CFA Institute Annual Conference

10-12 May 2004
Venue: Adam’s Mark Hotel, Denver, Colorado
Reported by William Bowler

Introduction

At this year’s annual conference, members of the previously known Association for Investment Management and Research voted overwhelmingly to change the name of the organisation to the CFA Institute, in recognition of the body’s primary function of administering and setting the examinations for the Chartered Financial Analyst qualification – now recognised as the leading qualification for investment professionals worldwide.

The conference was held at the Adam’s Mark Hotel in the beautiful city of Denver, Colorado. It was attended by close to 900 delegates from 48 countries, including 5 delegates from South Africa.

The conference ran for two and a half days and the format was the same as last year. Each day started with a selection of corporate breakfast presentations, which were followed by a general session comprising three papers delivered over the balance of the morning. The afternoons of the Monday and Tuesday were devoted to five concurrent workshop tracks across the fields of Equity Analysis and Management; Fixed Income Analysis and Management; Portfolio Management; Private Wealth and Alternative Investments; and Firm Management. Thus one could attend all of the general sessions in the morning but had to select four of the twenty workshop sessions depending on one’s particular area of interest.

Highlights of the presentations attended by the writer are set out below. The first three cover topical issues in today’s investment markets, while the balance deal with trends and developments in the industry. Please address any queries or comments to our executive officer, Ann Marie Wood at iassa@iafrica.com.

Commodities: The Real Bull Market

Jim Rogers

Jim Rogers – former Wall Street hedge fund manager, author and commentator, visiting professor at Columbia University and one of the doyens of the US investment industry – has twice driven around the world, once on a motorbike and most recently by car with his wife, covering over 150000 miles in three years.

He delivered a fascinating and thought-provoking presentation, drawing on his and his wife’s experiences and observations during their vast travels to support his core long-term proposition – namely that while the Eighties and Nineties were the great bull market in equities, and bear market in commodities, we are now in the early stages of a great bull market in commodities.

The highlights of his argument:

It’s a simple case of supply and demand. In the last 25 years only one new lead producer has emerged. There has not been a significant new oilfield discovered in the last 35 years, while existing fields have been progressively depleting.
The 21st century will belong to China. Despite the country being officially communist, its population of 1.3 billion is arguably the most capitalist-inclined in the world. They currently save around 40% of their income (compared with 2% in the US) – a vast savings pool to be unleashed on consumption and investment spending for decades to come.
Fundamental to China’s growth potential are the investments now being made in infrastructure, such as excellent roads, and human capital via quality education. This is in sharp contrast to India, whose growth potential is severely hampered by very poor infrastructure and education.
His advice to today’s adult generation: ensure your children and grandchildren learn to speak Chinese, which is likely to join English as one of the world’s two most important languages.
Commodity bull markets have historically lasted a long time, anything from 15 to 23 years. The supply/demand imbalances that fuel each run take many years to unwind because of the very long lead times to bring new production on stream. The current bull market commenced towards the end of the 1990’s and, in Jim Rogers’ view, will last another 10-15 years.
During this time there will be setbacks and perhaps quite severe corrections, but the primary bull market will remain intact. China is currently over-heating and measures have been introduced to cool the economy, but this will not upset the huge long-term structural growth story.
Note, however, that his enthusiasm for commodities does not extend to gold, which he rates among his least favoured commodities. As a negative he cites the fact that enthusiasm for gold has remained high, despite the long-run bear market in the metal. Some 75% of all global exploration expenditure last year was in looking for viable new gold deposits, notwithstanding the huge above-ground stocks of the metal – notably held by central banks, which are likely to remain sellers in years to come.

Global Politics Strikes Again?

Marvin Zonis

Marvin Zonis – professor emeritus of Chicago University’s Graduate School of Business, head of his own international risk consulting firm and a leading authority on Middle Eastern politics – presented a wide-ranging assessment of current world politics.

He is scathingly critical of US national strategy and foreign policy, which he views as formulated and controlled by a group he calls “The Neo-Cons” (neo-conservatives, including vice president Dick Cheney and Secretary of Defense Donald Rumsfeld), who believe the US has the economic and military power to transform the world into the way they want to see it.

The US’s huge economic and military might is illustrated by two statistics:

Of the total world GDP of some $32 trillion, the US accounts for nearly $11 trillion, or about one-third – in spite of having just 4.5% of the world’s population.
This year’s expected US military spending of about $470 billion will be as much as the entire defence expenditure of the rest of the world combined.

As he sees it, the major problem for the US military is that its forces have simply not been trained for the type of role they are now being called upon to play in Iraq. With their massive military superiority, defeating any enemy is relatively easy, but winning hearts and minds in an occupied country is simply not part of their skill set. Zonis does not see any solution in UN involvement, citing Iraqi mistrust of the organisation, but believes the US should be turning to its NATO allies to provide forces to assist in quelling the radical uprisings in the country and ultimately advancing its transition to democracy.

