the expansion of the GIPS
standards in Latin America is the high degree of intercon-
nectedness and competition between countries in the
region. The recent creation of a joint stock exchange link-
ing Chile, Colombia, and Peru is a clear indication of how
these markets are becoming more integrated. With this
integration comes a need for a common framework for
regulation and industry standards; the lack of commonal-
ity regarding regulation has been an impediment to the
full integration of the joint stock exchange. Add to this a
very real sense of national pride and competition among
the countries in the region, and the ground is very fertile
for expansion of the GIPS standards. Peru has claimed the
spot as first GIPS country sponsor in the region, but the
race is on to determine which country will be next.
The global financial crisis also has played a role in
increasing the demand for compliance. As investors strug-
gle to recover from the latest blow to trust and confidence
in capital markets, the need for ethical standards and
increased transparency has never been greater. Firms that
comply with a voluntary ethical standard not only distin-
guish themselves among their peers but also help rebuild
confidence in the market as a whole.
Finally, with the expansion of mandatory savings
plans and personal pensions, the need for a standard to
allow apples-to-apples comparisons between funds is
essential. An executive at one of the organizations inter-
ested in becoming a country sponsor stated that the need
for the GIPS standards in his Latin American country is
very personal. He wants the various funds to comply so
he can compare them and have confidence that their per-
formance has been calculated and presented in a consis-
tent manner. This benefit may be the most compelling
reason of all for the increased interest in the GIPS stan-
dards, which are based on the principles of fair represen-
tation, full disclosure, fair competition, and comparability.
It should come as no surprise that the GIPS standards are
in high demand.
Jonathan Boersma, CFA, is executive director of Global
Investment Performance Standards at CFA Institute.
GIPS Standards Taking Root in Latin America
Financial News Names CFA Institute
Director of Capital Markets Policy
a Rising Star
Financial News recently named Rhodri Preece, CFA, direc-
tor of capital markets policy at CFA Institute, in its inau-
gural ranking of 40 Under 40 Rising Stars of Trading and
Technology.
Preece, 32author of a January 2011 research pub-
lication on the Markets in Financial Instruments Directive
(MiFID) that calls for increased transparency and a level
playing fieldwas invited to speak at the European
Commissions public hearing on the directive, where he
chaired a panel on data consolidation. The U.K. Treasury
also asked Preece to meet with its securities and mar-
kets team to discuss his research findings.
To view The Structure, Regulation, and Transparency
of European Equity Markets under MiFID, visit
bit.ly/mifid.
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Is Global Say on Pay Here to Stay?
BY MATT ORSAGH, CFA, CIPM
Though this is the first year most U.S. public companies are
required to implement say-on-pay rules giving investors
a nonbinding up or down vote on executive compensa-
tion, say on pay has been standard in a number of markets
for years. The Netherlands currently requires a binding
shareholder vote on executive pay, while a nonbinding
vote is the model in the U.K., Australia, Norway, Spain,
France, Germany, and Sweden.
Here is a quick review of where say on pay stands
around the globe:
United States
Those who support say on pay will point to the record 40
companies so far in 2011 (versus only three in 2010) that
garnered a no vote or failed to receive approval from at
least 50 percent of their shareholders. Meanwhile, critics
arguing that say on pay is a waste of time will stress that,
of the more than 2,500 U.S. companies holding such a vote
this year, more than 98 percent received majority support
for executive pay practices. A closer look at the numbers
shows that about 8 percent of U.S. companies received less
than 70 percent of shareholder support for executive pay
practicesperhaps not overly alarming but indicative of
a trend of greater investor dissatisfaction on pay issues.
It appears that shareowners are only voting against
pay plans they deem the most egregious. After all, there
does seem to be a price to pay in the U.S. for a failing say-
on-pay votelitigation. In 2010, two of the three compa-
nies that failed to receive majority support in say-on-pay
votes were sued by their shareowners. That number already
has been surpassed in 2011 and is projected to go higher.
Canada
The say-on-pay movement in Canada has not led to any
proposed legislation to mandate advisory votes on execu-
tive compensation levels or practices. However, some
Canadian institutional investors and corporate governance
groups are beginning to press for the voluntary adoption
of say-on-pay voting.
In January 2010, the Canadian Coalition for Good
Governance (CCGG) proposed a model board policy on
shareholder engagement and say on pay recommending
that boards increase the level of engagement with all
shareowners. And it appears that Canadian issuers are lis-
tening. In 2010, 44 issuersor 19 percent of companies
in the S&P/TSX Composite Indexvoluntarily held
say-on-pay votes. As of May 2011, that number had risen
to 80 issuers (approximately 35 percent of S&P/TSX
Composite Index companies).
Brazil
In late April 2011, PDG Realty became the first Brazilian
company for which shareholders rejected a management
compensation plan at the companys annual meeting.
(Disclosure of maximum, minimum, and average com-
pensations paid to publicly traded companies executives
has been mandatory in Brazil since 2010, but a number of
companies still do not comply with the rule.)
Investors of PDG Realty ultimately approved the
executive pay scheme in late June but only after the com-
pany agreed to full disclosure of its CEOs compensation.
It remains to be seen whether this is a harbinger of
increased activism on the part of Brazilian investors or
an isolated event.
Australia
The Corporations Amendment Bill 2011 was introduced
in Australia this year, serving as a wake-up call to
Australian directors. The rule gives shareholders the
opportunity to remove directors if the companys remu-
neration report receives a no vote of at least 25 percent
at two consecutive annual general meetings (AGMs). In
such instances, shareowners would vote on whether to
spill the entire board and, if passed by a majority, would
hold a meeting within 90 days to elect directors.
Not surprisingly, the rule was warmly welcomed by
investor groups, while the Australian Institute of
Company Directors (AICD) called it a heavy-handed
black letter law approach that would create unnecessary
red tape.
Switzerland
According to the results of a recent survey by the Ethos
Foundation, 56 percent of the Swiss companies under
review (27 out of 48) have proposed at their 2011 AGMs
an advisory vote on compensation systems or reportsup
significantly from 38 percent in 2010. The level of share-
holder opposition rose in 2011 to more than 16 percent,
up from 11 percent the previous year. For the first time in
Switzerland, a remuneration report was not approved.
Despite the increasing number of Swiss companies
that have adopted say-on-pay voting, many still choose
not to do so stating that they do not want to change their
practices unless it is legally imposed.
Elsewhere in Europe
European-listed companies may soon have no choice
but to give shareholders the final say on executive pay,
depending on the outcome of a public consultation on
corporate governance by the European Commission.
CFA Institute has joined other investors, companies, and
INTEGRITY
Market
Going Global
Global campaign to promote Asset Manager Code of
Professional Conduct
CFA Institute recently launched a global online advertis-
ing campaign aimed at raising awareness for the Asset
Manager Code of Professional Conduct (the Code) among
institutional investors and promoting adoption of the
Code by asset management firms.
The online advertising campaignwhich launched
22 August and will run for six monthsfeatures banner
ads on the online sites of such
publications as the Financial
Times, Pensions & Investments,
Investment & Pensions Asia, and
Investment & Pensions Europe.
The Code enhances investor
protection by encouraging
investment firms to voluntarily
adhere to a strict set of ethical
standards. More than 560
firms in more than a dozen
countries now claim compli-
ance with the Code, which
CFA Institute last updated in 2009.
CFA Institute recently created a practitioner-led Asset
Manager Code Advisory Committee to review, maintain,
and promote the Code. The new committee held its first
meeting on 24 June.
For more information, visit www.cfainstitute.org/
assetcode.
concerned parties in submitting comments on this con-
sultation. A final decision regarding say-on-pay rules in
the EU is expected by the end of 2011.
While shareowners around the world appear to be
warming to a say-on-pay standard, the details of what say
on pay actually means vary from market to market.
Overall, these rules have generally accomplished what
they were designed to dothat is, to get investors and
boards talking about compensation so pay issues can be
settled before a companys annual meeting.
To review comments from CFA Institute on the Euro -
pean Commission consultation, visit bit.ly/SayOnPay.
Matt Orsagh, CFA, CIPM, is director of capital markets
policy for CFA Institute.
CFA Institute Appoints Director of
Capital Markets Policy for Asia Pacific
CFA Institute has appointed Padma Venkat, CFA, to the position
of director of capital markets policy for the Asia-Pacific region.
She will be responsible for promoting CFA Institute stan-
dards, policies, and positions in the Asia-Pacific region where
she will monitor markets, conduct research on topics that pro-
mote ethical standards, and participate in conferences, soci-
ety events, and other public awareness activities.
Most recently, Venkat served as area director for Analog
Corporate Services, a corporate service provider. She also
worked as a consultant for the International Federation of Red
Cross and Red Crescent Societies (IFRC) and as a manager for
PricewaterhouseCoopers.
CFA Institute is co-sponsoring a contest to usher in a new
era in tools for accessing information within eXtensible
Business Reporting Language (XBRL)-tagged reports.
In announcing the contest, XBRL USthe nonprofit
consortium for XBRL business reporting standards in the
U.S. market said it seeks to uncover the first generation
of open-source analytic tools that will mine financial data
in ways never before possible.
A US$20,000 grand prize will be awarded to the com-
pany, team, or individual developer that submits the most
inventive and useful application leveraging XBRL-format-
ted data from the U.S. SEC EDGAR database.
XBRL US will accept submissions through 31 January
2012, with final judging and awarding of prizes in
February 2012. To help with development, participants
will be given tools and support from XBRL US, including
access to a database of XBRL financial fundamentals from
all public companies and technical documentation on how
to work with XBRL data. Entrants also will have access to
XBRL expertise through a series of in-person and webinar
meetings to help in working with the XBRL data.
Collaboration between developers and end-user commu-
nities is encouraged.
For its part, CFA Institute continues to support the
advancement of XBRL reporting. The benefits and chal-
lenges presented in our 2009 guide for investors remain
applicable today, and the number of companies around
the world delivering tagged reports to their regulators
continues to increase. The potential for new applications
to tap into these resources represents the next horizon for
the growth and acceptance of this reporting standard.
We want to foster the development of a wide variety
of innovative applications that will show the power of
XBRL tags to deliver insights that are currently locked
away in financial filings in basic text or PDF format, says
John Rogers, CFA, president and CEO of CFA Institute.
Corporate data in XBRL format will clearly benefit
investors, analysts, and a host of others by making more
accurate, actionable data available in ways not even imag-
ined today.
To view the CFA Institute publication eXtensible
Business Reporting Language: A Guide for Investors, visit
bit.ly/XBRLguide.
CFA Institute Co-Sponsors XBRL Challenge
M
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T

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N
T
E
G
R
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T
Y
BY DOROTHY KELLY, CFA
Client interests come first. This message, often repeated by
CFA Institute members and candidates, is at the heart of
Standard III(A)Loyalty, Prudence, and Care. On the sur-
face the concept seems simple, but it seems to present a
particular challenge in pension management where the
party that hires asset managers (and signs the checks that
pay their fees) is not the party actually paying the fees.
The fees come out of investment returns, and those belong
to the beneficiaries of the pension trust.
In an attempt to eliminate potential confusion, the
10th edition of the Standards of Practice Handbook
expanded its guidance to include a section on Identifying
the Actual Investment Client. With regard to portfolios
of pension plans or trusts the client is not the person
or entity who hires the manager but, rather, the beneficiar-
ies of the plan or trust. The duty of loyalty is owed to the
ultimate beneficiaries, not to the client who signs the
contracts or pays the fees.
The duties embedded in Standard III(A) require mem-
bers to act for the benefit of their clients and place their
clients interests before their employers or their own inter-
ests. The underlying concept is based on fiduciary rela-
tionships. The term fiduciary comes from the Latin
word fiducia meaning trust. In a fiduciary relationship,
one party entrusts another to act on his behalf and in his
best interest just as pensioners must entrust trustees,
managers, and administrators to oversee their retirement
funds on their behalf and in their best interests. A fiduci-
ary relationship is the highest standard of care, meaning
that the fiduciary must at all times act for the sole benefit
of the beneficiary.
While the legal requirements regarding fiduciary rela-
tionships and obligations vary from country to country,
the CFA Institute standard relating to client loyalty is the
global standard for all members and candidates. Regardless
of the regulations in various regions, members and candi-
dates must place their clients interests before their own.
Perhaps if the CFA Institute standard relating to loy-
alty, prudence, and care were more widely embraced, pen-
sioners worldwide might breathe a little easier. Pensioners
from Asia to Europe to the Americas have discovered they
have more to fear than inflation, market volatility, and
longevity risk. Around the globe, some managers, trustees,
and administrators entrusted with pension assets have
failed to place client interests before their own. In Thailand
in 2009, the secretary general of the countrys largest insti-
tutional fund, the Government Pension Fund, was dis-
missed over allegations of front running. In Switzerland,
the former head of asset management for the BVK Person-
alvorsorge Des Kantons Zrich, a CHF6 billion pension
Pensions and the Duty of Loyalty
Ethics
FORUM
fund, was arrested on charges of taking an estimated
CHF1.5 million in bribes related to awarding investment
mandates. In Sacramento, New York City, and other U.S.
cities, investigators allegedly have uncovered millions of
dollars in payments to a handful of politically connected
placement agents for directing billions in pension assets to
certain managersincreasing fees and reducing the invest-
ment returns and assets of pensioners across the country.
The respective governments have brought charges,
launched investigations, and (in some cases) meted out
penalties that included lengthy prison sentences. Some
payments, such as those made to placement agents, may
have been unethical but may not have been illegal. Conse-
quently, some governments have proposed new regulations
to crack down on the misuse of public pension funds.
The Professional Conduct Program (PCP) monitors
cases such as these for possible member and candidate
misconduct. Many activities in these cases (even the legal
activities) violate the CFA Institute Code of Ethics and
Standards of Professional Conduct (Code and Standards)
most notably those relating to independence and objec-
tivity; loyalty, prudence, and care; additional compensa-
tion arrangements; diligence and reasonable basis; and
disclosure of conflicts. Few of the most publicized cases
involved members or candidates under CFA Institute
jurisdiction, but the PCP monitors the cases to ensure that
allegations of member or candidate misconduct are inves-
tigated and sanctioned appropriately.
What can members and candidates do? First, they
can continue to adhere to the CFA Institute Code and
Standards. Second, they can educate colleagues, clients,
and prospective clients in the pension world on the ethical
obligations relating to pension trusts.
CFA Institute offers two publications to help educate
trustees of pension plans. A Primer for Investment Trustees
is a recent publication of the Research Foundation of CFA
Institute offering trustees with little investment knowledge
a quick study of important issues such as governance,
investment policy, the funds mission, risk management,
performance evaluation, and ethics in investing. Trustees
with more experience may be interested in The Code of
Conduct for Members of a Pension Scheme Governing Body,
which provides an ethical framework and guidance for
trustees of pension plans. When adopted by a governing
body as a code of conduct, The Code of Conduct for Mem-
bers of a Pension Scheme Governing Body shows a commit-
ment to placing the interests of pensioners first.
Dorothy Kelly, CFA, is a senior investigator for CFA Institute.
DISCIPLINARY NOTICES
Revocations
On 8 August 2011, CFA Institute imposed
a Revocation of CFA Institute membership
and the right to use the CFA designation
on Robert Levack (Canada), a charter-
holder member. CFA Institute found that
Levack violated Standards I(A)Knowl-
edge of the Law, I(D)Misconduct,
III(A)Loyalty, Prudence, and Care,
IV(C)Responsibilities of Supervisors,
and VII(A)Conduct as Members and
Candidates in the CFA Program of the CFA
Institute Code of Ethics and Standards of
Professional Conduct (2005).
In 2007 and 2008, Levack was the
chief compliance officer and portfolio
manager for Sextant Capital Management
(SCMI), the registered investment adviser
for the Sextant Strategic Opportunities
Hedge Fund. SCMI and the fund were cre-
ated and controlled by a former dentist
turned money manager named Otto Spork.
The fund had about 250 investors and
C$30 million in assets under management.
In May 2011, the Ontario Securities
Commission (OSC) determined that SCMI
and Spork had perpetrated a major fraud
on investors by (1) selling investment
fund units with falsely inflated values, (2)
taking almost C$7 million in performance
and management fees based on the
inflated values, and (3) misappropriating
more than C$4 million in the form of
advances from investment funds. The
fraud was tied to a small company called
Iceland Glacier Products (IGP) that held
indirect rights to a glacier, which it
intended to use as a source for selling bot-
tled water. The OSC found that from July
2007 to December 2008, Spork arbitrarily
increased the value assigned to the funds
position in IGP by 1,340 percent despite
the fact that IGPs business was not oper-
ational and had never generated any rev-
enue. At times, the fund was more than
90 percent invested in IGP even though
the private placement memorandum pro-
vided to investors had stipulated that
no single position would ever exceed
20 percent.
Levack was one of three respondents
who had worked with Spork at SCMI
named in the OSCs complaint. Prior to an
administrative hearing before the OSC,
Levack entered into a settlement and
(U.S.), a charterholder member, automati-
cally suspending his CFA Institute mem-
bership and right to use the CFA designa-
tion. On 22 June 2011, the U.S. SEC barred
Kelsoe fromthe securities industry as part
of an administrative proceeding brought
against Kelsoe, Morgan Keegan & Com-
pany, Morgan Asset Management (MAM),
and another Morgan Keegan employee.
