In a sweeping conversation at the Fiduciary Investors Symposium at Chicago Booth School of Business, celebrated professor of finance Eugene F. Fama shared his thoughts on stock picking, private equity and the challenges facing democracy.

Stock picking is not a solution to today’s challenging investment environment, warned Eugene F. Fama, The Robert R. McCormick Distinguished Service Professor of Finance and 2013 Nobel laureate in economic sciences, best known for his empirical work on portfolio theory, asset pricing and the efficient market hypothesis.

Speaking at FIS Chicago the so-called father of modern finance said stock picking and active management run counter to diversification, key in the current climate.

“If you are an active manager you are not diversified,” he said. Moreover, successful active management depends on the challenge of accessing specific and unique information that isn’t in the market and no one else possesses.

“I don’t know anyone who has that information,” he said.

Inflation and Central Banks

Fama was sceptical of the ability of central banks to curb inflation with higher interest rates given the scale of QE over recent years. It is unknown how far rates will have to rise to curb inflation given the trillions in free reserves in the system. Compared to previous inflationary cycles he said.

“QE is a different ball game; I’m not sure how they are going to do it. Who knows? It’s a new experiment. We’ll have to see what Central Banks can do but I don’t think they can do very much.”

Nor does history suggest central banks are skilled in managing inflation. When inflation was at historic lows, the Federal Reserve was unsure why, or how, to tackle it. Elsewhere, he said the high inflation and interest rates that defined markets in the 1980s came on the watch of policy makers who should have known better.

Strategy

Fama advised investors to focus on diversification and how much risk they are prepared to take – a process that is complicated by the deafening noise in financial markets. Investors are also battling decision making against the backdrop of statistical uncertainty. There is so much uncertainty around true expected values and variance rates are so high, analysis of short periods of time doesn’t tell investors much.

For those wanting to avoid the uncertainty of equity markets he suggested short term bonds, and flagged the volatility and tail risk of emerging markets. Although he noted the diversification benefits of emerging market equities, he warned that looking at individual countries reveals stark volatility.

“Data never includes the markets that blow up,” he said.

Fama said new research has appeared on the fringes, but he argued that few new ideas are emerging in finance and nothing has altered his key beliefs. He noted the continued integration between macro- economics and finance. Casting back over his career, he said he benefited from so much being new and undiscovered when he started out. Early research included the risk of stocks versus bonds and developing a database for public securities.

Private equity

Fama flagged challenges around private equity investment. He warned that investors rarely see the full data on private equity allocations that have failed, and it is similarly difficult to ascertain why other investments succeed. Noting “most [private equity investments] fail, some do well,” he said it is difficult to see what leads to high returns because private equity lacks the data attached to traded securities. He noted that private equity investors may be told what something is worth now, but without selling the asset it is actually impossible to really know its worth.

ESG

The absence of data also feeds into his concerns about the rise of ESG investment. Fama argued that companies integrating ESG are not necessarily acting in the interests of shareholders. If governments want to integrate ESG they should back it in law rather than leave it to corporate choice, he said. He counselled against individual companies having multi-dimensional objectives that they can’t evaluate and stressed that laws should determine how business approaches ESG.

“You need the legal framework to make it work; you don’t want companies making those decisions.”

He questioned if companies most exposed to fossil fuels have actually seen their value decline, and said that land values in countries like Canada less subject to the impact of rising sea levels have not risen in line with the imminent threat of global warming. He highlighted a huge range of uncertainty in climate change and the speed of its approach.

“It’s much more complicated than the media says,” he said.

Crypto

Fama poured cold water on the rise of crypto: as long as it is not used as a medium of exchange, crypto has no value. He says crypto currently has no basis in reality – and monetary theory teaches that something that is highly variable shouldn’t be a medium of exchange: companies want a medium of exchange to be predictable but no cryptos are – even those supposedly pegged to the dollar have exploded.

“Crypto bothers me a lot; it’s non-sensical,” he said, adding that it could knock companies out of business if they were trying to take payments in crypto.

Crypto currencies are distinct from CBDCs. CBDCs are a way for individuals to clear their trades through Central Banks directly rather than via local banks, changing the payment mechanism. He said the medium of exchange would still be the dollar.

