12 – 15 May 2002, Toronto, Ontario, Canada

General Comment

The Conference was held at the Sheraton Centre Toronto Hotel, which is situated in the downtown area of the city. There are 128 000 people in Toronto involved in the finance industry, which comprises roughly one third of the Toronto economy. 13% of the world’s CFA’s are in Canada and almost 7% of the current Candidates are in Toronto. The AIMR-affiliated society in Toronto has 5 000 members.

There were 1 017 members of AIMR that attended the conference, one of the largest on record.

The following are my personal notes from the conference program, which I hope are a reasonable reflection of the proceedings, and need to be appreciated within this context. Occasionally I have appended my personal observations and interpretations to the speaker’s comments, noting these in square brackets and italics: [Observation].

Please feel free to contact me on ArthurThompson@yebo.co.za or 082 787-6807

Trade and Leadership – The Linchpin of Global Economic Growth

The Right Honourable Brian Mulroney,

(Senior Partner Ogilvy Renault)

The two great challenges to the USA, other than security issues, are:

• The emergence of China (not discussed further by Mulroney)
• International trade

Mulroney used the liberalisation of trade between the USA and Canada and the formation of NAFTA, as an example for how the governments were able to generate prosperity for their people. There is currently $700 billion trade annually between the two counties, with Ontario alone being more important to the USA than Japan.

International trade creates durable jobs and NAFTA, which involves 400 million people accounts for one third of world economic activity. Mexico is now the USA’s second largest trading partner, after Canada.

Canada is currently lagging the US in terms of growth, GDP per capita, productivity and technology. R & D expenditure is anaemic.

Some philosophies that Mulroney expounded are:

• The fundamental role of government is to make a better world for its citizens
• Political will is essential to groundbreaking changes – and will not always be popular – but you have to do what is right in principle and in the longer-term
• Do not go for 10-day popularity (as is the popular political activity) but do what is right on a ten-year perspective
• Increase consumption taxes, eliminate personal taxes and reduce corporate taxes
• Drop the borders totally between the USA and Canada but for security reasons strengthen and increase the barriers to entry from the outside [people barriers not trade barriers]

George W Bush was elected on a free-trader platform and Mulroney hopes it is a case of “one step backwards, to later go three steps forward”. Examples of current backward steps are protectionism with regard to steel, farming and softwood lumber.

[The importance of increased, freer, fairer global trade came through strongly, providing a platform for global prosperity. However, the current wave of protectionism is concerning and if this persists will result in lower global growth and less economic prosperity for its citizens.]

Globalisation and Trade:

Key developments for Investment Management

Ambassador Charlene Barshefsky

(Senior International Partner Wilmer, Cutler & Pickering)

Trade negotiators are used to dealing with tangible goods, such as autos, steel, etc., and struggle with financial goods – negotiations in this respect is complex and only really began in the nineties.

Protectionism is bad and bad policies when enacted are very difficult to remove, thus it is vital to prevent these. For example, GATT and its successor the WTO is taking many years to reverse the barriers that were erected earlier. New countries in the WTO, such as China, offer the best opportunities for “open” financial trade. China is opening up its banking and insurance activities, but more slowly with regard to their securities industry.

While the export of financial services is the fastest growing part of the services section of the USA current account, it is miniscule compared to similar domestic trade.

The current trade negotiations between the USA and Singapore and the USA and Chile are important indicators, not because of the size of the trade but because these countries are opinion leaders in their respective geographical areas.

The global trade-talks cycle is between 10 and 12 years, therefore the players have to take far-reaching and profound decisions.

The reward for successful trade negotiations include:

• More stable economies
• More interdependent economies
• Greater prosperity for all
• Less criminal activity
• Enhanced protection of intellectual property
• More employment

Closed economies are bad for growth for example, they tax the inputs that they require for the manufacture of the exports that they need for economic growth.

[I got the impression that negotiations with regard to financial instruments will be long and arduous, with many false starts. Given the innovative ability of financial market players, one wonders if the economic realities will not precede the official trade relaxation?]

Boom or Bust – Inflation or Deflation

(A More Challenging Investment Environment?)

Marc Faber

(Founder and CEO, Mark Faber Limited)

Faber’s presentation had much to do with the various waves of technology and innovation, each providing major investment opportunities, and trying to forecast the next major investment waves.