According to the SEC, Kelsoe, the
senior portfolio manager of five funds
managed by MAM, instructed Morgan
Keegans accounting department to make
arbitrary price adjustments to the fair
value of certain portfolio securities. The
SEC found that these price adjustments
ignored lower values for those same secu-
rities provided by outside broker/dealers
as part of the pricing process and often
lacked a reasonable basis. The SEC also
found that Kelsoe screened and influ-
enced the price confirmations obtained
from at least one broker/dealer. Specifi-
cally, Kelsoe induced the broker/dealer to
provide interim price confirmations that
were lower than the values at which the
funds were valuing certain bonds but
higher than the initial confirmations that
the broker/dealer had intended to pro-
vide. The interim price confirmations
enabled the funds to avoid marking down
the value of securities to reflect current
fair value. On other occasions, Kelsoe
induced the broker/dealer to withhold
price confirmations when those price con-
firmations would have been significantly
lower than the funds current valuations
of the relevant bonds.
According to the SECs order, Kelsoes
actions fraudulently prevented a reduc-
tion in the net asset values of the funds
that would otherwise have occurred as a
result of the deterioration in the subprime
securities market in 2007. Accordingly,
the SEC found that Kelsoe caused and
willfully aided and abetted the Morgan
Keegan entities violations of the Invest-
ment Advisers Act of 1940 and directly
violated several provisions of the Invest-
ment Company Act of 1940. In addition to
agreeing to be barred from the securities
industry, Kelsoe agreed to pay
US$500,000 in penalties.
On 15 June 2011, CFA Institute imposed a
Summary Suspension on Michael Kimel-
man (U.S.), a charterholder member,
agreed to testify against Spork. As part of
the agreement with the OSC, Levack
admitted that he breached his manage-
ment duties under the Ontario Securities
Act to the detriment of investors. Specifi-
cally, he (1) failed to report working capital
deficiencies to the OSC and failed to take
the steps necessary to ensure that the
noncompliance was remedied, (2) failed
to ensure SCMI complied with require-
ments relating to the concentration of
investments within the fund, (3) failed to
prevent SCMI and Spork from making pro-
hibited investments, and (4) failed to
supervise the trades made and advice
provided by SCMI. Levack also agreed to
the termination of his registration under
the Ontario securities laws, a 10-year pro-
hibition from becoming registered again
and a C$15,000 administrative penalty.
On 28 June 2011, a Hearing Panel imposed
a Revocation of CFA Institute membership
and the right to use the CFA designation
on Run Yu (Peoples Republic of China), a
charterholder member. The Hearing Panel
found that Run Yu violated Standards I
Fundamental Responsibilities, II(B)Pro-
fessional Misconduct, II(C)Prohibition
against Plagiarism, and III(E)Responsi-
bilities of Supervisors (1999), and Stan-
dards I(A)Knowledge of the Law, I(D)
Misconduct, IV(C)Responsibilities of
Supervisors, andVII(A)Conduct as Mem-
bers and Candidates in the CFA Program
of the CFA Institute Code of Ethics and
Standards of Professional Conduct (2005).
From 2004 to 2007, Run Yu organ-
ized and participated with others in a
scheme to misappropriate confidential,
proprietary, and copyrighted materials
pertaining to the CFA examination. He
then used (and allowed others to use) the
stolen materials to promote and conduct
a business that provided examination
preparation courses for CFA candidates.
In doing so, Run Yu knowingly and delib-
erately acted (and conspired with others
whom he supervised) to use dishonest
and deceptive means to record and pho-
tograph CFA examination questions and
undermine the security and integrity of
the CFA Program.
Summary Suspensions
On 18 July 2011, CFA Institute imposed a
Summary Suspension on James C. Kelsoe
Ethics
FORUM
Permanent Prohibition
On 8 August 2011, CFA Institute imposed
a Prohibition from participation in the
CFA Program on Dmitri Vassiljev (Esto-
nia), a CFA Level III candidate. This sanc-
tion was based on the determination that
Vassiljev violated Standards I(A)Knowl-
edge of the Law, II(A)Material Nonpub-
lic Information, and I(D)Misconduct of
the CFA Institute Code of Ethics and Stan-
dards of Professional Conduct (2005).
Vassiljev, a financial analyst, had
access to material nonpublic information
relating to the proposed takeover of two
telecom companies through his employ-
ment by a financial institution that was par-
ticipating in the preparation of the takeover
bid. Based on this information, Vassiljev
purchased shares and options in the
stock of the two target companies during
712 August 2009. On 24 August 2009,
the takeover bid was publicly announced
and shares in both of the target compa-
nies rose by more than 20 percent.
In November 2009, Estonian prose-
cutors charged Vassiljev with insider trad-
ing. In December 2009, an Estonian court
entered judgment against Vassiljev find-
ing him guilty of misuse of material non-
public information and fining him in an
amount equal to 100 days of daily income.
Suspension
On 10 February 2011, a Hearing Panel
imposed a Two-Year Suspension of CFA
Institute membership and the right to use
the CFA designation on Marcus W. Robins
(U.S.), a charterholder member. This
result was subsequently reviewed and
affirmed by an Appeal Panel on 14 June
2011. The hearing panel found that
Robins violated Standards IFundamen-
tal Responsibilities, III(E)Responsibili-
ties of Supervisors, and IV(B.7)Disclo-
sure of Conflicts of the CFA Institute Code
of Ethics and Standards of Professional
Conduct (1999).
In 2008, the Financial Industry Regu-
latory Authority (FINRA), a self-regulatory
organization in the U.S., found that
Robins violated several of its rules gov-
erning the conduct of research analysts.
Specifically, FINRA determined that
Robins traded inconsistently with his
research recommendations 12 times,
traded during restricted periods 24 times,
failed to disclose his personal holdings in
five securities he discussed in articles
published in Forbes magazine, and failed
to maintain records demonstrating that
the articles complied with the applicable
rules. In addition, FINRA found that
employees of Robins firm, whom he
supervised, violated rules prohibiting
trading inconsistently with research
reports and trading within restricted peri-
ods. FINRA also determined that the firm
and an employee did not disclose com-
pensation received from a covered com-
pany and that the firm, acting through
Robins, had failed to adopt appropriate
written supervisory procedures. As a
result of these violations, FINRA sus-
pended Robins for 20 business days and
fined him US$31,459, of which US$16,459
was disgorgement of ill-gotten gains.
The CFA Institute Hearing Panel
determined that Robins conduct violated
Standard I, which required that he main-
tain knowledge of, comply with, and not
knowingly participate in violations of laws
or rules governing his professional con-
duct. The Hearing Panel also concluded
that Robins failed to reasonably super-
vise the firms employees to avoid viola-
tions of the applicable rules, thus violat-
ing Standard III(E). The Hearing Panel
also determined that Robins failure to
disclose that he had personal holdings in
five of the securities that he discussed in
articles published in Forbes violated Stan-
dard IV(B.7). Finally, the Hearing Panel
concluded that although FINRAs inquiry
began in 2006, Robins did not disclose
the matter to CFA Institute in his annual
Professional Conduct Statement until
2008, after he had entered into the settle-
ment with FINRA.
Resignation
Effective 5 August 2011, James A. Moore
(U.K.), a charterholder member, perma-
nently resigned his CFA charter, CFA Insti-
tute membership, and membership in
any CFA Institute member societies in the
course of a CFA Institute Professional
Conduct Program investigation related
to his conduct in 2008.
automatically suspending his CFA Insti-
tute membership and right to use the CFA
designation.
On 13 June 2011, Kimelman was con-
victed of two counts of securities fraud
and one count of conspiracy to commit
securities fraud in connection with the
Galleon Group insider-trading case.
The charges alleged that Kimelman
received material and nonpublic informa-
tion related to the acquisition of 3Com
through a network of paid informants,
including attorneys at a prominent New
York law firm. Kimelman then earned
profits by trading on that inside informa-
tion. Kimelman faces a maximum sen-
tence of 45 years imprisonment on the
three counts.
On 15 February, 2011, CFA Institute
imposed a Summary Suspension on
Shawn D. Baldwin (U.S.), a former affili-
ate member, pursuant to Rule 10.1(b) of
the Rules of Procedure for Professional
Conduct (2010). Under this rule, the Des-
ignated Officer may suspend a covered
person who is barred permanently, or for
an indefinite period, by a self-regulatory
organization (SRO) or government agency.
In this case, the Designated Officer
determined that the Financial Industry
Regulatory Authority (FINRA), an SRO in
the U.S., revoked Baldwins registration in
2009 for refusing to pay a US$25,000 dis-
ciplinary fine and permanently barred him
in two separate disciplinary cases for fail-
ing to cooperate, both of which became
final in 2010. Baldwin subsequently
requested a review of his Summary Sus-
pension by CFA Institute, pursuant to
Rule 10.3.
On 8 June 2011, a Summary Suspen-
sion Hearing Panel conducted a hearing
by teleconference. In his testimony, Bald-
win confirmed that his registration had
been revoked, that he was permanently
barred by FINRA twice, and that all three
matters were now final. The Hearing
Panel affirmed the Designated Officers
decision to impose a Summary Suspen-
sion permanently prohibiting Baldwin
from being a member of CFA Institute.
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KEY POI NTS
After disappointing results since 2008, the life-settlement
market may be recovering and could become a buyers
market, in particular for institutional investors.
Life-settlement funds are complex vehicles suitable only for
investors who can adequately evaluate the risks.
Portfolio
PERFORMANCE
Settle for More?
The life-settlement market may provide opportunities for institutional investors
BY RHEA WESSEL
orth roughly US$12 billion dollars at its
peak in 2007, the life-settlement market
is rebounding as more financing becomes
available, particularly from Asian pension
funds and European hedge funds. The industry has
regrouped after disappointments starting in 2008 that
were linked to frozen credit markets, the economic
decline, and revised life-expectancy tables that caused a
sudden downward revision to the value of life-settlement
contracts. (For more background, see A Brief History of
the Life-Settlement Market on page 30.)
The prospects in this subset of the longevity market
could be promising for institutional investors because
experts say the market is likely to remain a buyers
market for some time. An increasing number of individu-
als in the U.S. who own policies with a high face value
are interested in selling their policies in order to finance
their retirements or pay for medical care, and the amount
of capital chasing those deals is still less than at peak
times as a result of some investors taking a more conser-
vative approach. Were able to generate better yield and
be more effective in our life-settlement portfolio construc-
tion at the moment, says Sam Rosenfeld, the chief oper-
ating officer of the Atlanta-based, longevity-focused
investment firm Carolus Capital Advisors.
A life settlement takes place when an individual sells
his policy onto the secondary market via life-settlement
providers, such as the Coventry Group or Magna Life
Settlements. The policy owners receive more than the sur-
render value of the policy but less than the face value to
be paid out upon death. The investor becomes the owner
and beneficiary of the policy and continues to pay policy
premiums, keeping the policies in force and assuming the
longevity risk. If the insured lives longer than expected,
the investors return will decline. If the opposite is true,
the returns will go up.
Given the potential investing and ethical pitfalls of this
alternative investment, to which some people object on the
moral grounds that strangers have no insurable interest in
others lives, investors likely will want to ensure thorough
due diligence and consider following best practices cham-
pioned by industry associationssuch as the European
Life Settlement Association (ELSA), which is developing
standards across the market, particularly in Europe.
P
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Patrick McAdams, CFA, current treasurer of ELSA
and a former chairman, says he is optimistic about the
market and its outlook, despite the earlier lack of stan-
dards and the poor construction of certain pools of
investments that caused some investors to have bad expe-
riences. We strongly believe in the asset class and its abil-
ity to generate low-correlation and low-volatility returns
for investors, as long as life settlements are structured
properly and the investor is aware of the risks, he says.
In the recent past, negative outcomes have generated
headlines. For example, in 2004 and 2005, Deutsche
Bank collected more than 550 million from investors in
two tranches and then discovered that its life-expectancy
estimates were too low and the cost of its policies too
high. In 2009, the bank offered to buy back investments
from its clients at 80 percent of their value and scaled
back its operations.
Still, Rosenfeld shares McAdams positive outlook.
Structured correctly and funded correctly, this is an
uncorrelated asset, he says. But you have to surround it
with the correct risk management methodology, and you
cannot treat life settlements as liquid investments. Youve
got to buy and hold them to realize value.
Some institutional investors work directly with prov-
iders of life settlements to access pools of policies. Others
choose to go through an intermediary, such as a fund or an
investment firmthat structures pools of life settlements.
Both open-end and closed-end funds are available,
and boutique shops will help clients develop their own
pool of policies so that institutions can white label the
products and resell them to other investors or keep them
on their books as a proprietary position. Buyers may be
hedge funds, offshore funds, banks, or occasionally pen-
sion funds, and transactions are typically private place-
ments of unregistered securities. Sophisticated individual
investors who want to get in on the market typically go
through agents or brokers representing the providers of
life settlements.
According to McAdams, who works as the investment
director at SL Investment Management (a U.K.-based firm
that pools settlements on behalf of institutional investors),
having an intermediary between the institutional investor
and life-settlement providers, such as an investment man-
ager or fund, can provide a needed buffer, because prov-
iders of life settlements receive a spread or fees on each
sale and therefore have an incentive to sell high volumes
Portfolio
PERFORMANCE
W
of policies to investors. Investors, on the other hand, want
to obtain only those policies that fit their investment goals
(i.e., those policies that will pay out or mature as expected
at the time of acquisition).
You would never want to see cross-ownership or
similar conflicts between the investment manager and the
policy provider, says McAdams. Those two should be
at arms length. Effectively, its a completely independent
counterparty relationship.
Typically, the pool for which SL Investment
Management facilitates investments contains policies on
the lives of 300500 U.S. citizens and is worth US$200
million or more. But it has put together pools as small as
US$50 million and as large as US$700 million. The invest-
ment of US$700 million was the acquisition value of a
pool of commingled policies structured for a group of
investors McAdams declined to identify.
We would generally tell any institutional investors
who are considering building their own pool and not
entering into a commingled or fund vehicle that they
would need to put to work at least US$150 million to
cover the acquisition value of enough policies to achieve
reasonable diversification and to cover a prudent level of
reserves for ongoing premium expenses, says McAdams.
If the institutional investor puts money into a pool with
others, investments can start as low as US$250,000.
Rosenfeld, the author of a seminal report on longe-
vity-based financial instruments,
1
also points to proper
diversification as a critical best practice for institutional
investors. The key to investing in longevity-based finan-
cial instruments like life settlements is to ensure that you
have effective diversification and proper risk management,
which is normally gained through portfolio construction,
he says.
Another point to consider is the average face value
of policies in the pool. Diversification really depends on
the number of policies rather than the amount of money
invested, says Jrg Finsinger, a professor of finance at
the University of Vienna and the head of the Life
Settlement Institute. If policies in the pool are small, a
US$10 million investment could be diversified. If policies
are big, US$50 millionUS$80 million dollars would be a
better choice.
Intermediaries, funds, and institutions that are work-
ing directly with life-settlement providers and want to
conduct their own due diligence, or brokers representing
the sellers of policies often outsource to multiple third
parties the review of the medical records of the insured
people in the pool. Specialty firms in the business include
Fasano Associates, AVS Underwriting and 21st Services.
Such firms typically review the underwriting of the life-
settlement provider for each insured life and come up with
a life expectancy.
Finsinger warns investors to choose their life-
expectancy providers with utmost care and to consider
the firms incentives or motives because the independence
and accuracy of estimates play such a huge part in the
overall value of an investment in a life settlement.
SL Investment Management, for example, undertakes
an annual rating-agency style assessment of its approved
underwriting service providers and then weights the use
of life expectancies in its pricing and valuation models
based on the level of confidence it has in the providers
underwriting methodologies, systems, and controls.
Jeremy Leach, the managing director of Managing
Partners Limited (MPL), a Cayman Islands company that
specializes in setting up and managing traded life policies,
agrees that how policies are valued is a key question for
most investors.
Life-settlement funds are inherently complex vehicles
to manage and only suitable for sophisticated investors
who have the ability to assess the risk, says Leach. A
portfolio manager must demonstrate now more than ever
before its ability to manage risk in challenging market
conditions. The primary risk considerations for the asset
class are longevity risk, including the accuracy or mortal-
ity predictions, and currency risk (i.e., how non-USD port-
folios are hedged, liquidity risk, and the accuracy of valua-
tion methodology). With an open-end portfolio, a firm
would typically apply a mark-to-model valuation,
according to Leach, because a mark-to-market method
is simply not equitable to investors with a buy-and-hold
strategy. With a mark-to-model methodology, every policy
should be revalued on a monthly basis, and for every
month that passes, each person is expected to live longer
than was assumed the month before. By moving out the
life expectancy in this way and recalculating the future
premium liability, a portfolio manager is able to make
regular valuation adjustments that will deliver smooth,
predictable investment returns for the investors.