Society

Fama voiced his concerns that society is increasingly removed from reality as people fail to understand what is good and what isn’t good. This led to the rise of Trump and further afield, now threatens Chile’s constitution. Fama called Trump dangerous, a man who put his own value above the value of the country and its institutions. He said the only reason Trump won the presidency was because he was running against Hilary Clinton.

He said democracy is threatened by a lack of education and the rise of trend followers.

“Nowadays, everyone can be educated,” he argued.  Regarding inequality, he outlined the importance of incentives driving human behaviour, comparing this to a socialist country “that doesn’t function very well.”

Closing the conversation with more thoughts on active management, Fama stressed the role of luck in investment performance. Investors that have done well in the past may not do well in the future so should not be compensated on past levels.

“There is a problem when it comes to differentiating between luck and skill,” he said.

He added that active managers make [market] returns less efficient – the market could be more efficient with fewer active managers. Trading is getting faster; the uniformed are pushing asset prices around in another reason to be diversified. He said the market didn’t look any more or less efficient today, despite the availability of data.

Still, he warned against being too quick to see trends and certainties in data now available through AI and big data. He warned that it is possible to see data as systemic and see things that aren’t there. “They look like they are there but they are only there by chance,” he concluded.

Europe is in the grip of historically high energy prices today, but markets are pricing in a lower risk premium ahead and the oil price is set to come off, predicted Edward Morse, global head of commodities research at Citigroup.  Speaking at the Fiduciary Investors Symposium at Chicago Booth School of Business, he said that European gas and Chinese LNG prices are already beginning to fall and will continue to do so through the rest of the year.

Morse forecasts that supply will begin to outstrip demand and rebalance the oil market, particularly if economic growth slows.

“We think demand is heading down,” he said. And in contrast to other analysts who predict another energy super cycle, he said that by the early 2030s GDP will grow, but oil demand will have peaked.

Indeed, the main agencies that forecast oil demand all mark demand growth coming down to a lower level. Even in the US, oil demand is not that robust, he said.

“Demand is going down no matter where you look.” He predicted that the world will steadily accumulate inventory that will weigh heavily on prices despite distortions in the market complicating the picture.

The spike

Before Russia’s invasion of Ukraine sent energy prices sky rocketing, prices were already beginning to rise on other important factors. For example, a lack of hydro power due to drought in some parts of the world was hitting energy production and pushing natural gas and coal prices higher. Low levels of wind also impacted energy production in Europe. Now Russia’s invasion of Ukraine has compounded the problem.

Morse noted that the war in Ukraine caused volatility in oil prices to spike, just as liquidity was drying up.

“The loss of liquidity in the market is causing volatility,” he explained. It has led to tight margin calls and a limited availability of credit. Oil and gas prices are moving by $5-$10 a barrel one way one day, and then back the other way the next.

Trade distortions

Morse also described distortions in the market. US oil has been bid up on the back of many countries no longer buying Russian oil. “Dislocation has caused a bidding up in the market for certain crudes,” he said. US exports of crude and petroleum products like jet fuel and diesel have shot up to the highest level of any other country. “As the market rebalances, these prices will come off,” he predicted. In contrast, Russian crude has been sold at a discount to buyers like India.

Supply

OPEC is unlikely to increase supply. Non-OPEC countries might add to the world supply like Canada and Mexico. However, he believes OPEC countries like Saudi Arabia and UAE are unlikely to put more in the market, particularly given the current strained status of US- Saudi relations resulting in US pressure not wielding much influence. He added that Russia’s long-term energy production will be hit by the loss of US companies that used to be in Russia, warning that Russia faces substantial long-term impairment to its energy industry.

Transition

The energy crisis will fuel Europe’s move away from fossil fuels where governments have promised to add billions to finance the energy transition. He said that getting off oil and gas requires countries speed up the use of hydrogen as an alternative fuel for making steel and abating fossil fuels in heavy industry. “Europeans think they can do it and determined and on a path.”

However, Morse noted a deceleration in the transition in the US, China, and emerging markets. China is prioritising energy security, and although China’s net zero goals require getting off coal, China is adding coal capacity. Elsewhere, he noted how emerging markets like Sri Lanka and Egypt are increasingly reliant on energy imports and said that emerging markets had expected more support in the transition from the developed world which hasn’t come.