[Faber’s presentation was extremely comprehensive and very competent, but possibly too wide-ranging thereby losing the important themes of the opening up of China and other densely populated regions such as India.  It seems as if Faber is fan of the long-wave theories of Kondratief and Schumpeter and possibly a hard-asset bug as well]

Some interesting points were:

• Markets are typically characterised by an overestimation of supply and demand forces, often leading to imbalances which investors can exploit
• The speed of change in new technologies is steadily increasing, with each successive technology wave reaching maturity sooner
• As the price of technology declines this has a deflationary effect, for example the declining cost of PC processing power has had a significantly negative downward bias on the USA GDP deflator
• Declining labour costs and interest rates have supported corporate profits, but is this trend sustainable in the future? [The next major move in interest rates is probably up and as labour’s share of GDP increases, the bargaining power of labour may be on the increase]
• Higher productivity does not necessarily translate into higher profits, since if your competitors are also increasing productivity, this can lead to overcapacity and lower margins. Global profit growth is likely to average out at nominal GDP growth
• The opening of the Chinese economy (and other large populous economies) as a result of the breakdown of communism will change the world economic landscape. Most promising sectors are:
  • Housing (long-term) – since China cannot compete via exports
  • Tourism – the major growth industry in Asia and from Asia
  • Commodities and food – China will become a major importer of these
  • Consumer products, including financial services, required by the emerging Chinese market economy
  • Chinese exports will pressurise the multinationals – unless they are part of it
  • In short, avoid industries in which China can compete, and invest in industries producing goods that satisfy China’s consumers
• Dependence on oil is increasing and future reserves and production will further concentrate in OPEC’s control, auguring badly for the long-term price trend
• The financing of US excesses by foreigners may be at an end. The extent of this financing is dependent on the relative performance of investment opportunities in the rest of the world – which are increasing.
• Financial market will remain volatile

Investment implications:

• USA bonds are likely to outperform US equities
• Government bonds are either peaked out or close to a high. Short (sell) Japanese government bonds
• Avoid equities that have inflated expectations (e.g. USA equities)
• Buy Asian stock markets but do not forget Eastern Europe and Russia
• Buy real estate in China’s leading cities
• Buy commodities, mining, basic industries, oil stocks and plantation stocks
• As the process of indexing unwinds, small stocks are likely to outperform large stocks
• The size of all hedge funds combined will make it difficult for this industry to perform well

Pension Funds and Investment Firms:

Redefining the Relationship
Keith P Ambachtsheer

(President, KPA Advisory Services)

The central theme of this talk was the “reverse food chain” in the pension fund industry and the possible effect on the investment industry of its normalisation.

What KA was suggesting is that pension fund beneficiaries (who should be at the top of the food chain) have played second fiddle to the investment advisory business, which has made a fortune out of them. This inverse food chain is what KA perceives is reversing.

Three reasons why the inverse situation has persisted:

• The Money Flood [Such a vast quantity of funds has flowed into the industry that it has been an advisor’s paradise]. Perversely, the agents (advisors) control and benefit from the funds that belong to the plan beneficiaries.
• Ineffective Pension Fund Governance, which has resulted in plan beneficiaries not always getting the optimal deal. Three observations from the book “Folly and Fortune” by O’Barr and Conely, mention some of these: pension fund organisational structures seem to be historical accidents, the culture has been one of responsibility shifting and blame deflection, strong personal relationships with advisors seem to be a top priority. KA and associates, through a survey of 50 funds, estimated these governance shortfalls to be equivalent to 66-100 basis points per annum.
• High Equity Returns [Presumably, these returns have been sufficiently high so as to not force the fund trustees to pressurise the advisory industry to reduce its fees]

The above 3 reasons are being negated by the current and prospective environment and governance finally improving.

The “New Paradigm” pension fund has 8 characteristics:

• The identification of a liability portfolio, defined by duration and inflation sensitivity [a low duration equity portfolio is similar to a high dividend yield portfolio]
• The funds risk-return benchmark is established in terms of the liability portfolio.
• The funds cost of capital is defined in terms of hurdle rate of taking risk on the fund’s balance sheet.
• Advisors and fund managers agree on a risk budget with green, red and amber risk zones.
• Fund’s executive functions are structured along risk budget lines with sub-allocations.
• Optimal and dynamic fund organisational structure without preconceived bias towards internal or outsourced mandates
• Compensation philosophy that aligns interests of stakeholders with that of the fund advisors
• IT systems that meet the fund’s governance, executive and operational functions.

The new way to think about asset allocation is in terms of a Risk Minimising (e.g. low risk or inflation linked bonds) strategy and Risky Strategies. The Risky Strategies in turn divide into Long Horizon (placing a value on uncertain prospective cash flows) and Short Horizon (Adverserial Trading strategies).

The investment decision then includes the asset allocation between these three broad classifications and the optimal weighting to achieve the desired balance between expected excess return and the volatility [risk] associated with this expected return.