Leach adds that constant repricing will keep
investors from being disappointed the next time the
Society of Actuaries issues new life-expectancy data
or valuation basic tables. Leach said the average life
expectancy on policies owned by MPL is six to seven
yearsany longer and the mortality expectations would
be less quantifiable. And with shorter policies, even small
variations in life expectancy create a significant difference
in value and risk.
Rosenfeld says his firms best practices for life-
expectancy estimates include pricing the curve rather than
relying on a single figure from set actuarial tables. The
commonly accepted practice for a long time was that a
life-expectancy report would produce a number, which
was the median. The nomenclature was the median life
expectancy for 1,000 lives. And it would be a number of
months, such as 48 months or 96 months. This number
is then used as the basis for computer calculations. To
me, adds Rosenfeld, it is a basic precept of finance that
if youre working off a probability curve, which is what
1 Life Settlements: Signposts to a Principal Asset Class, Wharton Financial
Institutions Centre working paper.
a mortality curve is, you price the curve, you dont price a
single number. Ive been advocating this for years.
If estimates are offeven slightlythe risk for insti-
tutional investors is overpaying for policies or, if they are
using an open-end fund, they may not be able to redeem
funds as expected. For these reasons and others, the Life
Settlement Task Force indicated in its 2010 report to the
U.S. SEC that the market needed more significant and
consistent regulation of life-expectancy underwriters.
In light of the crucial role that life-expectancy
underwriters play in the settlement process, states the
report, the Commission should consider highlighting
to Congress and state legislators that investors and
market participants could benefit from more significant
and consistent regulation. Such regulation could cover
areas including licensing and qualifications of underwrit-
ers, privacy of customer information, and physician
review standards.
Other risks faced by institutional investors include
so-called headline risk (or the chance that an investor
may receive negative press for participation in a life-set-
tlement investment). This risk may have been one
reason some investors, such as Goldman Sachs, pulled
out of the market altogether. To mitigate that risk, some
investors ensure a minimum amount of the investment
goes to the policy seller. They can then argue that the
investment was a winwin situation for both the policy
seller and the investor.
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Plus, the definition of a security under U.S. federal
securities law could be changed to include life-settlement
instruments. In fact, a recent SEC report recommended
such a change, a move that could have tax ramifications.
In addition, some observers, such as Chris Kaplan,
CFA, managing member of SLK Advisors, are concerned
that life-settlement investments could cause capital market
volatility. In other words, the longevity risk and other
risks inherent in the investments could be overlooked as
the policies are repackaged and resold. They argue that a
breakthrough in medical technology that caused people
to live longer could suddenly cause the investments to
implode, possibly leading to declines in capital markets.
In my opinion, says Kaplan, the markets for securi-
tized products, whether life settlements or subprime mort-
gages, are under-regulated and few people understand
these exotic multiasset securitizations.
Institutional investors would like to put an end to the
life-settlement industrys high fees. Fees have decreased
since 2002, and McAdams believes they can come down
even more. According to Finsinger, in the past decade,
providers typically took 4 percent of the face value of a life
policy to cover their own expenses, such as licensing costs
in multiple states, and to pay agent commissions. Manage-
ment fees are often expressed in terms of the death benefit
and can become a substantial portion of the net asset value
of the investment.
Rhea Wessel is a freelance journalist based in Frankfurt.
Portfolio
PERFORMANCE
Having gained experience in the process of buying and sell-
ing life policies but lacking a supply of appropriate policies,
some market players began in the 1990s to develop a market
based on the policies of healthy people who held insurance
policies with a high face value. This market became known
as the life-settlement market. As the market grew, expected
returns were high, sometimes reaching 20 percent a year.
But in 2003, a viaticals company with 28,000 investors,
Mutual Benefits, was declared a Ponzi scheme and was shut
down by the U.S. SEC. After underestimating life expectan-
cies, the company, which used its own doctors for mortality
estimates, began to take money from new investors to pay
premiums on existing policies of older investors, thereby
depleting new premium funds.
In 2004, returns on life settlements dropped significantly
after European investors began to flood the U.S. life-
settlement market, thereby driving up the prices that policy
sellers were paid for their policies and driving down the
rates of return that investors received. From 2004 to 2006,
the expected annual return dropped to around 7 percent as
a result of the additional investors capital and a lack of
supply, which pushed up the prices paid to policy owners.
Beginning in 2007, mortality rates were revised upward,
putting out of business some players that had guaranteed
results to their investors and were not indemnified. In addi-
tion, questions arose about the independence of providers of
life-expectancy estimates, and some people speculated that
some firms may have been getting kickbacks from life-settle-
ment providers who wanted to persuade investors with short
life expectancies.
Looking back, we now understand why reputable
underwriters failed to provide reliable data on life expectan-
cies, says Jrg Finsinger, a professor of finance at the
University of Vienna and head of the Life Settlement
Institute. Underwriters relied on the mortality tables of the
insurance industry, which were designed to be conservative
and project a high number of people dying, and they often
based their mortality estimates on average population
samples, while those people who sold their policies were
instead the healthier bunch.
A BRIEF HISTORY OF THE LIFE-SETTLEMENT MARKET
KEY POI NTS
Several project management methodologies help organiza-
tions deliver according to budget and schedule.
Anecdotal evidence suggests that the more mature organiza-
tions become in managing projects, the less they spend on
that function as a percentage of the total budget.
Analysts should be familiar with project management
methodologies and build potential risks and rewards into
their financial models.
An Overlooked Value Driver?
Project management has a direct impact on financial
performance, yet it is often neglected by equity analysts
Analyst
AGENDA
BY SHERREE DECOVNY
ome industries and sectors rely heavily on deliver-
ing projects on schedulewithin budget and
according to predetermined specifications. A close
inspection of an organizations project manage-
ment capabilities sheds light on its operational efficiency
and potential financial performance. Armed with a better
understanding of project management, analysts can esti-
mate the impact of certain projects on cash flows, build
assumptions into their earnings models, estimate divi-
dends, and make recommendations.
Analysts can gain some insight into how well an
organization manages its projects by looking at the finan-
cial statements. Projects are financed under operating
expenses and/or capital expenses. Operating expenses
affect the profit and loss statement, and capital expenses
affect the balance sheet. Projects that run over budget
increase operating expenses and capital expenses, thus
impacting both financial statements. If the costs are capi-
talized, the capital expenses
will be higher and will be
depreciated over time.
A project that is com-
pleted under budget or
ahead of schedule will yield
a net present value higher
than the original estimate.
Conversely, budget overruns
and delays negatively affect
the net present value and often result in inferior quality
of work because the project manager tries to rush deliv-
ery. In addition, overruns tend to increase the weighted
average cost of capital over time, making it more expen-
sive for the organization to finance future projects and
generate a profit.
Project management has an impact on financial per-
formance, yet determining the return on investment is a
challenge. The definition of project management varies
between organizations and industries. Overhead costs
(such as the project managers salary, software, hardware,
and training) can be built into the equation; accounting
for intangible factors, such as the impact on an organiza-
tions image, is more difficult.
Deborah Bigelow, executive vice president at PM
Solutions, a project management firm based in Glen Mills,
S
Pennsylvania, advocates using a balanced scorecard
approach to measure the tangible and intangible value of
project management. The four main categories are finan-
cial measures, customer measures, project and process
measures, and learning and growth measures. Financial
measures include economic value added, return on capital
employed, sales growth, productivity, cost savings, and
earnings per share. Customer measures are satisfaction,
retention, acquisition, profitability, market share, and use.
Project and process measures encompass cost and sched-
ule performance, meeting technical specifications, quality,
resource utilization, time to market, project completions,
and risk management. Finally, learning and growth met-
rics are designed to capture employee satisfaction and
turnover, training time, productivity, motivation, empow-
erment, and information system availability.
Because financial statements may not tell the whole
story, analysts should investigate how well an organization
manages its projects to identify factors that may lead to
the development of strategies for successful project recov-
ery. PM Solutions surveyed
163 high-level project man-
agement employees from
large, midsized, and small
organizations in various
industries, including manu-
facturing, health care, tech-
nology, professional services,
finance, and government.
The study reveals that the
average firm manages US$200 million in projects annually,
and more than one-third of those projects are at risk of
failing. But when project managers take specific actions to
get troubled projects back on track, they are successful at
least 75 percent of the time.
Many factors determine the success of project recov-
ery efforts, and the project manager is obviously one of
the most important. The causes of failure include require-
ments that were unclear, contradictory, ambiguous, and
lacked agreement; insufficient resources, conflicts, and
turnover; unrealistic schedules; poor planning based on
insufficient data and faulty estimates; and unidentified,
assumed, or unmanaged risks.
The actions organizations took for successful project
recovery were primarily people related, emphasizing the
importance of an effective project manager. They
If the organization has a culture
of managing projects well,
the stream of positive cash flows
likely will increase into the future.
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Analyst
AGENDA
improved communication, redefined the project, added
resources, and replaced the project manager with someone
more experienced. Moreover, firms that used a standard
project management methodology had fewer than half as
many project failures as those that did not.
When speaking with analysts, most managers are
not forthcoming about project performance, and the com-
ments they make generally are cast in a positive light.
Having a better understanding of project management
helps analysts ask the right questions and ultimately
draw the right conclusions.
According to Nipun Agarwal, release manager at ANZ
Banking Corporation in Australia, finance is theoretical,
so analysts tend to think in terms of capital asset pricing
models, discounted cash flows, and NPVs. Project manage-
ment, however, requires a different mindset. It is a practi-
cal discipline that focuses on risks, schedules, and costs.
Analysts usually ask financial-related questions
BY NIPUN AGARWAL
Project management is an engineering
discipline that can act as the pulse of a
companys culture, especially in the
technology, pharmaceutical, mining, or
engineering industries. How well a com-
pany implements project management
provides a strong indicator to an analyst
on how well the company will deliver
results in the future and how to value a
company. Successful companies will
usually have flexible but structured
project management practices that
foster a supportive and innovative cul-
ture that will help them deliver projects
successfully on a regular basis.
Despite the importance of project
management to company performance,
equity analysts and investment man-
agers often dont review how strong a
companys project management abilities
are. This oversight occurs because ana-
lysts have not directly experienced how
a project is delivered. In general, project
management is more an art than a sci-
ence. Efficient organizations will have
strong but flexible standards in place
for project managers to follow that will
provide structure and may help them
get projects delivered on time and
within budget. Some organizations lack
a methodology and just push their proj-
ect teams to deliver the end result. A
third type of project management cul-
ture has so many processes that they
go against the project teams ability to
deliver a successful project.
Some companies are good at deliv-
ering projects because they provide a
sustainable environment and supportive
WHY IS PROJECT MANAGEMENT OVERLOOKED?
culture to deliver market-leading proj-
ects. Other companies may deliver
some successful projects in the short
term but are unlikely to deliver the more
complex changes over time. Company
cultures also persist for many years.
Even if a new CEO joins the company it
could take years before the companys
culture starts to change. Therefore,
understanding the way a company man-
ages its projects can help analysts esti-
mate the success of future projects.
Quantitative methods for measur-
ing project management exist. One such
approach is called earned value man-
agement (EVM). But statistical methods
alone are not enough to analyze the
future impact. Statistics provide only a
backward-looking estimate based on the
data we already have. [For more on val-
uation methods, see the main Analyst
Agenda article beginning on p. 31.]
Although EVM is quantitative and
has a basis in financial analysis, even
this method is not generally used in the
equity valuation area. Equity analysts
will often use models to assess the
future cash flows of projects, but they
will not usually analyze the perform-
ance of the specific portfolio of projects
from a project management perspective,
which would explain whether a com-
pany has a culture of managing risk and
delivering projects within budget, on
schedule, and at a high level of quality
that will support positive cash flows
and a higher future stock price.
Analysts also need to understand
more qualitative factors, such as
standards, processes, procedures,
and the risk management culture of
an organization. These factors can be
critical in explaining how competent a
company is in delivering projects. Some
of the best companies have excellent
project management practices and are
more likely to deliver successful proj-
ects compared with other companies
that may not have such project manage-
ment competencies.
Unfortunately, equity research
departments and investment manage-
ment firms traditionally do not hire
people with expertise in project man-
agement, although there has been a
trend of hiring people with expertise in
other specific areas, such as biotechnol-
ogists and IT entrepreneurs. Project
management is a much broader compe-
tency that could be used for valuation
purposes. This skill may not be specific
to an industry, like understanding the
effect of a new drug on the potential
market, but it does explain how suc-
cessful a company will be in coming
up with this new drug in the first place.
Often, it is not the technical ability that
defines the future success of a company
but its ability to implement ideas
through the projects it undertakes.
Decision makers of investment and
research firms should consider using
the expertise of project managers in
the industry to understand how this
soft skill can help develop realistic
future valuations.
Nipun Agarwal has 10 years of experi-
ence in project management and is
currently a release manager with ANZ
Banking Corporation in Australia.
R E C O MME N D E D R E S O U R C E S
Chain Reaction: Due Diligence on Supply-Chain Management Offers
Clues About Future Performance
CFA Magazine (Sept/Oct 2011)
(www.cfapubs.org)
because they dont have a project management back-
ground, he explains. You need to know the operational
side, and you need to know the project management side
because that has a direct impact on what the financial
consequences would be.
A good place to start is by scrutinizing the organiza-
tions project management office. Some companies do not
have good processes and tracking mechanisms in place
and do not have experienced managers overseeing the
projects. Calculating a return on investment is difficult.
Anecdotal evidence indicates that as organizations mature
and become more advanced in project management, a
lower percentage of the total budget is spent on the proj-
ect management function.
Agarwal suggests finding out what methodologies,
processes, and procedures the organization uses to deliver
projects. Look for indications that the methodology is sup-
portive and that red tape is not blocking delivery of current
projects and innovation required for future projects. Check
to see that the organization has a track record of managing
project costs, quality, schedules, and risks and that previ-
ous projects delivered a positive earned value and net
present value. Determine whether projects align with the
organizations strategy. Finally, identify whether the organi-
zation has a project management specialization and, if so,
whether it supports continuous improvement in delivery.
A few project management methodologies are com-
monly used worldwide. Agile is a methodology that breaks
projects into small pieces and delivers one at a time. The
analysis, development, testing, and support teams work
together closely. Through improved collaboration and com-
munication, the project is delivered sooner. Other method-
ologies include Six Sigma, PRINCE2 (developed by the
U.K. Office of Government Commerce), and the Project
Management Book of Knowledge (PMBOK, developed by
the U.S.-based Project Management Institute).
These methodologies are the foundation for earned
value management (EVM), a formal technique used to
analyze planned versus actual performance. The EVM
concept has been around for almost 40 years and is widely
used in engineering and construction projects. About a
decade ago, the U.S. government mandated that contrac-
tors use it for projects worth more than US$50 million,
and it is strongly recommended for projects worth more
than US$20 million.
If youre 10 percent behind schedule or 10 percent
over budget at any given time during the project, then that
means you have to take action to try to bring it back to
the original schedule, explains Young Hoon Kwak, associ-
ate professor of decision sciences at the George
Washington University School of Business.
Earned value is the present value of the budgeted cost
of work performed (BCWP) compared with the budgeted
cost of work scheduled (BCWS). Say the organization is
working on a US$100 million project to deliver a new
technology within two years. According to the schedule,
25 percent of the work is to be completed in six months,
so the BCWS is US$25 million. If 30 percent of the work
is actually completed, the BCWP or earned value will be
US$30 million and the schedule variance will be +5 per-
cent. If the actual cost of work scheduled (ACWS) is
22 percent, the cost variance will be +3 percent.
Earned value has direct implications for the cash
flows of the organization. If the project has positive earned
value, it should provide a positive cash flow. If the organi-
zation has a culture of managing projects well, the stream
of positive cash flows likely will increase into the future.
Kwak notes that after implementing an aggressive
earned value program, the Federal Aviation Administra-
tion reduced the cost of managing projects from 22 per-
cent of the total project cost to 13 percent. NASA is
another government organization that has achieved suc-
cess with earned value management.
Yet most companies are not mature enough to use
EVM effectively. They lack skilled people who know how
to collect information to track the budget and schedule
until delivery, coordinate various parties and entities,
and troubleshoot any problems that arise along the way.
If you go to a lot of project management offices,
you notice that things are not being done as they should
be done, so you have a lot of projects on your budget
getting delayed, says Agarwal. Its not easy to deliver
a project, and the bigger the project, the more complica-
tions you have. There are multiple parties and people
and a lot of dependencies.
Greater maturity results in better project performance
with respect to meeting the cost, schedule, and specifica-
tions. Better performance leads to even more opportunities
and financial benefits. As the organization becomes more
mature, the cost of applying and implementing project man-
agement decreases and the return on investment increases.
If you are in an organization that most of the busi-
ness or operation is done by project or program, the better
you manage the project, the better that it will influence
the overall financial performance of the organization,
says Kwak. Its as simple as that.
Sherree DeCovny is a freelance journalist specializing in
finance and technology.
Some companies do not have
good processes and tracking
mechanisms in place and do not
have experienced managers
overseeing the projects.
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34
Private KEY POI NTS
Income-, estate-, property-, and sales-tax rates vary
significantly among the 50 U.S. states.
Non-tax expenses, such as homeowners insurance, are
often overlooked in the financial analysis of relocation.
