The Finance Professionals' Post

The Covered Bond: A Vehicle for the Shift to a Low-Carbon Economy?

In our first two articles focused on the emerging climate bond market, we spoke with Nick Robins, Director of HSBC’s Climate Change Center for Excellence, and to Sean Kidney, Cofounder and Chairman of the Climate Bonds Initiative. Here, we look at how the covered bond might be adapted as an investment vehicle to catalyze the funding of the critical transition to a low-carbon economy.

The International Energy Authority now estimates that $1 trillion will be required in annual “low-carbon” project funding out to 2050 if the global economy is to avoid the most catastrophic impacts of climate change. Meanwhile, the fallout from the global financial crisis has left both governments and the capital markets severely constrained in their ability to support those funding needs.

Time for Regulatory Change?

The shocking news out of JP Morgan this week about a $2 billion trading loss is a stark reminder that even Jamie Dimon, the CEO of such a major firm, can be completely in the dark about what's happening inside the very firm he runs. Dimon has said publicly that this surprised him.

Nonetheless, the timing is perfect for the politicians and regulators to pile on with their solutions to fix the banking industry. There are several regulations that will be referred to in the media and blogosphere during the next few weeks in relation to the JP Morgan trading losses.

Thankfully, you don't have to go to Washington, DC, or Wall Street for the debate. The New York Society of Security Analysts (NYSSA) is hosting a program called "Regulatory Changes as an Opportunity" this month. The speakers for the event will be Jim Allen, CFA, Head of the Capital Markets Policy Group for CFA Institute; and Kim Olson, a principal with Deloitte & Touche LLP.

Is Your Resume Getting Read By Robots Instead of Humans?

Recruiters report that due to the overwhelming supply of talent today, desperate job seekers are flooding every position—but that 50% or more of applicants are unqualified for the position to which they are applying. To save companies time and money, the hiring process has become largely automated. Almost all Fortune 500 companies and nearly 95% of all large firms use software filters to examine digital submissions.

Before your application gets seen or touched by human hands, it is almost certainly first examined by software. The Applicant Tracking System (ATS) is an automated system which scans and scores your profile, determining whether or not you are worthy of human review. It eliminates much of the chaff in the selection process. However, the down side is that a lot of wheat is left unharvested as well.

Recent Research: Highlights from May 2012

"The Death of Diversification Has Been Greatly Exaggerated"
The Journal of Portfolio Management (Spring 2012)
Antti Ilmanen and Jared Kizer

Diversification is famously referred to as the only “free lunch” in investing, but it has been under assault since the 2007–2009 global financial crisis, when virtually all longonly asset classes moved down together. Ilmanen and Kizer argue that the attacks are undeserved. Most investors were never as diversified as they thought they were, and there is ample room for improvement by shifting the focus from asset class diversification to factor diversification. They show that diversification into and across factors has been much more effective in reducing portfolio volatility and market directionality than asset class diversification. The benefits are greatest for long–short investing, which requires shorting and leverage but are also meaningful in a long-only context.

CFA Institute Integrity List: 50 Ways to Restore Trust in the Investment Industry

The CFA Institute Integrity List is a collection of 50 tangible steps that investment professionals can take to restore trust in the industry. The list was inspired by “real-world” ideas from CFA charterholders and members.

Counting Down to the CFA Exams

FOUR WEEKS TO GO...

By now you should have finished your first reading of the CFA curriculum. If you haven’t, then get a move on it—time is ticking away.

Make a plan for the critical phase that’s coming up: revision. There are lots of ways of planning your study time, but the simplest technique is to just divide your days up into blocks of study time, say a 2.5-hour block in the evenings after work or three 2.5-hour blocks on weekend days. This may sound obvious, but it’s crucial that your blocks are dedicated exclusively to study. Do, however, ensure that you give yourself time off in between your study blocks too.

The Checklist Manifesto

In 2009, Atul Gawande published The Checklist Manifesto: How to Get Things Right. Sometime later, a copy arrived at my office, courtesy of a money manager, but it sat unread for many months.

I shouldn’t have waited and, if you haven’t read it, neither should you. I knew of Gawande from his articles in The New Yorker, but despite the favorable notices I read when the book was published, I really didn’t expect much. Checklists? OK, right.