The rest of KA’s presentation posed rhetorical questions as to whether YOUR firm has the ability to offer real-value services to the new-paradigm funds.

The Theory of Adaptive Evolution and the Role of Symbiosis

(or how the Sell-Side survived Trading Automation)

Dr Benn Steil

(André Meyer Senior Fellow in International Economics Council on Foreign Relations)

Steil’s big question for the audience is whether brokers still add value to the trading process?

Brokers evolved as a mechanism through which buyers and sellers could interact with the trading floor. Exchanges, which provide the trading floor/platform used brokers to ration access to the floor. In the era of trading automation is there a need for intermediaries?

Since the marginal cost of adding a trader to a network is virtually zero, how can you charge much more than zero for it?

(Steil was once on the trading desk for a large broker and favours the unbundling of trading and research commissions/fees).

Steil provided a number of compelling arguments and research results that illustrated a meaningful saving as a result of disintermediation (eliminating the intermediary – the broker – in the price formation and trading process). The research covered the NYSE, NASDAQ and some European markets, employing actual historical data and available electronic systems.

On both the NYSE and Nasdaq, some 30 bps were added by the intermediary in explicit costs (fees and commissions) and implicit costs (efficiency of execution).

Soft dollar arrangements complicated the calculations, but research indicated that they do not add value for the trade principal (recipient of the soft dollar “benefit”).

The conclusions are that the broker does NOT add value in the process and that automated systems such as ECN’s or direct client-to-exchange systems should take over.

Accepting this copious research evidence, the question that begs an answer is: “Why does trade intermediation persist?” Some reasons are:

• Over half of US institutional commissions are targeted in advance (not directly related to the efficiency of the specific deal’s execution). This suggests that the commissions are directed to a specific broker because of soft dollar arrangements including research remuneration.
• An SEC survey indicated that almost two thirds of soft dollar arrangements were not committed to writing and that of these half were illegal in terms of SEC rules.
• Research indicates that in the US, “softing” costs between 24 and 29 bps and that only 60% of this is recovered by the value of the soft-service provided. To be added to this is an implicit cost of inefficient deal execution [soft-deals appear to be subject to front running, lax execution, etc]. Soft commissions attracted 28 bps explicit costs and 70 bps implicit costs. The respective figures for non-intermediated electronic transactions are 7 and 23 bps – a saving of 68 bps.
• Directed brokerage (formal softing) does not solve the problem and resulted in a 43 bps loss from delayed execution (being put at the back of the queue, i.e. front running).
• Many institutional dealers demand transaction immediacy when trading for soft commissions (a directed trade). Reasons cited are to minimise opportunity costs (a futile exercise) and minimise front running (a reality) and information leakage. Longer-term investment decisions are not dependent on trading immediacy, so it is not this that s driving these demands.
• The Myners Report in the UK, did not receive popular support, but suggested that fund managers should receive higher management fees, but be responsible for the brokerage charges. [This would certainly focus the advisor's attention on explicit and implicit trading costs]

Managing the Global Investment Business

Peter Chambers,

(Chief Global Investment Officer

Gartmore Investment Management Plc)

Chambers emphasised that the appropriate long-term strategy is essential for a firm’s successful development, positioning and competitiveness. He obviously does not think that being midsize (such Gartmore) is a problem, but you have to work harder to be successful. Conventional wisdom in the industry is that mid-size firms will wither and die.

[Midsize for Gartmore means Assets Under Management (AUM) of $100 billion (60 in London and 40 in Philadelphia) with an EBITDA margin range of 25 to 35%. Staff owns 10% of the equity and the controlling shareholder is Nationwide, which provides the balance sheet stability]

Chambers emphasised a number of time the importance of motivated, competent people that are part of the strategic process. Financial remuneration is not everything, but part of a total employee package.

To be successful in the Investment Management business you need to at minimum address the “4P’s” of investment management:

• Philosophy (e.g. what will make a stock or strategy outperform?)
• Process (the investment process, governance, controls, etc.)
• People: are they correctly skilled and incentivised? – your people ultimately deliver the results
• Performance – if the firm does not achieve at least “adequate” financial performance there is no long-term future.