A complete review of potential savings for wealthy clients
should include how their assets are titled and located.
Recent studies have found that tax rates are not a significant
motivation behind decisions to move.
C F A MA G A Z I N E N O V D E C 2 0 1 1
BY ED MCCARTHY
our clients choice of domicile could be damaging
their financial health. Because states set their own
tax rates on income, sales, property, and estates,
clients tax bills can vary significantly across the
country. Robert Keats, founder and president of
KeatsConnelly in Phoenix, advises clients frequently on
variations in tax rates. Many of his clients are Canadians
moving to the U.S., U.S. citizens moving to Canada,
Canadians and Americans doing business in each others
countries, and people with assets moving back and forth.
The potential tax savings from relocating can be substan-
tial for some clients, provided they choose the right state.
California, New York, Hawaii are probably the three
worst states for somebody to move to [from Canada],
says Keats. I mean, theres just no question about it. For
example, for a person I talked with this morning, his taxes
in California versus Arizona would probably be some-
where close to US$75,000 to maybe US$125,000 a year
higher in California than Arizona.
If your clients live in a high-tax state, some are likely
to ask about the potential savings of relocating out of
state. Conversely, if your firm is based in a low-tax state,
you may receive inquiries about relocating to your area.
Kristi Mathisen, managing director of tax and financial
planning at Laird Norton Tyee in Seattle, has found that
the full range of local taxes and fees can trigger client
complaints. Either theyre complaining about their cur-
rent income taxes or theyve gotten an estimate of their
potential estate taxes, she says. To a limited extent, if
its not a high-net-worth client, perhaps an elderly retired
client, theyll be complaining about their real estate taxes
or their sales taxes.
Not a Simple Question
The topic of which states have the lowest and highest
overall tax costs gets covered frequently in the media.
Those articles typically create a hypothetical taxpayer with
specified income, spending, and assets and survey the
resulting tax costs across states for those figures. Its
unlikely that your clients will match the profile exactly,
which makes the results less meaningful even among
financial peers. For example, if your firm follows a tax-
managed strategy for clients portfolios, the amount of tax-
able investment gains and interest a client reports may be
much less than another taxpayer with similar wealth.
The Domicile Decision
The analysis can be complex, but emotions usually rule
Y
CLIENT CORNER
The published comparisons can also overlook tax-rate
variations within states. Mathisen cites the example of an
article that reported California as having an 8.25 percent
sales tax rate versus Washingtons 6.5 percent. Thats not
completely accurate, though, because Seattle imposes a
higher rate. I happen to have a receipt on my desk that
has a 9.5 percent sales tax rate, she says. Most internet
surveys are only going to pick up the published state sales
tax rate. Here in our stateand I dont think that were
uniquethe localities are tacking on some pretty hefty
taxes. So, in fact, our sales tax rate looks worse than
Californias because its 9.5 percent in the city of Seattle.
Its a really multi-factored analysis.
Multiple Costs to Consider
Many comparisons overlook estate taxes as well. Allison
Shipley, a principal with PricewaterhouseCoopers in
Miami, did an analysis for a client from the Northeast who
was considering a move to Florida. The estate is a huge
factor, she says. In New Jersey, for example, there is an
inheritance tax, and that tax can be as high as 16 percent.
And its assessed on a gross estateanything thats more
than US$675,000. Granted, certain people are exempt, but
for a certain profile of client, that can be a pretty severe
situation. Were all focused on the federal estate tax and
how the exemption just went up to US$5 million for this
year and for next year. So you might have a US$5 million
estate and have no tax for federal purposes but a pretty
significant state exposure.
Overlooked expenses in the new location can offset
tax savings, as Shipley learned firsthand when she moved
from New Jersey. When I moved to Florida, I was thrilled
that there was no state income tax, she says. But what I
didnt realize was what the cost of insurance on my home
would be. It must have been well over 10 times what I paid
in New Jersey for homeowners insurance, almost to the
point where I would have rather paid state income tax.
Keats clients have had similar experiences in Florida.
Sometimes, depending on a persons lifestylefor exam-
ple, if they like a big house with lots of amenities and that
sort of thingthey might be better off in another state for
income tax purposes because of the high property taxes in
Florida. We have some clients out there [in Florida], and
its just absolutely mind-boggling when their property
taxes are US$5,00010,000 a month. Its incredible. They
R E C O MME N D E D R E S O U R C E S
Jeffrey Thompson, The Impact of Taxes on Migration in New England,
Political Economy Research Institute (2011)
Robert Tannenwald, Jon Shure, and Nicholas Johnson, Tax Flight Is a Myth,
Center on Budget and Policy Priorities (2011)
Myths, Folklore, and Misunderstandings about Taxable Investment
Management, CFA Institute Conference Proceedings Quarterly (September
2011) (www.cfapubs.org)
35 C F A MA G A Z I N E N O V D E C 2 0 1 1
dont pay any income tax, but with that US$5,000 or
US$10,000 a month, they might as well be in a state that
has an income tax and lower property taxes.
Running the Numbers
Software can facilitate the process of comparing expenses
in different locations. KeatsConnelly has developed spread-
sheets that include all 10 Canadian provinces and the
50 U.S. states. The software allows the firm to determine
which state will be most tax efficient for a client and to rate
each states Canadian friendliness from a tax perspective.
Jim Ciprich, a wealth manager with RegentAtlantic
Capital in Morristown, New Jersey, uses software that lets
him vary a clients retirement date and state. That allows
the client to compare scenarios and the financial impact of
living in different states. If its a particular retirement date,
we can change the tax assumption frombeing in a state like
New Jersey to going to a zero percent income tax rate in
But Does It Matter?
The decision of where one lives involves more than taxes,
of course. Most clients have local ties to family, community,
medical care providers, etc., that theyre reluctant to break.
Quality of life is another critical factor. Consequently,
according to the advisers interviewed for this article, its
extremely rare for clients to change their state of residence
solely for financial reasons. A partial-year relocation thats
sufficient to meet the new states domicile requirements is
much more likely, especially when clients already live part of
the year in the second state and have developed ties there.
Several recent academic studies support the notion
that tax savings are not a key factor in most relocation
decisions, although the controversy continues. A report
from the Center on Budget and Policy Priorities in
Washington, DC, Tax Flight Is a Myth, claims that lower
housing prices are a much greater incentive than lower tax
rates. The studys authors point to Florida, which has no
income tax. In the latter half of the 2000s, according to
the authors, the state lost population, although there was
no major tax policy change. What did change was housing
prices, which had been relatively lower than those in the
Northeast but became more expensive. New Jerseys 2004
experience after increasing taxes on those earning more
than US$500,000 also refutes the likelihood of tax flight,
the authors believe. They cite research showing that, at
most, 70 tax filers earning more than US$500,000 might
have left New Jersey between 2004 and 2007 because of
the tax increase. Another 2011 study of migration patterns
in New England by the Political Economic Research
Institute at the University of Massachusetts Amherst also
found that the impact of taxes on cross-state migration
was weak. The main reasons for moving to another
state, the authors wrote, are employment, family-related
matters, and education. Taxes account for little of the
migration from New England.
Fortunately, some clients may be able to reduce taxes
without a long-distance move by relocating to a nearby
lower-tax state. If somebody is not inclined to go as far
away, maybe due to family within the proximity of where
they want to be, they could always go to a state like
Pennsylvania, for instance, Ciprich says of his New Jersey
clients seeking tax relief. Just cross the Delaware, and it
[Pennsylvania] does give preferential treatment to some of
the income derived from retirement sources.
Ed McCarthy is a freelance financial writer in Pascoag,
Rhode Island.
What impact is that going to
have on your net income?
Would that enhance what you could
leave to children and grandchildren,
or could it increase the amount
that you could spend?
JIM CIPRICH
Florida, he says. We may run one scenario that assumes
you spend the rest of your life in New Jersey and then switch
it to another scenario that at age 65 or 70 you decide to
change your domicile officially to Florida. What impact is
that going to have on your net income? Would that enhance
what you could leave to children and grandchildren, or
could it increase the amount that you could spend?
Wealthy clients finances are often complicated, and
Mathisen believes its critical that all of the clients finan-
cial advisers be involved in the relocation analysis. She
notes that the accountant knows the specifics of the
clients tax return and the sources of their income and
their lawyer knows how their assets are titled, an issue
that has tax implications. For example, for a Washington
couple thinking about moving to California, if they
own Washington real estate, moving to California will
not avoid a Washington estate tax for them because
Washington gets to tax real estate thats located in
Washington, she says. Washington also gets to tax tangi-
ble personal property. So the 100-foot boat thats docked
on Lake Washington and the plane thats sitting at a pri-
vate airfield and all of their cars, all of that is subject to
Washington tax even if the client has actually and effec-
tively moved to California.
AHalf-Open
Is the renminbi on the way to becoming
an international reserve currency?
BY CHRIS WRIGHT
Door
In
the offices of Hong Kongs banks and fund
managers, a transformation that will shape
the world economy is in its early stages
the slow but steady process of turning the
Chinese renminbi (RMB) from a heavily
restricted currency to one that is open and internationally
traded. The likely outcome, many believe, will be an inter-
national reserve currency to rival the U.S. dollar, and that
day may not be far away.
China today is at a halfway house between restriction
and openness. The current account is open and the capital
account closed. The situation has created some quirks
one currency behaving in a wildly different way depending
on whether its onshore or offshoreand a host of oppor-
tunities besides. The big topic of discussion in Hong
Kong, and elsewhere in Asia, is where it goes from here.
Slowly Opening the Door
For most of Chinas modern history, the RMB has been a
purely domestic currency tightly controlled by the central
bank, the Peoples Bank of China (PBC). When Chinese
companies conducted business with foreigners, the trade
would be denominated in U.S. dollars and pass through
the PBC.
The first hint of a change of heart came in 2003, when
personal banking services in RMB were permitted for
Hong Kong residents. The gesture was largely symbolic
and went no further than deposit accounts and a handful
of credit cards. The next came in 2007, when a few main-
land Chinese financial institutions, starting with the China
Development Bank, were allowed to issue RMB bonds in
Hong Kong. The following year, a handful of foreign
banks incorporated in China, such as HSBC, were allowed
to do the same. And in July 2009, China tried out a pilot
trade-settlement scheme, allowing five coastal cities to
settle their trade with Hong Kong, Macau, and southeast
Asian countries in RMB.
But the big steps came in 2010. First, the Hong Kong
Monetary Authority (HKMA, Hong Kongs central bank)
said that any institution permitted to issue a bond in Hong
Kong (that is, more or less anybody) would also be per-
mitted to do so in RMB. Shortly after, limits on Hong Kong-
based companies converting RMB, or launching invest-
ment products in the Chinese currency, were removed.
At a stroke, this created a whole new capital market: the
so-called dim sum bond market. In the three years leading
up to June 2010, when only policy institutions and the
big banks could issue bonds, total issuance amounted to
RMB34.3 billion in bonds. Twelve months later, gross
issuance had quadrupled to RMB138 billion (with RMB175
billion outstanding as of early September). Over the next
three to five years, the total size of the market might reach
RMB1 trillion, which would be close to 50 percent of
the whole Hong Kong dollar debt market, says Linan Liu,
Greater China rates strategist at Deutsche Bank.
On the trade-settlement side, the original five-city
pilot scheme has been steadily extended, from 20 cities at
first, then to a wider area, and in August 2011 to the
entire country. So any transaction between a Chinese and
an international partner can now be settledoutside
Chinain RMB.
The latest round of liberalization came when Chinas
Vice Premier Li Keqiang came to Hong Kong on 17
August this year. It was a pivotal moment. What he said
would give a clear indication about whether China was
comfortable with or alarmed by the pace of international-
ization of its currency and where it would go next. The
vote came down firmly in the positive. Not only is Beijing
still comfortable with the rapid pace of offshore RMB
market development, but it is taking the process to the
next stage, says Donna Kwok, economist at HSBC.
Among other things, the vice premier said that Hong Kong
enterprises would be allowed to invest RMB back into
China through foreign direct investment. This is crucial
because, until now, while it has become increasingly
straightforward for money to leave China, its been rather
difficult for it to find any way to go back in again and
serve any useful purpose.
So thats where the RMB stands today. But what doesnt
it have? The main missing piece is convertibility in the
capital account, which is one of the reasons that, so far,
most of the flow across borders in RMB has been in one
directionoutward from China. And this arrangement is
having some peculiar effects.
A Strange Case
Onshore and offshore RMB are referred to in shorthand in
the Asian financial industry: CNY for onshore, CNH for
offshore. Ever since people started to distinguish between
the two, CNY and CNH have been behaving in radically
different ways. Offshore, interest rates on RMB-denomi-
nated assets are low and have been falling because there is
far greater demand for ways to invest the currency than can
currently be met. Onshore, interest rates have been rising.
Traders have spotted an arbitrage opportunity, but its
already making some bankers uneasy. CNH doesnt exist
except in our heads, says an Asia country head of a major
western bank. We are all for helping China in what I think
it means to do, which is to make the RMB an international
currency of trade and settlement. But the arbitrage Im
saying to our wealth management people, be very careful,
because if all this unwinds, youve got nowhere to turn.
The sense of a strangely artificial environment also
exists in foreign exchange. Three separate foreign
exchange (FX) markets now exist for exactly the same
dollarRMB trade: the onshore market, a non-deliverable
forward market (which is how foreigners used to trade the
currency before this process of liberalization), and now
CNH (or offshore RMB). And there are pricing discrepan-
cies between these markets, which traders are seeking to
exploit probably not what China had initially intended.
But the biggest impact of this half-open door has been
an intense supplydemand imbalance, which has had a
major impact on the way the offshore RMB bond market T
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has developed. The heart of the problem is the pace with
which RMB deposits have accrued in Hong Kong. From
only RMB90 billion in June 2010, they rose to RMB572.2
billion by July 2011, according to the HKMA. Before a
recent slowing, deposits had been growing consistently
at a rate of 10 percent a month.
These deposits need somewhere to go. They earn
almost no interest sitting in the bank, so the holders of this
cash are anxious to find a return. This dynamic under-
pinned the growth of the offshore RMB bond market: the
dim sums.
The Dim Sum Boom
In the early days after the July 2010 liberalization, the
issuers were natural borrowers: Hopewell Highway
Infrastructure, McDonalds (which needs RMB for main-
land expansion), China Resources Power. But as the sheer
level of demand and pricing power became clearthe
Ministry of Finance for China paid only 1 percent for a
three-year bond in November 2010 in a deal that was still
10 times oversubscribed by institutionsmore and more
companies decided they should issue too. By the end of
the year, issuers included Galaxy Entertainment Group
(an unrated Macau casino developer) and the Russian
bank VTB. While theres nothing necessarily wrong with
either of these companies, they were able to raise money
at dramatically lower yields then they would have had to
pay in the dollar markets. At the same time, low-rated
Chinese issuers (or their Hong Kong subsidiaries), partic-
ularly property developers, began to jump in. The market
had gone from top-ranked government-backed banks to
high-yield issuers within a matter of months.
It didnt take long for this trend to become alarming.
Lawyers who have dealt with Chinese high-yield issuers
in the dollar markets are familiar with many dangers in
buying their debt. In particular, investors often find they
have absolutely no security over assets in China. Exactly
the same issues in relation to taking of security arise
whether the bond is denominated in RMB or not, says
Joseph Tse, partner at Allen & Overy in Hong Kong. But
with RMB bond issuance there is an extra layer of regula-
tory issues separate from the security issues, particularly
around repatriation of proceeds. Yet investors, so keen to
get a decent return on their money, didnt seem to be seek-
ing any covenants from issuers. The market seems to
have accepted that it can get comfortable with no security
from these companies, particularly those which are listed,
Tse says. Some of the deals earlier this year may have been
restructurings that were simply waiting to happen.
Why the clamour? Investors arent just after the yield
on the bond. They also believe strongly that the RMB is
going to continue to appreciate against the dollar, and
they factor that expectation (commonly 35 percent or so
per year) into any decision about buying a bond. But the
supplydemand imbalance is not really healthy for anyone.
Growth of 400 percent in the past 12 months [in offshore
RMB deposits] is pretty spectacular, and that created the
demand side of the supplydemand imbalance, which is
how the market developed, says Eric Greenberg, manag-
ing director of the financing group and head of leveraged
finance in Asia ex-Japan at Goldman Sachs. Out of the
gate, because offshore RMB was receiving such low inter-
est rates from the banks, it made RMB offshore bonds that
much more attractive for investors. That meant an ineffi-
cient market with longer tenor, loose covenants, and at
rates below which one could borrow in onshore RMB.
This is one reason that the August announcement
around allowing RMB back into China as foreign direct
investment is so important. By finding a way to recycle the
Chinese currency back onto the mainland, it may relieve
some of this supplydemand pressure. Already, bankers
feel that some balance is returning to the market. In the
last few months, the market inefficiencies have started to
narrow as there has been some pushback from investors
and the forward curve for RMB appreciation has come
down, says Greenberg. While retail and private banking
clients have focused on enhancing their deposit yields,
Greenberg notes a stronger price and covenant discipline
among institutional buyers now. On top of that, one of
Vice Premier Lis other announcements in August was that
all Chinese companies will now be able to launch offshore
bonds, which should help increase the available pool of
issuers creating more competition, higher yields, and a
better deal for investors. The demand and supply situa-
tion is beginning to correct itself, says Rita Chan, an
executive director at Goldman Sachs. That is reflected in
more scrutiny around whether the bonds are rated by
international agencies, how liquid the bonds are, and
whether the issuer is listed. Were moving toward a true
Regulation S standard rather thanas it was in the first
half of this yeareverything can sell.
