The Finance Professionals' Post

Book Review: Financial Risk Management for Dummies

2016-01-04T14:28:03-05:00

Financial Risk Management for Dummies. 2016. By Aaron Brown. John Wiley & Sons, Ltd., www.wiley.com. 384 pages, $26.99.

The dummies to whom Financial Risk Management for Dummies is addressed are not outright novices. Rather, they exemplify the maxim that a little bit of knowledge is a dangerous thing. Aaron Brown, chief risk officer of AQR Capital Management, devotes much of the book to dispelling mistaken notions about his subject.

“Risk management is not about predicting or preventing disaster,” he writes. Neither, says Brown, is it about estimating probabilities or outcomes. The “frequentist” approach, with its analogies to casino games, has only limited application. “If all risks were playing roulette or drawing cards,” Brown states, “we wouldn’t need risk managers.” There is little in the book about measuring risk because generally speaking, risk that is measurable can be avoided, insured, hedged, or neutralized via diversification. Contrary to the likely expectations of many investment professionals, Value at Risk (VaR) does not enter the discussion until Chapter 6.

In view of the book’s masterful demolition of wrongheaded ideas, its readership should not be limited to aspiring risk managers. It constitutes essential reading as well for traders, portfolio managers, hedge fund investors, shareholders of financial institutions, and anyone else affected by risk management who has only a vague and probably incorrect understanding of what risk managers actually do. Brown makes his exposition accessible to the non-quants within those ranks by presenting almost no math more advanced than arithmetic. He also supplies valuable insights into the inner workings of trading markets, highlighted by a description of the way in which stop-loss orders prevent prices from moving straight to the level warranted by fundamental news.

When Brown at last takes up the topic of VaR, he disabuses readers of the common misconception that it represents a risk measure or a worst-case outcome. VaR is actually the best-case loss on the worst five per cent of days (in the case of a 95 percent one-day VaR). Many people often become incensed when an institution loses more than its VaR amount, yet it is expected that the one-day loss will exceed that amount more than once a month.

Brown, whose previous books include an exploration of the links between gambling and speculation, The Poker Face of Wall Street, excels at incorporating colorful and entertaining material into his highly instructive text. He reports, for example, that after a supposedly non-fiction book about alien abduction became a bestseller in 1987, the Florida-based St. Lawrence Agency sold more than 20,000 alien-abduction insurance policies.[1] In a discussion of statistical fallacies, Brown notes that if people’s height truly were normally distributed, some would have negative height, since a normal distribution includes all values from infinity to negative infinity.

One oddity of Financial Risk Management for Dummies is that although its author is American, the publisher’s British arm has brought it to market. The results are sometimes disconcerting. Early on, the reader learns that in round terms the stock market has turned £1 into £100 over the past 50 years but an accompanying graph of the distribution of daily returns displays data for the US$-based Standard & Poor’s 500. Elsewhere Brown illustrates a point about Value at Risk with an example involving betting conventions on American football.

This quirk does not detract from the richness of Brown’s book. It covers risk management in banking, asset management and insurance, in addition to addressing such practicalities as communicating with directors and dealing with regulators. The author offers tips derived from long experience in the field, including the counterintuitive advice to listen to idiots. (“Sometimes they say true things for bad reasons, other times what they say is false,” he explains, “but if you think about why they said it, it points to a valid reason.”) As a bonus, Brown debunks the standard narratives of ten famous financial debacles. These include not only Charles Mackay’s long-since-discredited account of the Dutch tulip bulb craze,[2] but also conventional descriptions of the Hunt brothers’ supposed attempt to corner the silver market and the savings and loan crisis.

Under a pedestrian title, Aaron Brown has produced much more than a how-to manual. Few financial books provide so much solid instruction in as lively and provocative fashion. Financial Risk Management for Dummies ranks with the ten great books on risk that the author summarizes in his final chapter.

-Martin S. Fridson, CFA, is chief investment officer at Lehmann, Livian, Fridson Advisors, LLC, New York City.

[1] Further investigation reveals that for $19.95 the purchaser receives a lifetime $10 million policy that pays a benefit of $1 a year for 10 million years or until death, whichever comes first. The claim form requires the signature of an alien who was on board the spacecraft involved in the abduction. Payment is doubled if the policy owner is eaten by the aliens. To date, the agency has paid out two claims, both in New York State. Source: http://www.consumerinsuranceguide.com/st-lawrence-agency/.

[2] See Famous First Bubbles: The Fundamentals of Early Manias (2001), by Peter M. Garber.

Life Lessons from an Unexpected Source

2016-01-04T14:23:12-05:00

The week after Thanksgiving, feeling remorseful after all the gluttony that ensued over the holiday weekend, I decided to drag myself to my favorite spin class. I expected to feel energized and accomplished from a nice, intense workout, but I didn’t expect that I would also come away reminded of some of life’s most important lessons.

Jogging on that bike jogged my memory of four key life lessons!

You will get much further if you take breaks along the way

When I hop on that bike, my goal is to get through the next 45 minutes of heart pumping cardio without falling off or passing out. Lucky for me, Avery, my awesome instructor, sets us up for a pattern of high intensity followed by a rest period. This plan makes sense since none of us are superhuman.

If we know to take a breather during a workout, why don’t we always remember to do so in life? It may sound like an abomination, but indeed many of us push ourselves too hard. We need to remember to slow down from time to time, take the well-deserved breathers to appreciate our accomplishments, and re-charge for the next “sprint.” Without these breaks, burnout is inevitable.

How many of you go through your day without lifting your eyes from your computer and cell phone? How many of you take “fresh air” breaks?

Takeaway: If you make it a point to give yourself regular “rest periods,” you will last a lot longer in the race of life.