BUT the 4P’s is not enough by itself:

• It is important to provide high added-value products that are differentiated, through an appropriate architecture, building competitive advantage while avoiding conflicts of interest. [Architecture in this sense means: “open” – products offered for distribution via a wide range of channels, “closed” – only through own proprietary distribution or “guided” – specialist third-party (non-owned) distribution channels]
• Once the firm has built your competitive advantage, leverage it and build up AUM

Your people have to:

• Have talent
• Have an alignment of interest with the firm (including buying into the process and the strategy)
• Be team players
• Good communicators
• Set and live to high standards
• Be prepared to make important decisions (don’t duck issues, move with the times, make the tough calls)
• Generate ideas that are usable and hold the potential for success

[Chambers brought the discussions back into perspective by stressing the firm’s long-term positioning – you can only address the more subtle aspects of investment management if your firm is able to generate the long-term returns to allow yourself this flexibility]

Economic Forces in Technology Industries

Hal R Varian

(Dean, School of Information Management and Systems

University of California at Berkeley)

Varian used a large, sponsored, international IT telephone survey, with particular emphasis on the Internet, as the basis for his presentations. [The results need to be interpreted within the context of each interview lasting only about a quarter of an hour and the IT managers interviewed possibly being biased towards answers that justified their existance]

Productivity is relatively simple in concept being output divided by input; however both terms are difficult to measure and subject to both interpretation and what factors are to be included. In the knowledge economy, productivity is even harder to measure. How do you measure the productivity gain by having “better” knowledge?

In summary, IT has improved productivity, but more substantially so in the USA than Europe. The slower pace of productivity improvement in Europe appears to be a function of lower labour flexibility, due to legislation, rather than a difference in the pace of the introduction of technology. [South Africa should take note?]

[Conventional wisdom seems to indicate that the major beneficiaries of the Internet are the consumers, who have had the benefit of increased choice and better prices due to aggressive competition. However, the technology may have decimated profit margins?]

Varian agreed with Marc Faber that productivity and profitability were not necessarily correlated.

No More Business as Usual

William C Taylor

(Co-Founding Editor and Co-Editor-in-Chief Fast Company Magazine)

[Bill Taylor spoke without notes and dealt essentially with soft, non-numerical issues. Within the context of the Conference it was a refreshing change of pace. He flies around the world interviewing corporate decision makers for his highly successful magazine and is thus well qualified to offer subjective opinions]

Taylor posed the question: Can we get back to building businesses that are role models and that we can trust? The euphoric era of business (the New Economy) ended with the collapse of Enron and after this cultural revolution are in the throes of a counter-revolution. Now people are just glad to have a job and do not want to be a start-up entrepreneur. How unexciting it has all become!

But there are problems with the post-New Economy type of company, for example:

• People don’t want to deal with the current companies
• People don’t want to work for these companies
• Most are impersonal and the service ethic is really bad – have you had a good experience with a call centre?
• You can’t believe their numbers

However, there are companies that have a genuine service ethic and make dealing with them a pleasure – these are the companies that are showing strong customer growth and in Taylor’s opinion will prosper.

Qualities that Taylor believes define the companies and leaders of the future:

• Great companies do not let the bad times bring out the worst in them. Some themes are:
  • Empathise with their customers, understand their desires and how they want them fulfilled
  • Market leadership means thought leadership
  • People enjoy working for them (in contrast, employees live in fear in bad companies)
  • Unleash the energy and brainpower of their people
  • Appreciate that killer results do not mean killing your people
  • Great companies do not prosper by beating up their customers
  • They prosper because their customers prosper (are happy with the service and products)
  • They answer the ‘phone and you can speak to a real person!
  • Surveys in the USA indicate that customer satisfaction is going south, creating opportunities for companies with a genuine, human, empathetic service ethic
  • They generate enthusiastic customers
• Appreciate that “talent is life” – concentrate on your people
• [If Bill Taylor had] only one question to ask of a chief executive it is: “Why would great people want to work here?”
  • [He appears to get some interesting answers, often uncertain and startled in nature]
  • You have to be deadly serious about the people that you hire and how they interface with your customers

Some traits that Bill Taylor has noticed about great leaders:

• They are pathological learners and seem inquisitive to learn about everything (but they do not seek this knowledge to dominate or belittle their people)
• They seek to step outside their comfort zones to find and benefit from new and alternative experiences
• They have personal strength but intellectual humility. They know that “nobody is as smart as everybody” in contrast to the pre-New Economy era where “the boss knew everything”
• They develop insights into your business [and empathy]

Remember that customers today have an over abundance of choices – they have the power.

Could there be a power shift away from giant, dictatorial corporations to a co-sharing of power with the customer?

Alpha and the Evolution of the Investment Management Industry

André F Perold

(George Gund Professor of Finance and Banking, Harvard Business School)

[Perold is a non-conventional, forward thinker whose seminal works have been used extensively in CFA studies. He is one of the doyens in the AIMR firmament]

It is conventional wisdom that “Everyone knows that you cannot add alpha” – yet there are some fund managers that have managed to consistently do so. [Essentially, alpha is the excess return achieved over the performance of a diversified passive portfolio, e.g. the Index]. Another conventional wisdom is that the Index, say S&P500, beats active management – yet there are some managers that have consistently managed to do beat the Index.

