Jan/Feb 2013

The Member Magazine for Investment Professionals

THE FUTURE OF
ASSET MANAGEMENT
CUSTOMIZED BETA:
NOW BOARDING
A “DOOMSDAY SCENARIO”
FOR DARK POOLS

The
Biological
Investor

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 Jan/Feb 2013

28 The Future of
Asset Management
A few key trends may be signs
of things to come
By Maha Khan Phillips
28
34 After Dark
Author Scott Patterson explains
why some experts believe the
proliferation of dark pools could
lead to a “doomsday scenario”
for markets “caught in an endless
loop of innovation”
34 By Jonathan Barnes

38 The Biological
Investor
The first in a series of articles
looks at how the new science of
38 decisions will transform investing
By Cynthia Harrington, CFA

44 Volcker Rules?
Because of Paul Volcker’s lasting
influence, “We have huge deficits
today, and yet we have the
lowest interest rates we could
ever imagine” says economist
William Silber
By Jonathan Barnes

44

COVER ILLUSTRATION
James Yang
Jan/Feb 2013

MANCE & R
CFA INSTITUTE NEWS
FOR
20
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PER ISK
EV
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TM U
Manager The Future of Finance

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By John Rogers, CFA

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App

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Improving Stakeholder Relations

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CIPM By Paul Smith, CFA

8 EMEA Voice

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Enhancing Disclosure of Bank Risks:
Pe

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The Investor Role
By Vincent Papa, CFA

11 “Moving the Needle” on society advocacy

15 13 13 Strategic renewal for the CIPM Program

VIEWPOINT
15 Investing in Worldly Wisdom
How can investors avoid the “man with
a hammer” fallacy?
By Robert Hagstrom, CFA

17 Letters

PROFESSIONAL PRACTICE
18 Getting a tailor-made off-the-rack fit
20 Expert networks and compliance risk
24 High-
High-frequency trading: good, bad, or ugly?

26 The rise of unified managed accounts

50
ETHICS AND STANDARDS
ETHI
51
50 Market Integrity and Advocacy
•F
Financial industry accountability
• The challenge of global OTC derivatives
regulation

55 Professional Conduct

3 In Summary
56 Chapter 10
56 Paradox and Paralysis
 IN SUMMARY
Breaking the Link
“Of your own motion you can’t ever alter the scheme or do a thing
that will break a link.” – Mark Twain, “The Mysterious Stranger”
On a hillside overlooking a medieval Austrian village, sev-
eral boys are playing when they encounter a mysterious
man with magical powers. He quickly reveals himself to
be much more than a mere conjurer. Indeed, he is an angel
with the alarming name Satan. But it’s just a family name.
Although the angel’s uncle is in fact the Devil, the rest of
the family remains in good standing.
The angel begins altering the lives of everyone he encoun-
ters—changing them for the better, or so he claims. How-
ever, “the devil is in the implementation,” to borrow a phrase
from Beth Kaiser, CFA, CIPM (“Seeking Optimal OTC Deriv-
atives Regulation,” p. 51). The angel’s improvements devas-
tate the village. “He didn’t seem to know any way to do a
person a favor except by killing him or a making a lunatic out
of him,” laments the story’s narrator, a boy named Theodor.
The angel’s motives are doubtful. He frankly despises the
human race, blaming all the world’s troubles on our moral
sense. “There shouldn’t be any wrong,” he says, “and with-
out the Moral Sense there couldn’t be any.” This may seem
backwards: Isn’t having a sense of morality a good thing?
But the moral sense is like vision—it sees both light and
darkness. Would the owner of the moral sense rather walk
in the hot, glaring sun or the cool shadows? Doing the right
thing isn’t always a comfortable choice, needless to say, and
often comes with increased risk of exposure. Or as John
Rogers, CFA, writes, “In the business of putting ethics back
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behavioral realities” (In Focus, p. 5).
Ethics in the classic sense is the “science” of right judg-
ment, which implies the ability to choose. Satan, however,
holds a grimly deterministic view of history. “Nothing hap-
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inevitable,” he tells Theodor. History can feel like a trap at
times, and human events often appear to unfold accord-
ing to a cyclical law of irony. For example, the rise of dark
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trying to front-run big institutional orders. A decade later,
dark pools themselves have become part of a high-frequency
dynamic that enables predatory trading against … institu-
tional orders (“After Dark,” p. 34).
Not all high-frequency strategies are bad. Still, distorted
incentives can lead to perverse outcomes, and the “awkward
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of evidence that this effect is real. In the quest for scale and
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a relentless game of “take the best and exhaust the rest”
(Trading Tactics, p. 24)? Some observers believe so. “The
rapid industrialization of asset management has suppressed
its craft heritage,” says Amin Ran, CEO of CREATE-Research
(“The Future of Asset Management,” p. 28).
Perhaps an antidote to industrial thinking can be found
in the study of “worldly wisdom,” as Robert Hagstrom, CFA,
contends (Viewpoint, p. 15). Or maybe the mechanized
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my doubts about seeing land treated like just another set of
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G. Sparks, CFA. “The biggest reason farm returns have low
correlation with security markets has more to do with the
stubborn nature of farmers” (Letters, p. 17).
IT IS A PECULIAR ASPECT OF HUMAN
BEHAVIOR THAT WE CAN BE MOST EMO-
TIONAL WHEN WE CONSIDER OURSELVES
MOST RATIONAL AND VICE VERSA.
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behavioral realities to exploit in the ethical “craft heritage”
of rustic villagers, a jittery herd given to irrational stam-
pedes. Murderous panics about witchcraft might have been
avoided if any of them had the prudence of Jason Hsu, chief
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“The question is, are these good ideas?” (Portfolio Perfor-
mance, p. 18). It is a peculiar aspect of human behavior
that we can be most emotional when we consider ourselves
most rational and vice versa. In fact, one team of neurosci-
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signals in what we think of as a hot emotional region [of
the brain]” (“The Biological Investor,” p. 38).
Such insights may have profound implications for invest-
ment theory and practice, but beware the kind of overly
reductive thinking that leads the angel Satan to dismiss
human existence as nothing more than “continuous and
uninterrupted self-deception.” Twain wrote “The Myste-
rious Stranger” during a time when science was setting
the stage for advances, such as quantum mechanics, that
would demolish the determinism of the 19th century. The
iron chain of causality vanished in a cloud of mysterious
uncertainty, and the role of the observer acquired strange
new power (i.e., collapsing the wave function). Moreover,
at that point in his life, Twain had suffered profound grief
and was struggling with ideas that obviously troubled him.
Can life be good when so much cruelty and tragedy occur?
(For that matter, can markets promote progress when they
contain so much malfeasance?) According to Ralph Wanger,
CFA, the long arc of history teaches a simple lesson: “Do not
allow a paradox to paralyze you” (Chapter 10, p. 56). Real-
ity frequently turns out to be more mysterious and much
stranger than we expect. Surprises are inevitable.
Roger Mitchell, Managing Editor (roger.mitchell@cfainstitute.org).
Jan/Feb 2013 CFA Institute Magazine 3
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Jan/Feb 2013 Vol. 24, No. 1 CFA INSTITUTE PRESIDENT & CEO PUBLISHER
John Rogers, CFA Ray DeAngelo
john.rogers@cfainstitute.org ray.deangelo@cfainstitute.org
CFA Institute Magazine (ISSN 1543-1398, CPM 400314-55) is published bimonthly—in MANAGING EDITOR ASSISTANT EDITOR
January, March, May, July, September, and November—by CFA Institute. Periodicals Roger Mitchell Jamie Underwood
postage paid at Charlottesville, VA, and additional mailing offices. POSTMASTER: roger.mitchell@cfainstitute.org
Send address changes to CFA Magazine, 560 Ray C. Hunt Drive, Charlottesville, GRAPHIC DESIGN
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Statements of fact and opinion are the responsibility of the authors alone and Kara Hite tim@communicationdesign.com
do not imply an endorsement by CFA Institute.
Copyright 2013 by CFA Institute. All rights reserved. Materials may not be ADVERTISING MANAGER CIRCULATION COORDINATOR
reproduced or translated without written permission. CFA®, Chartered Financial Tom Sours Matthew Hepler
Analyst®, and the CFA Institute logo are just a few of the trademarks owned by tom.sours@cfainstitute.org matthew.hepler@cfainstitute.org
CFA Institute. See www.cfainstitute.org for a complete list. EDITORIAL ADVISORY TEAM
Annual subscription rate for CFA Institute members is US$10, which is included Shanta Acharya Kate Lander
in the membership dues. Annual nonmember subscription rate is US$50. MASTHEADBashir Ahmed, CFA Casey Lim, CFA
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Phone: (800) 247-8132 or Phone: +44 (20) 7330-9500 Franki Chung, CFA Jerry Pinto, CFA
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Phone: +32 (02) 401-6828 Aaron Lai, CFA

4 CFA Institute Magazine Jan/Feb 2013

 CFA INSTITUTE NEWS
IN FOCUS

What Is the Future of Finance?

By John Rogers, CFA

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John Rogers, CFA, is president and CEO of CFA Institute.
Jan/Feb 2013 CFA Institute Magazine 5
 CFA INSTITUTE NEWS
APAC FOCUS
Improving Stakeholder Relations
By Paul Smith, CFA
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Enhancing Disclosure of Bank Risks:
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Jan/Feb 2013 CFA Institute Magazine 11
 CFA INSTITUTE NEWS

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Rose Fry is a freelance writer based in Richmond, Virginia.

BRIEFS

Volunteer with the DRC IN MEMORIAM

If you have a strong interest in helping to uphold
David H. Byerly, Jr. Thomas W. Ludlow, CFA
ethical conduct in the investment profession, are
Newtown Square, Pennsylvania Dresher, Pennsylvania
a CFA charterholder with no pending professional
conduct issues, have a fair and impartial tempera- Martin Bernstein, CFA Bret Thomas McConnell, CFA
ment, and have knowledge of or a desire to learn Livingston, New Jersey Tigard, Oregon
more about the CFA Institute disciplinary process,
Yvon Cote, CFA Stewart Ian Millman, ASIP
the Disciplinary Review Committee (DRC) would like
Quebec London
to hear from you.
The DRC, a committee of CFA Institute member William M. Denny Gary P. Motyl, CFA
volunteers who help evaluate and decide disciplin- Paoli, Pennsylvania Fort Lauderdale, Florida
ary cases, is accepting nominations for potential
Richard Glickman Francis C. Myer, CFA
new members to begin serving in September 2013.
New York City Beachwood, Ohio
DRC members are a central component of the
Professional Conduct Program, providing valuable Keith Michael Ganzer, CFA Raymond MacLennan Pendleton, CFA
peer input to the disciplinary review process for New York City Montreal
members and candidates facing alleged violations
Robert F. Hartkemeier Michael Frank Phang, CFA
of the Code of Ethics and Standards of Professional
Cincinnati, Ohio Scarborough, Ontario, Canada
Conduct, including the rules and regulations of the
CFA Program. For further details about the Profes- John W. Hemmer, CFA Stephen J. Phillips, CFA
sional Conduct Program, please visit the “Ethics Briarcliff Manor, New York Vancouver
and Standards” section of www.cfainstitute.org
James R. Hocking, CFA James K. Say, CFA
and select “Professional Conduct Program.” To
Roxbury, Connecticut Sterling, Illinois
request a DRC nomination application, please
e-mail the DRC administrator, Alexandra Parker, Richard P. Kost, CFA Donald S. Schmidt, CFA
at alexandra.parker@cfainstitute.org. Sarasota, Florida New Smyrna Beach, Florida

Russell H. Liebetrau, CFA William D. Thomas, CFA

Naples, Florida Kansas City, Missouri

12 CFA Institute Magazine Jan/Feb 2013

The CIPM Designation:
Beyond Performance and Risk Measurement
By Todd Jankowski, CFA

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Jan/Feb 2013 CFA Institute Magazine 13

 CFA INSTITUTE NEWS

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Old Curriculum Weights New Curriculum Weights

Performance Measurement Manager Selection Global Investment Performance

Standards (GIPS)
Performance Attribution Ethical Standards
Investing Performance Reporting
Performance Appraisal

14 CFA Institute Magazine Jan/Feb 2013

 VIEWPOINT
Investing in Worldly Wisdom
HOW CAN INVESTORS AVOID THE “MAN WITH A HAMMER” FALLACY?
By Robert Hagstrom, CFA
In 1994, at the University of California’s
Marshall School of Business, students in
Dr. Guilford Babcock’s Student Invest-
ment Seminar got a rare treat: a power-
ful dose of real-world knowledge from
a man whose thoughts on money are
considered priceless.
Charles Munger—Charlie, as he
is known throughout the investment
world—is vice chairman of Berkshire
Hathaway, the holding company run by
Warren Buffett, the world’s most famous
investor. Munger is an intellectual jewel
somewhat hidden behind his more cel-
ebrated partner. The anonymity is not
Buffett’s fault. Charlie simply prefers
the lower profile. Except for his occa-
sional appearances at business schools
and his prominent role at Berkshire
Hathaway’s annual meetings, Char-
lie remains largely out of public view.
When it comes to investing, Warren
Buffett, not surprisingly, commands
most of the attention. But very few
people know that Munger is also a great
stock picker. From 1962 to 1975, he ran
an investment partnership using the
methodology outlined by Ben Graham
and also followed by Warren Buffett.
Over that period, the Dow Jones Indus-
trial Average generated a 6.4% annual
return. Munger did a little better. Over
the 14-year time period, his partner-
ship produced a 24.3% average annual
return.
The students in Dr. Babcock’s class-
room that day in April waited anxiously
to hear Munger’s views on the market
and investing. At the outset, Munger
mischievously admitted that he was
about to play something of a trick on
his audience. Rather than discussing
the stock market, he intended to talk
about “stock picking as a subdivision
of the art of worldly wisdom.” For the
next hour and a half, he challenged the
students to broaden their vision of the
market, of finance, and of economics in
general and to see them not as separate
disciplines but as part of a larger body
of knowledge, one that also incorpo-
rates physics, biology, social studies,
psychology, philosophy, literature, and
mathematics.
To make his point about single-focus
thinking, Munger often cites the prov-
erb “To a man with only a hammer,
every problem looks pretty much like
a nail.” Speaking at the 50th reunion of
the Harvard Law School class of 1948,
Munger pointed out the “partial cure”
for this problem: having “a vast set of
skills” and knowledge of multiple dis-
ciplines. A man who has various tools
“will limit bad cognitive effects from
“I LEARNED THAT DIPLOMAS ARE NOT AWARDED
FOR WORLDLY WISDOM; IT IS A LIFELONG PROCESS
OF CONTINUING LEARNING.”
the ‘man with a hammer’ tendency,”
said Munger. “If ‘A’ is a narrow profes-
sional doctrine and ‘B’ consists of the
big, extra-useful concepts from other
disciplines, then clearly, the profes-
sional possessing ‘A’ plus ‘B’ will usually
be better off than the poor possessor of
‘A’ alone. How could it be otherwise?”
How does one achieve worldly
wisdom? To state the matter concisely,
it is an ongoing process of, first, acquir-
ing significant concepts—the models—
from many areas of knowledge and,
second, learning to recognize patterns
of similarity among them. The first is a
matter of educating yourself; the second
is a matter of learning to think and see
the stock market differently.
Acquiring knowledge of many disci-
plines may seem a daunting task. For-
tunately, you don’t have to become an
expert in every field. You merely have
to learn the fundamental principles—
what Munger calls the “big ideas”—
and learn them so well that they are
always with you.
A protest is commonly heard at this
point. “Isn’t that what college educa-
tion is supposed to do for us, teach us
critical concepts that have been devel-
oped over the centuries?” Most educa-
tors will tell you, in passionate terms,
that a broad curriculum grounded in
the liberal arts is the best way, perhaps
the only way, to produce well-educated
people. Few would argue with that posi-
tion in theory. But in reality, we have
evolved into a society that emphasizes
specialization over breadth.
This evolution is wholly understand-
able. Because students and parents
spend a small fortune on a college edu-
cation, they expect this investment to
pay off in the form of good job offers
after graduation. It is little wonder that
most of today’s students, faced with
this financial pressure, resist a broad
liberal arts education in favor of a spe-
cialty. This attitude, however, may soon
be changing.
Corporate recruiters have begun
to question the value of a narrowly
focused business degree, according to
a Wall Street Journal report by Melissa
Korn (“Wealth or Waste? Rethinking
the Value of a Business Major,” 5 April
2012). “The biggest complaint,” writes
Korn, is that “undergraduate degrees
focus too much on the nuts and bolts
of finance and accounting and don’t
develop enough critical thinking and
problem-solving skills through long
Jan/Feb 2013 CFA Institute Magazine 15
essays, in-class debates and other hall-
marks of liberal-arts courses. Compa-
QLHVVD\WKH\QHHGÁH[LEOHWKLQNHUVZLWK
innovative ideas and a broad knowledge
EDVHGHULYHGIURPH[SRVXUHWRPXOWL-
ple disciplines.”
The challenge of rethinking a business
education has recently been embraced
by the Aspen Institute’s Business and
Society Program. This past March, the
Aspen Institute convened its inaugural
consortium on Undergraduate Business
(GXFDWLRQDWWKH*HRUJH:DVKLQJWRQ
University School of Business in Wash-
ington, DC. The topic of the consortium
was “Rethinking Undergraduate Busi-
QHVV(GXFDWLRQ/LEHUDO/HDUQLQJIRUWKH
Profession,” based on the book of the
same title written by Anne Colby, Tom
(KUOLFK:LOOLDP6XOOLYDQDQG-RQDWKDQ
Dolle of Stanford University.
.RUQH[SODLQVWKDWFRDXWKRU:LOOLDP
Sullivan believes “the divide between
business and liberal-arts offerings,
however unintentional, has hurt stu-
dents, who see their business instruc-
tion as ‘isolated’ from other disciplines.”
According to Korn, “Colleges are taking
the hint.” George Washington Univer-
sity, Georgetown University, and Santa
Clara University are all tweaking their
undergraduate business curriculums
16 CFA Institute Magazine Jan/Feb 2013
to include more liberal arts courses.
When the Aspen Institute consortium
reconvenes in March 2013, I am sure
RWKHUXQLYHUVLWLHVZLOOKDYHÀOHGVLP-
ilar reports.
$WÀUVW\RXPLJKWWKLQNWKH´DUWRI
achieving worldly wisdom” is an elec-
tive you can do without. After all, there
is simply not enough time to read all
WKDWLVUHTXLUHGEHIRUHWKHQH[WGD\·V
opening bell, and besides, what passes
for reading today is more about adding
information and less about gaining
knowledge. But don’t despair. In the
words of Charlie Munger, “we don’t
have to raise everyone’s skill in celestial
mechanics to that of Laplace and also
ask everyone to achieve a similar level
in all other knowledge.” Remember, as
KHH[SODLQV´LWWXUQVRXWWKDWWKHWUXO\
big ideas in each discipline, learned only
in essence, carry most of the freight.”
Furthermore, attaining broad multidis-
FLSOLQDU\VNLOOVGRHVQRWUHTXLUHXVWR
OHQJWKHQWKHDOUHDG\H[SHQVLYHFRPPLW-
ment to college education. We all know
individuals who achieved a massive mul-
tidisciplinary synthesis of knowledge
without having to sign up for another
four-year college degree.
)LIWHHQ\HDUVDJR,WRRNP\ÀUVWVWHS
on a pathway toward a goal of achieving
“the art of worldly wisdom.” Munger is
TXLWHULJKWLWGRHVQRWUHTXLUHD3K'
level understanding of each discipline.
,WLVYHU\PXFKDQH[HUFLVHLQXQGHU-
standing the truly big ideas and then
connecting those ideas back to the econ-
omy and the stock market. But I also
learned that diplomas are not awarded
for worldly wisdom; it is a lifelong pro-
cess of continual learning.
According to Munger, the key to true
learning and lasting success is learn-
ing to think based on a “latticework”
of mental models. Building the lattice-
ZRUNFDQEHGLIÀFXOWEXWRQFHGRQH
it can be applied to a wide range of
problems. “Worldly wisdom is mostly
very, very simple,” Munger told the
Harvard audience. “There are a rela-
tively small number of disciplines and
a relatively small number of truly big
LGHDV$QGLW·VDORWRIIXQWRÀJXUHRXW
(YHQEHWWHUWKHIXQQHYHUVWRSV)XU-
thermore, there’s a lot of money in it,
as I can testify from my own personal
H[SHULHQFHµ
Illustration by Jesse Lefkowitz
Robert Hagstrom, CFA, is chief investment strat-
egist and managing director of Legg Mason
Investment Counsel. He is the author of eight
books on investing, including Investing: The
Last Liberal Art.
 VIEWPOINT
LETTERS
WHY FARMS HAVE RAT HOLES
$IWHUZHKDXOHGWKHODVWORDGRIEHDQVWRWRZQ,ÀQDOO\
got a chance to read the farm article by Sherree DeCovny
(“Portfolio Performance: Cultivating Returns,” September/
October 2012). Although Iowa does not permit institutional
land ownership, the article would be of interest to any pri-
vate investor in our state.
,DJUHHZLWKPRVWRIWKHÀJXUHVLWFRQWDLQVUHODWLQJWR
DJULFXOWXUHLQWKH86:HKDYHEHQHÀWHGSHUVRQDOO\WKH
past 25 years from a portfolio of half stocks, half farm
land, with modest leverage. There was plenty of volatility
in each asset class, but they tended to smooth each other
RXW7KHSDVWÀYH\HDUVIRUH[DPSOHZHUHQHWSRVLWLYH,·P
not claiming that we were insightful to set it up that way,
but we stuck with it, as DeCovny’s article describes. And it
did work out well. Maybe we got lucky. There is something
WREHVDLGIRUEHLQJWRRGXPEWRTXLW
Speaking personally and not as an investment adviser,
,VHHFRPPRGLW\FURSSURGXFWLRQDVDXQLTXHDFWLYLW\E\
which an American household can access global economic
H[SRVXUHGLUHFWO\*UDLQLVSULFHGLQDZRUOGZLGHDXFWLRQ
market, unlike almost everything else people produce or
GR&KDQJHVLQFXUUHQF\H[FKDQJHUDWHVLQWHUHVWUDWHVDQG
consumer spending everywhere in the world make their
ZD\UDWKHUHIÀFLHQWO\LQWRWKHORFDOSHUEXVKHOVHOOLQJSULFH
I don’t have any perspective on the idea of trying to farm
in developing countries—high risk, for sure, it seems to me,
operators have over distant and disinterested owners. The
usual principal–agent problems crop up wherever someone
manages land for someone else. The reason farms have rats
is to dig holes for investors to put their money in.
Returns to farming the past few years—fat years—have
been phenomenal. We’ve seen lean years too. I’ll close with
two jokes from the early 1980s when that highly levered
episode DeCovny mentions was unwinding. We lost 10%
RIRXUIDPLO\IDUPHUVWREDQNUXSWF\LQÀYH\HDUVVRPHWR
suicide. Our city lost more than 11,000 United Auto Work-
HUVVFDOHMREVDWORFDODJULFXOWXUDOHTXLSPHQWPDQXIDFWXU-
ers. Laughter was hard to come by, but I remember these
two: (1) What is the difference between a farmer and a
pigeon? The pigeon can still make a deposit on a new John
Deere. (2) A farmer won the lottery. They handed him the
check and asked what he planned to do with it. He replied,
“Reckon I’ll just keep farming until this is gone.”
Cheers, and may your harvest all be “safely gathered in,
HUHWKHZLQWHUVWRUPVEHJLQµ7KHRSLQLRQVH[SUHVVHGDUH
personal, not intended as investment advice.)
David G. Sparks, CFA
Waterloo, Iowa
SUFFICIENT UNTO THE FRAY IS THE DRIVEL THEREOF
“The Great Debate” (November/December 2012) was the
ÀUVWDUWLFOHWKDW,KDYHHYHUUHDGLQD&)$,QVWLWXWHSXEOLFD-
tion where I ended up knowing less at the end (confession: I
and high returns too, maybe, if you can hold onto them.
It might make more sense to get into the business on the
inputs side in those markets.
2QHWKLQJDERXWWKHDUWLFOHVWXFNRXWDVTXHVWLRQDEOH³
the statement that “U.S. agriculture consumes roughly
20,000 gallons of diesel fuel per acre.” At US$4.00-and-
change per gallon, that much fuel would cost something
like US$80,000 per acre. We sure burn a lot less in our oper-
ation. Michael Duffy, an economist at Iowa State Univer-
VLW\SXEOLVKHVDQDQQXDO´(VWLPDWHG&RVWVRI&URS3URGXF-
WLRQLQ,RZDµWKDWÀJXUHGWKHDOOLQSHUDFUHFRVWRIFRUQ
in 2012 at US$740. Machinery and grain handling costs,
which include fuel, total about US$75. (Duffy has published
his data online at www2.econ.iastate.edu.)
The trends DeCovny discusses for land ownership are
genuine concerns for public policy in both developed and
developing countries. I have my doubts about seeing land
WUHDWHG OLNH MXVW DQRWKHU VHW RI FDVK ÁRZV LQ D QHWSUHV-
ent-value framework. Institutional and investor owner-
ship inclines toward shorter-term thinking. I think the big-
gest reason farm returns have low correlation with secu-
rity markets has more to do with the stubborn nature of
farmers than with any attribute of the asset class. Farm-
ers don’t give up easily. The ones I admire feel deeply con-
nected to their land and treat it with respect. Stewardship
RIWKHODQGWUXPSVSURÀWPD[LPL]DWLRQ7KHVDPHIHHOLQJ
lives in the hearts of successful landlords. I won’t go into
WKHH[SHQVHFRQWURODGYDQWDJHVWKDWNQRZOHGJHDEOHIDUP
GLGQ·WZDVWHP\WLPHÀQLVKLQJWKHDUWLFOHWKDQZKHQ,VWDUWHG
It should have been titled “The Great Liberal Drivel.” If the
SRLQWZDVWKDW+D\HNKDGQRGHÀQDEOHHFRQRPLFWKHRU\WKHQ
why have an article? When you have to footnote the article
because the person being interviewed is taking people out
RIFRQWH[W\RXPLJKWKDYHDSUREOHP+RSHIXOO\WKLVZLOO
be a learning opportunity, and CFA Institute Magazine will
focus on educating rather than politicizing.
Chris Haag, CFA
Bloomington, Illinois
CORRECTION
An interview with Roger Urwin in the November/December issue
(“Mission and Vision”) incorrectly identified him as the chair
of the planning committee for the CFA Institute Board of Gover-
nors. In fact, Urwin is now the former chair. The current chair,
as of 1 September 2012, is James G. Jones, CFA.
The editor welcomes the views and opinions of readers.
Please e-mail comments to roger.mitchell@cfainstitute.org.
Jan/Feb 2013 CFA Institute Magazine 17
 PROFESSIONAL PRACTICE
PORTFOLIO PERFORMANCE