You can achieve a lot more than you think, but sometimes you can’t do it alone

There was a moment in spin class where my self-doubt started to creep in. I was convinced that I had nothing left in me to keep going. As I was about to give up, dropping my RPMs from 100 to 90, I heard my instructor’s motivating voice through the speaker: “Don’t you give up on me now – I know you want to slow down, but you have it in you to keep going!” That mini pep talk was all I needed to get out of my head and put my energy back into my legs. I even increased the RPMs to 105.

The truth is when you start to waiver and lose your conviction, having someone encouraging you will help you climb higher than you ever thought possible.

Takeaway: Find a mentor, friend, partner or coach that can help you stay the course, send encouragements along the way, and you will accomplish more than you ever thought possible.

Momentum is underappreciated

Spinning bikes are equipped with a weighted flywheel in the front that picks up speed as you pedal. The greater you set your resistance the harder it is to start pedaling but if you pedal through that initial resistance, the flywheel goes ever faster, making it easier to pedal once the initial resistance has been overcome.

The point is that Avery kept harping on us to pump up the resistance, give our legs just one more push and let the momentum of the flywheel do the rest. I have to admit, I was skeptical. How can increasing resistance make this easier? I decided to trust him and was shocked to find out that after the initial strain on my legs, the momentum of flywheel really did do the hard work for me.

Takeaway: The hardest part is getting started. Once you get going, momentum will be your best friend.

Preparation, preparation, preparation

I learned very early on in my spinning days that if I don’t set my bike up properly, optimizing seat height and alignment, I am bound to have a really crappy ride—knees inflamed, back pain, etc. Fortunately, I was on top of that. However, I did forget to bring a water bottle.

Now, imagine a spin class without water – doesn’t make for a pretty picture does it? While everyone else was sipping and spinning, I found myself getting off the bike to run to a water fountain. Unsurprisingly, my momentum and efficiency suffered.

Takeaway: When you aren’t prepared you are bound to have to compensate and give something up, taking away from your performance or confidence. Put more effort into your preparation, and you will have to give up a lot less later.

And lastly, I want to leave you with a quote that kept spinning through my mind as I was about to hit the wall in spin class:

“Life begins at the end of your comfort zone” – Neale Donald Walsch

…so does a spin class ;)

-Helen Dayen is the founder and CEO of Dayen Group. She is a career development & communication coach.

Through the Dayen Group, an executive coaching company focused on the financial services industry, NYSSA offers career and interview prep coaching packages to members at discounted rates. Please click here to explore available coaching packages and schedule your appointment.

Investment commentary numbers: How to get them right

2016-01-04T14:21:01-05:00

Investment commentary calls for lots of numbers: benchmark and portfolio returns, economic data, and more. When you get those numbers wrong, you undercut your credibility and embarrass yourself.

I have some ideas about how you can avoid mistakes by proofreading and checking your facts.

My expensive mistake

A bad experience impressed me with the importance of checking numbers. Reading the professionally printed copy of my employer’s third-quarter commentary, I noticed a goof. It referred to the second quarter, instead of the third quarter, in one spot. This happened even though four of us had read the piece before it went to the printer. However, the eye tends to read what it expects to see. We all glossed over my error. Oops!

That was an expensive mistake because we had to get the piece reprinted. However, at least we avoided the embarrassment of clients seeing our mistake. Also, it spurred me to develop techniques for catching numerical errors.

Tip 1. Add numbers to your checklist

Checklists, which I recommend in “5 proofreading tips for quarterly investment reports,” can help you catch numerical errors. For a typical quarterly investment publication, I’d add two kinds of numerical items to remind you to check for accuracy and timeliness.

Calendar information—record the current year, quarter, and ending date for the quarter. I don’t know about you but I sometimes can’t remember how many days there are in June so it’s handy to know that I should write about “the period ended June 30.”

Major index returns for the relevant periods—if you’re writing about multiple investment styles and periods, you’ll use multiple index returns. If possible, run a report that shows only the relevant returns and displays them in a logical order. If you lack the access to run or customize reports, create your own list and proofread it carefully.

After you’ve completed your writing, make one pass through your document to check that you’ve used the right calendar information and returns.

Tip 2. Standardize your sources for index returns

If you’re new to writing about investments, you might think, “The S&P 500 Index return for the fourth quarter is the S&P 500 Index return for the fourth quarter.” Uh oh. There’s not just one number. For example, the return number that comes directly from Standard & Poor’s may diverge from the number spit out by your firm’s performance measurement system. Which will you use?

Your firm needs to decide which are the official sources for index returns. And then, stick with using those sources. By the way, it’s also good to create a rule for how many places to the right of the decimal point you’ll go in reporting returns.

You should create similar rules for reporting portfolio returns, too.

Tip 3. Document sources for other numbers

What about sources for other numbers? Document those as you write. Footnotes can track your sources. Insert a footnote with your data source. Insert a link to the data if one is available. It’ll make fact checking easier later on.

Tip 4. Use a fact checker

Just as it’s hard for you to proofread your own work, it’s hard for you to fact check it. You’ll tend to see what you expect to see.

If you have an employee, colleague, or friend who can help, ask that person to compare every number to its approved source. Being unfamiliar with numbers, they’re more likely to pick up on mistakes.

Don’t have a helper? Fact checking will still catch some errors. I know it works for me, especially if I concentrate solely on fact checking in one pass through my document.

Tip 5. Catch contradictory numbers with informed readers

How can you catch two authors using contradictory numbers? Say, for example, one author says U.S. economic growth was 2.2% while another says it was 2.5%. Both provide a source for their numbers, as suggested in Tip 3, but they don’t match. If you’re lucky, your fact checker will catch the disparity. But you can’t count on it.