Another shift might help redress the balancea
change in investors views on the currency. Expectation of
a climb in the RMB is near universal, but as the world econ-
omy has deteriorated, hitting Chinese exports, expectations
of the pace of that climb have become more conservative.
Earlier this year, people were expecting 23 percent appre-
ciation per year for the next five years, says Chan. That
was one reason they were so enthusiastic about investing.
But over the past few months, the forward curve has
shifted around. Greenberg adds: Currency movements
have helped evaporate some of the market inefficiency.
From an investor perspective, the allure of RMB assets
remains very clear, and any change in supplydemand
imbalances is in their interests. For investors in CNH,
just like elsewhere, you need to form an opinion about the
strength and quality of the investment, says Li Cui, chief
China economist at RBS. In particular, a lot of bondhold-
ers are attracted by the longer-term strength of the cur-
rency. Whats attractive about the RMB is Chinas eco-
nomic and trade size, the potential growth, much healthier
balance sheet, and (importantly) macro stability, which
bolsters confidence in the currency.
And investment in these bonds is no longer restricted
only to Hong Kong retail investors and institutions with
a backlog of the currency to put to work. Across Asia,
the private banking community is finding ways to get
positioned.
Given what is happening in Europe and the U.S.,
I think that is ultimately going to force the Chinese to
speed up the internationalization of the RMB, says Lee
Boon Keng, head of the investment solutions group in
Singapore for Swiss private bank Julius Baer. He expects
continuing RMB appreciation, more foreign institutions
issuing offshore RMB debt, and a much faster liberalization
of the capital account than many expect. Maybe a couple
of years, instead of a couple of decades, he says. It
makes the Chinese growth story that much more com-
pelling. He considers the loosening of the Chinese cur-
rency a megatrend.
In positioning his clients for this megatrend, he has
worked with Asian bank DBS to launch a fund that invests
in offshore RMB bonds. He is also encouraging investors
to look at the Chinese stock market. Im telling clients
that the equity market is at valuations last seen in 2005,
he says. This is a great opportunity. Why are you waiting
for that minus 1015 percent potential drop before you
dip yourself into the water? We may have bottomed out
already. Julius Baer has a QFII quota from China (quali-
fied foreign institutional investor is a system whereby for-
eign institutions are permitted to invest a set amount in
the mainland Chinese market) and is using it to launch a
fund investing in both A-shares (Chinese domestic securi-
ties in RMB) and H-shares (Chinese companies listed in
Hong Kong and traded in Hong Kong dollars).
Another opportunity that will evolve for investors is
RMB-denominated IPOs in Hong Kong. There has been
only one so far, a real estate investment trust (REIT) issue
for Hui Xian REIT, a subsidiary of Hong Kong conglomer-
ate Cheung Kong Holdings, in April. It didnt go especially
well. But in due course, this market will likely evolve
into another major market. Elsewhere, mutual funds built
around RMB assets are beginning to spring up. In the
other direction, Chinese clients will soon be allowed to
invest in exchange-traded funds (ETFs) in Hong Kong.
The Future
So where is all this heading? Some still dont believe that
China is looking for full convertibility. Allowing Hong
Kong to develop RMB offshore product doesnt necessarily
mean China wants to open the capital account, says
Christopher Wood, strategist at Hong Kong-based broker-
age CLSA and author of the influential Greed & Fear
Report. He describes the growth of the market as more
from the political desire to give Hong Kong a new toy.
He wont be convinced full liberalization is coming until
banks are able to lend RMB offshore and doubts that full
openness would be in Chinas interests anyway. The PBC
will lose control of the whole system if they open the
capital account.
Wood is in the minority, however. I strongly believe
full convertibility is the goal of internationalization, says
Liu. Post-financial crisis there is a growing recognition
that growth should be less dependent on the U.S. dollar
in trade, the pricing of commodities, and reserve manage-
ment. She thinks the domestic market needs five to 10
years of structural reforms to address issues concerning
the onshore banking sector before China will be ready for
full openness. At the right time, she adds, I would defi-
nitely look to the RMB to become a global reserve cur-
rencynot to challenge the dollar or euro, but to be one
of four major currencies in the global FX system [the
other being the yen], with the RMB hopefully one of the
main currencies for emerging countries.
This ambitiona reserve currency, strongly reducing
Chinas exposure to a declining dollar in which it already
holds more than US$3 trillion in reservesmay explain
why China is willing to tolerate the oddities and arbitrages
that inevitably come with the process of gradual opening.
Others believe such a scenario is far-fetched. Cui says
the RMB as a reserve currency is still quite some time
away and not really the point of liberalization. In the
near term, she notes, the main aim is to boost its role as
a vehicle currency for trade and investment.
Cui believes a lot needs to be done in the domestic
financial system before full convertibility will appear sen-
sible to China, and others share her opinion. For the
RMB to be fully convertible, we have to make sure Chinas
financial market is ready, says John Sun, executive direc-
tor of fixed income at CITIC Securities International.
The banks must become fully market-driven businesses,
in his view, because convertibility will open the financial
system to foreign markets directly. At this moment,
he explains, the financial market in China is not robust
enough to do that. Its not going to happen in the next
three or four years.
And if the RMB cannot be fully convertible, adds
Sun, then it cannot become a reserve currency for a rela-
tively long period of time. I dont see the possibility in five
years or even longer.
The wild card in all of this is how the deterioration
of the U.S. economy and currency is seen in China and
whether it may force the countrys hand to move faster
than it had at first intended. I still have confidence in the
U.S. economyit is still two and a half times larger than
Chinas, says Sun. Having said that, there is a global
problem with U.S. dollar depreciation because of the trou-
ble it causes in commodity prices and export inflation
from the U.S. to other countries. No currency, including
the RMB, can replace the U.S. dollar, but a lot of countries
are going to try to find a better way to make their financial
markets more stabilized. And that could be a catalyst to
faster changeand a new world currency.
Chris Wright is a freelance business journalist based in
Singapore.
HIGHER EDUCATION is perhaps the worlds least
controversial subject. Everyone agrees that its good for
both the individual and society, and virtually every govern-
ment subsidizes it in one way or another.
Lately, however, the U.S. model for delivering and
financing higher education has come under intense
scrutiny. Costs and related debt continue to soar while
graduates default on student loans in record numbers.
Could college education, like homeownership in the
previous decade, be a social good that becomes a liability
if managed and financed unwisely? And does the resulting
debt pose risks to the stability of the financial system?
Put more bluntly, is U.S. student debt a bubble that is
destined to burst like tech stocks and housing?
Washington Takes Control
The concept of student aid in the U.S. dates from the 1840s,
when Harvard University began subsidizing its students
tuition. But things really got rolling after the Second World
War with the enactment of the GI Bill, which financed the
education of returning veterans of that war as well as
other subsequent wars. In the 1970s, nearly three-quarters
of Vietnam veterans paid for their education this way.
Around the same time, the federal government began
subsidizing and regulating loans made by commercial
banks directly to students. Washington decided who
qualified and what interest rates students would pay and
indemnified lenders against default. The result was a hugely
profitable, nearly risk-free business for commercial banks
and specialized lenders, such as Sallie Mae and Nelnet.
This asymmetry of risk and reward rankled lawmakers,
leading Washington in 2007 to halve the interest rate on
subsidized Stafford Loans (the main type of student loan)
and scale back a host of other bank benefits. Banks
responded by partially withdrawing from the market, and
in a legislative rider that was quietly attached to major
health care legislation in 2010, the U.S. Department of
Education (ED) cut the banks out altogether and began
lending directly to students.
This is where the story gets interesting. Because the
ED can borrow at low Treasury bill rates, student loans are
a hugely profitable business for the government, with
higher volumes producing higher earnings. As a result, the
maximum loan amount available to students continues to
increase, with no end in sight. For the 200910 academic
year, the College Board, a higher education industry trade
group, estimates that total federal student aid (including
grants) was approximately US$147 billion, a 136 percent
increase over the past decade, with new loans (not
including grants) accounting for the bulk of this growth
(see Figure 1).
Viewed charitably, the result is one of those rare
winwin bureaucratic scenarios in which a government
agency can further a laudable goal higher education
at no cost to taxpayers. Viewed cynically, the result is a
daisy chain of moral hazard in which lending can soar
without regard for the quality of the product it buys or the
ability of the borrowers to pay it back.
Rising Tuition
This steady increase in the availability of government money
creates an attractive business environment (or, depending
on how you look at it, a license for unchecked growth)
for colleges and universities. Because students are able to
borrow more each year, schools can raise tuition at a
similar rate, safe in the knowledge that their customers
have access to the necessary funds. As a result, growth of
tuition and fees at private, not-for-profit U.S. colleges and
universities has consistently exceeded the rate of inflation.
Theyve had amazing pricing power. How many businesses I
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are able to raise prices for decades at significantly above
inflation? asks Vikram Mansharamani, Yale University
lecturer and author of Boombustology: Spotting Financial
Bubbles Before They Burst.
The result of this long-term compounding is striking.
Within the University of California system, for example,
average tuition in 1990 was US$2,000, which represented
about 6 percent of the states median household income.
Today, the average tuition is US$10,000, which accounts
for 17 percent of median household income.
Soaring Debt
Combine a government that profits from lending to students,
schools that profit from raising tuition, and students who
believe a college degree is worth virtually any price, and
the result is a self-reinforcing cycle of increasing loan
availability begetting rising tuition begetting soaring student
debt. U.S. students have incurred US$300 billion in new
debt since 2006, with the burden growing by 10 percent
in the past year alone. Student loans have surpassed credit
card balances (US$830 billion versus US$825 billion) as
the second largest category of consumer debt, behind only
home mortgages.
Today, says Mark Kantrowitz, publisher of financial
aid-oriented websites www.finaid.org and www.fastweb.com,
the average debt at graduation is around US$27,000, not
counting parent-plus loans [which parents assume to cover
expenses beyond available student loans]. With them, its
US$34,000.
Meanwhile, private loans (offered by banks to students
who need more than the US$20,000 annually the govern-
ment is currently willing to lend) are growing at double-digit
rates. These loans generally carry higher, variable rates,
and though interest payments are deferred until six months
after graduation, they accrue from the inception of the
loan. So theres a lot of negative amortization going on,
says Kantrowitz. The result: graduates with private loans
end up owing considerably more than they spent on tuition.
He estimates that US$160 billion of private student debt
is currently outstanding.
Diminishing Ability to Pay
Even in good times, soaring student debt would be an
ominous trend. But for recent and prospective college
graduates, these are not good times. Since 2000, the real
cost of college is up by 23 percent, yet the real earnings
of college graduates is down by 11 percent. And unem-
ployment among recent graduates is high and stubborn.
Whereas graduates in 2006 and 2007 had a 90 percent
likelihood of holding a job by the following spring, only
56 percent of 2010 college graduates were as fortunate.
Delinquencies and defaults, as a result, are soaring.
According to the ED, 8.9 percent of federal student loan
borrowers who entered repayment between 2008 and 2009
had defaulted by the end of 2010, up from 7 percent the
year before. And default rates understate the real extent of
the problem, according to a March 2011 report by the
Institute for Higher Education Policy, a Washington, DC,
think tank, which found that only about 37 percent of
borrowers from the 2005 cohort managed to make timely
payments. Default rates do not include the many borrow-
ers who become delinquent on their federal education
loans, but manage to avoid default, states the report. It
is important to note that for every borrower who defaults
there are at least two others who were also delinquent on
their student loans, but successfully avoided default.
The more recent the graduation, the worse the situa-
tion, says Richard Arum, professor of sociology and
education at New York University. Were following the
kids who graduated in 2009, and a year after graduating,
31 percent were living with their parents. They couldnt
find jobs and are highly indebted.
Meanwhile, even in default, this debt doesnt go away.
The Bankruptcy Abuse Prevention and Consumer
Protection Act of 2005 declared that student debt cannot
be discharged in bankruptcy and gave the U.S. IRS the
power to garnish wages and withhold tax refunds to get
what the ED is owed. Missed payments are simply added
to principal, so failure to pay results in a higher balance
when and if a borrower lands that elusive well-paying job.
The current lack of job openings is no doubt the
biggest reason for the surge in student loan defaults. But
the economy is apparently not the only problem. First,
says NYUs Richard Arum, Americans belief in the eco-
nomic value of a college degree has been inflated by an
unusually positive recent past. Theres always been a
return to college, but this was especially true between
1980 and 2008, when a credential was quickly and easily
rewarded with a good paying job.
So while a college education remains a valuable asset,
the widespread assumption that any amount of tuition-
related debt is acceptable because the returns will more
than compensate is misplaced. The bottom fell out in
2008, and I dont think its coming back, says Arum.
Even more ominous, Large numbers of students are
going through university without really improving their
human capital. Theyre not coming out any more produc-
tive than they went in, says Arum. A study conducted
by Arum and University of Virginia sociologist Josipa
Figure 1
U.S. Federal Education Lending
US$ BILLIONS
SOURCE: BASED ON COLLEGE BOARD DATA
42.5
45.6
51.3
58.1
62.2
63.9 64.9
71
84.8
96.8
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
O
n the surface, the similarities between U.S.
higher education and the recent housing
bubble are compelling: A universally desired
good is dangled in front of an ever-growing
population of borrowers at ever-higher
prices and paid for with government-subsidized easy money
resulting in rising debt and deteriorating outcomes.
But is it actually a bubble, with all the future turmoil that
a bubble implies? Vikram Mansharamani has conducted a more
systematic analysis, viewing the higher education/student
loan market through five lenses:
Microeconomics. Normally, price is determined through the
interaction of supply and demand. A rising price depresses
demand and stimulates supply, leading to a stable or lower
price, and vice versa. But in a bubble, you have a reflexive
dynamic in which price and demand rise at the same time. With
higher education, tuitions are up dramatically but enrollment
keeps rising. We seem to have one red flag, says
Mansharamani.
Macroeconomics. Credit market dynamics [in the form of
student loan availability] are clearly supporting higher prices.
Federal financial aid has risen almost exponentially in the last
couple of years. This, says Mansharamani, recalls the
embedded financial instability hypothesis as described by
[former University of California professor] Hyman Minsky. He
talks about a migration of credit supporting prices that moves
from hedge financing to speculative financing to Ponzi financing.
Over time it takes more and more debt to support that same
asset price. [In education], credit volumes are rising even more
rapidly than prices, so an increasing amount of education
spending is supported by debt. Thats red flag number two.
Psychology. In a bubble, participants display overconfidence,
hubris, an almost religious belief in something. Today, as
Mansharamani sees it, the idea that a BA is a good thing has
morphed into the belief that going to www.diplomamill.edu
and getting an online degree in massage therapy for
US$50,000 is a smart career move.
Political Support. Mansharamani asks, Has the government
gotten involved and created a sense of moral hazard or price
manipulation? Is there a philosophical or value-based belief
thats driving the politics of funding? The similarity to the
housing bubble seems eerie. We once believed that housing
was a right that every American was entitled to; we now
believe the same thing about a college degree, he adds.
From this perspective, the EDs uncritical granting of loans for
virtually any type of higher education echoes the Community
Reinvestment Act, the rise of Fannie and Freddie, and the
subprime mortgage market.
Biological. Think of a speculative mania as a fever spreading
through a population. How many people are left to infect? If
taxi drivers are talking to you about internet stocks, its not a
good time to buy. When the topic becomes such a broad and
pervasive element of popular discourse and starts attracting
the marginal participants to the party, its usually a late-stage
phenomenon, explains Mansharamani. The for-profit
education sector indicates that were now going after people
who may not be appropriate, though the pervasiveness of this
problem is not yet clear.
His verdict: I see 4.5 out 5. Its bubbly, and its probably
overpriced generically. People should be willing to pay a lot
more for a brand name than for an unknown school, but you
dont see as much price disparity between the top- and lower-
level schools as you might expect.
Roksa found that 45 percent of U.S. college students show
no significant improvement in critical thinking, complex
reasoning or writing by the end of their sophomore years.
Systemic Risk for Taxpayers
With the government now the main provider of student
loans, the securitization flow has diminished. Nonetheless,
private student loans from such lenders as Sallie Mae
and Discover are still packaged into bonds (known as
student loan asset-backed securities or SLABS) and sold to
institutional investors. SLABS worth US$10.6 billion were
created in 2010, with a similar amount expected for 2011.
Perhaps due to the recent credit market turmoil,
Credit quality in the private loan portfolio has improved
markedly. The overwhelming majority of private loans
now require co-signers, wrote Alex Sellinger, an analyst
with New York City investment bank NewOak Capital
Advisors, in a recent note to clients. As a result, private
loanswhich require a private lenders credit approval as
opposed to the automatic disbursement under [federal
student loan programs] for qualifying borrowersmay
perform better than federally guaranteed loans. Thus, a
SLABS meltdown does not appear to be imminent.