A Tailor-Made Off-the-Rack Fit

CUSTOMIZED BETA IS TRENDY BUT NOT YET STYLISH
By Maha Khan Phillips

Once upon a time, investment management seemed straight- EXIIHUIXQGWKH86ELOOLRQ:\RPLQJ5HWLUHPHQW6\VWHP

forward. There were active managers and passive manag-
ers, and which type of manager or combination of manag-
HUV\RXFKRVHGHSHQGHGRQ\RXUYLHZRQPDUNHWHIÀFLHQF\
Active managers charged more but delivered on performance.
Passive managers gave you beta exposure with lower fees.
Or so the theory went.
7KHÀQDQFLDOFULVLVUHYHDOHGWKDWPDQ\DFWLYHPDQDJHUV
were not adding value. A large majority have struggled to
justify their fees while passive managers have gained ground.
In the year ending June 2011, worldwide, index assets grew
by 24.7% to almost US$6 trillion, according to Pensions &
Investments. But investors also realized that their portfolio
objectives went beyond outperforming a benchmark, par-
ticularly if that benchmark left them exposed to overval-
ued stocks, as market-cap-
weighted indices have been
As many investors have accused of doing. This prob-
lem is exactly where custom-
KEY POINTS
DQGLQWKH8.WKH…ELOOLRQ:LOWVKLUH&RXQW\FRXQFLO
and the €3.4 billion pension fund PNO Media. The French
state pension reserve fund said it would begin mixing tra-
ditional cap-weighted passive strategies with some track-
ing alternative-weighted indices, and the US$43.6 billion
Taiwan Labour Pension Fund in Taipei will run US$1.5 bil-
lion of its assets tracking the MSCI Global Minimum Vol-
atility and MSCI Emerging Markets ex-Taiwan Minimum
Volatility indices. In the Netherlands, the Blue Sky Group,
which manages the pension funds for Dutch airlines KLM,
says it is expanding its allocation.
´:HLQLWLDOO\VWDUWHGWRLQYHVWRIRXUHTXLW\DOORFDWLRQ
in these strategies but are now increasing this to 10% of our
equity allocation,” explains Ramon Tol, equities fund man-
DJHUDWWKHÀUP$FFRUGLQJWR7RO%OXH6N\LQYHVWVLQRQH
PD[LPXPGLYHUVLÀFDWLRQVWUDWHJ\DQGWZRDFWLYHO\PDQ-
aged low-volatility strategies.

become disenchanted
with active management ized beta can play a role.
and questions have been “It seems to be one of the
raised about market-cap- things that people are think-
weighted indices, custom- ing about more and more
ized-beta strategies (also in terms of their investment
known as smart beta) have strategy,” notes Andy Barber,
become more attractive as head of manager research
potential solutions. at Mercer, the investment
consultancy.
Pension funds around the
Customized beta is a the-
world have increased allo-
matic index solution that
cations to such strategies,
ranges in approach and vari-
which reflect a blurring of
ety. Strategies can be roughly
the lines between active
divided into three groups:
and passive management.
alternative strategies that
provide different approaches
to traditional market-cap-
weighted indices (including risk parity, minimum variance,
BLURRED LINES
)RULQYHVWRUVFXVWRPL]HGEHWDVWUDWHJLHVUHÁHFWDEOXUULQJ
of the lines between active and passive management.
´7KHLQFUHDVHGIRFXVRQ¶VPDUWEHWD·VROXWLRQVUHÁHFWV
investor appetite for the ‘core’ of their portfolios to work
harder for them, as they seek to reduce and bolster returns,”
says Oliver Cassin, head of the investment advisory depart-
PHQWIRUSXEOLFPDUNHWVDWEÀQDQFHWKH/RQGRQEDVHGLQGH-
SHQGHQWO\RZQHGFRQVXOWDQF\ÀUP´,QHVVHQFHWKHGHEDWH
between traditional index-based solutions within core port-
folios versus active management is now out of date, with
JUHDWHUGLYHUVLÀFDWLRQRIVWUDWHJLHVQRWVLPSO\WKHSUHVHUYH
of active management.”
In a survey commissioned by Northern Trust, Greenwich
Associates interviewed 121 institutional investors globally
in August and September 2011. These investors collectively
have 2.5 million employees and more than $500 billion in
assets under management. The survey results suggest that
DQGPD[LPXPGLYHUVLÀFDWLRQULVNIDFWRULQGLFHVZKLFK some investors are questioning the relevance of the separa-
IRFXVRQPRPHQWXPYDOXHDQGJURZWKDQGWKHXVHRI
VLPSOHHTXDOZHLJKWLQJLQDQLQGH[WRLQFUHDVHGLYHUVLÀFD-
tion, according to asset management consultancy Cerulli
Associates.
The main index providers, such as FTSE, S&P, and MSCI,
are all offering customized, or smart, beta products (the two
tion of alpha and beta in portfolio construction techniques.
Forty-one percent of European respondents said that they
do not consider alpha–beta separation to be very relevant to
their portfolios, although this view is not shared by North
American or Asian respondents.
WHUPVDUHLQWHUFKDQJHDEOHDQGVRDUHVSHFLDOLVWSURYLGHUV REASSESSING BENCHMARKS
VXFKDV&DOLIRUQLDEDVHG5HVHDUFK$IÀOLDWHVZKRVH)XQGD- 7KHPDMRULW\RILQYHVWRUVKRZHYHUGREHOLHYHWKDW
mental Index strategies have posted consistent growth since meeting their own unique investment objectives is more
inception. According to reports, pension funds that have made important than outperforming relative to their chosen bench-
allocations to the strategies include AP2 (the Swedish state marks. In Europe, 88% of institutions said this is true, as did

18 CFA Institute Magazine Jan/Feb 2013

RI$VLDQLQVWLWXWLRQVDQGRI$PHULFDQRQHV:RUOG- examining these alternative betas is whether the claim that
wide, approximately one-third of institutions participating performance is robust is true. So, we took the different alter-
in the study said that passive products make up 40% of their native betas and made simulations using the exact method-
HTXLW\DQGÀ[HGLQFRPHDVVHWVDQGDSSUR[LPDWHO\LQ ology in a variety of global markets—using as much data
of the institutions expect passive strategies to account for as possible, looking at decade-by-decade comparisons—and
PRUHWKDQRIHTXLW\DQGÀ[HGLQFRPHDVVHWVE\ what we found is that at least empirically, these strategies
Respondents also said that market-cap coverage, style tend to have been extremely successful in providing robust
biases, weighting methodology, and sector/country biases outperformance over the standard capital benchmarks for
are the most important criteria when evaluating and select- all regions and time frames,” says Jason Hsu, chief invest-
ing an index. These same institutions, however, expressed PHQWRIÀFHUDW5HVHDUFK$IÀOLDWHV
concern about the construction of cap-weighted indices. In fact, the S&P 500 Index recorded an annualized return
Globally, 37% of investors described themselves as “con- of 2.8% from October 2001 to September 2011, trailing the
cerned” or “very concerned” about methodology-related 6 3(TXDO:HLJKW,QGH[E\5HVHDUFK$IÀOLDWHVFDO-
ELDVHVLQVWDQGDUGLQGLFHV7KH\VSHFLÀFDOO\SRLQWWRELDVHV culated total returns for each customized beta strategy at a
toward larger-market capitalization in equity indices and monthly frequency from 1964 through 2009 for U.S. strat-
ELDVHVWRZDUGODUJHUGHEWLVVXDQFHLQÀ[HGLQFRPHLQGLFHV egies and from 1987 through 2009 for global strategies.
“In equities, it is more of a debate about whether market- These strategies were compared with the S&P 500 (for U.S.
FDSZHLJKWHGLVLQWHOOLJHQWEXWLQÀ[HGLQFRPHPRVWSHRSOH VWUDWHJLHVDQGWKH06&,:RUOGIRUJOREDOVWUDWHJLHV$OO
recognize that cap weighted is a problem because you end the strategies produced meaningfully higher returns than
up with exposure to the entity which has the most debt,” their cap-weighted benchmarks over the sample period.
explains Michael John Lytle, managing director of Source, “It’s important to think about why there has been this
a U.K.-based ETF provider. RXWSHUIRUPDQFHµVD\V+VX´:HGLVFRYHUHGWKDWDJUHDW
John Krieg, CFA, managing director of asset management commonality is that these strategies, even if they don’t
EMEA for Northern Trust, says that market-cap-weighted implicitly attempt to do so, end up being more value-orien-
strategies will always be around but that the middle ground tated stocks. And in half the cases, they tend to buy slightly
between benchmark indices and actively managed strate- VPDOOHUVWRFNV:HNQRZWKDWKLVWRULFDOO\WKHVHVWRFNVWHQG
gies will grow, giving investors a range of different options. to have stronger performance over time.”
“In the past, there wasn’t a lot of work being done on index Investors are realizing that the potential exists, but they
analysis,” says Krief. “A tremendous amount of work would have been slow to act. Clients of investment consultancy
have been done on asset allocation based around whatever 7RZHUV :DWVRQ KDYH DOORFDWHG … ELOOLRQ WR VPDUWEHWD
benchmark or index was used. But there was less research VWUDWHJLHVRYHUWKHSDVWÀYH\HDUVDQGWKHPDUNHWLVFXU-
GRQHDERXWWKHGHFLVLRQDURXQGWKHLQGH[:HDUHVHHLQJ rently estimated to be about US$200 billion globally. How-
that change now because market-cap indices do have biases.” ever, this amount is still just a drop in the ocean compared
But scalability can be a challenge. In the past, consul- with the size of total indexing assets, although development
tants have suggested that the strategies have not been LQWKHÀ[HGLQFRPHVSDFHLVDOVROLNHO\WRGULYHGHPDQG,Q
widely adopted because it is not in the interests of manag- -DQXDU\5HVHDUFK$IÀOLDWHVODXQFKHGDQHZJOREDOVRYHUHLJQ
ers to sell products that generate lower fees but still require bond index series with global bank Citi that is based on mea-
time to customize. sures of size. The indices decrease exposure to aging and debt-
“Customization comes into play when we allow laden economies, such as Japan and the U.S., and increase
the client to identify the amount of income or yield exposure to younger resource-rich countries, such as Aus-
play they want in their portfolio. It could be 2.5 times tralia and Canada. The index weights each country equally
WKDW RI WKH 06&, LQGH[ RU \RX FRXOG KDYH WKH ÁH[LELO- by four factors: GDP, energy consumption, population, and
ity of having a beta in your portfolio of less than 1,” UHVFDOHGODQGDUHD$FFRUGLQJWR5HVHDUFK$IÀOLDWHVDQG&LWL
explains Krieg. But he does agree that having scale makes WKLVQHZDSSURDFKUHÁHFWVHDFKQDWLRQ·VDELOLW\WRVHUYLFHLWV
it easier. “There is a trade-off in debt, which, in an age of sovereign
WHUPVRIVFDODELOLW\:HDUHVHWXS KEEP GOING debt crises, cannot be a bad thing.
to handle customized strategies “The question is, are these good
because we typically work with “Systemic Risk, Multiple Equilibriums, and Market ideas?” says Hsu. “The data seem to
very large clients, whether they Dynamics: What You Need to Know and Why,” support the fact that they are. But
Financial Analysts Journal (Sept/Oct 2012),
are central banks or sovereigns (www.cfapubs.org) it is early days. People are going
or large pension plans. If you are to have to spend the resources to
Expected Returns on Major Asset Classes,
working with smaller-sized portfo- Research Foundation of CFA Institute (June 2012), analyze it, particularly consultants.
lios, it becomes more challenging.” (www.cfapubs.org) This is not easy research.”
“The ‘New Normal,’ Cap-Weighted Indexing, and Maha Khan Phillips is a financial journalist
PERFORMANCE Passive Strategies in Europe and Asia,” CFA Insti- based in London and author of the novel
Ultimately, investors will be swayed tute webcast (Take 15 Series, Jan. 2012), Beautiful from This Angle.
(www.cfawebcasts.org)
by performance. “The very first
question that investors ask when

Jan/Feb 2013 CFA Institute Magazine 19

 PROFESSIONAL PRACTICE
ANALYST AGENDA

Cracked
AFTER A CRACKDOWN, COMPLIANCE RISK HANGS OVER EXPERT NETWORKS
By Rhea Wessel

Using alternative and primary sources of research to gain
an investment edge against the competition is standard
practice and makes plain, good sense. After all, analysts
should be encouraged to learn as much as possible about
their investments via any legal source they have access to
and should have the chance to be rewarded with a premium
for their due diligence.
Yet some types of legitimate research, including research
strategies that rely on an insider’s perspective, require
the users of the research to
take extra care in scrutiniz-
A 2011 insider-information ing the material and to apply
a checklist of best practices
KEY POINTS
TAPPING EXPERT NETWORKS
As the name indicates, expert networks are made up of
people with specialized knowledge, whether about electronic
goods produced in a particular Asian country or enzyme
UHDFWRUV7ZRGR]HQÀUPVSURYLGHH[SHUWQHWZRUNVDURXQG
the world, matching up their clients—usually institutional
investors—with experts who have signed on.
The experts receive payment for sharing their ideas about
markets, products, and companies. For instance, a clerk at a
video game store may be able to earn additional money by
sharing what he knows about which games are hot. Simi-
larly, a patent attorney may be able to boost her income by
discussing the intricacies of intellectual property rights for

crackdown that involved an

expert-network firm has led
analysts who use such net-
works to put more empha-
sis on compliance and lim-
iting potential liability.
Industry sources cite con-
cern about compliance risk
as the main reason why
related to the information.
The use of expert net-
works is a well-known and
accepted way of gaining a
new perspective on or learn-
ing the details of a market
segment with the help of
an expert found through a
medical devices.
Typically, conversations will focus on market context,
trends, or a technical aspect of a product or service. Insti-
tutional investors may conduct interviews directly with a
market source to quiz him or her about anything from prod-
uct details and customer preferences to buying trends. They
also use sources at distributors to perform ad hoc channel
checks (i.e., to learn more about how certain products are
matchmaker. However, fol- IDULQJLQWKHVDOHVSLSHOLQH
the expert-network market
lowing the 2011 insider- In these exchanges between experts and analysts that
has experienced a decline.
information crackdown that are part of building an investment thesis, the line between
Ethical best practices involved an expert network legal and illegal information can get blurry, especially if the
can limit the opportunity ÀUPFDOOHG´3ULPDU\*OREDO rules of engagement for the conversation are not stated and
for abuse and should be Research,” analysts who use clear to all participants from the beginning.
implemented by invest- such networks have put more In the crackdown on expert networks (which was part of
ment practitioners and the emphasis on compliance and the larger sweep that brought down Galleon Group founder
expert-network providers. limiting potential liability.
´:KHQZHWDONWRKHGJH
IXQGVDQGLQYHVWPHQWÀUPV
that are using expert networks, we suggest they work with
OUR CLIENTS WERE AHEAD OF THE GAME.
WKHQHWZRUNÀUPVWKHPVHOYHVWRXQGHUVWDQGKRZWKRVHÀUPV ... THEY WERE DOING RESEARCH WITHIN
go about selecting experts, how they screen the individu-
als, what compliance programs they have, and what train-
A FRAMEWORK WHERE THEY COULD
ing is offered to make sure individuals in the network are MONITOR IT, THEY COULD MANAGE IT,
not providing inappropriate information,” says R. Daniel
2·&RQQRUDSDUWQHUDWODZÀUP5RSHV *UD\LQ%RVWRQ
EVERY EXPERT WAS TRAINED, EVERY
O’Connor, who formerly served as the senior trial counsel EXPERT WAS SIGNING AGREEMENTS, AND
at the U.S. SEC, where he handled prosecutions and inves-
tigations related to securities fraud, now advises both users
THERE WERE ADDITIONAL RESTRICTIONS
of expert networks and the expert networks themselves to ON THE TYPES OF PROJECTS AND THE
ensure proper compliance regimes are in place. He explains,
´:KHQXVLQJDQ\W\SHRIDOWHUQDWLYHRUSULPDU\VRXUFHVIRU
AMOUNT OF PROJECTS THAT EXPERTS
research, it’s critical for analysts to vet the sources and con- WERE DOING.
stantly monitor them for compliance to avoid putting their
investment idea in jeopardy by receiving material, nonpub-
lic information.”