The US and other OECD members constitute the world’s 30 most prosperous nations, which achieve average annual growth rates well in excess of population growth – thereby progressively improving the living conditions of their people. Around 20% of the world’s population live in these countries. Successful emerging markets, containing 60% of the world’s population (40% in China and India), are also growing their economies faster than their populations are increasing. The problem lies with the 60-odd countries – Zonis calls them “Failing States” – where the reverse is occurring, i.e. over the last 20 years the hapless inhabitants of these countries – the remaining 20% of the world’s population – have simply become poorer and poorer. It is from these Failing States that all the terrorism atrocities and other global problems such as drug trafficking will emanate, in his view. These states include the likes of North Korea, Pakistan and Iran.

Some of his viewpoints which flow from this central theme of the risks posed by the Failing States:

Iraq aside, resolution of the Israel/Palestine conflict is the biggest issue by far for the entire Arab world. Ideological support for the Palestinian cause applies even in the case of Arab states such as Morocco, which is geographically remote from Palestine and is hardly affected by the conflict. Israel’s land policy, the Wall and the assassination of leaders such as Sheikh Yassin are all serving to raise tensions in the region.
He predicts a major terrorist event in the US between now and the presidential election in November. The UK is also at very high risk of a terrorist attack.
Osama bin Laden could well be captured or dead by the time of the election, but he would then become a martyr and a symbol of resistance to the US. Holed up as he is, probably somewhere in the mountains of Pakistan, he is no longer active in operations, which are now being directed by al Qaeda’s no. 2, Dr. Ayman al Zawahiri.
Because of its nuclear capability, Pakistan represents a grave risk, probably worse than the danger posed by North Korea.
Iran has numerous nuclear-related facilities spread across its vast country and is probably developing nuclear weapons.

Over-arching all these political issues is the primary challenge facing the US and the world over the next couple of decades – securing the oil and other energy resources so critical to economic growth. While the energy efficiency of the US has improved dramatically since the oil shocks of the Seventies, the fact remains that petroleum products are still vital to the world’s economic engine. Domestic US crude oil production is in secular decline, necessitating progressively rising imports. Small wonder that the establishment of stability in the Middle East ranks uppermost in the minds of global leaders.

The Outlook for Energy

Thomas A. Petrie, CFA

With high oil prices now a primary focus of attention in the investment markets, one of the most interesting and insightful papers delivered at the conference was by Thomas Petrie, whose company specialises in advising on energy-related mergers and acquisitions, and provides petroleum investment research. Previously he was the senior oil analyst at First Boston and for eight consecutive years was ranked the top oil analyst in the Institutional Investor annual survey of fund managers.

In his view, energy issues are now occupying centre stage of the investment arena and will remain there over the balance of this decade and probably into the next. He sees what is happening now as very different from the situation prevailing in the Eighties and Nineties, with similarities with what happened in the Seventies when major oil price shocks had such profound effects on the global economy.

Looking at the period 1975 to the present, there has been a clear, and probably irreversible, increase in crude oil prices from an average of around $19 a barrel in 1995-1999, to about $29/bbl over the period 2000 to date.

The problem is simply one of growing demand and dwindling supply: rising consumption, especially in China and India, versus maturation of the conventional petroleum resource base – and all complicated by the political dynamics and imponderables in the Middle East. The arithmetic looks approximately as follows:

	Barrels per day (‘m)
Current production	80
Depletion of current oilfields at say 5% p.a. over balance of decade	21
Likely additional demand from:
China	9-13
India	2-4
Russia	1-2
Potential supply deficit by 2010	33-40

Critical to the supply side of the market equation is the situation in Saudi Arabia, the world’s largest producer. Societal factors at work in the Kingdom create the risk of significant instability in the years ahead, with possible disruptions to crude output. And even if the country remains stable, its ability to increase production to meet some of the likely supply shortfall indicated above is questionable. Saudi output is currently about 8m barrels per day and the assertion of its official Aramco body is that this could be incrementally raised to 15m bpd by the end of the decade – and be held at this level through to 2050. Petrie and others question this forecast, in particular citing concerns over the maturity of the Ghawar field – by far the country’s largest.

The Ghawar field currently accounts for a full 60% of Saudi’s total output, with the balance coming from 14 other fields. Ghawar’s operations have become complicated by water coning issues – the encroachment of water on the oil wells – and horizontal drilling across the oil-bearing layer has been introduced in response to the problem. Petrie is sceptical that this will be the solution to enhance production. And if Ghawar is indeed starting to mature, then so will the entire Saudi industry – new fields that have been discovered are simply not good enough to replace lower output from Ghawar. Contrary to Aramco’s forecast, he sees Saudi production peaking at about 10-11m bpd.

