SECTION I

RESEARCH DIRECTOR’S

REPORT

Laurence B. Siegel

Gary P. Brinson Director of Research

CFA Institute Research Foundation

Luis Garcia-Feijóo, CFA, CIPM

Associate Research Director

Florida Atlantic University

In 2019, the Research Foundation disseminated four research monographs, a literature review, and six briefs.

Research Monographs

Beneficiaries First: Guidance for Fiduciaries

In Investment Governance for Fiduciaries, Michael Drew and Adam Walk propose a framework for the effective use of resources by the fiduciary (the agent) in addressing an underlying investment challenge affecting the beneficiary (the principal). Their framework emphasizes process over financial prowess. The focus is on investment governance expertise, not investment expertise, recognizing that achieving investment objectives is the reason the fiduciary relationship exists in the first place. Their framework involves a circular process with the following steps: Objective, Policy, Execute and Resource, Implement, and Superintend (OPERIS). The authors’ work follows up on the Research Foundation’s (RF’s) previous forays into trustee education, including A Primer for Investment Trustees: Understanding Investment Committee Responsibilities (2017) by Jeffrey V. Bailey, CFA, and Thomas M. Richards, CFA.

Engineering a Secure Retirement

William Sharpe said that retirement finance was the toughest engineering problem he had ever worked on. It is difficult to figure out how much to save because (1) you do not know how long you are going to live, (2) you do not know how much money you will need in each year you survive after retirement, (3) you do not know what return you will make on your investments, and (4) if you did know how much you needed to save, you would probably have a heart attack and die (solving the first problem expeditiously).

Jacques Lussier’s Secure Retirement: Connecting Financial Theory and Human Behavior is an engineer’s approach to solving these problems. He uses a series of Monte Carlo simulations to show the impact of each important decision on retirement outcomes. He also shows the impact of combined decisions (say, the decision to save more and invest more aggressively), which is a neat trick made possible by Monte Carlo technology.

Lussier’s analytics are not the only way to address retirement. His monograph is only one in an extensive series of RF works on this general topic. We have, over the years, also published three conference proceedings monographs on retirement organized by Zvi Bodie (2007, 2009, 2012); a literature review on Longevity Risk and Retirement Income Planning (2015); Moshe Milevsky’s 2013 monograph on life annuities; the 2007 monograph Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance, by Roger Ibbotson and three coauthors; and, this year, a brief on tontines (described subsequently).

The Great Headache

The Great Recession did not happen very long ago, but economic conditions have improved. But have they improved at a rate one would expect in a bounce back from the depression-like conditions of 2007–2009? Almost all economists would say no. Something is missing.

In The Productivity Puzzle: Restoring Economic Dynamism, David Adler and Laurence Siegel, who edited this collection of readings, focus on the slow growth of productivity. The authors of the articles in the monograph (many of whom spoke at a 2017 conference on the topic) present viewpoints that are all over the map. Two unifying themes, however, are particularly worth mentioning: (1) The idea that the age of great technological advancement is over—that today’s economy is as good as it is going to get—is absurd. Everyone who has prophesied that “everything worth inventing has already been invented” has turned out to be laughably wrong and will continue to be. (2) Nevertheless, technological change, including change that results in large advancements in standards of living, comes in waves. We may need to wait for another great wave of innovation to see the kind of long-term growth we have come to expect.

The authors suggest various solutions, including better education, apprenticeship programs, infrastructure spending, and increases in basic scientific research.

On Behavioral Finance and Classical Finance

In his monograph Behavioral Finance: The Second Generation, Meir Statman, a pioneer in behavioral thinking about finance, helps to build a bridge between the two sides. He sets forth a “Behavioral Finance 2.0” that describes people as neither rational (the classical assumption) nor irrational (the idea behind BF 1.0) but normal.

In Statman’s words, normal people “want three kinds of benefits—utilitarian, expressive, and emotional—from all activities, products, and services, including financial activities, products, and services.” It is not irrational to want these benefits, so normal people’s wants are consistent with the classical economist’s assumption that people are utility maximizers. Statman’s BF 2.0 offers a different and more complete perspective on what people value—that is, on what they are maximizing when they seek to increase their utility.

For example, those who are underperforming may well be satisfying some component of their utility function other than maximizing return subject to a concern about risk. One does not have to beat the S&P 500 Index, or any other index, to be a successful investor by one’s own lights.

Literature Review

How Performance Attribution Evolved

Carl Bacon, CIPM, provides an authoritative literature review on performance attribution from a historical viewpoint. It is entitled “Performance Attribution: History and Progress.” He starts by explaining what performance attribution is and why it is useful. He reviews the early contributions of the Bank Administration Institute, Peter Dietz, and the group surrounding Gary Brinson and then moves to more modern innovations. The history is valuable in helping the reader to understand how performance attribution evolved from a simple attempt to measure returns into a complex science that has its own journal, an army of sophisticated practitioners, and a large population of clients with varying needs.

Briefs

Money Doctors

A better potential solution to this problem is right in front of our faces. In Tontines: A Practitioner’s Guide to Mortality-Pooled Investments, Richard K. Fullmer, CFA, reaches back in time to an invention by Lorenzo de Tonti, a 17th-century Italian banker (hence the name “tontine”). A group of people pool their assets so that as each one dies, the surviving group members share the remainder.