20 CFA Institute Magazine Jan/Feb 2013

5DM5DMDUDWQDP-DPHV)OHLVKPDQDIRUPHUHPSOR\HHRI
H[SHUWQHWZRUN ÀUP 3ULPDU\ *OREDO ZDV FRQYLFWHG IRU
conspiracy to commit securities fraud and conspiracy to
commit wire fraud. Fleishman was sentenced to two and a
half years in prison for his role in supplying unauthorized
information, such as revenues or margins to hedge funds.
He had gathered this information from executives at such
companies as Advanced Micro Devices and Dell.
As of June 2012, the SEC has reported that 23 defendants
have been charged in enforcement actions arising out of its
expert-networks investigation. For example, one such case
involved Tai Nguyen,WKHRZQHURIDQHTXLW\UHVHDUFKÀUP
in California named Insight Research and a consultant for
DQXQGLVFORVHGH[SHUWQHWZRUNÀUP7KH6(&FKDUJHGKLP
with insider trading in June 2012, alleging that Nguyen
frequently traded the securities of Abaxis based on inside
information he received from a close relative employed
at the company and that he passed the information on to
hedge fund clients.
Such cases are one reason the expert-network market has
experienced a decline of late, with many users of expert net-
works reviewing or suspending use or putting further pro-
tections in place, according to Sandy Bragg, the CEO and
president of Integrity Research Associates, a New York–
EDVHGUHVHDUFKÀUP
MORE COMPLIANCE LAYERS
Many companies have taken a “caveat emptor” approach
and implemented or buttressed guidelines for the use of
H[SHUWQHWZRUNV7KHHIIRUWVDUHLQWHQGHGWRKHOSWKHÀUPV
steer absolutely clear of insider information and to avoid
even the appearance that an analyst may be in the gray
zone regarding insider information. In 2011, the New York
Times reported that Balyasny Asset Management, Millen-
nium Partners, and Och-Ziff Capital Management Group
had suspended use of expert networks.
%UDJJVD\VLQYHVWPHQWÀUPVDUHQRZIDFLQJPRUHVFUXWLQ\
from their own clients about their use of expert networks
because of the risk of bad press. “Clients want to know if
the asset manager has proper controls and is using expert
networks carefully,” he says.
Best practices for using expert networks include conduct-
ing mandatory training, running in-house spot checks of
analysts who rely on the networks, and engaging only those
network providers that have a strong compliance regime
and a restricted universe of experts.
According to O’Connor, training should cover the basic
rules of the knowledge-discovery process as it relates to
LQVLGHULQIRUPDWLRQDVZHOODVDFRPSDQ\·VRZQVSHFLÀF
policies and how to use restricted lists and watch lists. To
avoid getting into areas that are sensitive or could be put
into question later, analysts should also learn to evaluate
the credentials of the people they talk to before they get on
the phone with them.
Indeed, various reports have raised questions about the
appropriateness of some of the participants in expert net-
works, including consulting done for expert networks by
LQÁXHQWLDORSHUDWLRQDOPDQDJHUVDWOLVWHGFRPSDQLHV´'D\
The Rise of Expert Networks
Expert networks began to gain prominence in 2000, after the
SEC’s Regulation Fair Disclosure, or Reg FD, introduced new
rules. Suddenly, companies could no longer selectively disclose
material, nonpublic information. That change made it harder for
big investors to have an information edge, and expert networks
sprung up to try to fill that gap.
Expert networks are provided by boutique information pro-
viders that may sell subscriptions for access to the network
(charging up to hundreds of thousands of dollars a year); indi-
vidual experts may receive US$300–US$1,500 for a single con-
versation or interaction, although payments vary.
One market-leading provider of an expert network claims to
provide access to 300,000 experts around the world. According
to Integrity Research, roughly 25 companies are in the business
and the industry is expected to be worth approximately US$325
million in 2012, a decrease of 30% compared with 2011, partly
a consequence of the Primary Global scandal. In addition to
working with institutional investors, these firms serve consult-
ing companies, investment banks, law firms, marketing agen-
cies, and the not-for-profit and public sectors, as well as private
equity and venture capital customers. Many focus on particular
industry segments.
in and day out, buy- and sell-side analysts talk to CFOs, IR
[investor relations] directors, and others,” says O’Connor.
“Those folks are trained and understand the rules and
provide the right disclosure with what’s already out in the
PDUNHW:KHUHLWJHWVGLIÀFXOWLVLI\RXWDONWRVRPHRQHLQ
WKHÀQDQFHGHSDUWPHQWRUWKHVDOHVGHSDUWPHQW6RPHFRP-
SDQLHVKDYHFRQÀGHQWLDOLW\DJUHHPHQWVWKDWOLPLWWKHDELO-
ity of employees to speak publicly for the company. Some
expert networks don’t allow those folks in their network.
Others require some form of chaperone from the client side.”
Key questions to ask include the following: Does the
network allow company employees or company directors
WRVSHDNSXEOLFO\RQEHKDOIRIWKHFRPSDQ\":KDWDUHWKH
details of the contracts between the expert network and
WKHH[SHUWVLQWKHQHWZRUN":KDWDUHH[SHUWVDJUHHLQJWKDW
WKH\ZLOOQRWSURYLGHRUZLOOQRWGR":KDWW\SHRIWUDLQLQJ
does the network provide to its experts?
In addition to providing training for analysts using expert
QHWZRUNVÀUPVPD\LPSOHPHQWVSRWFKHFNVDQGPDNHVXUH
analysts are aware that their e-mail may be monitored or
DFRPSOLDQFHRIÀFHUPD\OLVWHQLQRQWKHLUFRQYHUVDWLRQV
with experts.
Some companies have decided to use additional services
provided by the expert networks, such as record-keeping
about the sources contacted and topics discussed or call
recordings. Bragg says the way clients are using the compli-
DQFHFDSDELOLWLHVDWH[SHUWQHWZRUNÀUPVLVPXFKPRUHSUR-
active than in the past. “After the crackdown, compliance
RIÀFHUVDWÀUPVDUHPRUHIUHTXHQWO\SUHDSSURYLQJFRQVXO-
tations before they occur or they audit consultations on an
unannounced basis,” says Bragg.
Jan/Feb 2013 CFA Institute Magazine 21
 PROFESSIONAL PRACTICE
ANALYST AGENDA
According to the Securities Industry and Financial Mar-
kets Association, companies should determine on a risk-
assessed basis what controls are appropriate to adequately
address the risks of interacting with consultants associated
ZLWKH[SHUWQHWZRUNVWKDWSRVVHVVFRQÀGHQWLDOLQIRUPD-
tion or material, nonpublic information. Such experts may
include current or recent employees of public companies;
NQRZQVLJQLÀFDQWVXSSOLHUVRUGLVWULEXWRUVWRSXEOLFFRP-
panies; attorneys, accountants, and consultants engaged
by public companies; or doctors serving on clinical trials.
O’Connor often recommends that users of expert networks
seek contractual protections that the network’s experts won’t
disclose proprietary information and require the expert to
verify that he or she is not violating any employment agree-
ments by providing information.
Other Strategies That Rely on an
Insider View
Besides expert networks, another research strategy that makes
use of an inside perspective is “channel checking.” Channel-
check reports supply analysts with compiled information from
resellers and distributors to provide a broad picture of a compa- sure agreement], there’s no training. And by the way, there
ny’s prospects in various sales channels.
Another strategy is “taking buy/sell cues from insiders.”
Apple is going to be introducing some sexy new component
that’s rumored, now I can’t invest in Apple,” says Bragg.
“Even though I’ve developed my thesis and done a lot of
other research, once I get something that’s material, non-
public information, I have to toss that all out. It’s really a
pain,” explains Bragg. “Maybe it didn’t work like this before
the fall of Galleon, but I think it does now. The ultimate
alpha is material, nonpublic information. But the trick is
getting alpha from legal means. The question is how to do
the due diligence on Apple legally so that I don’t cross that
line. People don’t want to do the perp walk. People don’t
want to go to jail.”
Bragg and O’Connor are among many who argue that
expert networks actually offer more protections to the user
than the more typical ways of talking up sources at indus-
try conferences or entertaining sources. “An analyst is going
to talk to sources as part of the investment process,” says
Bragg. “Expert networks give those conversations a struc-
WXUHWKDWLVRWKHUZLVHGLIÀFXOWWRUHSOLFDWHµ
A representative from a leading expert network puts
it differently. “Outside of expert networks, incentives for
experts are really informal. Can I buy you a drink? Can I buy
you dinner? There are no rules, there’s no NDA [nondisclo-
might be inebriation by the end of the night,” says Laurence
Herman, general counsel and managing director at Gerson
With this research strategy, investors follow the signals a com- /HKUPDQ*URXS*/*ZKLFKPDLQWDLQVRQHRIWKHODUJHVW
pany provides when it announces an open-market share buy- expert networks. “This is in stark contrast to what we do.”
back or when its officers purchase shares in transactions that Proper use of mosaic theory is the key to avoiding eth-
are subsequently reported to the authorities and shared with LFDOFRQÁLFWVIRUDQDO\VW&UDLJ(*RU\O&)$)RUPHUO\DV
the public. an analyst for U.S. media and telecom equities at Putnam
As with the use of expert networks, these strategies (also Investments, he used the expert network provided by GLG.
based on information from those with an inside perspective) Later, he was employed by GLG, where he managed the
should be used with caution and within the context of a larger technology, media, and telecom business in Boston. Now,
compliance regime. Goryl calls himself a primary research “do-it-yourselfer” in
his job as an analyst of global equities at Cabot Money Man-
DJHPHQWDVPDOOZHDOWKPDQDJHPHQWÀUPRXWVLGH%RVWRQ
Goryl shops his own sources, using social and business
QHWZRUNLQJVLWHVRQWKHZHEEHFDXVHKLVÀUPGRHVQRWVXE-
COST–BENEFIT ANALYSIS scribe to an expert network. For instance, he’ll call up
Additional layers of compliance have placed a heavier burden someone he found on LinkedIn to discuss the experience of
on using expert networks and have discouraged some com- EHLQJDFXVWRPHURIDSDUWLFXODUÀUPDVKHEXLOGVDPRVDLF
panies from using them altogether. WKHRU\*RU\OVD\VKHLVFDUHIXOWRDYRLGSRWHQWLDOFRQÁLFWV
´:H·YHWDONHGWREX\VLGHDQDO\VWVZKRDUHDIUDLGWRXVH RILQWHUHVWZKHQORRNLQJIRUSURÀOHVRILQGXVWU\H[SHUWV
expert networks anymore,” says Bragg. “You have to give a For example, he’ll never contact an employee of a company
‘Miranda’ warning before each consultation, meaning you he is researching.
have to notify the expert in set language what the ground ´:KHQ,JHWRIIWKHSKRQH,·PDOLWWOHIXUWKHUDORQJLQ
rules are, and very often they have to document [the con- FRQÀUPLQJRUGLVFRQÀUPLQJP\WKHVLVµH[SODLQV*RU\O´,I
sultation]. It’s just much more burdensome than before.” something happened in such a phone call that made some-
Another disincentive is the obvious fact that other research one want to run downstairs immediately and place a trade,
and investment opportunities are lost if an analyst must there’s probably something wrong with that research pro-
dump a thesis after inadvertently receiving material, non- cess. There’s a lot more to what makes a stock go up or down
public information. than what one customer thinks.”
“If I am an asset manager and I spoke to some semicon- :KHQLWFRPHVWRHYDOXDWLQJZKHWKHULQIRUPDWLRQLVLOOH-
ductor manufacturer in Taiwan who knows for a fact that gal inside information, Goryl says, “the CFA Institute Code

22 CFA Institute Magazine Jan/Feb 2013

of Ethics is my guide here. Fortunately, this code has been
ZLGHO\HQGRUVHGDQGDGRSWHGE\UHSXWDEOHLQYHVWPHQWÀUPV USING DILIGENT RESEARCH IS
Nothing should come directly or indirectly from employ-
ees of your research target. Beyond that, analysts can ask
FUNDAMENTAL TO WHAT MANY OF OUR
WKHPVHOYHVWZRVLPSOHTXHVWLRQV,VWKLVLQIRUPDWLRQ MEMBERS DO. IT’S IMPORTANT AND
FRQÀGHQWLDO"'RHVP\VRXUFHKDYHDULJKWWRVKDUHLW"
,IWKHDQVZHULV\HVWRWKHÀUVWRUQRWRWKHVHFRQGWKDWLV
YOU CAN DISTINGUISH YOURSELF AS AN
a compliance problem.” ANALYST BY DIGGING UP INFORMATION
INDUSTRY REACTION TO THE CRACKDOWN
THAT OTHER PEOPLE DON’T GET. ... BEST
After Primary Global ran into trouble and another provider PRACTICES LIMIT THE OPPORTUNITY FOR
was called into question by allegations from Massachusetts
authorities, GLG reacted to the negative press reports by
ABUSE AND SHOULD BE USED BY BOTH
engaging its clients and their clients on the importance of THE INVESTMENT PROFESSIONALS AND
expert networks and how to use them in a consulting frame-
work. Already in 2004 and 2005, GLG had begun to boost its
THE EXPERT-NETWORK PROVIDERS.
compliance regime and restrictions, according to Herman.
“Our clients were ahead of the game,” he says. “They weren’t
GRLQJUHVHDUFKEDVHGRQZKDWWKHÀUP·VPRVWDJJUHVVLYHDQD-
lyst wanted. They were doing research within a framework DO-IT-YOURSELF NETWORKS
where they could monitor it, they could manage it, every ,W·V QR VHFUHW LQ WKH LQGXVWU\ WKDW H[SHUWQHWZRUN ÀUPV
expert was trained, every expert was signing agreements, rely on business networking tools widely available to the
and there were additional restrictions on the types of proj- SXEOLFVXFKDV/LQNHG,QRU;LQJWRÀQGH[SHUWVIRUWKHLU
ects and the amount of projects that experts were doing.” QHWZRUNV:K\WKHQZRXOGÀUPVSD\WKHKLJKHUIHHVWKDW
About the same time, CFA Institute approached the SEC these expert networks charge for access to experts they
about the need for analysts to do primary research and build FRXOGÀQGRQWKHLURZQ"
mosaic theories and pointed to the potential chilling effect It’s about the service and compliance regimes that come
that the insider-information crackdown could have on pri- DVSDUWRIWKHSDFNDJHDFFRUGLQJWR%UDJJ:LWKDQH[SHUW
mary research. Subsequently, the head of enforcement made QHWZRUNÀUPDQDQDO\VWFDQKLUHVRPHRQHHOVHWRKHOSKLP
a statement in early 2011 to clarify that the SEC and pros- TXLFNO\ÀQGWKHULJKWVRXUFHWRDQVZHUKLVYHU\VSHFLÀFTXHV-
ecutors were not condemning expert networks but instead tions. “An expert network might triangulate on its network
insider information and insider trading. to identify the best source,” says Bragg.
“Using diligent research is fundamental to what many “Using LinkedIn takes a lot of time and effort,” she adds,
of our members do,” says Jonathan Stokes, director of Stan- “and I think all things being equal, most people would prefer
dards of Practice Development and Education at CFA Insti- to use an expert network, unless you have a really general
WXWHDQGDODZ\HUKLPVHOI´,W·VLPSRUWDQWDQG\RXFDQ question, like you want to get up to speed quickly on frack-
distinguish yourself as an analyst by digging up informa- ing technology.”
tion that other people don’t get. You can do that in a vari- %XWWKHPRUHVSHFLÀFWKHLQIRUPDWLRQUHTXHVWWRWKHSUR-
ety of ways.” vider of the expert network, the closer an analyst comes to
Stokes notes that CFA Institute fully supports the rights revealing her investment thesis to the wider world. That’s
of analysts to go after, seek out, and discover information WKHODVWWKLQJDEX\VLGHLQYHVWRUZDQWVÁRDWLQJDURXQG
that will assist investors in bringing more information to The desire to protect your investment thesis is yet another
the market. The danger of expert networks, however, is UHDVRQWRXVHDQH[SHUWQHWZRUNWKHÀUPVDUJXH7KHQHW-
that under the guise of hiring an expert to discuss general works often have policies and procedures to ensure that
trends or information on a particular company, an analyst LQYHVWPHQWWKHVHVDUHNHSWFRQÀGHQWLDODQGQRWXVHGIRU
could get material, nonpublic information. personal gain by employees of the expert network. Some
´:HZHOFRPHWKHVDIHJXDUGVWKDWVRPHLQYHVWPHQWSURIHV- forbid their employees from owning any common stock at all.
sionals have enacted to avoid acquiring illicit material, such All in all, whether an investor chooses to go it alone and
as only engaging certain providers source his own experts or prefers
of expert networks or recording KEEP GOING to rely on the services of a match-
calls,” says Stokes. “Best practices maker, this and all forms of primary
limit the opportunity for abuse and “In Defense of Legitimate Research,” CFA Institute and alternative research should
should be used by both the invest- Magazine (Mar/Apr 2011), (www.cfapubs.org) be used with caution and within
ment professionals and the expert- “Examining the Dark Side of Financial Markets: Do the context of a larger compliance
network providers to ensure that Institutions Trade on Information from Investment regime.
Bank Connections?” summarized in CFA Digest
material, nonpublic information is (June 2012), (www.cfapubs.org) Rhea Wessel is a freelance journalist based
not exchanged.” in Frankfurt, Germany.

Jan/Feb 2013 CFA Institute Magazine 23

 PROFESSIONAL PRACTICE
TRADING TACTICS

“An Ugly High-Frequency Mess”

DISTORTED INCENTIVES LEAD SOME HFT STRATEGIES ASTRAY
By Dennis Dick, CFA

The media debate continues to rage about whether high- one [stock] symbol affects the latency for all other symbols
IUHTXHQF\WUDGLQJ+)7LVJRRGIRUWKHPDUNHWRUEDGIRU
the market. Proponents cite increased liquidity, reduced
VSUHDGV DQG PRUH HIÀFLHQW SULFLQJ 2SSRQHQWV FLWH WKH
instability of market liquidity, manipulative activities, and
YDULRXVPDUNHWHYHQWVVXFKDVWKHÁDVKFUDVK
So, who is right? Rather than using a broad brush that
paints all HFT as either good or bad, perhaps individual strat-
egies should be examined before drawing any conclusions.
´$ORWRIWKHPHGLDGHEDWHLVRYHUVLPSOLÀHGµVD\V-DPHV
$QJHO&)$DVVRFLDWHSURIHVVRURIÀQDQFHDW*HRUJHWRZQ
8QLYHUVLW\·V0F'RQRXJK6FKRRORI%XVLQHVV´:HQHHGWR
EHPRUHVSHFLÀF+LJKIUHTXHQF\WUDGHUVHPSOR\DZLGH
variety of strategies. Many
of these strategies are ben-
Although high-frequency HÀFLDO WR WKH PDUNHW VXFK
as market making, and arbi-
KEY POINTS
processed by that CPU or network.”
,WDOVRVORZVGRZQUHJXODWRUVZKLFKPHDQV+)7ÀUPV
engaging in shady activities have less of a chance of getting
FDXJKW´,WPDNHVWKHDXGLWWUDLOVLJQLÀFDQWO\PRUHGLIÀFXOW
to follow,” says Hunsader.
Another source of quote pollution might come from a
manipulative strategy called layering, in which large amounts
of buy orders are placed in the order book to make the stock
appear to have excessive demand. The aim is to trick another
trader into paying more for the stock, and if that happens,
the layering participant will sell to that trader and subse-
quently cancel all its own bids.
´:HQHHGWRFODPSGRZQRQTXRWHSROOXWHUVµVD\V$QJHO
“It drives up bandwidth costs for everyone.” One solution to
address the quote pollution issue might be to introduce an
RUGHUFDQFHOODWLRQWD[LQZKLFKÀUPVWKDWFDQFHODQH[FHV-

trading often adds liquid-

ity to the market and trage. But some strategies are sive amount of their orders would be charged a fee. Although
increases pricing effi- harmful as well. Personally, VXFKDFDQFHOODWLRQWD[PLJKWUHGXFHTXRWHVWXIÀQJDFWLY-
ciency, some HFT strate- I’m very concerned about the ities, it also might negatively affect HFT participants that
gies appear to be counter- excessive quote pollution in DUHEHQHÀFLDOWRWKHRYHUDOOPDUNHWVXFKDVDUELWUDJHXUV
productive and raise ques- the market.” Arbitrage systems make markets around the fair value
tions of fairness. Quote t raf f ic on t he of securities. For example, if a certain stock is trading at
exchanges has been increas- US$36 on the Toronto Stock Exchange, and the Canadian/
An order-cancellation tax
ing exponentially in the past US$ exchange rate is 1.05, then the stock should be trad-
has been proposed as a
few years. The daily number ing at US$34.29 in New York. HFT arbitrage systems will
possible solution for mit-
of quotes can now exceed 2 surround the fair value of the stock with a US$34.28 bid
igating dysfunctional
billion on a very active day, and US$34.30 offer. As the market price moves in Toronto,
effects of certain HFT
according to Eric Hunsader, the HFT arbitrage system will adjust their New York quotes
abuses.
who specializes in analysis of accordingly.
Some experts believe the TXRWHWUDIÀFDQGLVIRXQGHU There is little doubt that this HFT system is adding liquid-
maker–taker model is a pri- of data-feed provider Nanex, LW\WRWKHPDUNHWDQGLQFUHDVLQJSULFLQJHIÀFLHQF\DVLWNHHSV
mary structural problem //& LQ :LQQHWND ,OOLQRLV the New York price in line with the Toronto price. But it is
and should be reformed or That total is 459 times more essential that these systems be able to move their orders
eliminated, but doing so TXRWHWUDIÀFWKDQGXULQJWKH to adjust for the price on the other exchange. If an order-
without unintended nega- internet bubble in 2000, cancellation tax were implemented, systems like this might
tive consequences could when the number of daily have to widen their spreads in order to absorb the extra fee.
be difficult. quotes was only 5 million. Statistical arbitrage systems that take advantage of the
:KHUH GR DOO WKHVH TXRWHV relative mispricing of securities also could be affected. One
come from? EHQHÀWRIVWDWLVWLFDODUELWUDJHLV´IXQJLEOHOLTXLGLW\µDFFRUGLQJ
Much of this excessive quote pollution comes from an WRTXDQWLWDWLYHWUDGHU-DIIUD\:RRGULII&(2RI4XDQWLWDWLYH
DEXVLYH+)7VWUDWHJ\FDOOHGTXRWHVWXIÀQJ´4XRWHVWXIÀQJ Investment Management based in Charlottesville, Virginia.
LVZKHQ+)7ÀUPVVXEPLWKXJHTXDQWLWLHVRIRUGHUVZLWKQR “There is a lot of liquidity that is associated with the
intention of execution,” says Hunsader. “They cancel these fungibility of highly correlated assets,” he says. “Take, for
orders before they can be physically accessed.” example, a medium-liquidity stock that is 80% correlated
“It’s a way for algos [algorithmic traders] to game other to the S&P. There are systems out there that will exploit
algos,” Hunsader adds. “By dumping excessive orders into that relationship, and that stock is more liquid because of
the system, it slows down their competition and can be used it. It spreads the liquidity around, and you can do more in
WRFRQIXVHRUIRRORWKHU+)7DOJRULWKPV4XRWHVWXIÀQJLQ that stock because of that added liquidity.”

24 CFA Institute Magazine Jan/Feb 2013

 An order-cancellation tax might cause this liquidity to founder of KOR Trading in Omaha, Nebraska, and former
disappear. “The devil is in the details,” says Angel. An order- head of order routing at TD Ameritrade. “Online brokerages
cancellation tax would have to be structured to deter quote do not want to send their market orders to the exchange
stuffers without harming legitimate users, such as market because they would have to pay those take fees.” The result
makers and arbitrage players. appears to be an ugly high-frequency mess.
Quote pollution is a problem, but Woodriff believes the To illustrate, consider how this works in practice. A retail
maker–taker pricing model of exchanges poses a more seri- brokerage charges its customers US$7 per trade. If a customer
ous threat. placed a market order to buy 3,000 shares of a stock and the
The typical maker–taker pricing model pays market par- brokerage routed this order to NYSE Arca, the take fee would
ticipants a rebate for providing liquidity and charges partic- be $0.0030 per share for a total cost of US$9. The brokerage
ipants a fee for taking liquidity. Typically, the fee is slightly actually would lose money on this trade. Instead, the bro-
higher than the rebate, and the exchange keeps the difference. kerage routes the order to an OTC market maker (in other
Angel is also uneasy with the maker–taker model. “Effec- words, an HFT internalizer) that actually pays the brokerage
tively, when brokers are being measured against their best- for the order (usually between US$0.0010 and US$0.0030
execution obligations, they are not allowed to take all the SHUVKDUH7KLVSUDFWLFHLVFDOOHGSD\PHQWIRURUGHUÁRZ
fees into account,” he says. “Imagine shopping on eBay and Why would an internalizer pay for an order? It gives
not being able to take the shipping fees into account. It dis- WKHP ÀUVW FKDQFH WR LQWHUDFW ZLWK WKH RUGHU DQG UHWDLO
torts the incentives that market participants face.” orders are attractive to trade against because they are typ-
“The notion that the exchanges need to pay rebates to pro- ically uninformed.
viders of liquidity is ludicrous,” says Woodriff, “The futures “They take the best and exhaust the rest,” says Woodriff,
markets have plenty of liquidity without those rebates.” referring to the practice whereby an internalizer picks and
These rebates have created an entire class of high-fre- chooses which orders to trade against, trading against the
quency traders called “rebate traders” that specialize in uninformed orders and routing the more informed orders
placing limit orders on the exchange for the sole purpose to other internalizers or to the exchanges.
of capturing these rebates. Even if such traders scratch the The broker routes to the internalizer to avoid paying the
trade, they make money because of the rebates. take fee. If the internalizer doesn’t want to take the other
And the exchanges cater to these types of traders. “The side, the broker routes it out to another internalizer or, as a
exchanges main responsibility used to be to maintain fair last resort, sends it to the exchange. “This practice is caus-
and orderly markets,” says Dave Lauer, market structure ing the lit markets to become a dumping ground of toxic
and HFT consultant with IEX Group. “But now they are for- waste in the marketplace [because everybody is trying to
SURÀWHQWLWLHVDQGWKH\PDNHPRQH\E\DSSHDOLQJWRWKHLU avoid paying the take fee],” says Nagy.
best customers, which are high-frequency traders.” “It sucks liquidity out of the market,” says Lauer. As more
Some exchanges have created exotic order types that OLPLWRUGHUVDUHOHIWXQÀOOHGZKHQLQWHUQDOL]HUVVWHSLQDQG
DUHGHVLJQHGWRSURÀWIURPWKHPDNHU²WDNHUVWUXFWXUH7DNH trade against the market orders that otherwise would interact
for instance the hide-not-slide order from Direct Edge. It’s with those limit orders, the limit-order traders are discouraged.
an order based entirely on the maker–taker structure. For “When you’re displayed prominently in the marketplace,
H[DPSOHLIVWRFN$%&LVRIIHUHGDW86DQ+)7ÀUP you’re always going to be on the wrong side on a limit order
buying the offer at US$25.50 would have to pay the take fee. because the only time you’re going to be executed is when
$OWHUQDWLYHO\WKH+)7ÀUPFDQSODFHDKLGHQRWVOLGHRUGHU it blows right through you,” says Nagy.
at US$25.50, and when the quote rolls (the offer becomes “We need internalizers to provide meaningful price
WKHELGWKH+)7ÀUP·VRUGHULVÀUVWLQOLQHDWWKHQHZSULFH improvement,” says Lauer. Such price improvement would
The order is held in place until the US$25.50 offer is gone, deter internalization and increase the amount of market-
at which time the hide-not-slide order becomes the best bid DEOHRUGHUÁRZRQWKHH[FKDQJHVZKLFKZRXOGHQFRXUDJH
at the top of the order queue at US$25.50. market participants to quote more aggressively, providing
“The whole maker–taker model creates a very complex more displayed liquidity.
battleground of HFT rebate traders,” says Woodriff. But retail brokers might be forced to pay more take fees
Rebate trading adds noise and if they couldn’t route to internaliz-
complexity to the market but may KEEP GOING ers, which could force the broker-
not be the worst defect of the age to raise commissions.
maker–taker model. The bigger “Dark Pools, Internalization, and Equity Market “You have to start with maker–
problem might be that the maker– Quality,” CFA Institute report (Oct. 2012), (www. taker,” says Nagy, who believes
cfainstitute.org/ethics/integrity)
taker model can act as a deterrent that if maker–taker didn’t exist,
for retail brokerages to route their “Flow Toxicity and Liquidity in a High-Frequency the whole complex system might
World,” summarized in CFA Digest (Sept. 2012),
market orders to the exchange, thus (www.cfapubs.org) get a lot simpler.
increasing the toxicity level of order Dennis Dick, CFA, is a proprietary trader at
“High Frequency Trading, Algorithmic Buy-Side
ÁRZRQWKHH[FKDQJH Execution, and Linguistic Syntax,” CFA Institute Bright Trading in Detroit and a member of
“This is the heart of the matter,” webcast (Sept. 2012), (www.cfawebcasts.org) CFA Detroit.
says Chris Nagy, president and