There’s a higher chance of catching the error if you have the two authors with overlapping topics read each other’s articles. Ask them to look for inconsistencies. Another approach is to get a third party to look for inconsistencies. You might even ask them to list all of the document’s numbers from non-standardized sources. That would make it easier to see that there are multiple sources for a single number. Be advised that all of this takes a lot of time, and that there’s no easy way to catch these contradictory numbers.

Susan Weiner, CFA, is the author of Financial Blogging: How to Write Powerful Posts That Attract Clients, which is tailored to financial planners, wealth managers, investment managers, and the marketing and communications staff that supports them.

The Great Mismatch: Addressing Barriers to Global Capital Flows (Part V)

2016-01-04T14:12:41-05:00

PART V: Ideas for Navigating Capital Flows

To succeed in the evolving global capital landscape, long-term institutional investors will need to be at the forefront of re-thinking long-standing assumptions and re-shaping markets. Enough success factors have already been identified to serve as a rough guide for investors to navigate the growing opportunities in emerging markets, while mitigating risks, in both the near term and beyond. (See Exhibit below.)

CHAPTER 4: NEARER TERM: A NEW STRATEGIC MINDSET

Today’s debates about capital flows differ in an important way from those of a generation ago, says Prudential Fixed Income’s Odenius: Today’s relationship between emerging and developed markets is much more complex. Years ago, emerging markets were bystanders in policy debates getting “crumbs left on the table” of policy consequences decided in the developed world. This is no longer the case, as is shown, for example, by the impact of the developed world’s quantitative easing programs.

“It’s a lot more interactive and a lot more codependent [today],” Odenius says. “Previously, seen from a developed-market perspective, it was good if the emerging markets were running good policies, of course. But now you have to concern yourself with the question of how the emerging markets set policy in response to central bank policy in the U.S., in Europe, and in Japan.”

RE-THINKING THE USE OF BENCHMARKS

To adapt to this new interactive world of capital flows, it is crucial to recognize and change mindsets that exist today. “There’s a tremendous amount of conservatism, in the bad sense,” says Prudential Fixed Income’s Rajan. “And it comes from not wanting to be the one who is the first to go out there to do something that is out of the ordinary. And it manifests itself through the indexing process and the standard asset allocation process. ”

For example, many investment managers look at asset class sizes to determine allocations. As noted earlier, markets in the developed world are much bigger than they are in emerging markets. “So if you make allocations based on the size of the markets,” Rajan says, “you’ll under-allocate to [emerging markets]—the place that has the best growth potential.”

The Barclays Global Aggregate Bond Index gives disproportionate weight to developed nations—the U.S. alone accounts for 42% of it. Meanwhile, it has an attribution weight for non-China emerging markets of about 8%, plus China at 1.1%, for a total for emerging markets of only 9.1%, which is very low by economic metrics, such as share of global GDP, demonstrating a bias against emerging markets.

This kind of contra-growth assessment is not the only consequence of an investment outlook that depends too much on the status quo. These benchmarks also over-allocate to over-indebted and over-priced debt markets and countries, many of which are in the developed world, Rajan says. He notes that such benchmarks “have become an albatross that the entire industry has to carry.” The recent yield on Japanese government 10-year bonds is one-half of 1%. “We’d rather lend to an emerging country at 5% when we’ve made sure that it has a sustainable debt-to-GDP ratio and a positive trajectory,” Rajan says. “But if a client comes in with a benchmark that has 20% Japanese bonds and they tell us ‘Don’t depart from this by more than five,’ we have no choice.”

Yields are higher in emerging-market bonds, and governments there often carry much less debt. “So it really makes one scratch one’s head when you think about how so many actors in the investment community are committed, even for the long term, in poorly constructed benchmarks,” Rajan says.

MOVING BEYOND THE NATION STATE AS THE UNIT OF ANALYSIS

In order to categorize investments in a more accurate way, it might be useful to stop using “region” or “nation” as the basis; there are circumstances where investments should be classified differently to produce a better analysis, and thus, better results, Wharton’s Nair says.

For example, “when thinking in terms of categories, where the categories are not defined by regions but are defined by risk premium—whether you think of it as yield, value, momentum, liquidity—those drive flows. So if there’s a high demand on flows on yield, then within some emerging markets, some instruments look pretty aggressively priced,” Nair says. “But if people don’t want to take liquidity risk, some other instruments look differently priced.

So when you start thinking in terms of where are people allocating capital, to which category are they allocating capital, and put on the lens of risk premium, it starts making more sense than if you worked with ad hoc political or non-economic categories.”

Similarly, “emerging market” itself may be a concept that is insufficiently precise to distinguish worthwhile investments from those that will not perform as well. Descriptions need to be more differentiated— moving the paradigm from investing in a particular country to investing in a particular industry, or, in the case of real estate and infrastructure, a particular portfolio of cities—because of the underlying growth prospects.[1]

For now, though, in holding on to traditional mindsets, many investors are failing to assess opportunities correctly when they lump all emerging markets together, rather than evaluating and pricing risks according to relevant local-market conditions. For example, Nair says, “there’s no reason to think that when there’s a protest in Turkey, India’s going through issues. So you can construct portfolios that have enough of different emerging markets [to protect against excess risk], but the overall perception of Turkey’s protest affecting the entire emerging-market basket cannot be diversified away. So that’s where all the spillover effects of risk aversion show up. But the reality of that risk may be diversifiable.”

A general wariness of all emerging markets may be the reason there is now a potential bubble in what are considered to be safe assets—often U.S. and other developed-market assets. These are relatively expensive, due to a widespread sentiment around the world that savings have few other safe places to go.

LOOKING BEYOND OUR OWN BORDERS

A less subtle form of this kind of excess wariness in investment is “home country bias”—the preference for investments on one’s own turf, which many investment advisors see as irrational.