Finance going into the energy transition has also slowed. Green bond and clean energy debt issuance has slowed; similarly, investment capital into the transition has also slowed. Instead of the trillions required, direct investment in the transition in the US is only in the billions and Morse urged multilateral lending organizations to do more to help finance renewable infrastructure.

He downplayed any decline in the use of the dollar as a form of payment [for energy] and said the world is not moving into a multi-currency environment. Although some countries, like Saudi Arabia, have said they are considering taking renminbi in payment for oil sales to China instead dollars, he said it wasn’t significant enough to matter.

Morse said that Europe has learnt that it needs to diversify its energy supply in a lesson that will be long-lived. Some European countries are further ahead than others in the transition away from Russia. Some, like Bulgaria, have developed alternative sources of energy but others like Hungary and the Czech Republic are still heavily dependent on Russia.

Investing in private credit brings income and supports capital preservation, but as more investors enter the asset class, competition for assets is set to heat up.Investors from South Carolina Retirement Systems Investment Commission, Investment Management Corporation of Ontario and Ohio School Employees Retirement System explain their approaches.

In recent years, the private credit allocation at South Carolina’s SC Retirement Systems Investment Commission has pivoted from targeting absolute returns to mid-market direct lending. The allocation was initially set up to invest in distressed opportunities coming out of the GFC, said Michael Hitchcock, executive director at the pension fund who told FIS Chicago attendees the allocation brings income and capital preservation in opportunities primarily accessed via SMAs with investment managers.

Hitchcock also explained how the allocation sits within South Carolina’s recently streamlined portfolio. Two years ago, South Carolina reduced its level of diversification when analysis questioned the efficacy of 21 different benchmarks and 18 different asset classes – now reduced to five. These five asset classes are categorized based on either ‘persistent of outperformance’ (private credit sits here) or ‘magnitude of return.’

At IMCO, the asset manager for public sector pensions in Ontario, private credit tends to deliver alpha while public credit typically provides liquidity and a useful signal on the private market, said Jennifer Hartviksen, managing director, global credit at IMCO. Hartviksen (pictured) who joined IMCO in 2020 to build out the global credit allocation, said her remit spans public and private credit markets, emerging market credit, levered loans, CLOs, and allocations to tactical solutions. IMCO allocates to external managers but is also building its internal capabilities.

Farouki Majeed, chief investment officer of the Ohio School Employees Retirement System, explained how he looks at investment through different prisms – one of which is shaped around the returns the fund needs to help close its deficit. Private credit yields around 7 per cent, a crucial solution to part of the problem, he explained.

The quest to invest in line with the fund’s objectives led Majeed to drop hedge funds from the portfolio when he first took the CIO helm. “Hedge funds didn’t help solve the problem of managing the fund to our objectives,” he said. A gap filled by the private credit allocation, grown from 0-5 per cent over the last eight years. The allocation begun life as an exploratory, opportunistic investment outside SAA targets.

Majeed said that one of Ohio’s advantages is that the private credit allocation is not too big, adding that size may impede big entrants now coming into the market seeking to deploy large amounts. “We can be nimble and target certain areas,” he said.

Defaults

For now, Ohio’s focus is on mid-market lending targeting direct corporate solutions and capital restructuring. The fund doesn’t invest in sponsor-backed private credit but does invest in a few distressed opportunities mostly via direct, controlled leverage with tight covenants. Ohio doesn’t get into leverage at fund level but controls it at an individual portfolio company level.  He noted how the history of defaults in private credit is very low, and many investments restructure and recover.

Hartviksen advised investors to conduct due diligence on managers’ historical track record regarding losses and recovery.

“Recoveries from private credit are high,” she said.

She added that resilient portfolios are diversified within corporate segments to avoid challenges in one sector. For example  direct lending to restaurants during the pandemic proved fraught with risk. Due diligence should include what managers own and how diversified they are, she said.

Hitchcock said SMAs allow investors to look through into the portfolio, contributing to due diligence. He added that floating rate financing acts as an inflation hedge, but warned that the cost of leverage is also going up, offsetting that protection. Elsewhere panellists explained that the macro environment is pushing some investors to diversify their allocation into private infrastructure and real estate credit which has a lower correlation and different cycle.