Jan/Feb 2013 CFA Institute Magazine 25

 PROFESSIONAL PRACTICE
PRIVATE CLIENT CORNER

Unified Flying Objectives

DOES RAPID GROWTH SIGNAL WIDER ACCEPTANCE FOR UNIFIED MANAGED ACCOUNTS?
By Ed McCarthy

8QLÀHGPDQDJHGDFFRXQWV80$VZHUHSURPRWHGDVWKHQH[W Many independent RIAs manage clients’ portfolios directly,
big thing in portfolio management during the early 2000s. The DQGPDQDJHPHQWIHHVDUHDVLJQLÀFDQWSDUWRIWKHLUÀUPV·
ÀQDQFLDOFULVLVLQ²VORZHGWKHLUDGRSWLRQDVÀUPV income. If they start hiring outside separately managed account
delayed installing new technologies. More recently, though, 60$DGYLVHUVSOXV80$RYHUOD\PDQDJHUVWKHLULQYHVWPHQW
asset balances in UMAs have seen solid growth. According to fee income from clients declines. Another drawback can be
UHVHDUFKIURPWKH0RQH\0DQDJHPHQW,QVWLWXWH00,DQG
Dover Financial Research, UMA assets grew from US$30.8
ELOOLRQLQWR86ELOOLRQLQWKHÀUVWTXDUWHURI
Data from Cerulli Associates show similar results, with UMAs
increasing from US$79.5 billion in the second quarter of 2010
to US$181.5 billion by 2012’s second quarter.
Despite the rapid growth, however, UMAs still account
for a small share of total managed account assets, accord-
ing to MMI and Dover. Separate account consultant pro-
a lack of access to the model inputs and technology, says
Pirker. Most RIAs aren’t set up to buy and implement port-
folio models from external investment managers that partic-
ipate in UMA platforms. Additionally, while the RIA might
have a portfolio-balancing tool, it’s probably not equipped
with the overlay technology needed to manage the process.
The independent RIA market is a prized target for UMA
vendors, although adapting the technology to RIAs’ multi-
ple business models is a challenge compared with the wire-
JUDPV 86 ELOOLRQ KRXVHPRGHO:LUHKRXVHVJHQHUDOO\KDYHDVLQJOHDSSURDFK
mutual fund advisory pro- on a single architecture to provide the same and recurring
Assets held in unified man- JUDPV 86 ELOOLRQ experience to all the clients of all the advisers, says David
and rep-as-portfolio-man- Gardner, senior vice president with Collaborative Consulting
KEY POINTS

aged accounts (UMAs)

have grown significantly ager or rep-as-adviser pro- LLC. In contrast, RIAs often offer clients unique services sup-
since the recovery from grams (US$514.6 billion and ported by multiple product vendors and multiple custodians.
the financial crash. US$542.6 billion, respec- “The Holy Grail, at least from our view from an opera-
Despite the recent growth,
UMA assets still lag behind
other managed asset
strategies.
Several large financial ser-
vices firms have been the
most active UMA adopt-
ers; use among indepen-
dent wealth managers
appears to be much less
widespread.
Several firms are working
to adopt UMA overlay port-
folio management plat-
forms to the independent
wealth manager market.
WLYHO\ZHUHPXFKODUJHUWKDQ WLRQVDQGWHFKQRORJ\VWDQGSRLQWLV+RZGR\RXHIÀFLHQWO\
UMAs in the second quarter capture all of those individual moving pieces and designs
of 2012. Additionally, UMA DQGGHVLUHVRIKRZWKH\>5,$ÀUPV@ZDQWWRVHUYLFHWKHLUFOL-
assets are concentrated in HQWV"µVD\V*DUGQHU´,QWKH5,$PDUNHWWKDW·VYHU\GLIÀFXOW
DKDQGIXORIODUJHÀQDQFLDO 0DQ\>80$@ÀUPVFRQWLQXHWRZRUNGLOLJHQWO\LQWU\LQJWR
VHUYLFHVÀUPV0RUJDQ6WDQ- ÀJXUHRXWKRZWRPXWXDOL]HWKHGHOLYHU\RIWKHVDPHOHYHO
ley Smith Barney, Bank of of services that you can create at a consolidated wirehouse
America Merrill Lynch, Fidel- to tens of thousands of individual RIAs.”
LW\ ,QYHVWPHQWV DQG :HOOV
Fargo collectively hold more THE MOTIVATION
than US$112 billion, with In the right circumstances, it’s easy to see UMAs’ appeal to
more than half of that total independent RIAs. For example, among advisers who work
at Morgan Stanley Smith as managers of managers, the technology promises more
Barney. HIÀFLHQWSRUWIROLRPDQDJHPHQWDQGWD[PDQDJHPHQWGHFL-
sions across clients’ holdings. Brent Morse, CFA, managing
CRACKING THE RIA MARKET director of Morse Capital Partners in Glen Allen, Virginia,
The industry data do not seg- cites UMAs’ operational advantages over traditional SMAs
ment the adoption of UMAs as motivating his decision to adopt the UMA technology.
by independent registered “As markets have changed and become so fast and trading
LQYHVWPHQWDGYLVHUV5,$V mechanisms and platforms have become so robust, it was
but industry observers note that RIAs have been much hurting us that we had to talk to our clients, get in contact
slower to adopt the platform. That’s at least partly because with our clients, get their approval and then sign paper-
the RIA market is not homogeneous, says James Penman, ZRUNMXVWWRKLUHDQGÀUHPDQDJHUVµVD\V0RUVH´7KDW·V
director with Collaborative Consulting LLC in Burlington, ZKDWOHGXVWR$GKHVLRQ>$GKHVLRQ:HDOWK$GYLVRU6ROX-
Massachusetts. Many RIAs follow a unique business model, WLRQV@DQGWKHLU80$SODWIRUP,W·VPRUHHIÀFLHQWQRWRQO\
DQGLQKLVH[SHULHQFH80$VVLPSO\GRQ·WÀWWKDWPRGHO for us internally, but we have found that it helps client per-
Alois Pirker, research director with Aite Group in Boston, IRUPDQFHLIWKH\OHWXVGRWKHKLULQJDQGÀULQJRIWKHPDQ-
Massachusetts, cites several other reasons for the low adoption. agers without their approval every single time.”

26 CFA Institute Magazine Jan/Feb 2013

 RIAs face a built-in challenge when managing multiple
60$VVD\V6FRWW:HOFKVHQLRUPDQDJLQJGLUHFWRUZLWK)RU-
tigent LLC in Rockville, Maryland. The traditional model
has been that wealth managers build portfolios of third-
party managers for their high-net-worth clients. Assets are
spread across SMAs to meet the client’s investment alloca-
tions. That arrangement is unnecessarily labor intensive,
:HOFKPDLQWDLQV´7KDW·VGLIIHUHQWVHWVRISDSHUZRUNIRU
each of those separate account managers, and rebalancing
is troublesome,” he says. “You have to get involved in the
wire transfers and all kinds of stuff that goes along with
rebalancing and managing a portfolio of SMAs.”
Fortigent, which was acquired by LPL Financial in Jan-
uary 2012, provides a UMA program with roughly US$730
PLOOLRQRIDVVHWV:HOFKPDLQWDLQVWKDWD80$FDQHOLPL-
nate much of the administrative work for the wealth man-
ager. “If I have those same managers willing to participate
in a UMA program and trading within sleeves of a UMA,
all of that noise goes away and I’m delivering a very com-
parable investment experience but with better operational
HIÀFLHQF\IRUWKHDGYLVHUEHWWHUWD[HIÀFLHQF\IRUWKHHQG
FOLHQWDQGMXVWDEHWWHUH[SHULHQFHµ:HOFKVD\V
LOOKING AHEAD
Collaborative Consulting’s David Gardner says that, despite
the challenges in adapting UMAs to RIAs, providers are
PDNLQJVLJQLÀFDQWSURJUHVVWRZDUGPHHWLQJLQGHSHQGHQW
advisers’ needs. “The service providers in the industry are
literally almost making monthly strides towards being able
to create the system architecture and platform capabili-
ties to be able to try to rationalize all the RIAs that are out
there,” says Gardner. It’s an impressive effort, he believes,
“especially considering how they [RIAs] use multiple sys-
tems, multiple providers, and multiple vendors to deliver
the level of service they do to their clients.”
His colleague James Penman also cites the importance
of recent advances in UMA technology in gaining RIA sup-
port for the platforms. Five years or so ago, he says, UMA
adopters had to do their own systems integration to bring
the platforms together. Firms had to select a trading vendor,
a portfolio management vendor, a compliance vendor, and
DÀUPIRUIHHELOOLQJSHUIRUPDQFHEHFDXVHWKHSURFHVVHV
ZHUHGLVMRLQWHG7KDW·VFKDQJHGVD\V3HQPDQ´:KDW\RX·UH
ÀQGLQJQRZLVWKHYHQGRUVHLWKHURIIHUDFRPSOHWHEXQGOHG
approach or they’ve partnered with other vendors to encap-
sulate a product offering. You’re seeing a lot more bundled
capability, a lot more maturity in the platform now.”
Another factor in UMAs’ favor is their increased ability to Ed McCarthy is a freelance financial writer in Pascoag, Rhode Island.
handle a wider range of investment strategies. SMAs com-
prise the majority of UMA assets,
followed by mutual funds and ETFs. KEEP GOING
However, it’s now possible to run an
actively managed long–short strat- “Identifying Characteristics to Predict Separately
egy inside a UMA sleeve, says Scott Managed Account Performance,” Financial Ana-
lysts Journal (July/Aug. 2011), (www.cfapubs.org)
:HOFK7KHWUHQGWRZDUGJUHDWHU
LQYHVWPHQW ÁH[LELOLW\ ERGHV ZHOO “A Unified Approach,” CFA Institute Magazine
(July/August 2005), (www.cfapubs.org)
for UMA adoption among RIAs,
he believes. “To the extent you can
include more of those sophisticated strategies in actively
managed sleeves inside the UMA, not only do you garner
WKHRSHUDWLRQDOHIÀFLHQF\WKDWFRPHVDORQJZLWKWKH80$
program generally, but you now have the ability to optimize
taxes across a broader array of sleeves within that program.”
Although several UMA vendors work with institutional
FOLHQWV$GKHVLRQ:HDOWK$GYLVRU6ROXWLRQVLQ&KDUORWWH
North Carolina, is one of the vendors that focus on indepen-
dent advisers. Barrett Ayers, managing director for Adhe-
sion’s overlay portfolio management, agrees that RIAs’ high
degree of client portfolio and client service customization
FUHDWHVFKDOOHQJHV+HVD\VWKDWKLVÀUP·VDSSURDFKWR80$
technology allows advisers to retain their desired level of cus-
WRPL]DWLRQZKLOHVWLOOUHDOL]LQJWKHSURFHVV·VEURDGHUEHQHÀWV
“In our platform, we push all the client customization, all the
deviations, down to the account level,” he says. “An account
may be following one of a dozen different kinds of higher
level asset allocations, but there are lots of deviations down
at the account level for things like tax management, for min-
imum trade sizes, for cash handling, for concentrated posi-
WLRQV:H·YHEHHQDEOHWRRSWLPL]HWKHWHFKQRORJ\WRPDNHLW
follow a strategy but deviate at the account level.”
Another key objective for the technology is to make it
VLPSOHU IRU WKH ÀQDQFLDO DGYLVHU WR XVH D 80$ DFFRXQW
according to George Raffa, senior vice president for sales in
the Asset Management Group with Raymond James Finan-
cial in St. Petersburg, Florida. In his view, increased ease of
use leads to a change of perspective: “Instead of the advis-
HUVFKRRVLQJDPDQDJHURUDÀUPWRSXWLQD80$WKHLU
REMHFWLYHLVWRÀQGWKHULJKWPRGHOWRPDWFKZLWKWKHFOL-
ent’s goals and objectives.”
As of late November 2012, the outlook for U.S. tax policy
and global economic growth remains uncertain. Despite that
XQFHUWDLQW\WKHFRQVHQVXVLV:HOFKEHOLHYHVWKDWWD[HVZLOO
increase over time and investors will face a relatively vol-
atile, perhaps low-return environment in the future. Taxes
and fees will play a larger role in determining net invest-
ment results in that scenario and will make UMAs’ optimi-
zation features important. “As an adviser, it could be hard
over the next two to three years to present yourself as some-
one who can deliver excess performance versus your com-
petition,” he argues. “That’s going to be a challenge because
WKHPDUNHWHQYLURQPHQWLVJRLQJWREHGLIÀFXOW%XWZKDW
you can control as an adviser is ease of use, client expe-
rience, cost, and taxes. Those are things that are in your
direct control as an adviser, and all of those things play
right into the use of UMAs.”
Jan/Feb 2013 CFA Institute Magazine 27
THEFUTUREOF
ASSET
MANAGEMENT A few key trends
may be signs of things to come By Maha Khan Phillips

A lot can change in a decade. In 2002, asset managers become compressed,” says Kevin Quirk, founding
were still smarting from the fact that Yahoo! did not, in SDUWQHURI&DVH\4XLUN7KHÀUPKDVSDUWQHUHG
with Institutional Investor’s U.S. Institute and
IDFWWDNHRYHUWKHZRUOG,QVWLWXWLRQDOLQYHVWRUVZHUHÀULQJ McLagan (provider of compensation consulting
balanced managers and replacing them with specialized services for the investment management indus-
ones. Liability-driven investing was just a buzz word, and try) to conduct a survey of 96 fund managers
exchange-traded funds (ETFs) were a new, niche product worldwide overseeing US$21 trillion in assets.
,WIRXQGWKDWSURÀWPDUJLQVVLQFHWKHÀQDQFLDO
area with little potential. Private equity and hedge funds crisis have been managed by controlling com-
were hot, and consultants insisted that funds of hedge SHQVDWLRQDQGEHQHÀWVH[SHQVH
funds were the best model for investors. Spreading risk Global consultancy Cerulli Associates points
through the use of structured vehicles like collateralized out that, although asset management revenues
were set to exceed US$200 billion by 2015, this
debt obligations was considered to lower risk, not increase achievement now looks unlikely. “There is a dra-
it. And it was generally agreed that Alan Greenspan was matic shift out of higher-margin products into
the wisest man in the world. lower-margin products,” says Shiv Taneja, man-
aging director of Cerulli Associates. “The share
Of course, things look different now. It is safe of equity on a global basis is falling. This has
to say that very few people saw this decade WZRVLJQLÀFDQWLPSDFWV,IFOLHQWVDUHJHWWLQJ
coming. But where does that leave asset man- out of higher-margin products and into lower-
agers who want to ensure that they are pre- margin products, that will have an impact on
pared for the next 10 years? A few key trends IXQGPDQDJHUV·SURÀWDELOLW\,QWKHSDVWZH·YH
may be signals of things to come. also said that owning stocks and stock invest-
ments will get you to your retirement quicker.
MARGIN COMPRESSION That is not the case anymore.”
According to Casey Quirk, a U.S.-based consul- So, what do increased competition and lower
WDQF\ÀUPIRULQYHVWPHQWPDQDJHPHQWÀUPV margins mean for product development?
worldwide, operating margins have still not For one thing, the ETF market will con-
returned to their 2007 level but have recovered tinue to grow and so will passive strategies as
from their 2009 lows, with a median of 32% a whole. ETFs already account for over US$1.3
LQ6RDVVHWPDQDJHPHQWUHPDLQVSURÀW- trillion in assets, according to Cerulli. Enhanced
able, but not as much as in the past. “This is an indexation, or engineered beta, will take on
industry where revenues have gone up year in, market share, growing from its current esti-
year out for a very long time. Our view is that mated market share of US$200 billion. A report
revenues are not going to grow nearly as fast released in June 2012 called “Innovation in the
as they have and margins in this business will Age of Volatility” by asset management advisory

28 CFA Institute Magazine Jan/Feb 2013

 CREATE-Research and Principal Global Inves-
tors predicts growth in products that will serve
WKHGHÀQHGFRQWULEXWLRQVFKHPHPDUNHW7KH
study forecasts that target-date funds will see
VLJQLÀFDQWLQQRYDWLRQDQGPRUSKLQWRDPRUH
comprehensive solution.
,IWKHÀQDQFLDOFULVLVKDVEHHQNLQGWR(7)V
it has been less so to hedge funds, which charge
higher fees. Five years ago, hedge funds were
widely expected to reach US$5 trillion in assets
under management by now, but in 2011, the
industry had US$2.46 trillion in assets under
management “The asset management industry
as a whole is changing, and the fund-of-hedge-
funds sector is going through a transition as
well. We see adjusting business models and
consolidation amongst the players,” says Lisa
Fridman, CFA, head of European research at
IXQGRIKHGJHIXQGVLQYHVWPHQWÀUP3$$0&2
“In general, the traditional ‘select and com-
pile’ approach is being put under pressure as
end investors are developing their own hedge
fund programs.” a key ingredient for the next decade. With a
Quirk believes that successful asset man- SOHWKRUDRIERXWLTXHFRQVXOWDQWÀGXFLDU\PDQ-
agers will have to offer either unique alpha DJHPHQWÀUPVRQWKHPDUNHWLWVHHPVLQHYL-
or unique, cheap betas. Firms that offer whole table that the large, mainstream asset manag-
solutions provision (that is, advice, portfolio ers will buy the solutions-driven expertise they
management, asset allocation strategies, and need rather than build it in-house. In a low-
FXVWRPL]HGVROXWLRQVDOVRZLOOEHQHÀW fundraising environment, however, any M&A
activity might take a while, given that manag-
RISE OF THE FIDUCIARY HUVPLJKWVWUXJJOHWRÀQGWKHFDSLWDOWRPDNH
7KHVHWUHQGVH[SODLQZK\ÀGXFLDU\PDQDJHUV big purchases in the near future.
DUHSRVWLQJVLJQLÀFDQWJDLQVLQDVVHWV1HDUO\
WZRGR]HQ(XURSHDQÀGXFLDU\PDQDJHUVKDYH FEES
seen a €110 billion increase in assets under In a low-return environment, fee structures
management as of October 2012, according to also will continue to come under pressure.
an annual survey conducted by Investments & “We have a lot of big challenges ahead of
Pensions Europe magazine. us if we are going to do a decent job for our
In general terms, fiduciary management clients. If we are going to be in a world of nom-
refers to the outsourcing of pension fund man- inal returns, we’ve got to make sure the level
agement to a single third party that takes con- of charges our clients are paying is kept rea-
trol of the fund or part of the fund from the sonable. If returns are just going to be, on aver-
scheme’s trustees, providing advice on manager age, 6–7%, you can’t have 150 basis points
selection, investment strategy, and portfolio taken out in charges. It’s too much of the pot,”
services. It is an area where traditional invest- says Alan Brown, FSIP, senior adviser to Sch-
ment consultants like Towers Watson and Mercer roder Investment Management and governor of
have established businesses and where boutique the Wellcome Trust. Brown is also a member
consultants are also drawing market share. of the 300 Club, a group of senior investment
“We understand client needs because we professionals from around the globe who have
come from a consulting background,” com- “joined together to respond to an urgent need
ments Andrew Drake, CFA, managing direc- to raise uncomfortable and fundamental ques-
tor of P-Solve, an investment advisory and tions about the very foundations of the invest-
ÀGXFLDU\PDQDJHU+HVXJJHVWVWKDW´FRQWHP- ment industry and investing.”
Illustration by Timothy Cook

porary,” or future-focused, asset managers are Brown has many concerns about the future,
UHDOL]LQJWKDWWKH\KDYHWRSXWWKHLUFOLHQWVÀUVW particularly about educating investors. “In a
and then work backwards, starting with what ZRUOGWKDWLVLQFUHDVLQJO\GRPLQDWHGE\GHÀQHG
clients need and then creating suitable prod- contribution,” he says. “I am very worried about
ucts for them, which will make customization how we manage the real-world outcomes for

Jan/Feb 2013 CFA Institute Magazine 29

 individuals. We are heading for a generation RI&5($7(5HVHDUFK´+LVWRU\WHOOVXVWKDWWKH
who will face a fairly miserable retirement.” only time to make money is to buy when others
Brown also points out that not everyone are selling. Many asset managers just can’t do
missed the crisis. Bill White, a Canadian econ- that. They don’t have the skills to buy on the
omist who served as head of the economic and dips and get the timing right. The other thing
monetary department at the Bank for Interna- is that clients won’t allow them to do it because
tional Settlements, predicted the crisis before clients have become very suspicious of managers
the subprime market collapse. In 2003, he having lost money in the past. The trust between
famously argued directly with Alan Greenspan asset managers and clients is so bad that cli-
at the Federal Reserve Bank of Kansas City’s ents can’t even spell the word trust,” he says.
DQQXDO PHHWLQJ LQ -DFNVRQ +ROH :\RPLQJ “If an asset manager wants to be a truly
White contended that interest rates ought to global business with repeatable processes and
be raised when credit expands too fast, forc- the ability to attract and develop talent, it has
ing banks to build up cash cushions for leaner to use analytics to get behind that track record
times. The argument fell on deaf ears. and truly measure what makes a manager skill-
Some industry participants envisage a world ful. Increasingly, the end client is demanding
in which mainstream asset management has this level of scrutiny and transparency,” says
hedge fund–type fee structures, where the bulk Rick di Mascio, CEO of Inalytics, a U.K.-based
of the charge is based on performance. “I’m a ÀUPWKDWSURYLGHVHYLGHQFHGEDVHGPHDVXUHVRI
bit ambivalent about fee structures. One way skill to both asset managers and pension funds.
that they could change is to become more per- Investor goodwill is key to the success of
formance related so you end up paying if the DQ\DVVHWPDQDJHPHQWÀUPWKDWZDQWVORQJHY-
value add is achieved,” says Andy Barber, part- ity, according to Katherine Garrett-Cox, ASIP,
ner in Mercer’s investment consulting business. FKLHIH[HFXWLYHRIÀFHURI$OOLDQFH7UXVWRQHRI
The idea may be good in theory but doesn’t the oldest and (at £2.8 billion in assets under
sit well with investors at the moment. “The idea management, largest U.K. investment trusts).
of getting paid more if your assets go up is an “Trust and transparency have to be at the heart
interesting one,” says Drake. “We’ve tried a RILQYHVWLQJµVKHVD\V´7UXVWLQÀQDQFLDOVHU-
number of different, innovative ways of poten- vices has been pretty rocked. But the invest-
tially charging our clients. But they have basi- ment management industry can play an impor-
cally said, ‘That’s interesting but we’ll just carry tant role in delivering it. Part of delivering it is
on as we have been.’” delivering on your promises.”
THE TRUST Barber believes that demand for less-con- The future of the industry will be based
BETWEEN strained strategies will continue to grow. “There on “intellectual capital,” says Garrett-Cox: “It
is some academic evidence to suggest that less- will be about getting relatively small groups of
ASSET constrained managers do better on any kind of people together in a much more entrepreneur-
MANAGERS risk-adjusted basis, so the days of index plus 1 ial way. If you can’t pay people as well as you
or 1.5 are gone,” he says. “People are no longer could 10 years ago, at least you can give them
AND CLIENTS expecting their managers to hold BP because it a sense of ownership of what they are doing.”
IS SO BAD is a big part of the benchmark.”
Andreas Utermann, global chief investment BUSINESS MODELS
THAT CLIENTS RIÀFHU DQG FRKHDG RI $OOLDQ] *OREDO ,QYHV-But skill is only one factor at play. As part of its
CAN’T EVEN tors, agrees. “There is going to be a return to report, CREATE-Research surveyed 289 asset
more fundamental investing. There will be less managers, pension consultants, and fund dis-
SPELL THE EHQFKPDUNGULYHQLQYHVWLQJµKHVD\V+HDOVR tributors in 29 countries with combined assets
WORD TRUST. points out that lower fees have other implica- under management of US$25.2 trillion. It found
tions. “We are in a low-return environment with that in an era of prolonged volatility, only 7%
margin compression in the industry, making it of respondents expect no more systemic crises
less lucrative.” over the rest of this decade; 27% expect one
crisis; 35%, two crises; 21%, three crises; and
SKILL 10%, four or more crises. “When you see some
This change, according to some participants, of the numbers in the report, you’ll be quite hor-
FDQRQO\EHJRRGQHZV$VWKHÁRZRIDVVHWV ULÀHGµVD\V5DMDQ´6RQLPEOHQHVVLQWKHRSHU-
from active funds to passive funds suggests, ating model becomes very important.”
investors do not believe that all active manag- %XWPDQDJHUVKDYHLGHQWLÀHGDUHDVZKHUH
ers have skill. “The rapid industrialization of they need to improve. Of those responding to
asset management has supressed its craft her- the CREATE-Research survey, 58% of respon-
LWDJHµVD\V$PLQ5DMDQFKLHIH[HFXWLYHRIÀFHU dents expect to develop better “shock absorbers,”