Longer term, however, the full-recourse feature
might actually become a liability. Unlike their housing-
bubble counterparts, [U.S. student borrowers] have
committed to a loan that they have to pay off no matter
what. No dropping off the diploma at the university
administration office and walking away from their debt,
says Massachusetts venture capitalist and author Eric
Janszen. College students are facing the worst employ-
ment market in decades. I expect theyll band together to
devise a way to not repay.
Does this scenario present systemic risks? Private
loans and their asset-backed securities are certainly prob-
lematic if borrowers demand a bailout en masse. But the
bulk of outstanding student loans carry a government
guarantee, so a mass default would mostly bypass the
securities markets and land directly on the federal balance
sheet, producing yet another increase in general taxpayer
liabilities. Whether this development would be decisive in
the overall scheme of U.S. finances is anyones guess.
The more serious risk may be to the U.S. economy
rather than its financial markets, says Mansharamani.
Giving kids an education thats useless and burdening
them with loans that they cant get out of is a negative for
the productivity of the country.
In any event, current trends cant continue much
longer, says Arum. Part of the system can maintain these
extraordinarily high tuition costs. Harvard will be fine.
But for broad-based access to higher education, I think
people will come into the industry and figure out how to
provide it more efficiently. Whether its the for-profits or
other entrepreneurs with disruptive innovations, there will
be a profound restructuring of higher education.
Growth Stocks or Short Candidates?
During the past decade, a whole universe of private,
for-profit companies has sprung up to run colleges and
trade schools, charging what the market will bear and
encouraging students to take out government loans.
Between 1.6 million and 2 million students attend these
schools, which generate taxpayer-funded revenues exceed-
ing US$20 billion annually.
The incentives built into the model and the societal
return on investment are controversial. In a nutshell,
the for-profits charge far more than community colleges
for degrees in such subjects as massage therapy and
computer-aided drafting. And unlike public universities
and private nonprofit colleges, they generally have open
enrollment, accepting anyone who can come up with
tuition, says Jeff Silber, an analyst who covers the industry
for Toronto brokerage house BMO Capital Markets.
Because the federal student loan program doesnt
discriminate between a student enrolling at Indiana State
University, Miami Dade College (a community college),
or for-profit Corinthian Colleges nursing assistant program,
the student attending the latter is able to qualify for loans
just as readily as those at the former.
And the for-profits revenue source (government loans)
is limited only by the number of students signing up. Not
surprisingly, for-profit college attendance has rocketed. Also
not surprisingly, for-profit graduates dont enjoy the same
success as those of more selective colleges. The former
represent about 12 percent of all higher education students
but account for 26 percent of all student loans and 46 per-
cent of all student-loan dollars in default. Currently, only
one-third of borrowers at for-profit schools are making timely
payments on their loans (see Table 1).
This flood of public financing has given the for-profit
industry stellar numbers and impressive market capitaliza-
tions (see Table 2). Lawmakers have responded with
tighter regulations. After a protracted debate (featuring
intense lobbying by the for-profits) Washington recently
issued new rules that require for-profit schools to prepare
students for gainful employment by 2014, defined as
having at least 35 percent of former students repaying
their loans.The final version of the rules was more
thoughtful and less onerous than the draft version we saw
last summer, says Trace Urdan, an analyst with Baltimore
investment bank Signal Hill. Another good thing thats
come from the regulations is additional disclosure. This
market works a lot better if consumers understand what
theyre getting.
Will this mitigate the moral hazard? Perhaps, says,
BMOs Silber. The new rules force them to focus more on
the outputs: retention, graduation, job placement as
opposed to just getting people in the door. Yet the basic
business model and its public financingremains
unchanged. For-profit education companies have 40 per-
cent earnings before interest, taxes, depreciation, and
amortization (EBITDA) margins and CEOs earning millions
of dollars, notes Mansharamani. You could cut those
funding sources by 20 percent off the top and theyd still
put up 10 percent EBITDA margins. What other industry
do you know that gets its funding from the government
and puts up those kinds of numbers? Its hard to imagine
in a resource-constrained society like this that well
continue to allow it.
John Rubino, a former financial analyst, is the author of
Clean Money: Picking Winners in the Green Tech Boom
and The Collapse of the Dollar and How to Profit From It.
Table 2
For-Profit Education Market Caps
US$ BILLIONS
DATA AS OF 19 JULY 2011
SOURCE: BASED ON DATA FROM YAHOO! FINANCE
Apollo Group 7,100
Bridegpoint Education 1,521
Capella 733
Career Education 1,900
DeVry 4,563
Education Management 3,590
Strayer Education 1,734
Table 1
Loan Default Rates
SOURCE: BASED ON U.S. DEPARTMENT
OF EDUCATION DATA
Predicted Three-Year
Type of College Default Rate for FY 2009
Public 4-Year 8.3%
Private Nonprofit 4-Year 7.8%
For-Profit 4-Year 29.4%
Has this financial crisis been predictable?
There are two sides to a crisis: the timing of when it unfolds
and what happens afterward. Predicting the timing is nearly
impossible. Some countries are more vulnerable than
others, and some bubbles are eventually going to burst.
But to predict the timingeven within a couple years of
a crisisis really impossible in theory and in practice.
The exact timing of the crisis depends on confidence,
which in turn depends on human emotion. Also, as
Reinhart and I show, there is often a lot of hidden debt
that comes jumping out of the woodwork when the crisis
unfolds. This can include debt the government was hiding
in its books and/or debt that is implicitly guaranteed. So, in
terms of when a crisis begins, one can perhaps talk about
a window of 510 years, but it is very difficult to be exact.
Now, after the crisis, there is a more predictable
pattern. The broad parameters of what happens in the
aftermath of a crisis (in terms of macroeconomic variables)
are surprisingly consistent across time, place, historical
circumstance, legal institutions, and political systems. It is
absolutely one of the things that fascinated us in research-
ing the book. We never imagined that there would be
such quantitative similarities.
By analogy, its extremely difficult to call the timing
of a heart attack. Even if a really good cardiologist finds
you have a lot of risk factors, you might go 20 or 30 more
years without an issue. On the other hand, even if you
exhibit no risk factors, it is still possible you might have
a major heart attack a week later. But once youve had the
heart attack, how it unfolds and how you recover has a
narrower range of trajectories.
What about the crisis surprised you most?
The single most surprising thing is how this crisis has
been tracking the average of the post-war financial crises
Reinhart and I examined in our January 2009 paper (The
Aftermath of Financial Crises), work that we present in
chapters 10 and 14 of our book. Would we have guessed
in January 2009 that the U.S. financial crisis would so
closely track our quantitative benchmarks on unemploy-
ment, housing output, equity prices, and debt run-ups by
government? The qualitative similarities are no surprise
we found them across crises. But the quantitative results
The Second Great
Contraction
THREE YEARS AFTER THE GLOBAL FINANCIAL CRISIS,
events are seeming eerily familiar to Kenneth Rogoff, co-author
with Carmen Reinhart of the 2009 book This Time Is Different:
Eight Centuries of Financial Folly. Historically, financial crises
and their economic effects have tended to follow a similar
pattern, and this one is no different, closely tracking the aver-
age for financial crises since 1945. In an interview with CFA
Magazine, Rogoff, the Thomas D. Cabot Professor of Public
Policy and professor of economics at Harvard University,
explains his views on the predictability of crises and their
aftermath, the likely time frame for recovery, why the current
crisis might more accurately be called the Second Great
Contraction, the link between debt burdens and growth, and
the possible return of financial repression.
The exact timing of the financial crisis may have been unpredictable, but
the trajectory of subsequent events has been entirely average and typical, says Kenneth Rogoff
BY JONATHAN BARNES
are remarkable. The U.S. crisis is so average. We are dazed
watching it unfold. Even the sovereign debt crises unfold-
ing today in Europe are part of a very consistent pattern.
As we strongly emphasize in the book and related papers,
sovereign debt crises tend to occur a few years after an ini-
tial financial crisis.
Are there likely outcomes we can expect?
The good news is that, so far, they have all ended. But the
time frame for recovery after a financial crisis is typically
more in the range of 610 years, compared with the time
frame for a recovery froma normal recession, which is typi-
cally a year or two. It has become very clear that we are not
going to have any kind of super-fast post-recession recov-
ery that, again and again, forecasters seem to be calling for.
Can anything be done to hasten the recovery?
There is an element to which the crisis just has to run its
course. Perhaps the biggest issue is how fast the country
can restructure debt and its financial system. The bad
news for the United States is that we did everything possi-
ble to preserve the status quo. We didnt directly tackle
mortgage debt in any aggressive way. We did everything
possible to kick the can down the road. We did everything
possible to preserve the existing financial system. In this
respect, we have paralleled the Japanese approach, a point
my co-author Carmen Reinhart has stressed from the
outset. There is a risk of a longer, slower recovery because
of this strategy.
What could have been done better?
You can look at examples like Canada and Sweden in the
early 1990s where recovery was faster, but these crises
were milder in many ways. The credit bubble was less.
These economies had their crises occur in isolation and
had giant depreciations of their exchange rate, which gave
them an export boost. Importantly, both Canada and
Sweden started with huge, overweening governments and
enjoyed big efficiency gains by shrinking those govern-
ments. I hesitate to say how much faster we could have
gotten out of the present situation, and there were risks in
any direction we moved. But there are things one might
have done differently.
I certainly would have had the U.S. government take
over more equity in the financial firms that it was helping.
I also think it could have been more aggressive in restruc-
turing senior bank debt, which was considered a third rail.
At least there should have been much greater conditional-
ity on the bank bailouts. At every turn I would have liked
to see the Fed have a more inflationary policy than it
didin order to accelerate deleveraging.
Whats your view on the U.S. debt-ceiling deal
of early August?
The silver lining in the debt deal is that Washington
finally began to get serious on the long-term government
debt trajectory. Unfortunately, that progress was poisoned
by the use of the debt ceiling as a blunt weapon for forc-
ing concessions. I think it is an awful way to do business.
Responsible countries separate the debt-ceiling issue from
fiscal decisions. The trouble isand I dont need to
explain this to your readerswe had already spent the
money. We were debating lifting the debt ceiling, but the
government had already locked in many commitments it
couldnt really back out of. To not raise the debt ceiling
was never really an option.
Do you see a link between debt burdens and growth?
Reinhart and I distinguish between public debt (owed by
the government) and external debt (owed by consolidated
public and private sector to foreigners). Our results on debt
and growth pertain to public debt for advanced countries,
where outright default is not the main issue. For advanced
countries, we find that public debt levels over approxi-
mately 90 percent of GDP are associated with slower
growth. Below 90 percent, the link is much weaker, though
subsequent IMF (International Monetary Fund) studies
suggest that more moderate levels of debt (e.g., in the 60
90 percent range) can also impact growth. Currently, the
U.S. is hovering around the 100-percent-of-GDP thresh-
old. It is important to stress that our work was the first
paper on this topic to use cross-country long-dated histor-
ical time series on public debt, the development of which
was one of the major academic contributions of our book.
Now that our dataset is out, there will hopefully be a great
deal of further work casting more light on the topic.
Can you describe the crisis index youve developed?
Reinhart and I wanted an index that captures the global
impact of a crisis. We include banking crises, sovereign
debt crises, inflation crises, exchange rate crises, and (in
some versions) stock price indices (the BCDI index is made
up of a weighted crisis score for each country in terms
of banking, currency, default, and inflation). Looking at
the current crisis, it is really the first one since the Great
Depression that registers as a global financial crisis, which
is why Reinhart and I call it the Second Great Contraction.
Does the BCDI index have predictive power?
No, its only an index of the severity of the crisis.
How would an early crisis warning system work?
There is a whole literature on trying to predict crises, but
it is very limited. The problem is that to really be quantita-
tive, you have to have actual numbers. If you are trying to
predict a crisis a year from now, you are not going to get
very far because of the short datasets. As I explained ear-
lier, the precise timing of a crisis is difficult to call. Even
a severely crisis-prone country can go for an extended
period before the ceiling caves in.
Subject to those huge qualifications, large credit-
fueled appreciation in housing prices is one of the better
markers. Again, that is an area where we were able to
make progress by developing a cross-country historical
index on the real housing prices, allowing one to look at
the behavior of housing around a crisis. Curiously, rating
agencies have fairly little predictive power, controlling for
other variables. They tend to be lagging indicators. When
a rating agency downgrades a country, it typically means
that things went wrong a while ago.
Where do you see the this time is different
syndrome now?
The dramatic This Time Is Different was the policymak-
ers going around beating their chests that they had done
things better, wiser, and smarter than their predecessors.
Look at the September 2009 G20 communiqu which
boasted it worked. The general forecast among the poli-
cymakers was that the recovery would be relatively rapid,
and they seem to have convinced many Wall Street fore-
casters as well. In the event, hyperaggressive policy has
kept us afloat, but the slow halting recovery has still been
a fairly typical one.
Could greater transparency help avoid a crisis?
Of course, transparency would make a difference. It would
make it more difficult for countries to dig as deep a ditch.
Reinhart and I find that after a deep financial crisis, debt
comes jumping out of the woodwork because there is all
of this hidden debt. Again, one of the reasons that it is
hard to call the timing of a crisis is the data are not easily
available.
It is ironic that post-crisis government investigations
are crucifying the banks for their accounting sins, which
of course there were. But banks have nothing on govern-
ments. The most remarkable thing is how much difficulty
Carmen and I had getting long-dated government debt
data that would allow one to calibrate risks. Even the IMF
and World Bank did not publish anything before our book.
For many countries, getting debt data is like getting the
nuclear launch codes.
In addition to transparency, you also need somebody
to process the data and serve as a watchdog agency for
financial markets and for the public. One idea that is
growing in popularity is the development of independent
fiscal councils. Sweden has one. The United Kingdom
has a nascent one, which essentially provides independent
experts who give assessments of the fiscal policy based
on their own independent forecasts.
We do have the Congressional Budget Office (CBO) in
the United States. The CBO has a well-deserved reputation
for its technical excellence, but it does operate under one
fundamental constraint. It is forced to assume that existing
laws will be put into place exactly as specified. A true
fiscal council needs to be able to make its own judgments.
The IMF can play an important role, but it needs to be
protected from political pressures.
What is financial repression? Why is it important?
Carmen and I discuss financial repression in our book,
but she has really developed the idea extensively in some
of her own recent work. In a developing country like India,
there are all kinds of restrictions on what people can do
with their money. China famously is very restrictive. The
typical Chinese peasants have little alternative but to put
their money in a state-run bank, which pays them a pit-
tance in interest even though the free market rate is
much higher. This is what financial repression is. It is a
form of hidden taxation.
If a country has financial repression, the government
can really stick it to debtholders with inflation, for exam-
ple, because they have no easy way to escape.
This occurs mainly in developing or emerging markets?
Today, it is mainly in developing countries and emerging
markets. Carmen has speculated that it may come back in
a big way to the rich countries. I can only say that she is
often right in her predictions.
Bringing back financial repression wont be easy, but it
can come in through the back door of financial regulations
forcing banks, pension funds, and insurance companies to
hold government debt at off-market prices. We are seeing
some of this in Europe. Ask the Irish, Greek, or Portuguese
pension funds what has happened to themlately.
Are the Basel Accords a form of this?
They are. The Basel Accords are basically going to force a
higher holding of government debt, but it is not on a scale
yet that we saw during the period of extreme financial
repression after World War II.
Whats your outlook on sovereign defaults in Europe?
It is very hard to guess because so much depends on polit-
ical choices; this is not a pure economics problem. Perhaps
the most likely outcome is that we see defaults in Greece,
Portugal, and Ireland, but then Germany will finally be
forced to draw a line at Spain and Italy, however painful
that may be politically. In that event, the remaining coun-
tries in the eurozone will need to enter a much closer
monetary and fiscal union.
Jonathan Barnes is a freelance journalist and author of the
novel Reunion.
Bringing back financial
repression wont be easy,
but it can come in through
the back door of financial
regulations forcing banks,
pension funds, and
insurance companies to
hold government debt
at off-market prices.
A
primary lever in the asset management toolkit is
the policy portfolio, but how many investors slav-
ishly rebalance their holdings to maintain a prede-
termined mix of asset weightings? Investors devote sub-
stantial resources to arrive at an appropriate asset allocation
after carefully considering their need for return, risk
appetite, time horizon, liquidity, and so on. After a few
years, however, the asset weights are likely to have drifted,
with the very people who ran the optimizers and approved
the strategic portfolio probably sitting on their hands.
In fact, the most aggressive rebalancing likely occurs
among portfolios of small investorsworkers who are
saving for retirement and directing their money into
multi-asset balanced and target-date funds. Balanced, or
life stage, funds strive to maintain a constant asset mix
while target-date funds readjust their weights to conform
to a predetermined glide path. Both follow traditional
asset allocation policies. They sell assets whose weights in
the portfolio exceed a range and buy more of the assets
whose weights have dipped below an allowable minimum.