Insuring Lives and Protecting Families - The Early Years of the $5 Trillion Life Insurance Industry

19th century blank check from the New-York Life Insurance and Trust Company

It’s hard to believe that life insurance, a $5 trillion industry in the United States, was once considered profane. After all, many initially thought it would be offensive to put a dollar value on a person’s life.

But the insurance industry, which already had been insuring ships and later the lives of marines in England as far back as the 16th century, began informally protecting human lives in the United States in the mid-18th century.

Diversification in Funds of Hedge Funds: Is It Possible to Overdiversify?

ABSTRACT

Many institutions are attracted to diversified portfolios of hedge funds, referred to as Funds of Hedge Funds (FoHFs). In this paper we examine a new database that separates out for the first time the effects of diversification (the number of underlying hedge funds) from scale (the magnitude of assets under management). We find with others that the variance-reducing effects of diversification diminish once FoHFs hold more than 20 underlying hedge funds. This excess diversification actually increases their left-tail risk exposure once we account for return smoothing. Furthermore, the average FoHF in our sample is more exposed to left-tail risk than are naïve 1/N randomly chosen portfolios. This increase in tail risk is accompanied by lower returns, which we attribute to the cost of necessary due diligence that increases with the number of hedge funds.

Book Review: Ben Graham Was a Quant

ABSTRACT

The author, unlike many others, views Benjamin Graham’s work as the origin of quantitative investing. He reviews the history of quantitative investing and uses Graham’s investment methodology to introduce such concepts as alpha, the Sharpe ratio, and the Fama–French model.

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The roots of value investing can be traced back to the 1934 publication of Benjamin Graham and David Dodd’s classic, Security Analysis. Graham later disseminated his views to the general public in the highly regarded book The Intelligent Investor. The influence of Graham’s methodology is indisputable. His disciples represent a virtual who’s who of value investors, including Warren Buffett, Bill Ruane, and Walter Schloss. As a measure of his enduring impact on the field, a search of “Benjamin Graham" on Amazon.com yields more than 900 results concerning Graham’s writings and works about his investment philosophy. Given the success of the master and his students, it is no wonder that Graham remains an investor of immense interest to practitioners.

The title Ben Graham Was a Quant: Raising the IQ of the Intelligent Investor (Wiley Finance) will probably cause readers to envision a book that traces Graham’s remarkable life and dissects his use of quantitative techniques that have become prevalent in modern finance. In reality, Steven P. Greiner has written a very different type of book. Greiner, the head of Risk Research for FactSet Research Systems, is the stereotypical Wall Street quant, holding a bachelor’s degree in mathematics and chemistry from the University of Buffalo and a PhD in physical chemistry from the University of Rochester. Greiner’s background in the hard sciences is evident in the quotations from either Albert Einstein or Isaac Newton at the beginning of nearly every chapter and in the author’s extensive use of examples from the hard sciences.

Throughout the book, Greiner pays homage to Graham, using his investment philosophy as the catalyst for examining quantitative investing. In the early chapters of the book, however, Greiner focuses mostly on his own view of quantitative investing. In spite of his strong quantitative background, he does a good job of making his ideas accessible to readers with a wide variety of backgrounds.

Greiner starts with a review of the history of quantitative investing. In most accounts, the story begins with Harry Markowitz’s seminal work on portfolio theory in 1952. For Greiner, however, the origins of quantitative investing date back earlier, to the work of Benjamin Graham. Greiner points out that Graham’s 1949 classic, The Intelligent Investor, lists seven criteria that defined the “quantitatively tested portfolio." These criteria include such factors as the size of the enterprise, earnings stability, financial condition, dividend record, earnings growth, price-to-earnings ratio, and price-to-book ratio. As Greiner points out, the definition of a quant as someone who designs and implements mathematical models for the pricing of securities does not mention the use of a computer.

As the pages go by, the link between Graham’s methodology and quantitative analysis becomes clearer. Chapters 4–6 begin to delve into the quantitative factors that Graham used in formulating his investment philosophy. Throughout these chapters, Greiner tests the empirical validity of Graham’s factors with a Fama–French type of model. Greiner criticizes the factors used by many MBAs that are linked to academic theories but may have no empirical validity. He writes, “Empiricism suggests the main drivers of stock returns are often market trading forces more than business financials." In testing Graham’s model, Greiner finds that such factors as book-to-price ratio, price-to-earnings ratio, and dividend yield do extremely well in predicting performance.