30 CFA Institute Magazine Jan/Feb 2013

41% will restructure the skill sets of their talent
pools, 40% will enhance execution capabilities,
38% will revamp their corporate culture, and
35% plan to hire or develop leaders who can
embrace volatility.
Quirk believes managers must have one of
the following value drivers: the ability to add
alpha, deliver cheap betas, provide compre-
hensive solutions, or focus on the distribution
side of the business as opposed to the manu-
facturing one. “There are winners and losers
here,” he says. “We see big money managers
with broad investment capabilities in multi-
ple markets who are looking at their business
models and saying, ‘Are we really in a strong
position for our future?’ The answer is no. Firms
that are pretty strongly orientated around the
value drivers I mentioned are probably in the
GULYLQJVHDWULJKWQRZ2WKHUÀUPVHVSHFLDOO\
ODUJHUÀUPVDUHWKLQNLQJDERXWKRZWKH\WXUQ
their super tanker around, where they go from
a business model that has a dated value prop-
osition to something new.”
Others argue that the boutiques will be more
against the wall, particularly if their investment
styles are not in favor or delivering returns.
Rajan believes the key will not be size but evo-
lution. Organizations that are quick to adapt to a
WE ARE CURRENTLY ENGAGED IN THE REGULATORY
REFORM DEBATE OF A LIFETIME. THE RULEBOOK
THAT RESULTS WILL FRAME THE FINANCIAL SYSTEM
FOR DECADES TO COME.
changing market environment will fare the best.
In some cases, the battle may already be lost.
The ETF market is dominated by a few play-
ers, such as State Street, Vanguard, Barclays,
Deutsche Bank, and Legal & General. “This is
not going to be a business where there are going
to be 50 players,” says Quirk. “So, that is going
to limit new players.”
REGULATION
The past few years have brought a wave of reg-
ulation around the world, and some of it will
have an impact on the global banking model.
Whether reforms will lead to a complete sepa-
ration of retail and investment banking is dif-
ÀFXOWWRSUHGLFWEXWPDQ\PDUNHWSDUWLFLSDQWV
believe that asset managers need to get more
involved in the debate. Speaking at the CFA
Society of the UK’s annual chairman’s dinner
in October 2012, Bob Jenkins, a member of the

Making Future Predictions

Tim Hodgson, ASIP, is head of the Thinking
Ahead Group at investment consultancy
Towers Watson. As early as 2002, the group
warned that debt would affect growth in the
future. That prediction may have come too
early, but it was prescient. Hodgson talks
about forecasting the future.
How easy is it to “think ahead” and
make predictions about the future?
There is a tendency for people to overesti-
mate how much is going to happen over 1
year but seriously underestimate how much
change is going to happen over 10 years.
We’ve been using our complexity model
to look at the future of the industry, but
the humbling thing about complex adap-
tive systems is that you have to be able to
give up the pretence of being able to make
predictions. I don’t know what the industry
will look like in 10 years’ time, and if anyone
thinks they can tell you, then send them to
see me. After saying that, though, it’s not
going to stop me from trying!
So, what trends can you identify?
I think there is already a nascent trend
toward lower fees. In banking, you can
already see that remuneration is under
pressure and that the pressure might have
started to spread to asset management.
We are definitely also seeing an upswell of
money going into smart beta. The move into
passive makes sense, and more money in
smart beta will reduce the fee take of the
industry. You should probably expect remu-
neration to fall further.
Will that affect the type of people
coming into this market?
Yes. The number of graduates heading to
Wall Street from U.S. business schools is
declining. Personally, I think it is kind of
ridiculous [that] the best and the brightest
of society were overwhelmingly choosing
finance as a career when society needs
really bright medics and engineers and
what-have-you.
What will happen to asset manage-
ment business models?
You would expect to see consolidation and
closures. If you look at market share, even
the largest managers in the P&I/Towers
Watson list of top asset managers are tiny
compared with other industries. Blackrock is
only 3–4% of the market, with around US$2
trillion. So, why could you not have some
very-low-cost, big asset managers manag-
ing around US$10 trillion or more?
If you can’t make accurate predic-
tions, how do you plan for the future?
When looking over 10-year horizons, I think
you have to use scenarios. I would encour-
age people to make some of their scenar-
ios very wild—wild on the upside and down-
side. You can’t predict the future, but you
can say, “What would I do if the world was
heading in that direction?”

Jan/Feb 2013 CFA Institute Magazine 31

 Bank of England’s Financial Policy Committee,
told attendees that they must act on the core
issues of banking reform, particularly in regard
to putting a limit on the use of leverage.
“We are currently engaged in the regula-
tory reform debate of a lifetime. The rulebook
WKDWUHVXOWVZLOOIUDPHWKHÀQDQFLDOV\VWHPIRU
decades to come,” he said, calling asset man-
agers the “missing piece” of the equation—one
that was staying silent. To the public at large, he
observed, there is no difference between asset
managers and investment bankers. Asset man-
agers who think that investment banking regu-
lations don’t apply to them should think again.
Garrett-Cox agrees. “I do think that once you
accept that regulation is a thing of the future,
then it becomes important not to be blindsided
by it,” she says. “From our point of view, par-
ticularly as the biggest investment trust in our
sector, we actively engage with industry bodies
and the FSA.”
And getting involved would be one way in
which asset managers can shape the decade
to come.
Maha Khan Phillips is a financial journalist based in London
and author of the novel Beautiful from this Angle.

Chief Executive 2.0?

The past few years have seen a plethora
of high-profile banking executives come
under intense scrutiny for mismanagement
or misdeeds. Fred Goodwin, who resigned
from the Royal Bank of Scotland in 2008—
one month before the firm announced a loss
of £24.1 billion—was the first in a series of
high-profile departures. More recent high-
profile resignations included Bob Diamond,
CEOS NEED TO GET BACK TO THE BASICS AND REMEMBER
THE QUALITIES THAT DEFINE STRONG LEADERS—INTEGRITY,
STRATEGIC VISION, GOOD JUDGEMENT, AND AN ABILITY
TO ATTRACT GREAT TALENT TO COMPLEMENT THEMSELVES.
chief executive of Barclays (who departed
because of the LIBOR rate-setting scan-
dal), and Kenichi Watanabe, chief execu-
tive of Nomura (who left after accusations
of insider trading at the firm). In the midst
of all the finger pointing, asset manage-
ment CEOs have managed to hold on to
their seats a bit more firmly, but their roles
are changing too.
“Perhaps in the last few years, some
CEOs have lost their compass and reacted
to short-term events,” suggests Marylin
Prince, partner at the financial executive
recruitment firm Prince Houston Group in
New York City. “CEOs need to get back to
the basics and remember the qualities that
define strong leaders—integrity, strate-
gic vision, good judgement, and an abil-
ity to attract great talent to complement
themselves.”
But how easy will this be, in practice?
Sarah Dudney, founder of London-based
career advisory firm Ignite, suggests that
five years of staff cuts have taken their
toll and that this will affect the caliber of
future executives. “The staff cuts which
people have made in this business have
gone through the fat, muscle, and the bone,
which will affect the pool of candidates for
leadership in 10 years’ time. So, you have
to hope that people have made the right
decisions.”
Dudney also suggests that chief exec-
utives of the future will have to be more
versatile and adaptable. “Nowadays, politi-
cians think that they run markets. CEOs will
have to have rapid access to governments
and understanding of how things work on
a supranational level.” They will also, she
suggests, have to get used to a life in the
spotlight because public scrutiny will only
continue going forward.
Michael Castine, chairman for asset and
wealth management at Korn/Ferry Inter-
national in New York, believes the role of a
CEO is becoming even more complicated. “A
CEO needs to be an operations person and
a financial person but also needs to be a
visionary and be out in the market. It goes
even beyond political sheen; you have to
deal with politicians and regulatory bodies,
but you also have to be conversant in inter-
national business. Many funds are looking
at the sovereign wealth fund opportunities
that didn’t exist 15 years ago, and so you
need to be able to wear a global hat. In the
words of [hockey player] Wayne Gretzky,
they will have to skate to where the puck
is going, not where it has been.”
But does this perfect new breed of
potential chief executives really exist? Con-
sultants seem to agree that it is about inter-
nal succession planning. Many firms have
succession plans in place; others haven’t
spent enough time considering the issues.
Some firms, whether they like it or not, are
carried by the name on the door, according
to some consultants. Take GMO’s Jeremy
Grantham and Fidelity’s Ned Johnson, both
very well-respected figures who are likely to
retire in the next 10 years and whose firms
were built around their personalities. Both
firms have succession plans.
Ultimately, though, the newly formed
“chief executive 2.0” will have to remem-
ber one thing. “Post the financial crisis, cli-
ents have experienced a lack of trust and
confidence, and therefore, CEOs of finan-
cial organizations must be more transpar-
ent and responsive to the changing envi-
ronment,” argues Jim Houston, partner at
Prince Houston Group.
Those who lack these attributes might
find themselves heading to the door pretty
quickly.

32 CFA Institute Magazine Jan/Feb 2013

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AFTER
By Jonathan Barnes
DARK
The proliferation of dark pools is a symptom of markets “caught
in an endless loop of innovation,” says author Scott Patterson
Trading in U.S. equity markets now occurs across 13
exchanges, 16 dark pools and more than 200 broker/dealers
WKDWLQWHUQDOL]HRUGHUÁRZ,QKLVERRNDark Pools: High-
Speed Traders, A.I. Bandits, and the Threat to the Global
Financial System, author Scott Patterson, a reporter for
the Wall Street Journal, tells the story of the rise of dark
pools and high-speed trading.
In this CFA Institute Magazine interview, Pat-
terson discusses implications for systemic risk
and regulators, the likely future of dark pools,
and the potential for a “doomsday scenario” in
the form of a “splash crash.”
Are dark pools a cause for concern—or
inevitable innovation?
A lot of things in the markets today aren’t really
black and white. Even though these things are
called dark pools, it doesn’t necessarily mean
they are a bad thing. They became very popu-
lar starting about 10 years ago because institu-
WLRQDOÀUPVZHUHWU\LQJWRÀQGDSODFHZKHUH
they could trade large blocks of stocks away
from the public so-called lit markets.
There is really nothing wrong with that—
and it makes sense. Dark pools are a symptom
of a growing problem in the markets that was
RFFXUULQJDVSUHGDWRU\WUDGLQJÀUPVZHUHWU\LQJ
to seek out big institutional orders and front-
run them (because if they could see a big order
in the market, that meant that the price would
34 CFA Institute Magazine Jan/Feb 2013
move and they would start trading ahead of it)
and that would impact the price. That is known
as market impact.
So, dark pools served a purpose. But increas-
ingly, in the past few years, we are seeing a
huge amount of trading taking place on these
so-called dark markets. That is not really a good
thing for the rest of the market, because you
see a lot of price discovery taking place where
most of the investors can’t see what is happen-
ing. These are dark areas in the market. So that
is a growing problem, and the exchanges are
in a tough spot because they are trying to com-
pete with these dark markets and often doing
things that may not necessarily be good for all
investors. It is obviously a problem and more
RIDV\VWHPLFLVVXHWKDQVRPHWKLQJVSHFLÀFDOO\
wrong with the dark pools themselves.
How do you see market structure evolving?
I think there is a growing outcry among insti-
WXWLRQDO ÀUPV DERXW ZKDW LV WDNLQJ SODFH LQ
the markets. That is going to put pressure on
the SEC to eventually do something. There is
growing talk about vast changes to the market
structure that really started bubbling up in the
past six months to a year. This is occurring for a
number of reasons. One is the growing amount
of trading taking place off exchanges—also we
are seeing these recurring computer glitches take
SODFHOLNHWKH)DFH%RRN,32ÁRSDW1$6'$4
and the Knight Capital trading error in August
WKLVRQHYHU\VRSKLVWLFDWHGWUDGLQJÀUP market could just go completely haywire. You
lost nearly half a billion dollars in a little more saw huge volatility in prices. That is one reason
than half an hour). why some people think there should be more
Another problem is that the markets, because trading taking place on the public exchanges.
of technology, are caught in an endless loop of You would have more liquidity, and it wouldn’t
innovation. They are constantly trying to add be as likely that you would have a scenario
new services and compete with one another to ZKHUHDIHZÀUPVSXOORXWRIWKHPDUNHWDQG
attract investors to their venue. That increases suddenly you have these huge gaps.
the odds for something to go wrong. I think that It is a balance between fragmentation and
regulators need to think about slowing down the competition. For years, the SEC has encouraged
cycle of innovation that we are seeing. There competition because of the idea that with com-
are a lot of different ways that this can go— petition you have better pricing and it works
we don’t really know right now. out best for clients. That is true. Pricing and the
cost of trading have gone down enormously in
What are the vast changes that are possible? WKHSDVW\HDUV1RZ,WKLQNSHRSOHDUHZRQ-
Stock exchanges now are largely run by a fee dering if the pendulum has swung too far and
system that is known as maker-taker [paying that that needs to be tamped down a little bit.
rebates to liquidity makers and charging liquid-
ity takers]. This system evolved in the late 1990s
and has become the dominant fee structure for “EXCHANGES ARE IN A TOUGH SPOT BECAUSE
the entire U.S. stock market. There are a lot
of people who think that maker-taker creates
THEY ARE TRYING TO COMPETE WITH THESE DARK
SHUYHUVHLQFHQWLYHVIRUSUHGDWRU\ÀUPVWRWU\ MARKETS AND OFTEN DOING THINGS THAT MAY
to earn these makes (also called make fees).
Exchanges are helping them do this—they
NOT NECESSARILY BE GOOD FOR ALL INVESTORS.
are providing them all sorts of advantages. IT IS OBVIOUSLY A PROBLEM AND MORE OF A
The exchanges provide these very data-rich
GDWDIHHGVWKDWDOORZWKHVHÀUPVWRWUDGHDW
SYSTEMIC ISSUE THAN SOMETHING SPECIFICALLY
extremely high speeds with very accurate and WRONG WITH THE DARK POOLS THEMSELVES.”
in-depth information about what is going on
inside of the market—simply to get the fee. It
has nothing to do with actual trading. Some
people think that actually helps the market
because it pulls in all of this liquidity, but I
think a lot of people are increasingly thinking
that it is perverting the market. One thing that
could happen is that the regulators could actu-
ally ban the maker-taker system.
There are other ideas too. Regulators could
force dark pools to provide real price improve-
ment. Right now, a lot of these off-exchange
Photo by Eleanor Patterson

systems say they provide price improvement,

but it is really just a fraction of a penny that
they are providing. Maybe if they offered real
price improvement, like a whole penny, then
you could trade away from the exchange—oth-
erwise you have to trade on an exchange. That
is another thing that people are talking about.
Should dark pools become a little more lit?
How much of a concern is increasing ,WKLQNVR0RUHEX\VLGHÀUPVDUHUHDOL]LQJ
fragmentation of liquidity? that there are things going on in these dark
7KDWLVGHÀQLWHO\RQHRIWKHSUREOHPVWKDWZH pools. It’s kind of ironic—in the early 2000s
VDZLQWKH0D\ÁDVKFUDVK7UDGLQJLVQRZ the dark pools were created as a place where
spread out over so many different venues—some- LQVWLWXWLRQDOÀUPVFRXOGJHWDZD\IURPSUHGD-
thing like 70 different places now trade stocks in tory trading activities, but now, because these
WKH8QLWHG6WDWHV2QWKHGD\RIWKHÁDVKFUDVK KLJKIUHTXHQF\ÀUPVDUHVRGRPLQDQWWKHGDUN
because of that fragmentation, liquidity was so pools have to attract them as well. So they are
thin that it created an environment in which the also catering to them.

Jan/Feb 2013 CFA Institute Magazine 35

 1RZWKHUHLVHVVHQWLDOO\QRSODFHWRKLGH
These dark pools are offering all sorts of advan-
WDJHVWKDWDOORZÀUPVWRZHHGWKURXJKZKR
they trade with. They can actually pick and
choose who they trade with. They can try to
DYRLG D ÀUP ZLWK VRFDOOHG KLJK DOSKDV WKDW
could hurt them.
A dark pool called Pipeline Trading actually
KDGLWVRZQVHFUHWSURSULHWDU\WUDGLQJRXWÀW
WKDWZDVWUDGLQJDJDLQVWLQVWLWXWLRQDOÁRZDQG
A LOT OF nobody knew about it. For years, this was hap-
TIMES, THE pening. That raises the question, what exactly is
going on in these places? Without a doubt, the
EXCHANGES SEC is taking a look at these operations. They
TRY TO SUREDEO\DUHQRWJRLQJWRÀQGDQ\WKLQJDVHJUH-
gious as Pipeline, but I really think the issue
PORTRAY THIS is that people just don’t know what is happen-
AS A SITUATION ing. That causes a lot of paranoia and fear. It
has become so complicated that it is really an
THAT BENEFITS entirely dark market.
EVERYBODY
And there are still order types that are ben-
BECAUSE IT efitting some investors over others, correct?
DRAWS ON Absolutely. These order types are often created at
WKHEHKHVWRIKLJKIUHTXHQF\ÀUPV<RXKDYHIRXU
THE LIQUIDITY PDMRUH[FKDQJHVULJKWQRZ1$6'$41<6(
OF THE 1<6($UFDDQG%$76:KDWKDSSHQVLVWKDW
WKHWUDGLQJÀUPVJRWRRQHRIWKRVHH[FKDQJHV
EXCHANGE— and say, “Can you create this order type for us
YOU GET MORE that lets us do X, Y, and Z?”
Often the exchange says, “Yeah, sure, we will
TRADING. BUT do that.” Then what happens is the high-fre-
ACTUALLY TXHQF\ÀUPVHQGVPRUHÁRZWRWKDWH[FKDQJH
7KHQWKHÀUPJRHVWRDQRWKHUH[FKDQJHDQG
WHAT IS says, “These guys are giving us this order type,
GOING ON IS why can’t you do it? And if you don’t do it, then
we won’t send you our orders.” That has taken
THAT THESE SODFHRQDIDLUO\ZLGHVFDOHRYHUWKHSDVWÀYH
EXCHANGES years or so.
,WKDVUHDOO\EDOORRQHG1RZWKHUHDUHWKRX-
ARE ENABLING sands of order types at exchanges. The SEC is
PREDATORY realizing that they have no idea what is going
on with these things. Why are exchanges
TRADING giving advantages to these firms? Why are
AGAINST WKHH[FKDQJHVJLYLQJWKHVHÀUPVRUGHUW\SHV
WKDWDOORZWKHPWRGRYHU\VSHFLÀFWKLQJVWKDW
INSTITUTIONAL PDNHWKHLUWUDGLQJSURÀWDEOH",WLVQRWOLNHLWLV
FIRMS. a win–win solution for everybody. This trading
LVWDNLQJPRQH\RXWRIRWKHUÀUPV·SRFNHWV$
lot of times, the exchanges try to portray this
DVDVLWXDWLRQWKDWEHQHÀWVHYHU\ERG\EHFDXVH
it draws on the liquidity of the exchange—you
get more trading. But actually what is going on
is that these exchanges are enabling predatory
WUDGLQJDJDLQVWLQVWLWXWLRQDOÀUPV7KHLQVWLWX-
tions are waking up to this. They are scream-
ing bloody murder because they didn’t know
what was going on.
36 CFA Institute Magazine Jan/Feb 2013
What is the concern over NASDAQ’s
“Benchmark Orders” plan?
The Benchmark Orders are algorithms that
1$6'$4SURYLGHVFOLHQWVWKDWDOORZWKHPWR
FDUYHXSWKHLUWUDGHVDQGWUDGHPRUHHIÀFLHQWO\
It is kind of like a product that a broker would
SURYLGHWRDWUDGLQJÀUP$EX\VLGHÀUPZLOOJR
to a broker and say, “We want to buy a million
shares of Microsoft, can you help us do that?”
The broker will have algorithms that help them
carve up that order in ways that make it more
HIÀFLHQW7KH1$6'$4LVVD\LQJWKDWWKH\DUH
going to provide the service themselves and
bypass the broker. I have never seen anything
like it. The SEC is really taking a hard look at
this. It is not real clear that they are going to
approve it right now.
What about the NYSE “PL Select” orders?
As they have it now (and they are thinking about
changing it), the PL Select will allow you to not
trade with any order size bigger than your own
order. Often, institutions put in large orders of
1,000 shares or 2,000 shares and if you are a PL
Select trader, and you are trading 100 shares
or 200 shares, you won’t trade against those
2,000 share orders.
,WDOORZVÀUPVWREHPRUHVSHFLÀFDERXWZKR
they trade against. In a way, it is like what the
dark pools provide, but in this case it is the
1HZ<RUN6WRFN([FKDQJHSURYLGLQJÀUPVWKH
DELOLW\WRQRWWUDGHDJDLQVWÀUPVWKDWKDYHVR
called high alpha. They can pinpoint those kinds
RIÀUPV³RUWKHNLQGVRIDFWLYLWLHVWKDWWKRVH
ÀUPVHQJDJHLQ%XWWKHUHKDVEHHQDEDFNODVK
against this, because the institutions are saying,
“This is giving people the ability to get around
us and not trade with us and instead trade with
VRFDOOHGGXPERUGHUÁRZµZKLFKLVSURÀWDEOH
What is the state of the Algo Wars?
They are evolving at a faster and faster rate
all of the time. In the United States it has been
going on for quite some time. If you want to look
where it is evolving now, you look overseas. It is
spreading to all countries where there are stock
markets. The computerized market system that
really took off in the U.S. is going to places like
India, Singapore (which now has the fastest stock
market in the world), Japan, and China. Austra-
lia is also having real problems with it right now.
In the U.S., it has almost reached its satu-
ration point. Trading has gotten so fast and so
competitive that it is really hard to see how it
can get much faster—although I am sure there
are people trying as hard as they can to shave
off another millionth of a second from the speed
of their trading.
What are the advantages in going EXWWKH\GRQ·WUHDOO\KDYHYHU\ÀUPREOLJDWLRQV
international? to maintain fair markets. That is one of the big-
7KHFRPSHWLWLRQRYHUVHDVLVQ·WDVÀHUFHDVLWLV gest Achilles’ heels in the market now—that it
LQWKH866RWKHVHÀUPVDUHJRLQJRYHUVHDV has come to rely on a large number of private
where there is a lot of [less-informed] trading ÀUPVWKDWKDYHQRREOLJDWLRQWRVWD\LQPDUNHWV
going on, and that is great for them. The [less during volatile times. When the market gets
LQIRUPHG@WKHWUDGLQJWKHPRUHSURÀWDEOHLWLV really volatile, you could see something like
for them. In the U.S. there is a lot of really smart May 6, 2010, happening again and
trading going on—very informed, very sophis- potentially, it could be even worse.
ticated traders going head to head.
High-frequency traders want to go to places What is the “splash crash”?
where there are still a whole lot of people day This is a doomsday scenario that
WUDGLQJ,WLVYHU\SURÀWDEOHIRUWKHVHÀUPVWR some people have talked about.
trade against day traders. They love it. Because, -RKQ%DWHVDQDUWLÀFLDOLQWHOOLJHQFH
usually, it is some guy sitting there trading expert at a trading services com-
with his E-Trade account and he isn’t doing the pany called Progress Software, sort
smartest thing. of coined the term “splash crash.”
For more than a year or so, Bates
What about Credit Suisse’s Light Pool? has said he is really worried about
I see what Credit Suisse is doing as a way to get a splash crash, which is a systemic
ahead of the regulators. Dan Mathisson, who is crash across all markets, not just
the brains behind Light Pool at Credit Suisse, stock markets.
could see that the regulators were gearing up The reason why this is a real pos-
to potentially radically change market struc- VLELOLW\LVWKDWDORWRIWKHVHÀUPVDUH
ture and maybe do something that could hurt trading across all sorts of different
WKHSURÀWDELOLW\RIGDUNSRROV asset classes—they will trade in
Mathisson runs the biggest dark pool in the futures and they will trade in cur-
ZRUOGFDOOHG&URVVÀQGHUDW&UHGLW6XLVVH6R rencies and they will trade in stocks and bonds.
in order to hedge his bets, he created Light Pool. They are trading correlations between all of those
It is still being rolled out—people can trade on different markets. Bates is saying that you could
it now and it doesn’t get a lot of volume—but see a huge move, perhaps in currencies if some-
WKDWLVZKDW,VHHDVWKHVLJQLÀFDQFHRI/LJKW thing happened in Europe. You could see the
Pool. Wall Street is trying to prepare for what euro take a huge dive, and because these guys
is going to happen. Reportedly, Mathisson is are trading on correlations, they will take that
trying to turn Light Pool into a stock exchange. move and shift it over to the futures market. And
I don’t know how that is going to work, but it is then they will shift it over into the options mar-
just another example of how the market is just kets and then, potentially, to the stock market.
constantly evolving and trying to stay ahead. You could see really wild swings in asset
classes that really aren’t related, but they are
Can high-frequency trading in dark pools splashing over into one another. Then, because
lead to market instability? DOORIWKHÀUPVDUHRIWHQWUDGLQJRQWKHVDPH
$EVROXWHO\7KHÁDVKFUDVKZDVLQPDQ\ZD\V signals, everybody picks it up and exacerbates
FDXVHGE\KLJKIUHTXHQF\ÀUPVSXOOLQJRXWRI the trading and it becomes something like a
WKHPDUNHW³ÀUVWVHOOLQJDOORIWKHLULQYHQWRU\ self-reinforcing feedback loop that causes global
which pushed prices down, and then getting equity markets to crash—on something that
out. They brand themselves as market makers, may have been bad news but not something that
and the primary job of the market maker is to should crash entire markets. It is purely com-
maintain a fair and orderly market. puter driven and algorithmic driven. I think it
+LJKIUHTXHQF\ÀUPVDUHFRPSHQVDWHGIRU is a real concern that something like that could
WKDW>IXQFWLRQ@\HWWKHVHÀUPVGLGQRWGRWKDW KDSSHQ7KDWZRXOGGHÀQLWHO\LPSDFWWKHHQWLUH
They are not regulated as market makers. They global economy. Even if markets bounced back,
try to act like they are providing this great ser- if people realized that there wasn’t really any
vice to the market—and therefore they deserve fundamental reason for the crash, it could really
all of these advantages that they are getting put a scare into them. People might stop trust-
from the exchanges—when in fact they are ing the markets because they will worry that
not regulated as market makers, by and large. their wealth will get wiped out.
7KHUH DUH VRPH RQ WKH 1HZ <RUN 6WRFN Jonathan Barnes is a financial journalist and author of
Exchange (so-called designated market makers), the novel Reunion.