There is some good news, especially in the area of natural gas production – a major source of possible price mitigation. Production could grow by 25 billion cubic feet per day in the Atlantic Basin alone, and the Pacific Basin has similar potential. Prospects in numerous areas around the world are highly viable, and projects are moving ahead. Major expenditures in natural gas are now being considered by the oil majors. Even deep water projects in areas such as the Gulf of Mexico and West Africa are likely to attract substantial investment, with new floating platform technologies making many previously uneconomic fields viable.

Greatly intensified global competition for energy supplies is likely to be the result of these dynamics, of a magnitude not seen since the period 1973-82. If Ghawar starts to fail, crude prices in the $40-60/bbl range are highly probable, and what would that mean for the world economy?

Petrie’s conclusion is that the energy investment environment, while rewarding overall, is likely to be chaotic and often very challenging. Current US and EU policymaking shows few signs of providing constructive solutions, and indeed carry the real danger of making a bad situation worse. He advises energy sector investment strategies that allow for a continuing series of exogenous events – this was the great lesson of the Seventies.

Creating Sound Corporate Governance: The Shareholder’s Perspective

John (Jack) C. Bogle

Jack Bogle is listed in a recent issue of Time as one of the world’s 100 most influential people. He was also named by Fortune as one of the investment industry’s four “Giants of the 20th Century”. In 1975 he founded The Vanguard Group, a leading provider of mutual funds and other financial products to institutional and individual investors.

While the common theme running through the Enron and other corporate scandals was the failure of the “gatekeepers” – auditors, regulators, attorneys and investment bankers – to properly perform their roles, investors themselves also need to look inwards and recognise their responsibilities as the owners of the businesses.

The precursor to Enron et al was the replacement of owners’ capitalism by managers’ capitalism, allowing for the rise of the imperial CEO. Management compensation became “outrageous”, with the average CEO’s pay rising from 42 times the lowest paid worker to around 530 times. Coupled with this was an overriding reluctance on the part of the institutional investment community to exercise their effective control.

Illustrating the general apathy of institutional investors was a report published at the end of 1999, giving the findings of interviews conducted with 119 analysts on financial reporting and the audit function. The overwhelming majority expressed confidence in the auditors, despite accepting their lack of proper independence, and also said most financial reports could be trusted. The American Institute of Certified Public Accountants was clearly delighted!

The 100 largest US institutions own 56% of listed corporate America, and through this control should be able to act as good corporate citizens. One of the problems has been that investments have become so actively traded, with the average holding period down to just 11 months, that most fund managers queried the point of assessing governance issues.

What’s to be done? The critical issue for investors is to re-take control of corporate America and return it to its rightful place, i.e. wrest control away from its managers and give it back to its owners, so that corporate democracy can be re-established. Owners need to start behaving as proper owners rather than just voting with their feet when they are unhappy. The rights of proper ownership include electing the board and being involved in determining executive compensation. Investors have the responsibility to act as good corporate citizens.

Compensation is an issue requiring particular attention. This should be related to real achievements in building long-term economic value, not bonanzas arising from absurdly dilutive option schemes. The terms of option schemes need much tougher owner-driven conditions.

Ethics, Earnings and Equity Valuations

Robert D. Arnott

Robert Arnott is the editor of the Financial Analysts Journal,chairman of Research Affiliates, LLC and the author of numerous investment articles. His paper on day 2 was a logical extension of Jack Bogle’s opening presentation on corporate governance.

The link between good business ethics on the one hand, and prosperous economies with profitable businesses on the other, is incontrovertible. Ethical lapses, such as bogus financial numbers, will inevitably cause investors to demand higher risk premiums. The temptation to indulge in unethical conduct is that it can be astonishingly profitable in the short term, but it will always be unprofitable in the long run.

A distinction needs to be drawn between legal and moral ethics:

Legal ethics essentially revolve around two questions. Is this action forbidden by law? And if I hurt others and am caught, what are the consequences?

Moral ethics are quite simply knowing what is right and what is wrong.

Society often reacts to ethical lapses by over-regulating, which often has unintended consequences. For example, business start-ups can be severely impeded by overly onerous regulatory requirements.

One element of dubious business ethics has been aggressive accounting. There is a demonstrable link between accounting red flags and stock price performance. Companies with conservative accounting policies deserve higher ratings.

Risk Management for Institutional Investors

P. Craig Ueland, CFA

Craig Ueland is CEO of Russell Investment Group, global multi-managers and investment consultants, and was previously a pension consultant for Prudential Insurance Company of America.