Ohio targets managers with deep lending, restructuring and recovery experience over cycles. He noted that middle market opportunities are not typically large transactions that could blow up a portfolio and explained how private credit can offer an alternative to private equity. For example, the asking price is often too high for equity – investors don’t want to pay that much to get into private equity. By offering debt, companies can tap liquidity and investors a healthy return. Elsewhere, he noted the importance of quarterly dispersions. “A 7 per cent yield is a pretty decent steady stream of quarterly cash flows.”

Ahead

Panellists reiterated that the primary purpose of the allocation is yield and that all private credit investors’ primary concern should be getting paid back over time and guarding against the risk of a default. Reflecting on the next cycle, panellists warned that the market hasn’t gone through a credit cycle without central bank support. They flagged opportunities most likely would be accessed through smaller, more focused groups with strategic partners with look throughs in tightly held solutions.

Hitchcock advised on the importance of keeping investment as simple as possible despite the complexity of the asset class. He concluded that investment relied on great teams with credit experience, good processes, and procedures.

 

Funds of enormous scale will require a new cross-disciplinary approach, and innovative incentive and rewards schemes to foster the organisational culture needed, according to chief investment strategist at CPP Investments’ Geoff Rubin, as it looks to move beyond a total portfolio approach to a “one fund” approach.

With a number of funds set to cross the $1 trillion threshold in the coming decades, new cross-disciplinary approaches will be needed to tap into investments spanning multiple asset classes and risk categories, according to the chief investment strategist of the investment arm of the $539 billion Canada Pension Plan.

A ‘one fund approach’ that breaks down organisational silos can target investments that don’t fit neat boxes, therefore tapping into outsized risk-adjusted returns, according to Geoff Rubin.

CPP’s total fund approach’ has been picked up by numerous organisations around the world, including Australia’s Future Fund and New Zealand Super. Now Rubin is looking to a “one fund” approach where investments can “span asset classes, span the risk spectrum, [and] might require certain kinds of commitments over time that go beyond the individual, siloed, compartmentalised way that most investing in our industry happens,” Rubin said, speaking at the Fiduciary Investors Symposium held at the Chicago Booth School of Business.

Speaking with Amanda White, director of institutional content at Conexus Financial, Rubin said this could, for example, be an investment that is a combination of equity and credit, or an infrastructure opportunity that involves acquiring adjacent real estate to take advantage of the increasing effectiveness of the infrastructure.

Rubin said it is possible in the one fund approach to allocate funds to an investment with a return of zero or even negative expected return if it is a contributor overall in terms of diversification.

Contrasting the one fund approach to the total portfolio approach that is now in vogue, Rubin said doing this requires a deep change in organisational culture that draws on the skills and contacts of all employees in different teams, and an incentive and attribution scheme that encourages and rewards the required cross-organisational behaviours.

“The total portfolio approach… does not require the tearing down of silos,” Rubin said. “It requires an ability to look into each silo and understand exactly what you have, so you can manage that portfolio.

“One Fund is something different. We actually break down those silos and bring those investment teams together in a way that allows you to invest differently, in a way that allows you to pursue different types of Investments.”

At CPP, incentive compensation is geared to the performance of the total fund, but Rubin admitted that for organisational staff, those results can sometimes “feel somewhat remote from the work they do day to day,” and the organisation is considering more explicit expectations and reward structures “for those who reach out across silos.”

“We’re also going to try to ensure that we’re building a culture where that becomes a reflex…really trying to build a means of encouraging people to connect across their areas and make sure that they’re doing so with real passion.”

He admitted this becomes difficult when you start looking at attribution and incentive compensation. The funds management industry is accustomed to being organised by way of assigning benchmarks to teams who judge performance against their benchmark, “and don’t tell me about what’s happening in the rest of the fund,” he said.

“I think that works really well due to its simplicity, it works really well because we’re all accustomed to it,” Rubin said. “Not at all clear how that construct is going to allow our organisation, or any of these organisations, to address investment opportunities that don’t fit those neat boxes.”

This problem is yet to be fully solved, he said. “We’re going to have to work on driving our organisational culture and incentive compensation and alignment and reward systems, both formal and informal to really encourage that kind of appetite to solve a bigger problem than one that just resides within a group or team.”