Jan/Feb 2013 CFA Institute Magazine 37

THE BIOLOGICAL
The new science of decisions will
transform how we think about investing
By Cynthia Harrington, CFA Illustration by James Yang
INVESTOR
What caused the financial crisis? Animal spirits. What
caused the blind trust in our real estate and mortgage system to
drive real estate prices to dizzying heights? Animal spirits. And
what caused people to lend money to this (largely shadow) bank-
ing system, driving credit expansion beyond comprehension? Yup.
According to economist Robert Shiller, our basic nature is the cause
of our financial booms and downfalls.
But what are these “spirits,” and how can we get them to stop
messing up? Finding the cause of such behaviors and, even more
appealing, the ability to predict them has long been the Holy Grail
of economic study. Until recently, investigators have been limited
to surmising the reasons by observing behaviors from the outside.
Now, with the development of advanced imaging technologies (such
as functional magnetic resonance imaging, or fMRI) and sophis-
ticated genetic tests, researchers are revealing 3.3 billion years
of evolutionary data resident in the human condition. How asset
managers use this knowledge may well change the way invest-
ment risks are minimized and investment returns are maximized.
Behaviors in life and in markets are the result of many things—
social processes, physiological development, genetic predisposi-
tion, and even the color of the room we happen to be in, to name
only a few. Moreover, at the simplest level, behavior is described as
a response to a stimulus. But in a great many conditions, an organ-
ism displays no outward behavior in response to stimuli.
Humans—and human biological processes—are complex sys-
tems made up of systems of complex systems. For instance, the
rules that govern a heart cell are different from the rules that govern
the heart organ and the rules for the total organism are different
from the rules for the single organ. To understand one system does
not mean you understand the behavior of the whole organism. A
series of articles over the next few issues will report on subsys-
tems. A final article will deal with the whole system.
The first installment of the series looks at biochemical messen-
gers (Part 1) and neural processes (Part 2) that have direct impli-
cations for better understanding how to manage investments and
better understanding ourselves as investors.
38 CFA Institute Magazine Jan/Feb 2013
CHEMICAL MESSENGERS
Of the thousands of chemical messengers in the
human body, three—testosterone, serotonin,
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three also have basic biological functions that
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messengers vary from the equilibrium condi-
tion, behaviors vary, and researchers can study
WKLVYDULDQFH%\DOWHULQJWKHOHYHOVDQGREVHUY-
ing behavioral changes, scientists have learned
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TESTOSTERONE AND TRADING RISK
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ulating such things as the onset of puberty and
males developing longer and denser bones than
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level of the hormone and variance in testoster-
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tosterone in high-frequency traders in London,
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“winner effect,” shown in much-replicated stud-
ies of athletes, elevates testosterone in winners
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his co-authors, successful traders experience a
rise in testosterone, along with characteristics
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persistence, appetite for risk, and fearlessness in
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increased impulsivity and sensation seeking
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book The Hour between Dog and Wolf
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study, having traded derivatives at Goldman
6DFKVDQG0HUULOO/\QFKLQ1HZ<RUN&LW\+LV
own experiences and observations formed some
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ing to the conclusions in his research, this tran-
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cial markets to deviate from the predictions of
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just a momentary reaction but perhaps a funda-
mental difference in which some people with a
higher degree of testosterone production natu-
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It is what bonds mother to child, and the level
of oxytocin surges before and after childbirth
to deaden the pain that could interrupt that
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such as seeing a loved one, oxytocin acts on
the receptors in many brain regions, including
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:LWKHOHYDWHGOHYHOVRIR[\WRFLQERWKPHQDQG
women experience diminished memory perfor-
mance and have an impulse to behaviors that
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istered in the lab, this bonding turns behav-
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bonded but only with people with whom they
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as a kind of shorthand measure for the equilib-
rium level of testosterone in a male, based on
the theory that some males have higher expo-
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dence of returns was commensurate with the
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the jury is still out about the exact correlation
of returns and testosterone, there is evidence
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ever-increasing Sharpe ratios, with many above
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provides one of the few documented and testable
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It also provides one of the two solid, prac-
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out whether an employee has a trading skill
worth paying for, employers can plot a rising
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SUBJECTS
cations for investing because the bonding mech- WERE PRE-
anism could be the physiological drive behind
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SENTED WITH
In one study, subjects were presented with A SCENARIO
DVFHQDULRRIOLIHRUGHDWK7KH\FRQWUROOHGD
switch that would divert a runaway train, saving
OF LIFE OR
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WOULD DIVERT
the one person on the other track had a name A RUNAWAY
familiar to the test subject, they chose not to
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TRAIN, SAVING
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group” be one factor in herding behavior related
to investments? Perhaps the bonding feeling
of being in a group of winners was behind the
 SUHSRQGHUDQFH RI $SSOH VWRFN DW ODUJH
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(the subsequent exodus from which was blamed
banks are amplifying the shifts in risk prefer- IRUWKHOLTXLGLW\FUXQFKLQ$XJXVW´:H
ences by upping allocations for winning trad- know that people often conform to others with
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the physiological shift in risk preferences and, whether oxytocin’s effects on in-group favorit-
like an athlete with a physical trait, train and LVPDUHVXIÀFLHQWO\SRZHUIXOWRDFWXDOO\LQÁX-
PDQDJHIRUJUHDWHUHIIHFWLYHQHVVµ ence individuals’ subjective preferences, and
thus stimulate in-group conformity, remained
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males, oxytocin is discussed primarily in relation HIGH ANXIETY, LOW SEROTONIN
WRIHPDOHV7KLVFKHPLFDOPHVVHQJHUDFWVERWK $WKLUGFKHPLFDOPHVVHQJHUWKHQHXURWUDQVPLW-
DVDKRUPRQHDQGVRPHWLPHVDVDQHXURSHSWLGH ter serotonin, regulates equilibrium functions,

Jan/Feb 2013 CFA Institute Magazine 39

 VXFKDVEUHDWKLQJ5HODWLYHLQFUHDVHVRUGHFUHDVHV
in the compound can affect the level of anxiety
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tonin and periodic changes in serotonin levels
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whelmingly uncooperative after drinking con-
coctions designed to reduce the levels of sero-
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one player in a dyad is given a sum of money
and instructed to split the sum with the other
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scores on neuroticism and negative affect and
lower scores on positive affect, suggesting that
these individuals are ex ante focused on the neg-
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determined that that brain activity of short-
versus long-allele subjects also correlated
with the previously established understand-
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regions, the anterior insula (involved with gen-
erating negative emotional reactions, such as
despite the fact that to reject means the sub- DQ[LHW\RUGLVJXVWDQGWUDFNLQJRXWFRPHULVN
MHFWJHWVQRWKLQJ6XEMHFWVZLWKGHSOHWHGVHUR- and the nucleus accumbens (responsible for
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concluded that missing the moderating effect
of normal serotonin levels changed the percep-
tions of subjects, who thus impulsively rejected
what might have previously been considered to
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of serotonin is the subject of a multipronged
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IHVVRURIÀQDQFHDWWKH.HOORJJ6FKRRORI0DQ-
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wants to know more than just what happens to
behaviors as a result of the presence or activity
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classical neuroeconomists, she seeks causes of
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ÀQDQFLDOGHFLVLRQPDNLQJOHW·VVHHKRZWKH\
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that brain areas are responsible for these emo-
tional states and are in play when people make
ÀQDQFLDOGHFLVLRQVµ
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ways associated with differences in risk prefer-
ences among people, and the study of serotonin
also revealed a genetic link to risk-seeking or
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versions of the serotonin receptor gene invest in
fewer equities, are passive investors, and (when
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ing, risk-avoiding anterior insula activated in
short-allele people and the reward-seeking
nucleus accumbens lit up for long-allele sub-
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who want to encourage an investor to invest in
risky assets to make a very clear case for the
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causes a misperception, it’s possible to balance
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So, what are professional investors to do with
all this new knowledge? One might imagine a
daily testing regime, accompanied by a “mood
cocktail,” to keep the chemistry in proper bal-
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iology could be used to measure trading prof-
its in a way that combines “big data” with the
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in his book Moneyball&RDWHVVXJJHVWVDVWDII
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rate models demand a better understanding of
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experts in computational cognitive science are
studying the layers and layers of processes and
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though there was little difference in education
levels, intelligence levels, overall wealth, or the
amount of assets, the risk preferences between
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the emotional makeup of test subjects further
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logical, emotion-driven differences between
those carrying the short and the long alleles,”
40 CFA Institute Magazine Jan/Feb 2013
NEURAL PROCESSES
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rons, the brain accounts for the majority of
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takes to read this article, a mountain of new
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 A prevailing theory about the brain is that
the evolutionary process has brought the organ’s
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seems to reveal some quirks that skew the per-
ception of risk and reward processing that leads
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cial decision makers are in a heightened state
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quest to create alpha comes from the expand-
ing knowledge of risk–reward processing, how
humans choose to exhibit behaviors or inhibit
them, and the neural correlates of social versus
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BEYOND THE MONKEY BRAIN
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ago, Peter Bossaerts, a professor of experimen-
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behind the brain’s reward-processing mecha-
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Because the trade-off between risk and return
forms the basis of investment decisions, Peter
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Experimental Finance has since done pioneer-
ing work on neural processing of both risk and
UHWXUQ$ORQJWKHZD\WKH\·YHDOVRGLVFRYHUHG
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the neural signals behind the magnitude of the
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Risk-prediction errors were unknown until
2008 because monkeys, the previous test sub-
jects, lack the neurons in which the human errors
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assess risk in an advanced way, which might be a
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As with serotonin studies, research on risk
processing focuses on the brain region called
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the brain location in which emotions are trans-
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at neural activity under experimental condi-
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in what we think of as a hot emotional region,”
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a quantitative analysis of uncertainty-induced
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Bossaerts’ team designs experiments around
games, observes behavior, and measures brain
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trust games, in games in which subjects trade
WE FOUND THESE COOL MATHEMATICAL SIGNALS
IN WHAT WE THINK OF AS A HOT EMOTIONAL
REGION. THIS GIVES US THE MEANS TO DO
A QUANTITATIVE ANALYSIS OF UNCERTAINTY-
INDUCED NEURAL ACTIVATION.
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ical examples of all social interchanges, and
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ferences in neural responses to intentional risk
versus non-intentional or naturally occurring
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in response to risks created by goal-directed
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tional risks include weather conditions, water
pipe eruptions, slipping on ice, or crises that
occur naturally because of the complexity of
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interesting area handles complex emotional and
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rior section activates; if we see someone else
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rior insula is where we process empathy for
others in pain, our own feelings of awareness
and consciousness, and the awareness of our
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malfunctions in antisocial personality disor-
ders; people with the disorder do not have the
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dence of hard-wiring in the brain, which sug-
gests the possibility of constructing models for
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ment tests for portfolio managers or traders that
measure the degree of risk- and reward-predic-
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is headed toward creating applications of the
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while the person might get new or novel inputs,
the processing algorithm is the same; thus, the
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Jan/Feb 2013 CFA Institute Magazine 41
 MEET THE BASAL GANGLIA
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WDWLRQ:LWKGHJUHHVLQHOHFWULFDOHQJLQHHULQJ
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has applied all the knowledge from his studies
in doing award-winning research on the basal
SUBJECTS JDQJOLD+LVJRDOLVWRXQGHUVWDQGWKHFKRLFHVZH
EXPERIENCED PDNHWRDFWRUQRWDFWWRH[KLELWDEHKDYLRURUQRW
On average, the human brain has an esti-
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THEIR OWN LPSXOVHV SHU VHFRQG 'HVSLWH WKLV FRPSOH[-
ity, we usually display a relatively controlled
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OPTIONS WITH can provide major advances in understanding
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OUTCOMES. symptoms of jerks and shakes and inability to
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is intimately connected with the brain’s cortical
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TRANSLATED we understand how the mind works, we will
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pharmacological substances to see how inter-
ventions in those pathways might change behav-
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nition by administering cabergoline, prescribed
for women to prompt production of breast milk,
and haloperidol, used to treat psychotic disor-
ders and dysfunctional motor control problems,
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the behaviors were as impacted as strongly as
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pathways learn from both positive and negative
feedback, and these integrated pathways learn
more than those that have the preference for
HLWKHUSRVLWLYHRUQHJDWLYHIHHGEDFN´/RWVRI
the work shows how we process the good and
bad outcomes to actions that we are not aware
WKDWZHDUHSURFHVVLQJµVD\V)UDQN
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lar and systems-level effects that are undoubt-
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gation are more advanced than the old ways of
diagramming brain function and thus speed up
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cult to model with the thing that is being mod-
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learning processes, we are ready in some ways
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social context, whether as part of a team or in
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also to gain relatively more than a subject with
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serotonin and testosterone, different people
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affect dopamine [neurotransmitter associated
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ways learn differently from positive feedback
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42 CFA Institute Magazine Jan/Feb 2013
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options not chosen heighten risky behaviors,
especially in competitive environments, has par-
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evaluate our choices, and that is the teaching
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Jan/Feb 2013 CFA Institute Magazine 43

Volcker
Rules?
Because of Paul Volcker’s
lasting influence, “We have
HUGE DEFICITS today, and yet
we have the LOWEST INTEREST
RATES we could ever imagine”
says economist William Silber

By Jonathan Barnes

$QHZELRJUDSK\RIIRUPHU86)HGHUDO5HVHUYHFKDLU- Why is Volcker so trusted?

PDQ3DXO9ROFNHUGHVFULEHVKLVUROHLQDEDQGRQLQJWKH86 He is trusted primarily because of what he did
as chairman of the Federal Reserve beginning
GROODU·VFRQYHUWLELOLW\WRJROGLQWKH*UHDW,QÁDWLRQ LQ$IWHUDGHFDGHRIDFFHOHUDWLQJLQÁD-
RIWKHVDQGWKHÀQDQFLDOFULVLVRI,QVolcker: tion, Volcker was determined to do what was
The Triumph of PersistenceDXWKRU:LOOLDP6LOEHU0DUFXV QHFHVVDU\WREUHDNWKHEDFNRILQÁDWLRQ6RKH
Nadler Professor of Finance and Econom- changed the operating procedures of the Fed,
allowing interest rates to go much higher than
LFVDW1HZ<RUN8QLYHUVLW\·V6WHUQ
LFV DW 1HZ <RUN8QLYHU \ anyone—including himself—expected:
himself— over 15%
6FKRRORI%XVLQHVVIROORZV on long-term Treasury sec securities and over 20%
Volcker up to and beyond on commercial loans to pr prime customers. That
his 1979–87 term as VXFFHHGHGLQEULQJLQJGRZQWKHUDWHRILQÁDWLRQ
VXFFHHGHGLQEULQJLQJGRZ
from over 12% to under 4% within three years.
Federal Reserve chair-r But he didn’t stop there. He worried that when
man. In this interview, WKH86HFRQRP\VWDUWHGWR
WKH86HFRQRP\VWDUWHGWRUHFRYHUWKHUHZRXOG
6LOEHU H[SODLQV KRZ EHUHQHZHGLQÁDWLRQ6R
EHUHQHZHGLQÁDWLRQ6RKHUDLVHGLQWHUHVWUDWHV
K
Volcker changed the before we actually reached
reache full employment—
when unemployment was still 7.5%.
way the Fed operates 6RKHGLGWZRWKLQJV+HVWRRGXSWRSROLWLFDO
6RKHGLGWZRWKLQJV+H
and broke the back of pressure to raise rates in 11979 and then raised
LQÁDWLRQZK\KHFRQ- rates again before the economy
econ got back to full
WLQXHVWRH[HUWVLJQLÀ- employment in 1984. Those
Tho increases pushed
Congress to balance the budget,
bu which took the
FDQWLQÁXHQFHWRGD\DQG pressure off the Federal R Reserve.
how the Volcker Rule is
often misunderstood. What was happening in 19 1979?
In 1979, there was a major
ma debate between
the monetarists and the K Keynesians. Monetar-
ists, most notably Milton F
Friedman, felt that in
RUGHUWR JHWLQÁDWLRQXQG
RUGHUWRJHWLQÁDWLRQXQGHUFRQWURO\RXKDG
to control the money sup
supply (demand depos-
its plus currency) and ththat if you controlled
WKHPRQH\VXSSO\HYHQWXDOO\LQÁDWLRQZRXOG
WKHPRQH\VXSSO\HYHQWX
come under control.
Photos by Matt Greenslade

But if you control the money supply, you

cannot simultaneously co control interest rates.
You can either control the price of something
or the quantity of someth
something. You can’t con-
William Silber trol both. And what Volcker
Vol did in October