“In an ideal world, each investor would hold the same portfolio,” says QMA’s Keon. “Why should Belgian investors hold 80% of their assets in Belgium? In the long run, that’s sub-optimal.” More accurate assessments of investment opportunities should reduce this bias, he says. But it is unlikely to disappear completely, because it is based on practical considerations, not prejudice.

It is natural, he says, for investors to “feel more comfortable owning stuff [they] can see.” Moreover, he says, currency fluctuations can make home country investments less risky. “If your obligations come in dollars, holding a dollar-denominated portfolio makes a lot of sense.”

At the end of the day, most investors are reluctant to break away from their routines. Escaping this trap will require leadership. Those who are first to take the right steps will be rewarded by good returns, Rajan predicts.

For now, pension funds in the U.S. and Europe are still hugely under-allocated to emerging markets. “There is an information barrier. When you’re in the realm of the new, you need leadership to create new practices,” says Rajan. “And of course there’s always a bleeding edge. But while there’s a bleeding edge on the risk side, there’s a leading edge on the returns side. Technology keeps lowering those information barriers, so somebody can and will lead the change.”

This report was jointly produced by Prudential Investment Management (PIM) and Knowledge@Wharton, the online research journal of the Wharton School of the University of Pennsylvania.

The paper was researched and written with the close cooperation of investment professionals within the investment businesses of PIM, and scholars and practitioners affiliated with Wharton. The primary interviewees include:

Franklin Allen, professor of finance and economics, The Wharton School (currently on leave at Imperial College London)  
Mauro Guillén, professor of international management and director of the Joseph H. Lauder Institute of Management and International Studies, The Wharton School  
Edward F. Keon Jr., managing director and portfolio manager, QMA, a business of Prudential Investment Management  
Joshua Livnat, managing director and senior researcher, QMA, a business of Prudential Investment Management  
Vinay Nair, visiting professor, The Wharton School, and founding principal, Ada Investments  
Jürgen Odenius, managing director, chief economist and head of Global Macroeconomic Research, Prudential Fixed Income  
Arvind Rajan, managing director and international chief investment officer, Prudential Fixed Income  
Michael Schlachter, managing director and head of Multi-Asset Class Solutions, Prudential Investment Management

The full report is available for download here.

[1] The Wealth of Cities, http://wealthofcities.prudential.com/

DIY Financial Advisor- A Book Review

2015-12-02T17:07:09-05:00

The Alpha Architect, LLC team of Wes Gray, Jack Vogel, and David Foulke has produced a dynamic, fun, and accessible text that has the power to free readers from agonizing over implementing a disciplined investment process and making investment decisions. The processes offered convincingly depict a route to success in investing. The authors present ample evidence that provides simple solutions to achieving selected investment objectives considering asset class risks and correlations among domestic and foreign stocks, US Treasuries, US real estate, and commodities.

The book is divided into two parts: Why You Can Beat the Experts, and How You Can Beat the Experts. This division aids the book’s overall purpose: to provide a sensible and systematic introduction to “doing investments yourself.” Why You Can Beat the Experts is fun to read and direct in its message. The authors question the real value of so-called experts. While the experts have access to information, more data, and experience, they are often wrong. Think about it: why would more data necessarily support better investment decisions? Rather than analyzing data until blue in the face, why not model the investment process? The authors “bust” many investment myths in this section of the book, and in doing so, entice the reader to pursue systematic decision-making—and be healthy skeptics.

The process to becoming a DIY family office is straightforward, according to the authors. It is a three-step progression that involves assessment of the current adviser/broker relationship, sticking to the FACTS (Fees, Access, Complexity, Taxes, Search) and understanding portfolio management fundamentals such as asset allocation, risk management and security selection. The authors probe asset allocation and modern portfolio theory with a vengeance. In discussing Harry Markowitz’s portfolio diversification techniques to maximize return while minimizing risk, they question the best way to achieve this, considering the length of the sample periods tested and the estimates of return and volatility used to calculate allocation methods that could change in the future.

Gray, Vogel and Foulke create a simple investment process through the magic of combining value and momentum strategies. Some may consider momentum strategies to be technical analysis, but no matter what they are called, they have delivered measurably better investment performance over long and shorter periods when used in combination with valuation strategies. Academia picked up on this in the 1990s. The authors present many compelling examples from the real world and the ivory tower to support their case for momentum as part of every investment strategy.

As the reader reviews the presentations in subsequent chapters entitled, “A Simple Asset Allocation Model That Works,” “A Simple Risk Management Model That Works,” and “Simple Security Selection Models That Work,” the authors make a convincing case for returns that can be achieved with a minimum of investment discipline. I choose not to give away the recipes in this review and will only say that they are straightforward and replicable. The companion website intended for readers who are financial professionals (found at http://www.alphaarchitect.com under tools--The Alpha Architect Financial Tool Kit) includes a screening tool to find value and momentum stocks described throughout the book, an asset allocation backtesting tool, and an active blog about developments in quantitative investing. Readers will want to delve into the Robust Asset Allocation (RAA) Solution after testing the tools on their own.

Tooled with fresh ideas and technical assistance when needed, what is a reader suffering from inertia supposed to do? Get started! Having read DIY Financial Advisor, you will be armed to invest on your own—or, if you prefer to work with an advisor, to be a better investor. When you have questions as I did, you will find that they are answered in the book. (My particular questions related to strategy replication and rebalancing.) Still, some investors may find it challenging to apply the newly absorbed strategy solo. The authors’ support is always available at the click of a mouse. Readers at high levels of investment interest and all levels of investment experience will be energized and enlightened by DIY Financial Advisor, assured that the authors’ advice and time-tested investment processes should help preserve and grow their assets.