Thus, it appears that the pursuit of alpha can be a worthwhile exercise.

Major industry trends and observations:

The “alpha factories” of today are the hedge funds, and there is currently a trend for boutique money managers to become (or offer) hedge funds. At the same time there is a trend for the boutique firms to be absorbed into the large mutual funds and simultaneously for these to offer hedge fund activities.

From a branding point of view, the large mutual funds have the largest brand equity, and you pay for service. In contrast, the boutiques do not have the brand prominence but charge for service. The alpha factories have low brand prominence and the investor pays for performance (return).

How to make money using these trends? Try combining brand prominence with an alpha factory. Fidelity is starting to offer hedge funds as part of its multi-manager strategy – is this going to become more common?

In 1991 there were 692 hedge funds in the USA with Assets Under Management of $31 billion. By 2001 this had grown to 5 462 funds with $562 billion AUM.

Carrefour, the French retailer, offers shoppers an $880 million hedge fund at its outlets – extraordinary – is this a sign of the hedge fund (alpha factories) becoming a commodity?

The double and treble alpha effect:

Efficient and consistent production of alpha requires research and implementation strategies. Being long only holds the promise of “single alpha”, metaphorically playing ball using only one hand; being long and short holds the potential of “double alpha”, while being able to concentrate your skills and assets, for example in commodities or utilities, holds the potential of “treble alpha”.

[While the above presupposes that you have placed your bets correctly and managed to hedge out most of the risk – big assumptions – the argument is appealing]

It should be noted that in every active fund there is a measure of hedging when compared to the benchmark. Any under- or overweight portfolio holdings represent a moderate bet against the index (benchmark).

A paradox – what is the “right” quantum of assets?

The smaller your fund the more it costs you to trade, e.g. because the block trader quotes you a low-volume price, yet the diseconomies of being too big are high transaction costs due to size relative to the market (market impact).

Alpha transport

The concept of alpha transport is becoming popular, for example:

An equity fund (through a swap dealer) swaps the S&P500 return for the Bond Index return. Assume the equity fund portfolio is constructed to achieve the S&P500 return plus 2% alpha. After the swap, the return is Bond Index plus 2% [of S&P500] alpha. Post the swap you may have a radically different risk-return profile.

To illustrate, the “Old Way” of investing was say 60% stocks and 40% bonds, while the “New Way” is Bonds with an equity alpha in addition to some equity overlay (dependent on the proportions of the swap). A wide range of risk-return permutations exists.

Hedge funds are starting to get creative with offerings such as alpha transport, structured products, tax-efficient wrappers, etc.

Investment vehicles could be classified along a continuum of:

Low investor ability to control combined with low transparency (and high agency costs): e.g. venture capital, through to maximum investor ability to control, very high transparency (and virtually-zero agency costs) e.g. Exchange Traded Funds [such as Satrix40, which is freely and cheaply tradable with its portfolio contents continually visible]

Hedge Funds would typically tend towards the venture capital side while Index funds and Index futures – not quite as efficient or transparent as ETF’S – approaching the ETF side. [This can be expressed in a graphical form with Investor Ability to Control on the vertical axis and Transparency on the horizontal axis. Venture Capital would be in the bottom left corner and ETF’S in the top right corner, with the other investment opportunities plotted diagonally between the two extremes]

How do you find your alpha manager and understand (feel secure about) the agency costs/transparency? It is not easy and this implies that the hedge funds need to develop good public relations and brand awareness and confidence.

In one sense brand is developed and supported by guarantees. “Customers” buy products that they expect to perform as advertised (e.g. a refrigerator, a money market fund) – effectively guaranteed, while “Investors” appreciate that there is risk (no guarantees) and buy a range of products to diversify away from this risk. Products that work develop brand-equity; hedge funds need to develop products that work consistently and thereby build brand.

“Brand-equity” or “Franchise-value” means that people are prepared to cut you slack because they trust you.

Some thoughts to ponder when deciding on the appropriate AUM scale:

• What is the capacity? (Of the firm, the market segment, the instruments)
• Is it scalable?
• Who else is doing the same thing?
• How do you package and market the alpha?
• What fees are appropriate?
• Level of transparency desired and demanded by the investor?
• What are the processes and the business model?
• What talents and skills do you require?
• How do you keep your people?
• Are you a product factory or a distribution channel?