44 CFA Institute Magazine Jan/Feb 2013

1979 was to say, “We are going to pay atten-
tion to the money supply and let interest rates
go wherever they have to go.” That was a seri-
ous break in the way that the Federal Reserve
operated until then.
Money supply is controlled through open
market operations, correct?
Yes, the Federal Reserve’s main contact point
with the economy is buying and selling gov-
ernment securities, called “open market oper-
ations.” When the Fed buys government secu-
rities, it pays with a check drawn on itself, and
when the bank deposits that check in its regional
Federal Reserve Bank, it receives reserves. When
banks have more reserves, they can create more
loans and deposits.
If the Federal Reserve sells government secu-
rities, it withdraws reserves, forcing banks to
cut back on loans and on the money supply.
6RWKH)HGFRXOGPDNHVXUHWKDWUHVHUYHVGRQ·W
grow by more than some percentage. It could
then calculate how that would translate into
money-supply growth. It wouldn’t work on a
weekly basis, but over a month or over three
months, it would be fairly easy to control the
money supply.
What was the relationship between Volcker
and Milton Friedman?
They were both strong-willed individuals. They
should have been allies because both of them
KDGDVWURQJYLVFHUDORSSRVLWLRQWRLQÁDWLQJ
But they didn’t see eye to eye in terms of how
to go about it. Friedman was much more rigid.
He wanted to just let the money supply grow
ZLWKRXWWU\LQJWRÀGGOHZLWKLW9ROFNHURQWKH
other hand, thought you had to use judgment
too and certainly keep at least one eye on inter-
est rates. Money supply was important, but it
was not the only thing that mattered.
Friedman also did not want the central bank
to start meddling by trying to make things
better. He felt that if the Federal Reserve tried
to make things better, it would wind up making
things worse.
Was Volcker under pressure to monetize the
Reagan deficits?
3UHVLGHQW5HDJDQZDVFOHDUO\DJDLQVWLQÁDWLRQ
But almost every Reagan lieutenant— including
7UHDVXU\6HFUHWDU\'RQDOG5HJDQDQGDIWHUKLP
James Baker—argued that the Federal Reserve
was not doing what they wanted it to do. In their
eyes, the Fed was making interest rates much
too high and not managing the money supply.
6RWKHUHZDVDORWRIGLVDJUHHPHQWEHWZHHQWKH
Federal Reserve and Reagan’s cabinet.
,WWRRNJXWVRQ9ROFNHU·VSDUWWRVWDQGÀUP
and keep interest rates high. That pressure
forced Congress and the [Reagan] adminis-
tration to get the federal budget under con-
WURO7KH5HDJDQEXGJHWGHÀFLWZDVSXVKLQJXS
interest rates, and Volcker refused to cave in by
PRQHWL]LQJWKHGHEW7KDWFUHDWHGWKHFRQÁLFW
between the Treasury and the Federal Reserve.
Do you see the same pressures today?
:HKDYHKXJHGHÀFLWVWRGD\DQG\HWZHKDYH
the lowest interest rates we could ever imag-
LQH7KDWLVEHFDXVHWKH8QLWHG6WDWHVLVVWLOO
EHQHÀWLQJIURPWKHLPSOLFLWWUXVWWKDWWKH86
will, in fact, get its budget under control. That
trust, I believe, began with Volcker’s monetary
policy during the 1980s.
If we are to maintain that trust, the Federal
Reserve is going to have to start raising rates as
the recovery builds steam. I am not quite sure
that Fed Chairman Ben Bernanke—or who-
ever follows Bernanke—is going to have the
same kind of resolve to raise interest rates, to
sop up some of the liquidity that is in the bank-
ing system right now. I don’t know whether the
same kind of public support that Volcker had to
NHHSLQÁDWLRQXQGHUFRQWUROH[LVWVQRZ
So, interest rates will need to rise?
:H·YHKDGÀYH\HDUVRIXQHPSOR\PHQWVRUDLV-
ing interest rates before the economy com-
SOHWHO\ UHFRYHUV ZLOO EH GLIÀFXOW %XW WKDW LV
ZKDW\RXKDYHWRGRLQRUGHUWRVWRSLQÁDWLRQ
before it starts.
VOLCKER’S OBSESSION WITH INFLATION STARTS
WITH A BELIEF THAT INFLATION UNDERMINES
TRUST IN GOVERNMENT. WE AS CITIZENS GIVE
THE GOVERNMENT THE RIGHT TO PRINT MONEY,
AND WE TRUST IT NOT TO ABUSE THAT RIGHT BY
INFLATING. WHEN THE GOVERNMENT INFLATES,
IT IS BREAKING THAT TRUST.
What became of the monetarist–Keynesian
debate?
The debate about whether to control reserves
or interest rates is largely historical. In fact,
since the middle of 1982, right after Volcker
EURXJKWGRZQWKHUDWHRILQÁDWLRQIURPRYHU
12% to about 4%, the Fed abandoned trying to
control the money supply and instead just said,
“We are going to raise interest rates as high as
Jan/Feb 2013 CFA Institute Magazine 45
 QHFHVVDU\LQRUGHUWRFRQWUROLQÁDWLRQµ6RWKH Does Volcker believe in narrowing the
monetarist preoccupation with money supply Fed’s mandate?
largely disappeared midway through Volck- The Federal Reserve has what we call a “dual
er’s term as Fed chairman and throughout the mandate”—to promote price stability and to
Greenspan era and through today. promote low unemployment—unlike the Euro-
pean Central Bank (ECB), whose only objective
To what degree was Volcker a student of is to maintain price stability. The Fed also has
Friedrich Hayek? another objective, which is to serve as a lender
Volcker says his favorite book as an undergrad- of last resort during periods of panic. But the
uate was The Road to Serfdom. I think the most panic stage is over.
important impact of Hayek’s book on Volcker In his 1990 Per Jacobsson lecture, Volcker
is in a very brief passage. Toward the end of said he favors the Federal Reserve having just
the book, Hayek suggests the only way mone- one objective: price stability. He felt that having
tary policy can promote more employment is in an employment objective confused the issue
an underhanded fashion—by tricking workers because in the long run, the Federal Reserve
into thinking that their real wages are going can’t push unemployment below a level consis-
up only to disappoint them when prices go up tent with the natural workings of the economy.
to match those wage increases. 9ROFNHUXUJHGMXVWIRFXVLQJRQLQÁDWLRQFRQ-
9ROFNHU·VREVHVVLRQZLWKLQÁDWLRQVWDUWVZLWK trol. He repeated that message again in 2011.
DEHOLHIWKDWLQÁDWLRQXQGHUPLQHVWUXVWLQJRY- He believes that the right objective is to control
ernment. We as citizens give the government LQÁDWLRQEHFDXVHZHNQRZWKH)HGHUDO5HVHUYH
the right to print money, and we trust it not to LILWZDQWVWRFDQFRQWUROLQÁDWLRQ
DEXVHWKDWULJKWE\LQÁDWLQJ:KHQWKHJRYHUQ-
PHQWLQÁDWHVLWLVEUHDNLQJWKDWWUXVW How did Volcker’s role in ending Bretton
Woods change his career?
What would Volcker do as Fed chairman now? %UHWWRQ:RRGVZDVDV\VWHPRIÀ[HGH[FKDQJH
Volcker has some reservations about QE3, the UDWHVEDVHGRQWKH86GROODU·VFRQYHUWLELOLW\LQWR
most recent installment in monetary easing. My JROG9ROFNHUEHOLHYHGLQWKHÀ[HGH[FKDQJHUDWH
V\VWHPEXWUHFRJQL]HGWKDWWKH8QLWHG6WDWHV
own belief is that it is just plain misguided. It is
a mistake because we don’t need more monetary could not maintain its promise to exchange dol-
HDVLQJWRGD\:HQHHGÀVFDOVWLPXOXVEXWWKDWLVlars for gold. There was too little gold in Fort
FRPSOLFDWHGE\WKHORQJWHUPEXGJHWGHÀFLWVR .QR[DQGWKHUHZHUHWRRPDQ\GROODUVÁRDW-
you might have to increase unemployment com- ing around the world.
pensation but at the same time rein in Medicare When Nixon suspended the convertibility
DQG6RFLDO6HFXULW\7KDWZRXOGSURYLGHVRPH of the dollar into gold in 1971, it was largely
stimulus and at the same time give people con- based on a plan that Volcker had devised. Vol-
ÀGHQFHWKDWWKH8QLWHG6WDWHVZLOOEDODQFHLWV cker hoped the suspension would give him a
budget at full employment. What QE3 has really FKDQFHWRPDLQWDLQÀ[HGH[FKDQJHUDWHVZKLFK
done is push out even more reserves and liquid- he failed to do, so he proceeded to negotiate
ity that will eventually have to be withdrawn. DWUDQVLWLRQWRÁRDWLQJH[FKDQJHUDWHV,QWKH
process, he turned himself into an international
What is Bernanke’s rationale, in your opinion? ÀQDQFLDOGLSORPDWZKHUHDVEHIRUHKHZDVSUL-
Bernanke is certainly aware of what happened marily a monetary technocrat. The press began
LQWKHVEXWKHVHHPVWRWKLQNÀVFDOSROLF\ to refer to him as the “Henry Kissinger of inter-
won’t do anything so monetary policy must do QDWLRQDOÀQDQFHµ
everything. I think he has taken on a respon- He built up credibility among foreign cen-
sibility that he will not be able to deliver on. WUDOEDQNHUVDQGÀQDQFHPLQLVWHUVLQFOXGLQJ
Bernanke is telling us not to worry. He implies +HOPXW6FKPLGWZKREHFDPHWKHFKDQFHOORURI
that we will be able to withdraw excess liquid- West Germany, and Valéry Giscard d’Estaing,
ity in the economy when that’s necessary. But ZKREHFDPHSUHVLGHQWRI)UDQFH6R9ROFNHU·V
that is easy to say and hard to do—just like diet ZRUNWU\LQJWRPDLQWDLQÀ[HGH[FKDQJHUDWHV
and exercise. I’m not certain Ben Bernanke will transformed him, even though he did not suc-
really be willing to raise rates—and when I say FHHGLQNHHSLQJH[FKDQJHUDWHVÀ[HG
raise rates, I don’t mean from 1.7% to 2.1%. I
mean from 1.7% to 5%. It is not clear that the Has Volcker ever expressed a longing to
Fed will have the political clout or the courage return to a fixed exchange rate system?
to do that. He doesn’t know—and neither do All the time. He still thinks there has been too
I—how high rates will have to go. much volatility in international exchange rates.

46 CFA Institute Magazine Jan/Feb 2013

, GRQ·W WKLQN KH ZRXOG VXSSRUW ULJLGO\ À[HG
exchange rates—and he didn’t after 1971. He
ZDQWHGWREXLOGLQVRPHSUHGHWHUPLQHGÁH[L-
bility to keep exchange rate movements under
some control.
He recognizes that greater stability of ex-
change rates would require greater coordina-
tion of domestic monetary policy among differ-
ent countries in the world.

Are we seeing that between the U.S. and the

European Union?
We do see some coordination between the Fed
and the European Central Bank, even though
WKH(&%LVVXSSRVHGWRIRFXVRQO\RQLQÁDWLRQ
It has also taken on increasing responsibility
for avoiding panics.
When central banks pursue very different
monetary policies and very different interest
rate policies, that puts tension into the exchange
rate. For example, if Europe has an interest
UDWHRIDQGWKH8QLWHG6WDWHVKDVDQLQWHU- HOW CAN REGULATORS MONITOR WHETHER BANKS
est rate of 1%, a lot of people are going to want WILL SPECULATE? BUT BANK MANAGEMENT CAN
WREX\WKHHXURDQGLQYHVWLWDW6RLWLVWKH
international coordination of monetary policy AND WILL MONITOR IF YOU MAKE THE CEO OF EVERY
that really produces an economic incentive for FINANCIAL INSTITUTION PUBLICLY ACCOUNTABLE.
exchange rate stability.

Does Volcker have nostalgia for currency

backed by gold?
No. Remember, he was the architect of Nixon’s
suspension of the convertibility of the dollar into
gold in August 1971. He has never expressed
a desire to go back. By the way, there is a real
public misperception of Volcker’s support for the
gold standard. In fact, last year on August 15,
2011, the 40th anniversary of the suspension
of the gold standard, there was an op-ed piece
in the Wall Street Journal which lamented the
suspension of the dollar’s convertibility into gold
and said that the only person against the sus-
SHQVLRQDW&DPS'DYLGLQZDV3DXO9RO-
cker, when in fact, it was Volcker’s idea.
What’s your opinion of the Volcker Rule?
If you told me about the Volcker Rule before
President Obama proposed it, I would have
thought there was no chance the Volcker Rule
would make it out of the White House, much
OHVVRXWRIWKH6HQDWHFORDNURRP+RZFDQUHJ-
ulators monitor whether banks will speculate?
But bank management can and will monitor
LI\RXPDNHWKH&(2RIHYHU\ÀQDQFLDOLQVWL-
tution publicly accountable. A trading manag-
er’s job at a commercial bank is to make sure
that a market maker remains a market maker
DQGGRHVQRWVSHFXODWH'RWKH\KDYHD´EULJKW Jonathan Barnes is a financial journalist and author of
line” which shows the difference between the the novel Reunion.
two? The answer is no, but managers look at
all sorts of things that traders do: the frequency
of quoting “bids and offers,” the size of their
inventory, and how long securities stay in inven-
tory. Trading managers will prevent their trad-
ers from speculating if CEOs are forced to attest
publicly that their institutions have complied
with the Volcker Rule.
How much can the Volcker Rule reduce risk?
The Volcker Rule was never intended as an anti-
GRWHWRWKHQH[WÀQDQFLDOFULVLV7KH9ROFNHU5XOH
was designed to protect the commercial bank-
LQJVHFWRU³ZKLFKEHQHÀWVIURPIHGHUDOGHSRVLW
insurance and the ability to borrow from the Fed-
eral Reserve—from unnecessary risks. If we are
going to subsidize the banking system, we want
to insulate it as much as possible from risks that
are not associated with its core business.
Could the Volcker Rule succeed in doing
WKDW"7KHDQVZHULV\HV'RHVWKDWPHDQWKDW
WKHUH ZLOO EH QR ÀQDQFLDO FULVHV" $EVROXWHO\
not. It can happen elsewhere in the economy,
and the government has to be able to say to
those other institutions, “If you get into trou-
ble, you will fail.”

Jan/Feb 2013 CFA Institute Magazine 47

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Klas Andersson, CFA
Bobbi K. Beehler, CFA
John Paul Broussard, CFA
Geoff J. Bunton, CFA
Damon W. Byrd, CFA
Robert Cummisford, CFA
Moris Danon, CFA
Craig R. Delveaux, CFA
Garvin K. Deokiesingh, CFA
Philip Fanara Jr., CFA
Kenneth B. Gordon, CFA
Candise C. Holmlund, CFA
Stephen M. Horan, CFA, CIPM
Laura R. Huntington, CFA
David C. Jordan, CFA
David Koulish
Aurelia M. Kovatch, CFA
David M. Lavelle, CFA
Eric R. Lind, CFA
Peter Kurt Nielsen, CFA
David C. Oglesbee
Robert W. Panasiuk, CFA
Edward Ramos, CFA
Raymond D. Rath, CFA
Timothy M. Roberts, CFA
Mark Allen Roble, CFA
Anke Sach, CFA
Michael Schiffman, CFA
Jurg Schiller, CFA
Richard Louis Sega
Joseph Damiani Shaw, CFA
David Jiongxin Shen, CFA
Frederick W. Siegrist, CFA
Keith D. Swanson, CFA
Sanjay B. Varshney, CFA
Keith Wibel, CFA
David M. Zahn, CFA

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CFA UK
CFA Society Philadelphia
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CFA Society Edmonton
CFA Society Toronto
CFA Society Washington, DC
CFA Society San Diego
CFA Society Buffalo
CFA Society Seattle
CFA Society Colorado
CFA Society of South Florida
CFA Society Minnesota
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CFA Society Toronto
CFA Society Los Angeles
CFA Society Phoenix
CFA Society Milwaukee
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CFA Society Hartford
CFA Society Toronto
CFA Society Seattle
CFA Society Sacramento
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Karin B. Bonding, CFA

James F. Cameron, CFA
CFA Society Calgary
Yvan Chevrette FRM, CFA
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Robert Alexander Ernst, CFA
CFA Society Washington, DC
Philip J. Keating, CFA
CFA Society of South Florida
Mark K. Lauber, CFA
CFA UK
Thomas J. Marthaler, CFA
CFA Society Chicago
V. John Palicka, CFA

Christian-Marc Panneton, CFA
CFA Quebec
Mary Helen Stults, CFA
CFA Society Colorado
Thomas Mathew Tholoor, CFA
CFA Society Bahrain
Mary H. Wladkowski, CFA
CFA Society of Idaho
Teong Keat Yap, CFA
CFA Singapore
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Hiroshi Amemiya, CFA
Yoshio Arai, CFA CFA Society Japan
Peng Keong Chon, CFA The Hong Kong Society of
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Taro Iwata, CFA CFA Society Japan
Swee Sum Lam, CFA CFA Society Singapore
Lara E. Misner, CFA CFA Society Toronto
Tomoyoshi Omuro, CFA CFA Society Japan
Alexander Plenk, CFA CFA Society Germany
Izumi Shaw, CFA CFA Society Japan
Ryuichi Shiina, CFA CFA Society Japan
Kazuhiro Takahashi, CFA CFA Society Japan
Luis Felipe Vallarino-Medina, CFA CFA Society Mexico
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 ETHICS AND STANDARDS
MARKET INTEGRITY AND ADVOCACY
Financial Industry Accountability:
Sanctions or Amnesty?
 By Kurt N. Schacht, JD, CFA
Since the dark days of 2008, there has
been no shortage of discussion and debate
on what—and who—caused the global
ÀQDQFLDOFULVLV:KLOHZHQRZNQRZWKDW
a multitude of forces (from banks’ reck-
OHVVEHKDYLRUDQGLQÁDWHGFUHGLWUDWLQJV
to failures in regulation and policy) were
the main drivers of the meltdown still
reverberating throughout the economy,
RQHLPSRUWDQWTXHVWLRQUHPDLQV:KR·V
being held responsible?
In the four years since Lehman Broth-
ers went bankrupt and AIG collapsed, public frustration has
only grown over the limited number of criminal prosecu-
WLRQVRIKLJKSURÀOHSOD\HUVDW:DOO6WUHHWDQG(XURSHDQ
ÀQDQFLDOLQVWLWXWLRQVIRUWKHLULQGLYLGXDOUROHLQWKHFULVLV
Now, an interesting debate is brewing over whether and
KRZWRKROGDFFRXQWDEOHWKHÀUPV³YHUVXVLQGLYLGXDOV³DW
WKHKHDUWRIWKHÀQDQFLDOFULVLV Indeed, an article by colum-
nist Damian Reece in London’s Daily Telegraph in October
(“Punishing Banks Is Now Doing More Harm Than Good”)
WDNHVFULWLFDODLPDWWKHQRWLRQRIVDQFWLRQLQJÀQDQFLDOFULVLV
ODUJHO\EHFDXVHRIWKHIUDJPHQWHGDSSURDFKLQWKH(XUR-
pean Union to both sanctions and, on a more fundamen-
WDOOHYHOWKHYHU\GHÀQLWLRQRILOOHJDOEHKDYLRU(YHQLQWKH
FDVHRIWKH(80DUNHW$EXVH'LUHFWLYH³DLPHGDWUHGXFLQJ
WKHLQFLGHQFHRIPDUNHWDEXVHDFURVVWKH(XURSHDQ8QLRQ³
sanctions are set by Member States and implemented by
QDWLRQDOUHJXODWRUV$VDUHVXOWWKHGLVSDULW\HYHQZHDN-
ness, of provisions in national law to protect investors can
greatly affect the prospects of success for legal action, dis-
FRXUDJLQJLQYHVWRUVIURPVHHNLQJUHGUHVVDQG(8SURVHFX-
WRUVIURPLQLWLDWLQJVXFKFDVHV$VDUHVXOWRQO\DOLPLWHG
IHZLQVWLWXWLRQDOLQYHVWRUVHYHQDWWHPSWWRVXH
,QDQ\HYHQW(XURSHDQODZPDNHUVDUHRQWKHULJKWWUDFN
ZLWK UHFHQW HIIRUWV WR VODS WRXJK (8VLGH FULPLQDO VDQF-
WLRQVRQLQGLYLGXDOÀQDQFLDOZURQJGRHUVLQFOXGLQJSRV-
VLEOHMDLOWHUPVIRUWKHPRVWVHULRXVFDVHVRILQVLGHUWUDG-
LQJDQGPDUNHWPDQLSXODWLRQ,W·VDZHOFRPH³DQGYLWDOO\
necessary—direction for future deterrence and improving
WKHSURVSHFWVIRUEHWWHULQYHVWRUWUXVWDQGPDUNHWLQWHJULW\
At the same time, if some sort of inclusive global settle-
ment of claims against institutional players in the crisis could
be structured—in effect, a limited amnesty—might it put
ZURQJGRHUV´,IODZ\HUVDQGUHJXODWRUVZDQWWRSXUVXHMXV- DQHQGWKDQNIXOO\WRDGLIÀFXOWHUDDQGDOORZWKHVHÀUPV
tice they are going about it in entirely the wrong way and and the industry to refocus and heal? Here is hoping for a
resulting in an entirely unfair outcome for ordinary people FUHDWLYHVROXWLRQ
and the economy as a whole,” Reece states, criticizing the Kurt N. Schacht, JD, CFA, is managing director of Standards and Finan-
decision by New York’s attorney general to sue JPMorgan cial Market Integrity for CFA Institute.
&KDVHRYHU%HDU6WHDUQVPRUWJDJHEDFNHGVHFXULWLHV,WLV
DIDLUSRLQWWKDWWKHVHÀUPOHYHOSHQDOWLHVKXUWQRRQHEXW
existing shareholders and may actually remove bailout dol-
ODUVLHQHHGHGFDSLWDOLQMHFWHGE\WKHJRYHUQPHQWLQWKH
ÀUVWSODFH0RUHRYHUWKHEDUUDJHRIFULVLVUHODWHGODZVXLWV
DJDLQVWWKHVHÀUPVLVFRQVWDQWDQGQHDUO\DOOFRQVXPLQJRI
management focus in many instances—a perverse outcome
and hardly the environment for either effective deterrence
RUUHVWRUDWLRQRIDQLQGXVWU\LQGHVSHUDWHQHHGRIUHEXLOGLQJ
Others strongly argue that the stakes are too high to
forgo proper legal and regulatory actions against both the
ÀUPVDQGLQGLYLGXDOV3XQLVKLQJWKHKXPDQDQGFRUSRUDWH
SHUSHWUDWRUVRIWKHÀQDQFLDOFULVLVZKHUHYHUWKH\PD\QRZ
reside, is essential to avoiding yet another form of moral-
KD]DUGDVVLVWDQFHWRWKHÀQDQFLDOLQGXVWU\
7KH-30RUJDQ%HDU6WHDUQVFDVH³WKHÀUVWÀOHGXQGHUWKH
James Allen, CFA, head of capital markets policy for CFA Institute (far right),
auspices of a state–federal task force on mortgage fraud— is moderates a panel discussion on bank regulations at the recent Dodd–Frank
OLNHO\RQO\WKHWLSRILFHEHUJ,WLVH[SHFWHGWROD\WKHJURXQG- Two Years Later: Implementation and Impact conference, sponsored by the
work for suing other large banks in an effort to hold them CFA Society of Washington, DC. Other panel participants (left to right) are Bert
Ely, principal of Ely & Company; Abby McCloskey, director of research at the
DFFRXQWDEOHIRUFRQWULEXWLQJWRWKHÀQDQFLDOFULVLV Financial Services Roundtable; and Robert Birmingham, director of compliance
%XWVXFKOHJDOSURFHHGLQJVDUHOHVVFRPPRQLQ(XURSH and fair lending at Treliant Risk Advisors.

50 CFA Institute Magazine Jan/Feb 2013

Seeking Optimal OTC Derivatives Regulation
By Beth Kaiser, CFA, CIPM

are struggling to adopt and implement those recommen-

2QHVLJQLÀFDQWFXOSULWRIWKHÀQDQFLDOFULVLVZDVWKH
GDWLRQVDVWKH\HDUHQGGHDGOLQHTXLFNO\DSSURDFKHV
opacity, interconnectedness, and size of the over-the-counter
8QWLOQRZWKH86&RPPRGLW\)XWXUHV7UDGLQJ&RPPLV-
27&GHULYDWLYHVPDUNHW'HVSLWHJOREDOHIIRUWVWRGHYHORSD
sion (CFTC) has set the pace for adoption and implemen-
regulation regime for the largely unregulated market, steps
to implement a harmonized global regulatory system to reinWDWLRQRIWKH*²SULQFLSOHVDOWKRXJKWKH(XURSHDQ6HFX-
in the US$648 trillion market remain mired in regional andrities and Markets Authority has caught up considerably in
SROLWLFDOGLIIHUHQFHV UHFHQWPRQWKV7KH-DSDQHVH)LQDQFLDO6HUYLFHV$JHQF\KDV
Beginning in September 2009, G–20 leaders have sought passed most of the appropriate regulations and has begun
to deal with the issues created by the largely unregulatedWKHLPSOHPHQWDWLRQSKDVH
PDUNHW.H\WRWKLVHIIRUWLVIRUDOOVWDQGDUGL]HGDQGVWDQ- But while policymakers in many markets are working
dardizable OTC derivative contracts to (1) trade on reg- furiously to adhere to the goals, some have said openly they
ulated exchanges or electronic trading platforms, where ZRQ·WEHUHDG\E\WKHGHDGOLQH2WKHUVKDYHVWDWHGWKH\KDYH
appropriate; (2) clear through central counterparties; andno intention of adhering to many of the reforms any time
VRRQLIDWDOO$QXPEHURIPDUNHWVDUHVLPSO\ZDLWLQJWR
UHSRUWWRWUDGHUHSRVLWRULHV7KHWDUJHWGDWHIRUDFKLHY-
LQJWKHVHJRDOVLV\HDUHQGDWWKHODWHVW VHHZKDWNLQGRIUHJXODWLRQVWKH86DQG(XURSHDGRSWVR
At the same time, the G–20 stated that non-centrally- WKH\FDQGHFLGHKRZWRSURFHHG
FOHDUHGFRQWUDFWVVKRXOGEHVXEMHFWWRKLJKHUFDSLWDOUHTXLUH-A prime example of the global stalemate is the FSB rec-
ommendation to trade standardized OTC derivatives on
ments and asked the Financial Stability Board (FSB) to assess
ZKHWKHULPSOHPHQWDWLRQRIVXFKUHIRUPVZRXOGVXIÀFLHQWO\ H[FKDQJHV$FFRUGLQJWRWKHODWHVWSURJUHVVUHSRUWRQLPSOH-
improve transparency, mitigate systemic risk, and protect PHQWDWLRQRIGHULYDWLYHVPDUNHWUHIRUPWKH86DQG(8
DJDLQVWPDUNHWDEXVH,QWKH)6%LVVXHGUHFRPPHQ- DUHIDUWKHVWDORQJWKRXJKWKH(8ZLOOKDYHDORQJHULPSOH-
dations for OTC derivatives regulatory structures, a pro- PHQWDWLRQSHULRG,Q-DSDQQHZUXOHVGUDIWHGLQ0DUFK
SRVDOWKDWWKH*²SURPSWO\DSSURYHG&)$,QVWLWXWHKDV 2012) will be “phased in to allow providers and users of
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IRUWKH)6%·VVXJJHVWHGUHIRUPVDQGWKH*²REMHFWLYHV gapore, South Africa, and Switzerland, according to the
report, “indicate that more analysis of the liquidity of the
THE DEVIL IS IN THE IMPLEMENTATION markets and instruments is needed” before they will adopt
In the past few years, G–20 members have set out to pass UXOHVVLPLODUWRWKHUHFRPPHQGDWLRQV
corresponding regulation to adhere to the FSB’s recommen- :LWKWKHHIIHFWLYHGDWHVIRUPDUNHWSDUWLFLSDQWVWRDGRSW
GDWLRQV'HVSLWHKDYLQJKDGDIHZ\HDUVWRFRPSO\PRVW the CFTC’s swaps regulations beginning to pass, it has