-Janet J. Mangano co-chairs NYSSA’s Private Wealth Management Committee and is a member of the Society’s Programming Committee. She formerly held the position of Senior Portfolio Manager at PNC Wealth.

Gray, Wesley R, Ph.D., Vogel, Jack R., Ph.D., and Foulke, David P., DIY Financial Advisor: A Simple Solution to Build and Protect Your Wealth. (Wiley Finance Series) Hoboken: John Wiley & Sons, 2015, 207 pages, $34.95.

The Great Mismatch: Addressing Barriers to Global Capital Flows (Part IV)

2015-12-02T16:59:42-05:00

PART IV: The Barriers to Efficient Capital Flows (continued)

Efficient cross-border capital flows—allowing investors to search for reliable returns, and in the process, meet legitimate capital needs wherever they are—would be a more effective way to finance the global economy than today’s system. In theory, few dispute this. In practice, many barriers have been erected that hamper efficient flows. The deliberate or inadvertent barriers to efficient global capital flows have been erected by a unique combination of regulators, governments, historical conventions and path-dependencies, investor mindsets and capital-seekers themselves (see below exhibit).

CHAPTER 3:  INVESTORS AND THEIR INCENTIVES

Systemic factors like government regulation and lack of supporting structures are relatively easy to identify in many markets. Harder to acknowledge are the preconceptions, mindsets and incentive structures of investment professionals and investors. These too are a source of barriers to efficient capital flows.

At first glance it seems indisputable that capital, when put to work, can foster economic growth and its attendant benefits. Roads in India, schools in South Africa, new businesses in China or Bulgaria or Argentina—these cannot be built without capital, and in many cases that capital is missing. This is also true in many developed countries, which are rightly fretting about crumbling infrastructure without clear plans for a fix. (In fact, global demand for the funding of infrastructure investments could easily reach $57 trillion by 2030, according to global management consultancy McKinsey & Company.[1])

Yet the past two decades have supplied skeptics with plenty of ammunition. The economist Jagdish N. Bhagwati famously wrote in 1998, “When we penetrate the fog of implausible assertions that surrounds the case for free capital mobility, we realize that the idea and the ideology of free trade and its benefits [...] have, in effect, been hijacked by the proponents of capital mobility.” Bhagwati’s point is that the classic arguments for free trade apply when nations trade goods, but not when they exchange capital. There is a difference, as he puts it, between “trade in widgets” and “trade in dollars.”[2]

THE TROUBLE WITH “HOT MONEY”

The problem with capital exchanges is that capital mobility makes it all too easy for investors to  chase high but short-term yields in nations where borrowing for the short term is commonplace. And this problem of inherently unreliable “hot money” is not confined to equity portfolios or bank loans. Even direct investment in bricks and mortar can be withdrawn, albeit more slowly, if investors are fearful of loss. Since the great upturn in private investment in emerging markets in the 1990s, nation after nation has coped with sudden floods and droughts of capital and their effects. In many cases, the influx (and exit) of foreign capital merely exacerbated problems that were inherent to the nations’ financial systems. “Most crises have resulted from the opening of unsound systems to capital flows,” Maurice Obstfeld of the University of California, Berkeley, has written.[3]

Thus, there is little doubt that international capital flows expose nations to risk in ways that domestic investment does not. The list of emerging-market crises that affected foreign investors over the past 25 years is long: It includes Chile in the early 1980s, and, in the 1990s alone, Argentina, Mexico, Russia and Turkey. And, of course, that was also the decade when Thailand triggered a slew of currency and payment crises throughout Asia in 1997-1998 following heavy borrowing in foreign currencies and the subsequent deep devaluation of the baht. In addition to Thailand, Indonesia and South Korea were deeply affected, with others suffering significant economic setbacks. (See Exhibit below.)

At the same time, emerging markets have found themselves whipsawed by the changing goals and assessments of developed-market investors, who can flood a nation with investment one year and pull out fast in the next. Many of the 1990s crises in emerging-market nations, for example, were triggered or exacerbated by foreign investors abruptly taking their money out.

On the other hand, cross-border capital flows can also trigger a virtuous cycle, spurring the creation of jobs, increasing income and thus increasing demand for goods and services, which in turn creates more jobs. Capital invested from other nations is a spur to economic growth in nations that lack indigenous sources of capital and is a boon to local investors.

In short, capital flows have obvious benefits, but these do not occur in all times and places. Nor  do different modes of capital flow have the same effects—direct investment, for example, is less susceptible to sudden changes, while bank loans are more so. It is not sufficient then to promote any and all forms of cross-border capital flow at all times. It is vital for investors to identify which types of capital flow should be fostered in particular nations at specific times.

This report was jointly produced by Prudential Investment Management (PIM) and Knowledge@Wharton, the online research journal of the Wharton School of the University of Pennsylvania.

Franklin Allen, professor of finance and economics, The Wharton School (currently on leave at Imperial College London)  
Mauro Guillén, professor of international management and director of the Joseph H. Lauder Institute of Management and International Studies, The Wharton School  
Edward F. Keon Jr., managing director and portfolio manager, QMA, a business of Prudential Investment Management  
Joshua Livnat, managing director and senior researcher, QMA, a business of Prudential Investment Management  
Vinay Nair, visiting professor, The Wharton School, and founding principal, Ada Investments  
Jürgen Odenius, managing director, chief economist and head of Global Macroeconomic Research, Prudential Fixed Income  
Arvind Rajan, managing director and international chief investment officer, Prudential Fixed Income  
Michael Schlachter, managing director and head of Multi-Asset Class Solutions, Prudential Investment Management

The full report is available for download here.