 

In a wide-ranging session at the Fiduciary Investors Symposium at Chicago Booth School of Business investment executives from HOOPP, CalSTRS, USS and Cbus reflect on the need for strong governance in the current climate, diversification and liquidity.

The need for diversification when so many assets are struggling requires detailed conversations with trustees and governors about how to make the portfolio better factor balanced, said Michael Wissell, chief investment officer of Canadian fund, HOOPP.

“It is helpful to bring management and the board together,” he said in a panel session that recognised the importance of well-defined risk parameters and governance to support positions if market conditions deteriorate. Wissell, who said HOOPP’s portfolio is still defensively positioned, cited the fund’s thoughtful approach to opportunities where he predicts picking up assets today that will sow the seeds of decent future returns.

Scott Chan, deputy chief investment officer of CalSTRS noted how the market is struggling to price in uncertainties around inflation, supply chains and de-globalisation. CalSTRS priorities include managing liquidity and providing lines of credit where they are needed. Chan noted that this could lead to the fund selling assets in some parts of the portfolio as values fall in a risk mitigation strategy.

“We will liquidate and get into a position to invest in distressed assets,” he said. In March 2020 CalSTRS was already with billions on hand to “go shopping” but in the event only needed to ride equities back up in the V-shaped recovery. Chan said CalSTRS is also focused on building out its private credit allocation that will provide a degree of inflation protection. “Doing more of these types of things will move the needle,” he said.

Tilts

At Australia’s Cbus, strategy includes making asset allocation tilts, positioning around shorter duration and more domestic equity relative to international equity. Cbus has also structured option protection strategies in the last month, said Kristian Fok, CIO at Cbus. Elsewhere, the fund is seeking resilience to rising interest rates and inflation via property and infrastructure. Fok noted how infrastructure will continue to provide a buffer, smoothing the risk-free rate and providing an uplift from GDP activity and inflation protection, but only as long as rates don’t rise too much.  Fok added that the fund is also seeking to build more capability internally.

Panellists noted how construction companies have come under pressure via inflation and supply chain issues, forcing some to collapse. It is creating a changing dynamic for investors in greenfield property and infrastructure, pushing investors to get comfortable with risk sharing and develop new skills.

Cbus is not the only investor titling to opportunities. Rather than owning the S&P, investors could tilt to inflation sensitive equities or green-energy orientated equities. At the United Kingdom’s USS tilts to public markets include  assets set to do well from the cost of living and high inflation. Bruno Serfaty (pictured), head of dynamic asset allocation at USS told delegates that strategies require a strong governance process to understand the scope of a tilt over an investment period.

Hedging provides another protective seam with panellists referencing tail risk mandates and strategies that hedge when markets are falling. However, they stressed the importance of sizing allocations correctly, difficult when the scale of the drawdown is unknown, and flagged that these strategies are also usually associated with a drag.

Panellists added that regulatory frameworks make it difficult to take large positions unless investors can change their strategic asset allocation to suit the investment environment.

Reflecting on where they would invest if they had a free-hand, Serfaty highlighted opportunity in energy and the safety of cash. Away from the elevated risk premiums inherent in financial assets, he said energy is currently not expensive.  Other investors cited opportunity in real return bonds, a focus on cash management and pivoting to new areas. Fok concluded that a new political regime in Australia signals opportunities in renewables where he predicted private capital may increasingly invest alongside public investment in a scenario that could bring guarantees, but also the ability to take risk.

Pandemic learnings

Panellists discussed how their organisations had weathered the pandemic. HOOPP wrote more tickets in March 2020 than ever before and emerged confident in its ability to work from home. On the flip side, Wissell noted challenges around mental health, particularly in the younger team members.

Chan explained how CalSTRS added more hires during Covid to build out its direct investment model. CalSTRS now insources around three quarters of its public markets allocation in a strategy designed to slash fees.

“During Covid we captured lots of hires, and now it’s hard to hire,” he said. The fund has emerged from Covid focused on its organisational objectives, particularly trying to shape its framework around net zero.

At Cbus, pandemic challenges included $2.4 billion of withdrawals from the fund as beneficiaries pulled money out following government policy allowing members’ access to their accounts. Elsewhere, the fund invested in the local market and navigated new rules on super funds and allocations to better performing funds only.