In investment theory, risk is defined in terms of various measures of volatility, but reduced to simple terms it is the possibility of suffering loss or harm. When managing other people’s money, it typically takes two forms:

Losing beneficiary money – this is often quantifiable in advance.
Losing your reputation – this is seldom quantifiable in advance. A good example is Martha Stewart, who risked hundreds of millions of dollars for perhaps a hundred thousand on the Imclone trade.

Risk can never be eliminated, but it can be managed. For example, if you don’t want Alpha risk, then stick to index investments.

Russell organises risk into five broad categories:

Fiduciary. Trustees carry the responsibility of ensuring that proper policies and procedures are in place, and are effectively implemented. Fiduciary risk arises with inadequate policies and procedures.

Asset/Liability. There are insufficient assets to meet the fund’s liabilities. This can occur when accurate data are not timeously available. It is probable that only a few defined benefit funds will consider moving to an all bond fund in order to minimise this risk.

Structural. This is the risk of underperforming the broad market because of structural over/under-weights.

Investment Implementation. Ineffective implementation of investment decisions.

Operational. This is the risk arising when proper policies and procedures are in place, but are ineffectively implemented. Many high profile risk management failures have been process failures, where poor fiduciary oversight has allowed for ineffective operational implementation.

At the core of reducing enterprise-wide risk must be a strong culture that emphasises integrity, ethics and the organisation’s fiduciary purpose.

Russell believes managers of defined benefit funds should:

Consider broader diversification, including greater exposure to alternative investments such as hedge funds, private equity and commodities.
Recognise the importance of implementation costs, particularly in a low return environment.
Place more emphasis on regular quantitative risk measurement and reporting, which is particularly important for asset/liability matching.
Focus the search for alpha on areas where alpha is more likely to be delivered – especially as alpha is expensive, which conflicts with the desire to reduce costs.

For defined contribution plans, Russell recommends:

Using balanced asset allocation as the default option. If the default is some kind of money market fund, lawsuits could be brought in future by retirees who find they do not have enough to live on.
Turning participant inertia into an advantage, to rebalance within the core/balanced options, and to enable managers to be changed without participant action in the core/balanced options.
Discouraging momentum investing by using diversified, multi-style core options and building an education programme around them.
Encouraging proper equity diversification by limiting exposure to the company’s own stock. Trustees are not meeting their fiduciary resposibilities if a major portion of the fund’s assets are in the company’s own stock.

Key points for institutional investors are:

Broadly define the sources of investment risk. Beating the market is not the primary objective.
Recognise the importance of process risks. Process issues have accounted for most failures.
Reconsider the asset allocation strategy. Most investors should broaden their asset class diversification.
Consider likely behavioural impacts when designing defined contribution and other plans involving employee choice.

The Pension Fund Crisis

Ronald J. Ryan, CFA

Ronald Ryan is the founder and president of Ryan Labs, Inc., which he formed as a quantitative research firm and asset manager in 1988. He was previously the director of fixed income research at Lehman Bros. and designed the Lehman government/corporate bond index.

The pension fund crisis in the US is acute. The deficits of public and private plans now amount to around $300 billion and $260 billion respectively. To these figures must be added the medicare deficit of $30 trillion and the social security deficit of $10 trillion – the latter indicating that retirees will not even be able to fall back on social security if their pensions are inadequate.

Exacerbating the problem are unrealistic actuarial and accounting practices used in valuing fund assets and liabilities. Public funds are pricing their liabilities using a discount rate of 8.5%! With US interest rates substantially lower than this, the effect is to understate liabilities materially, so that even plans that think they are fully funded certainly aren’t. In the equity bear market years of 2000-2002, pension fund assets lost to pension fund liabilities by more than 50%.

Workshop: Combining Technical and Fundamental Analysis

John Bollinger, CFA

John Bollinger is the founder and president of Bollinger Capital Management, which offers technically driven money management services to institutions and individuals. He is also the founder of several websites, including EquityTrader.com, FundsTrader.com, GroupPower.com and BollingerBands.com. He is one of the first technical analysts to address the CFA Institute Conference – testimony to the growing respectability of the discipline!

The core tenet of technical analysis is that the market is right. Markets are efficient, but not as efficient as propounded by the efficient market hypothesis. The first combination of fundamental and technical factors really started in the 1960’s with the rise of quantitative analysis, and the next evolution came in the 1970’s with behavioralism, now an acknowledged mainstream discipline which introduces psychological factors in the belief investors are not rational (i.e. the efficient market hypothesis is wrong).

So there are now four bodies of practitioners, pitted against the disciples of the efficient market hypothesis who say only index investing is sensible. The combination of these four streams can be described as Rational Analysis, a union of technical, fundamental, quantitative and behavioral analysis.