Illustration by Robert Meganck

Jan/Feb 2013 CFA Institute Magazine 51

 ETHICS AND STANDARDS
MARKET INTEGRITY AND ADVOCACY

SURSRVDOEHFRPHVÀQDOLWZLOONLOOWKH86VZDSVPDUNHW
become critical for all regulations to address the fact that a
ODUJHQXPEHURIVZDSVWUDQVDFWLRQVRFFXUDFURVVERUGHUV7R 2WKHUVKDYHRSLQHGWKDWWKHLQWHUSUHWDWLRQLVMXVWULJKWDQG
ignore this reality would mean mass confusion about how to exactly what is needed to blunt systemic risk and protect
treat registration with the CFTC and which regulators are WKH86HFRQRP\DVZHOODVWKHJOREDOHFRQRP\
VXSHUYLVLQJWKHSURFHVVDVWKHHIIHFWLYHGDWHVNLFNLQ$OVR Trying to ease global concerns, the CFTC has reiter-
if cross-border interpretation is not provided by the effec- ated that Section 722(d) of the Dodd–Frank Act states that
WLYHGDWHV86ÀUPVZLOOKDYHSOHQW\RIRSSRUWXQLWLHVQRWswaps reforms shall not apply to activities outside the United
to mention incentive, to skirt the regulations and conduct 6WDWHVXQOHVVWKRVHDFWLYLWLHVKDYHD´GLUHFWDQGVLJQLÀFDQW
WKHLUVZDSVEXVLQHVVRIIVKRUH7KLVVLWXDWLRQZRXOGPDNH connection with activities in, or effect on, commerce in the
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ÀOHVFDQGDOVKDYHEHHQWKHUHVXOWRI86ÀQDQFLDOLQVWLWX-
EXTRATERRITORIAL BARRIERS tions executing swaps offshore—for example, the London
A critical aspect of bringing the G–20 plan together is rec- DQG&D\PDQ,VODQGDIÀOLDWHVRI$,*/HKPDQ%URWKHUV&LWL-
ognizing that many OTC derivatives transactions occur JURXS%HDU6WHDUQVDQG/RQJ7HUP&DSLWDO0DQDJHPHQW
in different markets based on where each counterparty is Although this initiative is important, we at CFA Institute
ORFDWHGRUZKHUHWKHLQIUDVWUXFWXUHEHLQJXVHGHJFOHDU- believe that multilateral action would be optimal and the
LQJKRXVHLVORFDWHG7KHFURVVERUGHUQDWXUHRIWKHPDUNHW &)7&VKRXOGQRW´JRLWDORQHµLIDWDOOSRVVLEOH2XUFRP-
ment letter expresses support for dealing with extraterrito-
riality and allowing substitute regulatory regimes to super-
THE CFTC IS GRAPPLING WITH THE FACT vise when regulations are comparable through individual
ÀUPUHTXHVWVDQGPHPRUDQGXPVRIXQGHUVWDQGLQJ028V
THAT MOST OVERSEAS REGULATORS To help in this regard, we have advocated for contingen-
ARE NOT AS FAR ALONG. AS A RESULT, FLHVIRUWKHLQWHULPWLPHIUDPHZKLOHQRQ86UHJXODWRUVDUH
moving toward the reforms called for by the G–20 (reforms
U.S. MARKET PARTICIPANTS WILL HAVE WKDWZRXOGQRWKDYHEHHQUHDG\E\WKHHQGRI)DLO-
TO ADHERE TO A NEW SET OF RULES ure to allow for this interim would result in massive costs
IRUÀUPVIRUFHGWRUHJLVWHUZLWKWKH&)7&RQO\WRGLVFRYHU
WHILE COUNTERPARTIES IN OTHER later that they didn’t have to and could have used a substi-
MARKETS WILL CONTINUE TO OPERATE WXWLQJUHJXODWRU
UNDER PRE-2008 STRUCTURES.
PHDQVWKDWWUDQVDFWLRQVDQGFRXQWHUSDUWLHVDUHVXEMHFWWR
different regulatory regimes, thus calling into question how
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1RZ WKDW PDQ\ RI WKH 86 UHJXODWLRQV RQ VZDSV DUH
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pling with the fact that most overseas regulators are not as
IDUDORQJ$VDUHVXOW86PDUNHWSDUWLFLSDQWVZLOOKDYHWR
adhere to a new set of rules while counterparties in other
MOVING TOWARD RESOLUTION
In the meantime, the CFTC must wade through nearly 300
comment letters from market participants and observers
EHIRUHLVVXLQJLWVÀQDOLQWHUSUHWDWLRQ7KHHYHQWXDOGHFL-
VLRQFRXOGVLJQLÀFDQWO\DIIHFWWKHVZDSVPDUNHWV$VWKH
Wall Street Journal has reported, the extraterritoriality rules
“likely will not be in place by year-end because regulators
DUHVTXDEEOLQJDERXWWKHGHWDLOVµ'HVSLWHVXFKGLIÀFXOWLHV
we are encouraged that the CFTC is working multilaterally
WRGHYHORSDPXWXDOO\DJUHHGXSRQVROXWLRQ
(XURSHKDVDOVRSURSRVHGUXOHVRQH[WUDWHUULWRULDOLW\
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PDUNHWVZLOOFRQWLQXHWRRSHUDWHXQGHUSUHVWUXFWXUHV
In mid-2012, the CFTC proposed interpretive guidance in
an attempt to deal with these extraterritorial issues, such
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ipants register with the CFTC or requirements for clear-
LQJWUDGHH[HFXWLRQDQGUHSRUWLQJRIFURVVERUGHUVZDSV
Despite attempts to calm global fears by proposing to substi-
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diction where appropriate, the proposals have done little to
VWHPWKHFRQWURYHUV\DERXWWKHSURSRVDO
In particular, some market participants, not to mention
UHJXODWRUVKDYHFRQYH\HGWKHYLHZWKDWWKH86JRYHUQ- Beth Kaiser, CFA, CIPM, is director of capital markets policy for CFA Institute.
ment is overreaching with its proposals, arguing that if the
52 CFA Institute Magazine Jan/Feb 2013
WXUH5HJXODWLRQ(0,57HFKQLFDO6WDQGDUGV7KHVHVWDQ-
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In an effort to coordinate cross-border regulations, the
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Advisory Committee (GMAC) and global regulators from
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conveyed a desire for cooperation and provided a sense of
hope that the global regulatory community can reach an
DJUHHPHQWDVVRRQDVSRVVLEOH
CFA Institute Holds Global Advocacy Summit
In late November, CFA Institute hosted John Rogers, CFA, president
a Global Advocacy Summit in Washing- and CEO of CFA Institute (left),
speaks with Scott Stewart, CFA,
ton, D.C. The event brought together advocacy chair of the Boston
approximately 100 CFA Institute volun- Security Analysts Society,
teers, society leaders, and staff members during a break at the Global
Advocacy Summit.
to discuss industry issues and strategies
for generating more member and soci- Christopher Addy, CFA, chair
ety engagement in advocacy worldwide. of the Capital Markets Policy
0HPEHUVRIÀYH&)$,QVWLWXWHSROLF\ Council, participates in a policy
council roundtable to provide
councils—the Corporate Disclosure society volunteers an overview
Policy Council, the Capital Markets of current advocacy work.
Policy Council, the GIPS Executive Com-
mittee, the Standards of Practice Coun-
cil, and the Asset Manager Code
Advisory Committee—were on
hand for the two-day event as
well as volunteers from 18 CFA

Photos by Leslie E. Kossoff Nordby/LK Photos

societies actively advocating for
ethics and CFA Institute stan-
dards and policy positions in
their local markets.
In addition to gaining greater knowledge
of the organizational priorities, advocacy
work plans, and volunteer roles, smaller
workshop sessions were designed to
prepare volunteers for media, industry,
and policymaker outreach.

Now available from the Research Foundation of CFA Institute:

Fund Management: An Emotional

Finance Perspective
David Tuckett and Richard J. Taffler
This publication is available online for free in PDF and e-book
format and can be purchased in paperback for US$9.95.
To increase understanding of the real world of the fund manager, the authors
apply principles from emotional finance. They report their findings from analysing
in-depth interviews of 52 traditional and quantitative-oriented equity managers.
In particular, they examine the importance of storytelling in the managers’
ability to act in the face of uncertainty. The nature of the fund managers’ job
requires them to cope with emotions that, particularly if denied, can threaten
to overwhelm their thinking.

The Research Foundation funds, publishes, and distributes monographs, literature

reviews, and periodic papers on a variety of relevant investment topics. It traces
its roots to 1965 when one of the predecessor organizations of CFA Institute
established the CFA Research Foundation in an effort to generate research and
publications relevant to the needs of investment professionals worldwide.

Jan/Feb 2013 CFA Institute Magazine 53

 ETHICS AND STANDARDS
MARKET INTEGRITY AND ADVOCACY
New Committee Appointments
CFA Institute has announced the appointment of several new policy council volunteers to provide critical industry
H[SHUWLVHDQGWRJXLGHRXUVWDQGDUGVDQGSXEOLFSROLF\DGYRFDF\ZRUN
ASSET MANAGER CODE ADVISORY
COMMITTEE (AMCAC)
CFA Institute has appointed Michael G.
Trotsky, CFA, as chair of the Asset Man-
ager Code Advisory Committee, which
serves as an advisory body on mat-
ters related to the CFA Institute Asset
Manager Code of Professional Conduct.
Trotsky is the executive director and
chief investment officer of the Massa-
chusetts Pension Reserves Investment
Management Board (Mass PRIM). The
following new members also have been
appointed to AMCAC:
Ronald D. Peyton is chairman and CEO
of Callan Associates Inc., where he
works with large institutional investors
to effectively plan, structure, and evalu-
ate investment programs, products, and
organizations.
Erling Skorstad is head of fixed income
DK/Euro and investment risk management
for Nordea Investment Management, a
Nordic-based global asset manager serv-
ing a diverse base of institutional clients.
CAPITAL MARKETS POLICY COUNCIL
(CMPC)
CFA Institute has appointed Christopher
Addy, CFA, as chair of the Capital Markets
Policy Council, which is a diverse group of
investment professionals who provide a
global watch on market issues and events.
Addy is founder, president, and CEO of
Enterprise Castle Hall Alternatives in Mon-
treal, where he provides operational due
diligence services to hedge fund inves-
tors. The following new CMPC members
also have been appointed:
Namit Arora, CFA, is a director at Stan-
dard Chartered Private Equity in Mumbai.
Robert Fijalkowski, CFA, is director of risk
and compliance for Healthcare of Ontario
Pension Plan.
54 CFA Institute Magazine Jan/Feb 2013
Bruno Colmant, CFA, is a member of the
management team of Roland Berger in
Brussels.
Martha Freitag, CFA, is a principal at
Martha E. Freitag Consulting in Bellevue,
WA.
CORPORATE DISCLOSURE POLICY
COUNCIL (CDPC)
CFA Institute has appointed Ashwinpaul
Sondhi as chair of the Corporate Disclo-
sure Policy Council, which helps mon-
itor standard-setting activities related
to financial reporting around the globe.
Sondhi, who provides financial consult-
ing and investment advisory services, is
a member of the Emerging Issues Task
Force of the Financial Accounting Stan-
dards Board (FASB). The following new
CDPC members have been appointed:
Richard Schreuder, CFA, is equities port-
folio manager at Saemor Capital in the
Netherlands.
Manoj Bahety, CFA, works in institutional
equity research at Edelweiss Securities in
India, where he follows large-cap compa-
nies listed in India.
Jack Ciesielski, CPA, CFA, owns R.G.
Associates Inc., an investment research
and portfolio management firm in Bal-
timore. He also publishes The Analyst’s
Accounting Observer, a research service
for security analysts.
Brian Gibson, CFA, is former senior vice
president, equities and absolute return
strategies, of Alberta Investment Man-
agement Corp and former senior vice
president, public equities, for the Ontario
Teachers’ Pension Plan.
Erin Greenfield, CFA, is portfolio manager
of the Trimark Global Balanced Fund at
Invesco Canada.
Guy Walker is head of equity research
and consumer sector analyst at Schroder
Investment Management in London.
GIPS EXECUTIVE COMMITTEE (EC)
The nine-member GIPS Executive Com-
mittee is composed of a diverse group of
investment professionals who develop
and promote the adoption and implemen-
tation of the Global Investment Perfor-
mance Standards as the single, global
standard for calculating and presenting
investment performance
Karyn D. Vincent, CFA, CIPM, who pro-
vides GIPS standards consulting and ver-
ification services, is chair of the GIPS Ver-
ification/Practitioner Subcommittee and
also serves on the GIPS EC.
Martin Schliemann, managing director
at Frankfurt Finance, Audit Wirtschafts-
prufungsgesellschaft mbH in Germany, is
chair of the GIPS Council and also serves
on the GIPS EC.
Sue Pike, CFA, CIPM, senior manager
of performance services of Wellington
Management Company, chairs the GIPS
Investment Manager Subcommittee and
also serves on the GIPS EC.
STANDARDS OF PRACTICE COUNCIL (SPC)
CFA Institute has appointed James E.
Hollis, CFA, as chair of the Standards of
Practice Council, which helps develop
and maintain CFA Institute ethical stan-
dards, in particular our Code of Ethics and
Standards of Professional Conduct.
Hollis is managing director of Cutter
Associates in Duxbury, Massachusetts, a
provider of research and consulting ser-
vices to investment management firms.
 ETHICS AND STANDARDS
PROFESSIONAL CONDUCT

DISCIPLINARY NOTICES

REVOCATION
On 11 October 2012, a Review Panel imposed a Revo-
cation of CFA Institute membership and the right to
use the CFA designation upon Chi Keung “Edmond”
Leung (Hong Kong), a charterholder member. The
panel found that Leung violated Standard I Funda-
mental Responsibilities and Standard V(A) Prohibition
against Use of Material Nonpublic Information of the
CFA Institute Code of Ethics and Standards of Profes-
sional Conduct (1999).
In August 2009, the Hong Kong Market Miscon-
duct Tribunal found that Leung engaged in insider
dealing based on material nonpublic information he
received from an equity salesman at another firm. The
tribunal found that Leung was told in confidence by
the salesman that his firm’s investment bankers were
negotiating a below-market-price private placement
for China Overseas Land and Investment (COLI), a
company listed on the Hong Kong Stock Exchange.
Based on this inside information, Leung sold more
than 4 million shares of COLI held by the funds he
managed to avoid a substantial loss from what
he anticipated would be a fall in the market price
following public disclosure of the private placement.
The tribunal concluded that Leung knowingly traded
on the basis of material nonpublic information.
As a result, it barred Leung for eight months from
managing investment funds or dealing in securities.
Leung appealed, and in April 2012, the Court of Appeal
affirmed the decision of the tribunal.
The CFA Institute Review Panel similarly determined
that Leung violated Standard V(A) because he traded
COLI on the basis of material nonpublic information
that was disclosed to him in confidence and that he
knew or should have known was misappropriated by
the salesman at the other firm. In addition, by violating
the laws in Hong Kong relating to insider dealing, Leung
violated Standard I, which requires that members know
and comply with all applicable laws and rules.
SUMMARY SUSPENSION
On 29 August 2012, CFA Institute imposed the sanction
of Summary Suspension upon Grenville M. Gooder,
Jr. (U.S.), a charterholder member, automatically
suspending his CFA Institute membership and right to
use the CFA designation. Gooder was suspended for
his failure to cooperate with a Professional Conduct
Program investigation. Because he did not request
a review within the time provided under the Rules of
Procedure, the Summary Suspension automatically
became a permanent revocation on 1 October 2012.
On 30 July 2012, CFA Institute imposed a
Summary Suspension upon Thabo Ted Moloto (South
Africa) for failure to cooperate with a Professional
Conduct Program investigation of an industry-related
matter. Moloto is a covered person as defined by
CFA Institute Bylaws. Because he did not request a
review within the time provided under the Rules of
Procedure, the Summary Suspension automatically
became a Permanent Prohibition on 30 August 2012.
On 21 February 2012, CFA Institute imposed a
Summary Suspension on Yiu Hoi Yan (Hong Kong). Hoi
Yan was suspended for her failure to cooperate with a
Professional Conduct Program investigation. Because
she did not request a review within the time provided
under the Rules of Procedure, the summary suspension
automatically became a permanent prohibition.
PRIVATE REPRIMAND
On 23 October 2012, CFA Institute imposed a Private
Reprimand upon a Charterholder Member for violat-
ing Standard I(A) Knowledge of the Law and Standard
IV(C) Responsibilities of Supervisors of the CFA Insti-
tute Code of Ethics and Standards of Professional
Conduct (2005).
The Member, the compliance officer of a hedge
fund, consented to pay a monetary fine for failing to
adequately supervise another employee of the fund
who arranged for a trading firm to make undisclosed
payments to the hedge fund to secure a more favor-
able fee for executing certain types of trades. The
regulator found that the hedge fund’s disclosure that
it could engage in unspecified outside business was
inadequate in the circumstances. The hedge fund’s
compliance procedures required that all financially
related business relationships be fully disclosed to its
investors. The Member knew that the hedge fund had
a financially related business relationship with the
trading firm, but he failed to supervise and make sure
that it was fully disclosed to investors.

Now available from the Research Foundation of CFA Institute:

Expected Returns on
Major Asset Classes
Antti Ilmanen
This publication is available online for free in PDF and e-book
format and can be purchased in paperback for US$9.95.
Can the art and science of investment management be reduced to a set of
patterns that markets generally follow, in apparent violation of the efficient
market hypothesis? Can investors reasonably expect to make money from the
knowledge of these patterns, even after they have not only been identified but
also widely exploited? Although one’s first guess might be that the answers to
these questions are no, at least sometimes, the answer is yes.

The Research Foundation funds, publishes, and distributes monographs, literature

reviews, and periodic papers on a variety of relevant investment topics. It traces
its roots to 1965 when one of the predecessor organizations of CFA Institute
established the CFA Research Foundation in an effort to generate research and
publications relevant to the needs of investment professionals worldwide.

Jan/Feb 2013 CFA Institute Magazine 55

 CHAPTER 10
Paradox and Paralysis
A PARADOX CAN BE RESOLVED BY A VALUABLE DISCOVERY—ALWAYS BY SOMEONE ELSE.
By Ralph Wanger, CFA
Why does the sun shine? That sounds
like a really stupid question. We know,
kind of, that a complex fusion process
powers the sun. However, there was a
time when this stupid question was an
unanswerable paradox.
Up to about the year 1800, almost
everyone (in the Western world)
believed, on the basis of strictly literal
biblical studies, that only a few thou-
sand years had elapsed since the cre-
ation of the earth and the sun. By 1860,
VFLHQWLÀFVWXGLHVRIJHRORJ\DQGSDOH-
RQWRORJ\KDGUHYHDOHGDPXFKORQJHU
time scale for the earth.
William Thomson, later Lord Kelvin,
ZDVWKHOHDGLQJSK\VLFDOVFLHQWLVWRIWKH
late 19th century. He made various calcu-
ODWLRQVWKDWVKRZHGWKHDJHRIWKHHDUWK
to be at least 20 million years old and
possibly as old as 400 million years. This
UDQJHLVQRZREYLRXVO\ZD\WRRORZEXW
LWZDVDFKDQJHLQWKHULJKWGLUHFWLRQ
How about the sun? Up until 1800,
WKHUHZDVQRWPXFKVFLHQWLÀFWKHRU\
DERXWHQHUJ\7KHLQYHQWLRQRIWKHVWHDP
HQJLQHFKDQJHGDOOWKDWEHFDXVHIRU
WKHÀUVWWLPHHQJLQHHUVKDGWRXQGHU-
VWDQGKLJKHQHUJ\SURFHVVHV7KHUPR-
dynamics was the science that allowed
WKHHQJLQHHUVRIWKH,QGXVWULDO5HYROX-
tion to invent railroads, automobiles,
JUDYLWDWLRQDO FROODSVH ZRXOG
FUHDWHDORWRIHQHUJ\ZKLFK
would appear as sun-
OLJKW 7KH HQHUJ\
ZRXOGODVWDORQJ
t i me but not
ORQJHU WKDQ 
million years.
The sun could not
be very old.
So, by 1870, scien-
tists had a solar system
with a very old earth
DQGDYHU\\RXQJVXQ
This was obviously
a nonsensical situ-
ation, an unsolved
pa r adox . T hom son
admitted as much but offered
WKHKRSHWKDWVRPHVRXUFHRIHQHUJ\
unknown to him could provide an
explanation. Fusion turned out to be
WKHFRUUHFWDQVZHUDOWKRXJKLWVWLOO
took until the 1930s for scientists to
understand solar fusion.
$V7KRPVRQDJHGKHEHFDPH
FURWFKHW\DQGVNHSWLFDOLQVLVWLQJ
that the earth was not much older
than 20 million years, despite sophis-
ticated calculations by others that put
WKHDJHRIWKHHDUWKLQWKHELOOLRQVRI
years. (Current science today has the
yield to him and accept his views.”
7KHSRLQW,DPIDVFLQDWHGE\
is that for a period of 70 years, in
which all the sciences made enor-
mous advances, no one could reconcile
the data that showed that the earth was
YHU\ROGDQGWKHVXQYHU\\RXQJ7KH
paradox was frequently discussed,
but life went on.
$UH WKHUH VWLOO SDUDGR[HV LQ
VFLHQFH"<HVLQFOXGLQJDELJRQH
7KHJDOD[LHVWKDWPDNH
up our universe are
QRW ´DFWLQJ ULJKWµ
To m a k e c a lc u -
ODWLRQV RI JUDYLW\
match the observable
XQLYHUVH FRVPRORJLVWV QRZ
need “dark matter” and
´GDUNHQHUJ\µ³WZRHQWL-
WLHV ZLWK VWUDQJH FKDU-
DFWHULVWLFVWKDWWRJHWKHU
must make up 96% of
all the matter in the uni-
YHUVH,IGDUNPDWWHUDQGGDUN
HQHUJ\GRH[LVWWKHUHDUHQHZ
laws of physics to be found; if
they don’t exist, the current
ODZV RI SK\VLFV DUHQ·W WUXH $
IDPRXVSUREOHPLQÀQDQFHLVWKH3HWHUV-
EXUJ3DUDGR[7RXQUDYHOLWUHTXLUHVD
column of its own.)
tractors, airplanes, chemical manufac-
WXULQJDQGDLUFRQGLWLRQLQJ$QGWKH
OHDGLQJ WKHRULVW RI WKLV QHZ VFLHQFH
was Thomson.
,Q WKH V KH GHFLGHG WR DQD-
lyze the sun. What caused the sun to
shine? The simplest idea was that the
VXQPLJKWEHDODUJHOXPSRIFRDORQ
ÀUHEXWLWZDVHDVLO\VKRZQWKDWFRP-
bustion would burn up all that coal
in a couple thousand years. Thomson
hypothesized that lots of meteorite
impacts would heat up the sun, but the
number of meteorites required made
this idea unworkable. Hermann von
Helmholtz, a German scientist, calcu-
ODWHGWKDWLIWKHVXQZDVVKULQNLQJLWV
56 CFA Institute Magazine Jan/Feb 2013
DJHRIWKHHDUWKDWELOOLRQ\HDUV Such paradoxes offer lessons pro-
7KRPVRQPDGHKLVODVWFKURQRORJLFDO
estimate in 1897, which put the earth’s
DJHEHWZHHQPLOOLRQDQGPLOOLRQ
years, probably nearer 20 than 40. His
SUHVWLJHDVDVFLHQWLVWZDVVXFKWKDWPLO-
lions of people accepted his erroneous
LGHDVLQFOXGLQJWKHIDPRXVO\VNHSWLFDO
Mark Twain, who wrote in Letters from
the Earth, “6RPH RI WKH JUHDW VFLHQ-
WLVWVFDUHIXOO\FLSKHULQJWKHHYLGHQFHV
IXUQLVKHGE\JHRORJ\KDYHDUULYHGDW
the conviction that our world is prodi-
JLRXVO\ROGDQGWKH\PLJKWEHULJKWEXW
Lord Kelvin is not of their opinion. …
$V/RUG.HOYLQLVWKHKLJKHVWDXWKRULW\
LQVFLHQFHQRZOLYLQJ,WKLQNZHPXVW
fessional investors should learn. First,
JUHDWH[SHUWVFDQEHZURQJ6HFRQG
the existence of an unresolvable para-
GR[VXJJHVWVWKDWWKHUHLVDQLPSRUWDQW
discovery to be made that will solve the
problem. But you are unlikely to be the
RQHZKRLVVPDUWHQRXJKWRGLVFRYHULW
Third, do not allow a paradox to par-
DO\]H\RX7KURXJKRXWKLVWRU\IDUPHUV
planted their crops and harvested them
Illustration by Robert Meganck
ZLWKRXWZRUU\LQJWKDWWKHVXQZRXOG
VXGGHQO\JRRXW&DUU\RQ
Ralph Wanger, CFA, is a trustee of Columbia
Acorn Trust and an adviser at Wanger Invest-
ment Management.
 The Global Leader in CFA® Exam Prep
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