[1] http://www.mckinsey.com/insights/financial_services/money_isnt_everything_but_we_need_$57_trillion_for_infrastructure

[2] Bhagwati, Jagdish. “The Capital Myth: The Difference Between Trade in Widgets and Dollars” Foreign Affairs. 77 (1998): 7.  

[3] Obstfeld, Maurice. “Reflections Upon Rereading The Capital Myth”, (2005): pdf downloaded from http:// www.columbia.edu/~ap2231/jbconference/Papers/Obstfeld_Bhagwati%20Conference.pdf.  

Three Critical Steps for Extracting Great Insights (Step 3: Entice a Thorough Response)

2015-12-02T16:52:09-05:00

Have you ever found yourself going into a store or making a call for something you need only to be disappointed by the salesperson? As soon as the experience began to deteriorate, you probably had little interest in sharing your needs because you thought “let me just end this pain and find a better option.”

The problem here is the salesperson hadn’t developed good influencing skills which are required to entice the customer to share his or her needs. As analysts, we’re “salespeople” because we need to sell the person we’re interviewing on the idea they will benefit by giving us the information we need. This post continues a 3-part series covering our ICE™ framework for effective questioning. Step 3 focuses on the “E” of the ICE™ framework, “entice a response.”

The best equity research analysts utilize influencing skills in a manner that provokes others to want to fully answer the question. The tactics below can be used in an interview or email exchange. For face-to-face and phone interviews, try to construct questions in advance so your mind is focusing solely on their response (and not wondering what you will ask next).

Use Names and Adoration

Starting the question with the interviewee’s name (said in a friendly tone) can help promote the ego and thus compel him or her to feel obligated to provide a response. For example: “Jerry, why has NewCo’s (the company’s name) return on investment declined over the past two years?” Be careful not to overuse this tactic because it, if used repeatedly, can begin to appear disingenuous.

Play up interviewee’s level of experience or role within their firms to make them feel like not responding would expose their lack of knowledge: “Based on your 20 years of experience, would it be better for revenue to grow at double digits or to see the firm’s return on capital exceed 10%?”

If the interviewee works for the company being discussed, attempt to work the company name into the more important questions because it suggests the company is a leader in the field, and so the implication is that management must have thoughts on the topic. For example if meeting with Delta Airlines management: “As one of the three major carriers, how many new aircraft do you expect Delta to purchase next year?”

Exploit Cognitive Dissonance

“Cognitive dissonance” is the discomfort most humans have when holding two contradictory beliefs, a condition that can be used to your advantage. First ask the interviewee about a belief the interviewee holds and then follow with a question about a specific related concern. Cognitive dissonance compels interviewees to show how their actions are consistent with their beliefs.

For example start with, “Does management have a hurdle rate for investments?”

Presumably, after the interviewee responds “yes”, follow it with this question: “Does management review completed projects to determine if they exceeded or fell short of the hurdle rate?”

Presumably, after you receive another “yes” answer, follow it with this question:
- “Why did the major oil sands project not generate the expected returns?” or
- “Which major projects have fallen short of the hurdle rate over the past two years?”

Management will feel compelled to explain that its actions are consistent with its philosophy, which often leads to a more detailed answer than simply asking the last question in the example above.

Reference Other Credible Sources of Information

The interviewee often wants to be considered the smartest person in the world on the topic (which hopefully will be the case if you have great information contacts). With this in mind, bringing up the following can often lead the interviewee to provide a more detailed answer than if these other sources were not mentioned:

Competitor’s performance: “Why does XYZ (competitor to company being interviewed) spend less capital as a percentage of sales than ABC (the interviewee’s company)?”

Competitor’s disclosure: State that a competitor of the company has shared a specific piece of information with the hopes that this management will divulge the same piece of information (or at least provide information about where they stand relative to the competition). “When I spoke with XYZ (competitor to company being interviewed) last week, I was told their production was running at 100% of capacity. Are you experiencing the same?”

Respected Expert: Reference a respected expert’s view to tease out management’s forecast. For example, “Can you help explain why ABC (the interviewee’s company) is more optimistic than McKinsey Consulting’s report forecasting demand for this product to be relatively small for at least the next two years?”

Consensus: Referencing consensus can be a powerful tool to extract insights. For example, “Consensus appears overly optimistic to assume ABC (the interviewee’s company) can grow EPS faster next year than this year.”

Your forecast: If the above tactics are not applicable, reference your forecast. For example, “If I assume only modest growth in each of your divisions and average cost inflation, I arrive at EPS growth of 15% for each of the next three years, which is more conservative than management’s guidance. Can you please help me better understand what I’m missing in my forecast?”

Question View Towards the Stock

Mention your internal portfolio manager or external clients have a concern that needs to get addressed: “Many of the PMs/clients I speak with have trouble understanding how the company will achieve a double-digit growth rate.”

Suggest you cannot get more positive without a better answer: “I’m not sure I can get more constructive towards your stock unless I can get more comfortable with management succession plans.”

Encourage Elaboration

Encourage the interviewee with terms such as “I see,” “Interesting…” or nodding (do not overuse the nodding or it will become disingenuous)

Specifically encourage the interviewee to elaborate with phrases such as:
- “Can you elaborate?”
- “Please tell me more.”

Use silence. When interviewees haven’t fully answered your question, pause for 5 seconds. Often they will feel the need to fill the awkward silence by elaborating further.

Restating the interviewee’s answer will often result in more detail (referred to as “echoing”). For example: “So the entire shortfall in the quarter was due to weather?”

Conclusion

If you’ve been following all three posts on the ICE™ framework, the exhibit below will hopefully help tie it all together. This framework isn’t overly complicated, but it requires time to effectively use these best practices in preparing for interviews and email exchanges. After you’ve utilized the framework for five to ten interviews, it will hopefully become a natural process in your mission to extract the informed insights required for great stock picking.