In Charlotte Beyer’s brief, Relationship Alpha: The Emerging Competitive Advantage in Wealth Management, she suggests that a private wealth advisor must develop a long-term relationship with his or her client in order to better determine the client’s goals (risk aversion and investment objective), the best course of action and possible hurdles (e.g., taxes), and the level of financial sophistication expected at client meetings. The relationship must also help the client better understand the advisor’s capabilities and limitations. In short, the advisor must become a “money doctor” (to borrow a term from a related academic research piece published in the Journal of Finance).¹

A Somewhat Unhappy Anniversary

We still do not know exactly what went wrong in the global economy and financial markets between the summer of 2007 and the spring of 2009. There are many guilty parties. Whatever the proximate cause, the meltdown was spectacularly awful. No living market participant had ever seen anything like it.

To address this fiasco, New York University and the Annual Review of Financial Economics convened a group of central bankers and economic researchers to reflect on the causes, events, and long-run out-comes of the Global Financial Crisis. This event took place around the 10th anniversary of the crisis, hence the title of the Research Foundation’s brief based on the conference, Ten Years After: Reflections on the Global Financial Crisis.

The highlight was the central banker roundtable, which featured Stanley Fischer as moderator(!) and Ben Bernanke, Lord Mervyn King, and Jean-Claude Trichet as the principal speakers. All four were heads of central banks at the time of the crisis.2 Their comments, as well as those of the many other economists who participated in the conference, are available on video at the RF website as well as in the brief.

Tontines: Betting on a Long Life

One of the oddest missing links in the financial system is the absence of a secure, transparent, and low-cost mechanism for investors planning for retirement to insure against longevity risk. The mirror image of mortality risk (the risk of dying), longevity risk is the risk of outliving one’s money. Life annuities are a step in the right direction, but most are overpriced and opaque as to both costs and benefits.

Fullmer’s RF brief develops the tontine idea into a full-fledged suite of hypothetical financial products. He shows the math behind a design that would allow participants of different ages and/or life expectancies to enter a tontine pool at actuarially fair prices. This approach would make the formation of large, anonymous pools practical.

Endowment Funds: Providing Perpetual Support for Education

Endowment funds play a central role in supporting the long-term survival and smooth operations of colleges and universities, but donations and market performance fluctuate, making sound management imperative. In this context, Richard Franz and Stephan Kranner’s brief, University Endowments: A Primer, offers an excellent overview of both how endowments work and how they should work. Assets under management at college and university endowments in the United States totaled approximately $570 billion as of June 2017.

Endowments have some unique features. Their time horizon is not merely long term; it is perpetual, giving them an advantage in earning an illiquidity premium. But illiquidity can also pose a risk, because schools typically have the greatest need of liquidity for spending when it is least available. Franz and Kranner cover these and other important issues in endowment management.

Setting Spending Rates for Endowment Funds and Similar Institutions

Setting spending rates for individuals with a limited but unknown length of life is difficult because of longevity risk: We do not know how long the money needs to last. But why does setting spending rates for perpetual endowment funds and for other long-lived trusts seem equally hard? Universities, foundations, and families have wrestled with this problem seemingly forever and have come up with a variety of conflicting answers:

Spend only investment “income.”
Spend income and realized but not unrealized capital gains.
Spend an amount each year that is fixed in constant dollars (i.e., ratchet up spending each year by the inflation rate).
Spend a fixed percentage of the market value of the assets each year.
Decide how much to spend each year.

The second-to-last answer, a fixed percentage of market value (or some variant, such as a fixed percentage of a rolling three-year average of market values), is currently in favor. The Ford Foundation advocated this method in an influential 1969 report, and the approach is still with us a half-century later. But the question remains open.

Although “income” can be a legal or accounting concept, the word also has an economic meaning: namely, what you can consume in a given period without being worse off at the end of the period (in real terms) than at the beginning, assuming no change in market valuations. In the RF brief A Cash-Flow Focus for Endowments and Trusts, James Garland, CFA, builds on this concept to define the “fecundity” of an asset in exactly that way. (Fecundity, in biology, is the fertility of an organism per unit of time—high for rabbits, low for elephants.) For bonds, fecundity is yield, minus an allowance for defaults if the bond is risky; for stocks, it is a concept akin to free cash flow, representing the economic profit of the company.

A spending rule tied to fecundity (and ignoring market values) will give very different results from the currently popular rule specifying a percentage of market value. It will increase spending, relative to the market-value rule, when markets are cheap and will decrease it when markets are expensive. It will also produce a smoother spending path. Each institution or individual will have to decide which spending rule makes the most sense in that institution’s or individual’s particular situation.

African Local Capital Markets: Past, Present, and Future

Demographic trends and economic growth expectations indicate that future investment opportunities with attractive risk–return profiles will likely come from outside developed markets. In particular, African markets are regarded with promise. They are, however, not a unitary construct. For example, MSCI classifies South Africa and Egypt as emerging; Kenya, Mauritius, Morocco, Nigeria, Tunisia, and the countries in the West African Economic and Monetary Union as frontier; and Botswana and Zimbabwe as neither emerging nor frontier, although they have their own standalone market indices. Some countries export oil and gas; others, precious metals and minerals or coffee; and yet others, non-commodities such as textiles. Furthermore, sovereign and corporate bond markets, as well as exchange-traded funds, need to be understood in these countries.

The brief African Capital Markets: Challenges and Opportunities, produced in collaboration with the African Securities Exchanges Association (ASEA), addresses these issues for South Africa, Namibia, Botswana, Zimbabwe, Mauritius, Kenya, Tanzania, Uganda, Rwanda, Nigeria, Ghana, Egypt, and Morocco and presents aggregate data on the size and liquidity of the equity and fixed-income markets in these countries.

¹Nicola Gennaioli, Andrei Shleifer, and Robert Vishny, “Money Doctors,” Journal of Finance 70 (February 2015): 91–114.
²Respectively, in Israel, the United States, the United Kingdom and at the European Central Bank.