Whether conforming a fund to fixed asset proportions
or to orchestrated shifts, shedding relative winners and
buying relative losers represents a contrarian investment
strategy, with the implicit assumption that the market
will reverse at a time and to a degree that will enable the
investor to realize returns superior to a strategy of buying
and holding the market.
But no one can predict when the market will reverse.
What if, over a time period, the market trends more than
it reverses? Does it make sense to sell winners in what might
be a prolonged bull market or load up on losers in a free
fall? Even if investors wanted to revise their policy portfo-
lios to conform more closely to the market environment,
how many can perform the sophisticated analyses required
to arrive at a new strategic allocation that accounts for
expected returns and correlations of assets?
In his Graham and Dodd award-winning article
Adaptive Asset Allocation Policies (Financial Analysts
Journal, May/June 2010), William Sharpe, STANCO 25
emeritus professor of finance at Stanford University, pro-
poses an approach to rebalancing the policy portfolio that
many investors will find relatively simple to implement
and that also minimizes or avoids contrarian behavior.
Sharpe believes that both small investors and institutions
could find the model helpful when faced with the choice
of making significant trades to return the strategic port -
folio to predetermined weightings, abandoning the current
asset allocation policy for a new policy portfolio, or
doing nothing.
This is one of the most important challenges to tradi-
tional asset allocation that weve had in a while, says
Rodney Sullivan, CFA, FAJs editor, who reviews all articles
but doesnt get to vote on the Graham and Dodd awards.
I dont see as much research these days on asset allocation,
and you think theres nothing new to add until Bill Sharpe,
whos supposed to be retired, comes along with this pro -
vocative paper.The difference between being retired and
not being retired, says Sharpe, is that I dont get paid.
PassiveAggressive Behavior
The FAJ advisory council and editorial board honored
Sharpe with the top 2010 Graham and Dodd award at a
ceremony held this past September in San Francisco,
where Sharpe presented his paper to the CFA Society of
San Francisco. In a nutshell, Adaptive Asset Allocation
Policies describes a method for developing a funds asset
allocation policy that readjusts the major asset class
weightings not in relation to constant, predetermined pro-
portionsthe traditional asset allocation approachbut
relative to their proportion of total market value. Adaptive
asset allocation, as Sharpe calls it, implicitly recognizes
an investors risk appetite relative to, not irrespective of,
market proportions.
To understand the intuition behind adaptive asset
allocation, it might be helpful to review a key feature of
the strategy that it proposes to replace. A traditional asset
allocation policy states a target for each asset class as a
percentage of the total value of the fund. The percentages
are derived after considerable analysis and changed only
episodically. To accommodate disparities between policy
proportions and actual holdings, targets are set within
allowable ranges.
Over time, without active rebalancing, the disparities
can become quite substantial. Investors may frequently
rebalance their portfolios to restore asset proportions to
the predefined ranges, or they may revisit their asset allo-
cation policies when they become uncomfortable with the
size of the disparities. If they rebalance, they may believe
that they are taking a passive stance by following an invest-
ment style that goes against prevailing market trends.
Staying close to the policy portfolio, they pride themselves
on being disciplined in their investing by avoiding the
impulsive behavior of investors who jump ship as the
stock market is tanking or load up on equities in an
upswing. They may not realize it but making large and fre-
quent trades to bring a portfolio back to a previously set
asset allocation policy is active contrarian investing.
Adaptive Asset Allocation
In an award-winning article, William Sharpe
proposes an asset allocation approach that down-
plays contrarian behavior by setting asset weights
relative to (not irrespective of) the market
A key assumption underpinning the traditional, con-
trarian investment approach is that someone will take the
opposite side of the trades. But who are these investors
who will abandon their own traditional asset allocation
policies to trade with the contrarian investor? To be work-
able, a traditional approach to asset allocation policy
requires trend followers who will take the other side of the
contrarian approach in transactions. Obviously, not all
investors can be contrarians, and as a result, not all
investors can follow a contrarian policy.
Market Efficiency
Why would an investor adopt a contrarian strategy? There
are two possible reasons. The investor may believe that
markets are efficient. When adopting an investment strat-
egy, an investor must make an assumption about the
nature of future security markets as well. Contrarian
strategies will outperform buy-and-hold strategies in mar-
kets that experience frequent reversals (so-called sideways
markets); buy-and-hold strategies capitalize on markets
that are trending and end up far from their starting points.
It is possible that an investor who rebalances fre-
quently to conform to a policy portfolio is less concerned
than the average investor about inferior returns in very
good or very bad markets. But this seems highly unlikely
for the typical balanced-fund or target-date fund investor.
A more likely rationale for frequent rebalancing is a
belief that markets in the future will tend to move side-
ways more often than they trend, that markets are ineffi-
cient, and that investors who take the other side of con-
trarian trades do not fully understand the nature of asset
returns. Such trend followers, the thinking goes, will con-
tinue to hold assets that have become overpriced, enabling
contrarian investors to take advantage of them.
Sharpe believes that the majority of institutional
investors who adopt traditional asset allocations do so for
reasons that have nothing to do with their views on
market efficiency. Rather, they adopt a policy that reflects
both their riskreturn preferences and their special cir-
cumstances at the time. But when the portfolio begins to
drift from its initial proportions, it no longer serves its
original purpose.
In my experience in dealing with pension and
mutual fund boards, the discussion is, Where do we want
to be on the riskreturn spectrum? Do we want to put
more money into private equity because we dont need liq-
uidity as much as the average investor? Sharpe says.
The institutional investors adopt a policy and then really
dont follow it. They may shore up their asset allocation
policy at the time or shortly thereafter, but then they give
the equity money to specialized equity managers, their
fixed-income money to fixed-income managers, and so on.
Then, as the markets move, they basically leave the money
with their managers.
Maybe they do a little bit of reallocation with cash
flows, Sharpe continues, but they really dont act in a
contrarian way month by month, week by week, day by
day. It may be inertia, it may be just the whole nature of
delegated portfolio management, which the big funds use.
Or maybe you really dont want to just run around buying
losers and selling winners every day after all.
Highly Complex
The gold standard for arriving at an asset allocation policy,
Sharpe points out, is to get the inputs for portfolio opti-
mization by first performing a reverse optimization
backing out consensus capital market expected returns for
each asset class, as implied by the current capital market
mix of assets, and then incorporating the investors views
about the expected performance in order to arrive at
revised estimates of risks, returns, and/or correlations for
the major asset classes. These new inputs are plugged
back into the optimizer, yielding the preferred asset alloca-
tion policy.
Notice that the policy portfolio is, crudely speaking,
a function of investor characteristics and market forecasts.
Market forecasts are based on historical information, eco-
nomic theory, and market values at the time the strategic
policy is formulated. Why should market values inform
forecasts? Because current market values incorporate the
consensus view about the probabilities of future prospects.
Thus, market values should be taken into account when
managing a portfolio. But how many organizations have the
resources to develop a formal system that accommodates
real-world aspects? Such a systemrequires complex models,
and relatively few organizations are willing to undertake
the process frequently. Yet market value information is too
2010 GRAHAM AND DODD AWARDS
The Graham and Dodd Award for best article is presented
annually for the most outstanding article published in the pre-
vious years Financial Analysts Journal. In addition, several
articles are chosen to receive the highly respected Grahamand
Dodd Scroll Awards. The Graham and Dodd Best Perspective
Award recognizes the favorite perspectives article. FAJ readers
are also invited to weigh in by casting their vote electronically
for the most thought-provoking article from their viewpoint
(the Readers Choice Award). All awards salute excellence
in financial writing while paying tribute to Graham and Dodd.
The 2010 winners are as follows:
Scroll Awards
Economic Growth and Equity Investing, by Bradford Cornell
(January/February 2010)
In Defense of Optimization: The Fallacy of 1/N, by Mark
Kritzman, CFA; Sbastien Page, CFA; and David Turkington, CFA
(March/April 2010)
The Risk of Tranches Created from Mortgages, by John Hull
and Alan White (September/October 2010)
Best Perspectives Award
The Importance of Asset Allocation, by Roger Ibbotson
(March/April 2010)
Readers Choice Award
Opportunities for Patient Investors, by Seth Klarman and
Jason Zweig (September/October 2010)
important to ignore when setting the policy portfolio.
The inevitable conclusion is that an investors asset
allocation, expressed in the traditional manner as percent-
ages of total value in each asset class, should change over
time to reflect changing market values, even if the
investors characteristics are unchanged, Sharpe writes.
This conclusion is the key tenet of this article.
As an alternative to a reverse optimization/optimiza-
tion protocol, Sharpe describes a method that can be used
by a majority of investors to adapt their asset allocations
periodically in light of changes in asset values without
resorting to contrarian investing. With a few computations,
the policy proportions of the major asset classes can be
adjusted as market values change.
Follow the Math
In the article, Sharpe takes as an example a hypothetical
fund that invests only in U.S. stocks and bonds. The fund
establishes an asset allocation policy at the end of
February 1984 of 80 percent stocks and 20 percent bonds.
At the time, the proportion of each asset class to total
market value is 59.62 percent U.S. stocks and 40.38 per-
cent U.S. bonds. This information is taken into account
when setting the policy weights.
At the end of October 1990, the market capitalizations
of both asset classes have increased substantially. The ratio
of the ending to initial market cap is 1.6096 for stocks and
2.5757 for bonds. However, although the market values
of both stocks and bonds have risen, stocks are a much
smaller proportion of overall market value47.99 percent
compared with 59.62 percent.
To compute the new asset value proportions for a
portfolio with the same degree of risk relative to the
market as at the portfolios inception, the policy weight of
each asset is multiplied by the ratio of its ending value to
initial value. Thus, the initial policy weight of stocks, 80
percent, is multiplied by 1.6096, equaling 128.77 percent.
The same is done for bonds: 20 percent is multiplied by
2.5757, equaling 51.51 percent. The two adjusted propor-
tions are summed, equaling 180.28 percent (the sum is
greater than 100 percent because the outstanding values
of both assets have increased substantially).
Finally, the adjusted proportion of each asset class is
divided by the sum. For stocks, 128.77 percent is divided
by 180.28 percent, equaling the new asset allocation of
71.43 percent. From representing close to 60 percent of
the total market value, stocks have fallen to less than 48
percent. The policy weighting falls from 80 percent to an
allocation of 71.43 percent.
Its All Relative
The elegance of the formula is that relatively little trading
is required to bring the portfolio in line with its new asset
allocation. In a world with a fixed set of traded securities,
an investor who reinvests all cash flows in its own asset
class and makes no additions or withdrawals fromthe port-
folio would be in compliance with the adaptive asset allo-
cation at all times. Despite the real-world complications of
new stock issues, buybacks, redemptions, and so forth,
investors who follow an adaptive asset allocation policy
are not likely to have to engage in large asset purchases
and sales with investors who do not follow such policies.
The situation contrasts sharply with investors who follow
traditional asset allocation policies that ignore changes
in the capital market portfolio allocation.
The chart above shows how a multi-asset fund that
markets itself as aggressive might adapt the proportions
of its asset classes in light of changing market values in
every period. Rather than thinking of an aggressive fund
in absolute terms, it might be thought of as one that pro-
vides relatively more risk than the market at all times.
Using adaptive asset allocation techniques, the manager
rebalances the portfolio relative to the market.
The chart shows the actual stock proportions for a
fund that wishes to hold an 80/20 mix of U.S. stocks and
bonds when the market proportions are 60/40. Although
the proportions oscillate over the 35-year time period pre-
sented, the fund remains more aggressive than the market
throughout the period. The scenario suggests a simple way
to convert an existing balanced fund to an adaptive one.
A target-date fund can also convert from a traditional asset
allocation to an adaptive target date fund by applying the
adaptive formula to base allocations in every period along
the glide path.
Looking Forward
Although the examples in this article included only two
asset classes, adaptive asset allocation can be followed with
any number of major asset classes. Using adaptive policies,
funds should routinely compare their asset allocations with
current market proportions in order to ensure that any
differences are commensurate with differences between
their circumstances and those of the average investor.
The lack of available data on market values can make such
comparisons difficult. In time, sufficient interest may
develop among those who provide benchmarking indices
to make this valuable data more readily available.
Susan Trammell, CFA, provides business plan writing and
marketing research through her New York City consulting firm.
The chart shows the performance of an aggressive balanced fund that
has an intended 80/20 mix of U.S. stocks and bonds when their pro-
portions of total market value are 60/40. Note that at the four times
when the total market value of stocks is close to 60 percent and the
total market value of bonds is close to 40 percent, the funds asset
allocation policy dictates a value close to the intended 80/20 mix.
Asset Allocations: Market and an Aggressive Balanced Fund
100
80
60
40
75 80 85 90 95 00 05 10
R
a
t
i
o
(
%
)
Market
Fund
50
EMEA
VOICE
C F A MA G A Z I N E / N O V D E C 2 0 1 1
BY VINCENT PAPA, CFA
uring the last decade of its existence, the Inter-
national Accounting Standards Board (IASB)
has enjoyed various successes, including the
proliferation in the global adoption of Interna-
tional Financial Reporting Standards (IFRS)with these
standards being adopted by more than
100 countries. There was particular
impetus towards IFRS adoption as a
result of the EUs requirement that
consolidated accounts of listed com-
panies be reported under IFRS with
effect from 2005. Aided by the ongo-
ing collaborative convergence memo-
randum of understanding (MOU) with
the Financial Accounting Standards
Board (FASB), there was a rise in the prospects for U.S.
adoption. More recently, however, the destination of the
standard-setting process has become uncertain. To begin,
the question of if and how the U.S. would adopt IFRS is
now up in the air. The U.S. SEC has been undertaking a
multi-phase
1
evaluative process of assessing the benefits
and costs of IFRS adoption by U.S. companies, and it is
difficult to predict the likely outcome. In addition, there
have been delays in completion of convergence-designated
projects. Three of the projects that had been prioritised for
completion, namely revenue recognition, leases and finan-
cial instruments, are still under development. Discourse
on what should be the IASBs primary focus is especially
important for jurisdictions that apply IFRS, including
those that fall within the Europe, Middle East, and Africa
(EMEA) region.
Having faced multiple accounting reform objectives
with mixed successes during the past decade, the shift
should now move towards reviewing an appropriate for-
ward agenda. In this vein, it is important to highlight two
considerations that are inextricably related to the efficacy
of any charted way forward. These are the effectiveness of
due process and evidence-based standard setting.
Effectiveness of Due Process
An area of improvement for the IASB relates to minimising
the occurrence of incomplete projects. There are a number
of projects that have received significant standard setter
development effort and stakeholder consultation but have
subsequently been put on hold. Examples of such projects
include financial statement presentation and liabilities and
equity. Should these deferred topics reappear on the future
A New Era for International Accounting Standards?
D
agenda, their further development will likely entail a
duplicative consultation, and there is also the risk of
discontinuity in staff resourcing.
Hence, to ensure resource allocation efficiency, the
existing due process should be improved to minimise
project deferrals. In the event that a deferral is made,
the IASB should be accountable to all stakeholders. This
should entail communicating any change in the initial
rationale used to justify the project (bearing in mind that
the review of a decision to defer or drop a project is just
as important as the review of whether to include a project
in the agenda).
Evidence-Based Standard Setting
An idea that has been getting some traction is the need
for a greater degree of field testing and evidence-based
standard setting. It is important to ensure the operational
nature and economic benefits of any new accounting stan-
dard. However, this call for evidence should not become
an impediment towards financial reporting reform. A
common refrain from stakeholders is that accounting
standards are not significantly broken and, therefore,
only need minimal tweaking. This mindset of preserving
the status quo could reflect an understandable aversion to
disruptive discontinuity in financial reporting information
that some issuers or users may be accustomed to.
However, while it is important for the IASB to seek
ex-ante evidence, as well as establish and communicate
why accounting standard reform is necessary, it is also
important for the IASB to pursue innovation with a bold
mindset. Ultimately, accounting standards reform and
improvement ought to be the IASBs raison dtre. The
IASB will be less relevant as an entity if it is simply a pur-
veyor of the status quo. The status quo of financial report-
ing information has often been the result of an ad hoc,
piecemeal and sometimes politicised standard-setting
process, and accounting standards are inherently ripe
for significant improvement.
One obvious lesson learnt from the last decade is that
it is not what goes into the standard-setting agenda that
counts but the quality and completeness of the ultimate
outcome. Hence, while it is laudable to have stakeholder
input and debate on what should be the agenda items, a
more pointed focus should be towards ensuring that initi-
ated projects reach the finish line in a timely manner,
which will necessitate an improvement in the existing
due process.
Vincent Papa, CFA, is director of financial reporting policy
for Europe, Middle East, and Africa at CFA Institute.
1 The SEC issued a road map in 2008, a work plan in 2010 and recently
issued the condorsement evaluation plan.
51 C F A MA G A Z I N E / N O V D E C 2 0 1 1
CFA Institute
BRIEFS
Ten Years On
Scholarship fund continues to help students directly affected by 9/11 attacks
BY RHEA WESSEL
Olga Loginovas life changed on 11 September 2001. It was
the day her stepfather died as the second tower of the World
Trade Center fell in lower Manhattan. Loginova was 15
years old at the time and recalls that she struggled to find
her way in school and turned angry toward life follow-
ing the terrorist attacks.