If you’d like to learn more about this framework, AnalystSolutions offers an on-demand workshop that delves deeper: Generate Differentiated Insights Through Better Discovery, Questioning and Influencing.

©AnalystSolutions LLC All rights reserved. James J. Valentine, CFA is author of Best Practices for Equity Research Analysts, founder of AnalystSolutions and was a top-ranked equity research analyst for ten consecutive years.

Water Megatrend Creates Compelling Backdrop for Investors

2015-11-19T16:17:49-05:00

Despite water covering 70.0% of the earth’s surface, only 3.0% is fresh, and just 0.5% accessible to humanity. Presently, 2.5 billion people, almost 40.0% of the world’s grain production, and approximately 25.0% of global GDP are at risk because of non‐sustainable water use¹. The problems of water scarcity, contamination, and uneven distribution of the resource are becoming increasing prevalent around the world, as water use has grown at more than twice the rate of last century’s rise in population². Consequently, pressure is mounting on the demand side as the global population increases while the availability of potable water dwindles and lessens supply. The supply and demand imbalance also increases pressure on food and energy security around the globe. As a result, according to Ladenburg Thalmann Senior Water Equity Research Analyst, Richard Verdi, water will be the resource to define the next several decades via a substantial increase in its value.

As recent drought conditions in California show, water scarcity is reaching crisis levels. The California drought is not merely alarming for other areas of the United States, but is directly affecting the country’s food and business industries. The widening supply-demand gap must be addressed urgently, to avoid the same kind of damage to ecosystems, health and livelihoods caused by drought conditions in other parts of the world³.

According to the 2030 Water Resources Group, in less than 20 years, worldwide demand for water will exceed supply by 40.0-50.0%. Past efforts to leverage technology to expand freshwater supplies will close only an immaterial portion of this gap. Thus, the development and implementation of new technologies that facilitate environmentally friendly efficient use of the world’s most meaningful resource will be vital in addressing these challenges. Significant resources have already been invested toward this end but so far, this spend has had only a subtle impact on an overall worsening condition. The Environmental Protection Agency estimates that a $400.0 billion investment in water infrastructure is needed in the U.S. alone, up $100.0 billion from the group’s earlier estimate dating back to 2002.

Due to the increasing water supply-demand gap, as well as the potential danger it bestows upon mankind and the substantial investment tailwinds the imbalance creates, Mr. Verdi sees water industry spending and investment continuing its upward trajectory for the next several decades. According to Mr. Verdi, increased spending will benefit five sub-industries: Water Utilities, Water Equipment & Technology, Water Treatment, Water Engineering & Consulting, and Water Rights. He believes these verticals should continue to gain as they strive to alleviate the world’s growing water supply-demand disparity. In light of the above, as global governmental bodies take action to remedy this issue, Mr. Verdi sees many potential investment opportunities.

^{-Richard Verdi is a Managing Director - Water & Sustainable Infrastructure Equity Research at Ladenburg Thalmann.}

¹University of Michigan; The USGS Water Science School; World Business Council for Sustainable Development

²The 2030 Water Resources Group

³International Food Policy Research Institute; Growingblue.com

Donald Trump, grade level, and your financial writing

2015-11-17T16:22:12-05:00

Donald Trump’s appeal has surprised many observers of presidential elections. Love him or hate him, you can’t ignore his presence. Part of his appeal rests on his use of plain language, according to a recent article. That’s something financial professionals should note because of its implications for your writing.

Trump speaks at a fourth-grade level, according to “For presidential hopefuls, simpler language resonates,” which appeared in The Boston Globe. The newspaper calculated the grade level of presidential candidates’ announcement speeches. Lower grade levels use fewer characters and syllables per word, as well as shorter sentence lengths.

Simpler language wins

“Simpler language resonates with a broader swath of voters in an era of 140-character Twitter tweets and 10-second television sound bites, say specialists on political speech,” according to the article.

Trump’s language hit the lowest level of the 19 presidential announcement speeches analyzed for the article. After Trump, the next simplest were John Kasich at grade level 4.7 and Ben Carson at 5.9. On the Democratic side, Hillary Clinton and Martin O’Malley hit the lowest grade level for their party. They tied at 7.7.

Is it a coincidence that the presidential front runners have among the lowest grade levels for their parties? Perhaps not.

Less tolerance for higher grade levels

Political speeches of the past hit higher grade levels. Here are the levels of some presidential speeches, according to The Boston Globe:

9 for President George Washington’s “Farewell Address”
9 for President John F. Kennedy’s 1961 “State of the Union”
11 for President Abraham Lincoln’s “Gettysburg Address”

I believe that readers are generally less patient with wordiness than they were even five years ago. I know I am.

Message for financial professionals

What does this mean for you as a financial professional who writes? If you want to attract and retain readers, lower the grade level of your writing.

I’m not suggesting that you aim to write at a fourth-grade level, although that might work for a blog post on a basic topic. I do suggest that you become more aware of your output’s grade level and work to boost the ease with which readers can grasp your message.

Try this exercise: Calculate your grade level. You can find it using Microsoft Word’s readability statistics or the website I discuss in “Free help for wordy writers!” Then, try to lower your writing’s level by two grades.

If you can delete some unnecessary words or break a long sentence into two, you’ll have made progress.

Many financial communications exceed grade 12. That may be too high for audiences with short attention spans. However, you may find it hard to hit the direct marketers’ idea of eighth grade or lower.

When you write about complex topics, sometimes longer sentences are easier to understand than short sentences. Lower grade levels may also sacrifice nuances—or fail to satisfy your compliance officer. While I often hit an eighth-grade level on this blog, I am happy when I get my clients’ work down to a tenth-grade level. Even that isn’t always possible. Still, I do my best to make even technical topics relatively easy to understand.