Using the Graham factors, Greiner goes on to build a factor model for predicting returns. Because he cannot confer with Graham on which factors to include in the model, Greiner does not use stepwise regression to identify the best ones. Rather, he elects to use all the factors in order to remain true to the Graham methodology. Throughout the book, Greiner provides numerous tables and graphs to document the effectiveness of the Graham factors in predicting security returns and to support the fundamental tenet of the book—that empiricism should trump theory in modeling security returns.

Continue reading "Liquidity Level or Liquidity Risk?" »

How Do You Find a Job in the New Economy? Use a New Approach

There is little question that the new economy has brought changes in the way business is done. It is painfully obvious to those seeking positions in the financial industry that business-as-usual is anything but the same-as-it-ever-was. The good news is that the changes can work to your advantage.

The new economy is one that requires workers to be far more adaptable; always on the prowl, and in a state of perpetual job search. What you have done and what has worked in the past (and what is most comfortable) in most cases will not work for you anymore.

Video: The Positives of Investing in Technology Micro-caps

The volatility of investing in mirco-caps may scare away some investors, but there are many opportunities to find hidden gems in the sector. As seen on CNBC's Talking Numbers, Barry Sine, Managing Director of Drexel Hamilton, gives an overview on the positives of micro-caps. The ability to pinpoint specific markets and segments can be especially rewarding when investing in new technologies, which are in favor this year.

Positives of microcaps:

• The financial statements are much simpler. Financial statements of microcaps are very straight forward, as opposed to having multiple sectors and a complex balance sheet .
• The management teams are very accessible. It is common to have direct communication with the management team and CEO of a micro-cap company.
• There is the ability to pinpoint a very specific market down to a country, or even a state.
• You can zero in on a specific technology or trend and capitalize on it. With trends and innovations like social media, display technology, and memory, there is potential for great rewards.
• If you do not want to invest in the companies that make these new technologies, you can invest in the companies that own the patents.

Update: Commodities Are Different (in a "Full World")

The concern I raised last June that we should enforce the Bank Holding Company Act and not allow the too often irresponsible, gigantic, TBTF, and taxpayer-subsidized banks to engage in proprietary physical commodities trading has now been raised in a new article by Reuters. Abuse by large-scale, trading-driven firms, more so in physical commodity markets than in financial markets, can lead to drastic harm in the real economy as we learned from Enron's manipulation of the California electricity markets. But, as I detailed in my post, the issue is much bigger than speculators driving price swings in commodities. A world with finite resources and planetary boundaries will have allocation problems that markets cannot handle effectively or fairly. Rising commodities prices, and the effects they have on the poor, are primarily due to the fundamentals of limits to growth we are beginning to bump up against. The confluence of allocation, pricing, equity, and limits questions when dealing with scarcity of critical resources where there are no easy substitutes is already posing real challenges, as we discussed in our “Big Choice” essay.

The Formula to Approaching CFA Level II Formulas

The Level II curriculum is chock-full of formulas which makes it very easy to jumble it into a massive helping of Greek alphabet soup in your head on exam day. Here are some tips to avoid this exam-day scenario:

DO NOT Memorize

Instead of memorizing, find ways to understand and categorize the cirriculum at a functional level.

Prof. John Veitch, PhD, CFA teaches candidates to eliminate memorizing almost all formulas in the foreign exchange section (Level II SS 4) by conceptualizing cross-currency calculations as triangles and covered interest rate parity as boxes. If you know what the sides of the triangles and boxes mean, all that’s left is to plug in the variables. This technique can be used for calculating rates and arbitrage opportunities. For exchange rate predictions, he "standardizes" the approach as the beginning rate times an adjustment factor that has a common form regardless of whether it's inflation or interest rates doing the adjustment.

Beware of Unintended Economic Consequences

Unissued bank note from the Second Bank of the United States

Many observers are beginning to examine the unintended economic consequences of major reform legislation in the areas of health care (The Patient Protection and Affordable Care Act) and financial services (The Dodd-Frank Wall Street Reform and Consumer Protection Act). Such consequences have often followed sweeping actions taken by various elements of the federal government. All three branches have at times seemed equally oblivious to the unintended economic consequences of their decisions.