A few years later, after graduating from high school,
Loginova began a program to study fashion merchandising
but had no clear idea about the career she wanted. No
one had any advice to give, she says.
About that time, Loginova heard about a scholarship
sponsored by CFA Institute for people directly impacted
by the attacks, but the recipients had to major in finance
or accounting to apply. Loginova knew she had a knack
for accounting, but she hadnt considered the course of
study until then.
Because of the prerequisite for the scholarship, I got
interested in accounting and decided to drop fashion mer-
chandising, she explains. I knewI was good at accounting.
Now Im even going for a masters degree in accounting.
Loginova is one of dozens of American and interna-
tional students to benefit from the September 11 Memorial
Scholarship fund established by the Research Foundation
of CFA Institute. Begun shortly after the attacks, the fund
draws from an endowment of US$1 million. Loginova
received more than US$29,000 from the fund over three
years for her undergraduate studies at Pace University,
along with several other awards from other organizations
for people directly impacted by the terrorist attacks.
In the end, Loginova still had to work nearly full time
in an accounting job to pay for the costs of attending Pace
University, which can reach US$50,000 a year. I am so
grateful for the scholarship, she says. Otherwise I could-
nt afford Pace, or I would have had to take loans.
Tom Bowman, CFA, former president and CEO of
CFA Institute, was instrumental in setting up the fund
for dependent children, spouses, or domestic partners of
those who died or were permanently disabled as a result
of the attacks. A primary purpose was to honor the
memory of the 56 CFA charterholders killed in the
attacks, hence the focus on enabling more people to
study finance and economics.
We came to the conclusion that by attacking the
worlds largest financial center, 9/11 was an attack on our
system of free and open capital markets, something CFA
stands for with its code of ethics and standards of prac-
tice, says Bowman.
One way to do our part was to encourage the fami-
lies of victims to study finance and economics, adds
Bowman, looking back at the 10-year anniversary of the
fund. We were trying to understand the impact of 9/11
on the industry and the global financial system, and we
decided to request that the scholarship fund be started
with US$500,000.
During the next conference call with the board,
Bowman floated the idea. The board responded immedi-
ately: Lets make it a million.
In addition to Loginova, other recipients have
expressed their gratitude for the scholarships. For exam-
ple, Christopher Lombardi believes that because of the
scholarship, his father and his fathers colleagues (firefight-
ers from Rescue 5) are not forgotten heroes of yesterday.
Another recipient, Edward Sankey (pictured), has
enrolled in a masters degree program in taxation at St.
Johns University. He received money from the fund to
help pay for a bachelors degree in finance and
accounting from the State University of New
York at New Paltz. Sankeys father is
a firefighter who became disabled
with severe asthma after working
on the cleanup. He happened to be
off work on September 11 for a
dentist appointment.
Sankey, who also has studied
in Europe, says he would never have
dreamt of continuing for a masters
degree or studying abroad had it not
been for his scholarships. Studying in
Brussels brought me a global perspective,
he explains. I lived with a host and learned things I
wouldnt have learned in school.
Sankey is now enrolled at the Queens campus of
St. Johns University but has the option of attending the
Manhattan campus just a few blocks from where the
World Trade Center stood. If I do study there, he says,
it will bring me closer to the reason I have been able to
progress this far in my education, and I will have a much
greater appreciation for all the help I have been given.
Rhea Wessel is a journalist based in Frankfurt.
The September 11 Memorial Scholarship fund was designed
to be self-liquidating over 20 to 25 years, and no active
fundraising is ongoing. However, donations are still being
accepted by the Research Foundation of CFA Institute.
CFA Institute
BRIEFS
June 2011 CFA Exam Results
In June, CFA Institute administered the CFA exams simultaneously to 115,027
candidates at 266 test centers in 189 cities around the world. Of this group, 43
percent passed. The Level I global pass rate was 39 percent, the Level II global
pass rate was 43 percent, and the Level III exam global pass rate was 51 percent.
In Memoriam
John Jay Burris
JACKSONVILLE, FLORIDA
Aigars E. Egle, CFA
RIGA, LATVIA
Vincent Thomas Hitchcock, CFA
GLENCOLE, ILLINOIS
Benjamin Yoke-Thong Lee, CFA
SINGAPORE
Edward B. Smith
SUNNYVALE, CALIFORNIA
Jonathan R. Tvedt, CFA
FEDERAL WAY, WASHINGTON
Call for CFA Institute Board Nominations
Each year, CFA Institute goes through an extensive process to identify leaders
from our profession to serve on the CFA Institute Board of Governors. For a
volunteer-driven organization, its particularly important that governors are
representative of and nominated by the membership itself. Thats why the
Boards Nominating Committee is asking for your participation. If you would
like to nominate someone, please use the nomination form available on the
Governance/Board of Governors section of the CFA Institute website. The nomi-
nating process is ongoing and year round, but to have a nominee considered for
the next election, please submit nominations by 25 November 2011. To access
the nomination form, go to www.cfainstitute.org/about/governance/leadership
and select Recommend a Candidate for Governor.

The global membership organization that awards the CFA
and
CIPM
designations, CFA Institute leads the investment profession globally by

setting the highest standards of ethics, education, and professional excellence.
SENIOR INVESTIGATOR, INDUSTRY MATTERSLONDON
DIRECTOR, EXAMINATION DEVELOPMENTHONG KONG
DIRECTOR, EXAMINATION DEVELOPMENTLONDON
Details for this and other available opportunities can be found at
www.cfainstitute.org/careers
We offer an excellent compensation and benefits package, including medical, dental, retirement plan,
life and disability insurance, educational assistance, training and educational opportunities,
International Rotation Assignment Program, Wellness Program, Leave Program, and more.
Please respond by sending resume with cover letter
and remuneration requirements via e-mail to hr@cfainstitute.org.
EOE
www.cfainstitute.org
Planting Seeds
Americas
OUTLOOK
BY ROBERT JOHNSON, CFA
abriela Franco, regional head of Latin America
for CFA Institute, and I recently spent time in
San Salvador, El Salvador, promoting CFA
Institute and the CFA Program. Why would
we spend time and resources in a country where our
database lists only a few CFA candidates and one CFA
charterholder? This visit occurred because of the efforts
of one very remarkable member, Marcelo Suarez, CFA.
Suarez was in Charlottesville this past summer participat-
ing in CFA Program activities and met
with CFA Institute president and CEO
John Rogers, CFA, and me. He was
quite enthusiastic about our organiza-
tion and obviously very proud of
earning his charter. He wanted to
encourage others in his country to
do the same and believes that having
more ethically centered, knowledge-
able investment professionals in his
country and throughout Latin American will help raise
standards in the capital markets and bring greater pros-
perity to the populationbeliefs that are consistent with
the mission of our organization.
Gabriela and I were busy from the time we landed in
San Salvador to our departure, and in three short days we
accomplished a great deal. We met with the leaders of the
financial markets in El Salvadorleaders of the stock
exchange, central bank, securities regulators, the bankers
association, and several major employers. We made a CFA
Program presentation to the human resources heads of
several major employers in an effort to gain their support
in encouraging employees to pursue the CFA charter. All
of the individuals we met with pledged their support and
offered their organizations assistance.
Growing awareness of the CFA Program and CFA
Institute among university students is also critical to our
outreach activities. We made a presentation on the CFA
Program to an eager audience of more than 50 business
administration students and a dozen faculty members at
Universidad Centroamericana Jos Simen Caas. We
were also able to meet with the dean of Escuela Superior
de Economia y Negocios (ESEN) and the founder of the
university. They were all very enthusiastic, offered their
support, and said they would encourage students to
pursue the CFA charter upon graduation.
We are excited to announce that later this calendar
year we will be convening the first ever CFA Institute
Research Challenge in Central America. Teams fromuniver-
sities in El Salvador, Guatemala, Panama, and Costa Rica
are slated to participate in the competition. In addition to
G
the first ever challenge in Central America, there will be six
other challenges throughout Latin AmericaArgentina/
Uruguay, Brazil, Chile, Colombia, Mexico, and Peru. The
winners of these local challenges will advance to the
Americas finals in New York City next April. Students par-
ticipating in these events are ambassadors for both the CFA
Institute Research Challenge and CFA Institute.
One of the planks of our Latin American strategy is to
raise awareness of the CFA Program and CFA Institute via
the media. To this end, Suarez arranged for several media
interviews. The first of the interviews resulted in a very
prominent article in El Diario de Hoy, the leading daily
periodical in El Salvador. We were also able to hold a CFA
Institute conference in San Salvador where more than 50
people participatedincluding leading members of the
financial and business community. I gave a presentation
on The Crisis of Confidence and Restoring Trust in the
Capital and Political Markets; Gabriela presented on the
CFA and CIPM Programs. The question and answer ses-
sion and the reception afterward provided us with assur-
ance that the conference had a very positive impact.
None of this would have been possible without the
time, effort, and initiative of Suarez. He arranged all of
these meetings and took three days away from his job as
a private wealth manager at Scotiabank to introduce and
accompany us, and all he wanted in return was to raise
awareness of the CFA charter and CFA Institute in his
country. His efforts didnt end with the completion of
our visit. He is in the process of creating a precursor
CFA Institute society in Central America.
I am continually reminded of what an influential
organization CFA Institute has become. We are a great
organization because of the exceptional people who buy into
our mission and vision for the worlds capital markets.
Robert Johnson, CFA, was formerly CFA Institute senior
managing director for the Americas region.
Why would we spend time
and resources in a country where
our database lists only a few
CFA candidates and one CFA
charterholder? This visit occurred
because of the efforts of one very
remarkable member.
Asia-Pacic
FOCUS
Commitment to Lifelong Learning
BY JOEY CHAN, CFA
n this highly competitive investment world, it is
essential for our members to enhance their career
opportunities by keeping abreast of developments in
the industry; continuously seeking to improve their
knowledge, skills, and abilities; and adhering to the high-
est ethical standards.
The public, regulators, investors, and various stake-
holders consider a professionals commitment to continu-
ing education very important. As bearers of the global
gold standard, CFA charterholders have the opportunity
to improve their knowledge by reading industry journals,
discussing issues with their peers,
and reflecting on their professional
practices. In addition, well-organized,
structured, and comprehensive pro-
grams can help charterholders in their
pursuit of excellence.
Every year in their professional
conduct statements, our members
affirm to maintain and improve profes-
sional competence and to practice in an
ethical manner. CFA Institute supports members in this
endeavor by offering educational events and conferences
with continuing education opportunities. In the last quar-
ter of FY2011, 45 live events and conferences were held
throughout the Asia-Pacific region. Educational seminars
and investment conferences have delivered membership
value and brand awareness, and our events continue to
gain traction through high attendance and favorable
media coverage.
Around 300 people attended our most recent event,
the Australia Investment Conference, and it received
strong coverage in the most influential national business
and finance mediareaching more than 14,000 people
through Twitter and generating interest via the CFA
Institute Facebook fan page.
Our events feature high-caliber speakers who provide
unbiased, quality continuous learning content in the
form of cutting-edge ideas and practices for our members.
This careful selection of speakers brings value to members
and the industry and attracts an audience of senior practi-
tioners, C-suite executives, and exchange and regulator
officials. Topics focus on the current economic environ-
ment, making the information highly relevant and resilient.
At the Australia Investment Conference, international
speakers included Jing Ulrich, managing director and
chairman of global markets (China) at J.P. Morgan;
Richard Baum, a professor at UCLA; and Michael Pettis,
a professor at Peking Universitys Guanghua School of
Management. They identified and discussed policies and
politics, explored the impact of Chinas economic growth,
and evaluated the possibility and risks of a downturn. The
event also included insights from CEOs and chief invest-
ment officers on how the current economic situation will
impact Australias finance industry.
To leverage our conferences, CFA Institute also holds
an academy for financial journalists, a half-day seminar
based on the CFA Program curriculum. Training, backed
by case studies, ranges from financial statement analysis to
asset allocation and private wealth management and com-
plements the investment conference. For CFA Institute,
the journalist academy is an effective method to build and
develop closer relationships with the media and further
enhance the CFA Institute brand.
CFA Institute conferences offer high-quality profes-
sional presentations with distinguished speakers and
dynamic panel discussions and provide an integrated
platform that reaches out to regulators, exchanges, top
employers, universities, and the media. In addition, live
events and conferences are leveraged to create other life-
long learning products (e.g., webcasts, interview podcasts,
and publications), extending the audience reach and shelf
life of a conference as members tap into these valuable
resources through My CFA.
We now have annual plans to organize three to four
large-scale investment conferences in major markets in the
Asia-Pacific region, supplemented by other forms of semi-
nars and events so that we provide continuing education
opportunities throughout the regionincluding in mar-
kets where there is a substantial number of charterholders
but no local CFA Institute member society.
We strive to make a lasting impact on the industry at
large by improving our programs and aiming to better fit
our members needs and industry preferences. The ultimate
criterion for determining the success of a lifelong learning
programis the extent to which the events contribute to
improving the standards of professional excellence or
making a difference in professional practice and investment
outcomes. We strive to keep our events relevant and valu-
able to both investment professionals and CFA charterhold-
ers and are constantly looking for suggestions on themes,
topics, and speakers and ways to assist and improve our
members commitment to lifelong learning. If you have
comments on or recommendations for events, please e-mail
apevents@cfainstitute.org.
Joey Chan, CFA, is director of planning and program develop-
ment for the Asia-Pacific region at CFA Institute.
I
Of Laundry and
Lavish Compensation
BY RALPH WANGER, CFA
f you are a young CFA charterholder, you may occa-
sionally wonder how you can do better in your career.
Is anyone acting on your ideas? Are your recommen-
dations worth acting upon? Is anyone paying any
attention to you at all? I spent 50 years as an analyst, so
I have a couple of suggestions.
A lot of jobs are highly structured. A clerk comes into
the office in the morning, observes an inbox filled with
folders, takes down the top one, opens it, adds a routine
step, and puts it in the outboxand repeats. As a CFA
charterholder, you probably have a lot more freedom in
deciding what you do each day, so it is very important to
spend your time looking at things that are important.
We all spend a lot of our time doing routine chores
that someone has to do but dont bring in the big bucks. I
put all these in the generic category of laundry. Laundry
is an important function, without which your office would
smell terrible. While doing laundry is necessary and can be
done badly, there is a topside to how well laundry can be
done, and even the person who does it well doesnt get paid
very much. There are plenty of people who would cheer-
fully do your laundry for $20 an hour. If you want to make
$100 an hour or more, your first priority should be to mini-
mize the amount of time you spend on laundry. If you want
to make a million dollars a year, you need to get paid by the
idea, not by the hour, and that is a topic for another article.
Unlike the clerk shifting folders from the inbox to the
outbox every day, a CFA charterholders job is much less
structured. The key question then becomes What shall I
do today? There are an unlimited number of companies
that you can look at, so how should you proceed? I always
liked the idea of management by exception. At my firm,
I set up a database that gave estimated two-year returns
for every stock our analysts followed. Most estimates fell
in a range from 6 percent to 15 percent, which is pretty
much the market rate. If your belief about a company is
the same as the market opinion, there is no point in
spending much time on this company. Since these esti-
mates of future returns are famously imprecise, I consid-
ered all these data points to be average. If you spend a
day working on one of these companies in the average
pile, you are unlikely to come up with a conclusion that
will take the stock out of the average category. If you are
unlikely to get a surprising conclusion, then you will have
spent that day doing laundry.
I What is management by exception? All of the
important work you will do will be on companies with an
expected return outside the 615 percent range, because
those are the exceptions where your estimate is very differ-
ent from the market. If you can confirm your estimate,
you can write a meaningful recommendation on the
stockand that will be an important non-laundry day.
When I was supervising analysts, I would sort the
database every week to find which of their stocks esti-
mated returns disagreed with the market and tried to per-
suade the analysts to work on those. I was surprised by
how few of my analysts did not run our databases on their
own and do some work before I had to call them on it.
Hint: If your firm has such a database, run it yourself
before the boss does. If your firm does not have such a
database, put one together yourself (not a gigantic project)
and consider it your secret weapon.
A lot of the time these discrepancies are not interesting.
For instance, the stock might have had a 2:1 split, but the
figures hadnt been adjusted yet, causing an erroneous high
return. Once in a while, however, the anomaly is signifi-
cant, and if you have the courage of your convictions, you
can make a buy or sell decision that is really important.
Really important decisions are infrequent but crucial.
In real life, you can decide to get married or take a differ-
ent job. Any of these events affect your life dramatically
and are clearly not laundry. When you are at work and
have your best idea, sell it hard, and make sure it is acted
upon. It will be a pivotal action that takes up well below
1 percent of your time but will be the source of your pro-
motion (or your dismissal).
Those rare achievements will make your career a suc-
cess. If your work produces a stock portfolio that matches
the market, then you have produced a result that you
could buy for a fee of 8 basis points. Your whole year was
laundry. In contrast, if you can consistently beat the
market by a couple of percentage points per year, then you
are an extremely valuable player and should expect to be
compensated lavishly.
Ralph Wanger, CFA, is a trustee of Columbia Acorn Trust.
He is also an adviser to Wanger Investment Management.
Chapter 10
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