At USS Serfaty described an early pandemic scramble to navigated margin calls and collateral issues. In a second stage, USS stepped in to support funding for some of its private market investments hit hard by Covid like Heathrow airport. He said that strategies at USS have subsequently focused on redirecting its position away from fixed income into assets including commodities.

Former Federal Reserve governor Randall Kroszner argues crypto assets are mislabelled as “currencies”, and said digital currencies like China’s digital Renminbi could one day challenge the primacy of the US dollar, in a wide-ranging conversation.

Blockchain technology is “extraordinarily interesting and has a lot of potential,” but Bitcoin and other crypto coins should not be considered currencies as they are rarely used as mediums of exchange, according to former Federal Reserve governor Randall Kroszner.

Kroszner also labelled cryptocurrency Tether a “Ponzi scheme,” predicted “a lot of regulation” to enter the space in coming years, and said China’s digital Renminbi could potentially be a longer term challenge to the primacy of the US dollar, in a wide-ranging conversation at Conexus Financial’s Fiduciary Investors Symposium held between May 23-25 at the Chicago Booth School of Business.

Speaking with American historian, academic and author Stephen Kotkin, Kroszner said a more accurate description of crypto coins is “crypto assets,” as they are mostly used as a store of value.

“Elon Musk was taking Bitcoin for a short period of time to buy a Tesla, my guess is he sold, like, five or six Teslas on Bitcoin,” Kroszner said. “So it’s not really being used as a medium of exchange.”

“It’s a store of value, a very volatile one,” Kroszner said. “And so I prefer to think of it more, at least so far, in terms of crypto assets.

Kroszner is the Deputy Dean for Executive Programs at the University of Chicago Booth School of Business and Norman R. Robins Professor of Economics. He was Governor of the Federal Reserve System from 2006 to 2009, and represented the Federal Reserve Board on the Financial Stability Forum–now the Financial Stability Board–as well as on the Basel Committee on Banking Supervision.

Kroszner said stablecoins such as TerraUSD had tried but failed to be as close as possible to money by promising comparable value to currencies like the US Dollar.

“Just because someone promises something to be stable, doesn’t necessarily mean that it’s stable,” Kroszner said.

With billions of dollars flowing out of stablecoin Tether, the company had refused to publish an audited financial statement of their backing “for reasons that escape me,” Kroszner said.

“I mean, it’s not like an audited financial statement is something new or wild in the financial services world, that’s sort of fairly standard,” Kroszner said. “If you don’t do that, people are going to continue to question. People are going to keep wondering, can I have an attack on Tether that will work?

“And we have seen a lot of money coming out of Tether over the last few weeks, but interestingly, you know the people, it’s a Ponzi scheme. And so, once the money starts to flow out, they’ll never be able to do it.”

Tether is holding out a little below US$1 for each coin despite the outflow of money, and this is “where a lot of regulation is going to come in,” Kroszner said.

Blockchain technology has a lot of potential, but we are still in the very early stages of understanding what this potential is, along with its applications, he said.

“They’re still far from being used as currencies, but I think these interesting experiments are worthwhile to be undertaken,” Kroszner said. “But they’re not for the faint of heart. And so anyone who’s putting a significant fraction of their personal wealth into this is taking, I think, an excessive risk.”

Kotkin asked Kroszner about the prospects for digital currency, including a Federal Reserve digital currency. The Fed is clearly “thinking about it,” Kroszner said, but is taking a wait-and-see attitude to allow the private sector more time to innovate and experiment.

But China’s digital Renminbi is one of the most interesting experiments, he said, with a longer-term prospect of challenging the primacy of the US Dollar.

“The dollar really has no challengers,” Kroszner said. “The dollar is still the go-to currency when something goes wrong.

“But with the digital Renminbi, that’s where you potentially could see a longer term, not a short term, but a longer-term challenge to the dollar,” he said. “The challenge for China is that they’ve got major capital controls. No-one is going to rely on a currency with their major capital controls.

“But could a digital Renminbi allow them, if they’re monitoring and have the technology to look at each individual transaction and follow each of those transactions, would that allow them to do some sort of selective opening of the capital markets? I don’t know whether that’s technologically feasible, but my guess is they have that in mind.”