You may think my advice doesn’t apply to you. You may figure that institutional clients or smart people will plow through whatever you write. I disagree. No one ever says, “Please rewrite this in a hard-to-understand style.”

Three Critical Steps for Extracting Great Insights (Step 2: Calm Their Concerns)

2015-11-17T16:09:13-05:00

“I can’t believe you would be so insensitive!”

“How could you say something like that?”

Have you ever heard these statements directed at you? What was your initial reaction? A voice in your head probably said, “Be very, very careful what you say next.” It’s human nature to raise our defenses when we feel attacked, which is an important concept for equity research analysts to internalize when interviewing or emailing information sources (including management of the stocks under coverage).

In a prior post, I made the case that by using best practices found in journalism and the legal and law enforcement professions, analysts can elicit more thorough answers from their information sources. Using my ICE™ framework, I discussed the “I” for identifying parameters as the first step for success. In this post I cover the “C” to calm their concerns.

Be mindful, none of the individuals you interview are required by law to provide answers to your questions and as such, it’s imperative to put them in a mindset where they are comfortable responding. The more interviewees are put at ease, the more likely they will give full and helpful responses. (Conversely, if they feel defensive, your likelihood of getting helpful information is almost nonexistent.)

In situations when the interviewee has no restrictions on what can be said (such as senior management of a non-public company or industry consultant), this step has less importance, but when the interviewee is concerned about sharing too much, these tactics can help extract answers that will develop unique insights critical for stock picking.

Use Non-threatening Language and Terms

Phrase questions positively; if you’re too forceful or negative, it will exert control over the interviewee, who will likely attempt to gain back control by being restrictive with the response
- Avoid this: “Why has management allowed margins to drop to such disappointing levels?”
- Instead be more positive: “Can you help me understand why margins are 300-500 basis points lower than your competitors?”

Use “and” rather than “but” to be less confrontational
- Avoid: “As I understand it, the company saw the new expansion wasn’t going well, but continued to do more marketing.”
- Instead be less confrontational: “As I understand it, the company saw the new expansion wasn’t going well and continued to do more marketing.”

De-personalize sensitive questions, by avoiding the use of “you” and instead using “company” or “management.” Use “us” and “we” (instead of “I” or “me”) to show it’s not just you that has a concern:
- Avoid: “I would like to know why you had such poor holiday traffic.”
- Instead be less confrontational: “Please help us understand why NewCo (the interviewee’s company) experienced holiday traffic well below its competitors”
Avoid using words and phrases that will put the interviewee on the defensive. Examples of bad vs. good words include:

Bad	Better
Huge mistake	Poor strategic decision
Crash	Collide/accident
Tell me... Give me... What is... How much did you...	Can you help us understand… How much would you estimate...

Use terminology and vocabulary level that puts the interviewee at ease. If you’re speaking to the manager of a coal mine, use mining terms that will be understood and avoid financial terms like “ROIC”, “EBITDA” or “DCF” which could cause anxiety.

For sensitive topics, refer to the past rather than ask for a forecast:
- Avoid asking for a forecast: “Do you expect pricing to continue to drop?”
- Instead reference the past: “Has pricing continued to decline?”

Use passive voice (vs. active) to avoid putting the interviewee on the defensive. With the active voice the interviewee (person, manager, company, etc.) performed the action, whereas passive implies the action was performed on the interviewee. Here are examples:

Active (not recommended)	Passive (recommended)
Did management invest too much into the new model handset?”	Was too much invested into the new model handset?”
Will your company likely achieve its growth target?”	Will management's growth target likely be achieved?”

Desensitize Deficits

When probing management about its company’s deficit areas:

Blame criticism as coming from others…”I noticed Golden Bull Securities recently downgraded your stock over concerns your growth rate is slowing. Is their thesis warranted?”

Focus the criticism on the numbers or performance, not the people:
- Poor practice: “Why did you so badly disappoint this past quarter?”
- Best practice: “Why were EPS 10% below consensus this past quarter?”

When applicable, start the question with a lead-in to show the company is not an outlier. “Many companies didn’t think they would be significantly hurt by the recession and yet every stock in the sector is down at least 20%. What are some things that could have been done at your company to soften the impact of this downturn?”

Use the Right Question Type and Order

Start with easy questions first and then move on to more difficult ones; it will help the interviewee build confidence and feel less defensive, which is critical for getting insightful answers to some of the more sensitive topics

Be careful not to use too many closed questions because they take control from interviewees (for example, “Which is your most profitable product line?”)

Avoid these question types because they will not likely yield an answer that helps in stock picking:
- Rhetorical: making an assertion or eliciting a response from the interviewee that the interviewee is unlikely to answer directly, such as “Why does the company seem to get beaten up so much by the sell-side?” (What value does the analyst gain in the response?…probably none and it ultimately wastes time that could have been focused on a much better question.)
- Complex or nested: when multiple topics are covered in one question. For example: “When and where will the next generation of the software be introduced, and why has it not occurred in the original forecast timeframe?” The interviewee may choose to only answer the easiest part of the question, hoping the other elements are forgotten.
- Insulting: delivered and received in a manner that is likely to be interpreted negatively by the interviewee. For example: “With all due respect, can you explain why your operating margins have been horrendous forever?” Instead, ask in a manner that will elicit a good response such as, “Can you help us understand why your margins are among the lowest in the industry?”

Conclusion (for now)

There’s more to cover in the ICE™ framework, which I’ll need to discuss in a future post. I hope I’m helping convey that if you “calm their conerns” you’re likely to get a better response.

©AnalystSolutions LLC All rights reserved. James J. Valentine, CFA is author of Best Practices for Equity Research Analysts, founder of AnalystSolutions and was a top-ranked equity research analyst for ten consecutive years.