CFA Institute

“Our monetary policy deliberations and decisions build on what we have learned about inflation dynamics both from the high and volatile inflation of the 1970s and 1980s, and from the low and stable inflation of the past quarter-century. These lessons are guiding us as we use our tools to bring inflation down. . . . We will keep at it until we are confident the job is done.” — Jerome Powell, 26 August 2022 In “The Eye of the Storm: The Fed, Inflation, and the Ides of October,” I recommended that investors temper their enthusiasm in response to a strong equity market rally and not underestimate the US Federal Reserve’s resolve in its battle against inflation. On 26 August 2022, Fed chair Jerome Powell spoke at the annual Jackson Hole Economic Symposium. His forceful language and deliberate references to the lessons of history laid to rest any hope that the Fed will shift away from its tightening strategy. Equity markets responded with sharp declines. The Fed leadership has struggled over the last nine months to convince the markets that its dovish bias of the past 40 years no longer applies. What explains the communication challenge? Many investors simply do not understand that this is a rare and dangerous inflationary event. The inflation of 1919 to 1920 that followed World War I and the Great Influenza is the most relevant parallel. Although such major crises often lead to temporarily high inflation, the Fed still must act aggressively to contain it. Failure to do so could allow temporary inflation to transform into a repeat of the Great Inflation of the 1970s and early 1980s. In his speech, Powell emphasized three distinct lessons from financial history that explain the Fed’s approach. By framing the speech around these lessons, he showed that the Fed recognizes the severe danger if inflation persists at today’s elevated levels, that it accepts its unique responsibility to eliminate this risk, and that it is committed to avoiding its predecessors’ mistakes regardless of the short-term pain that will likely entail. 1. “The first lesson is that central banks can and should take responsibility for delivering low and stable inflation.” In the Fed’s 108-year history, the Great Inflation stands out among its gravest errors — rivaled only by the Great Depression. The flawed monetary policies of this period resulted, in part, from the common belief that the Fed was obligated to synchronize monetary and fiscal policy. When successive US presidents pursued overly expansionary fiscal policies, such as the Great Society and the Vietnam conflict, the Fed’s leadership hesitated to counterbalance them with contractionary monetary policy. In 1965, after the Fed pushed for higher interest rates (or cuts in spending), President Lyndon Johnson reportedly pinned the Fed chair, William McChesney Martin, Jr., against a wall at his Texas ranch and shouted, “Martin, my boys are dying in Vietnam and you won’t print the money I need.” When President Richard Nixon was asked whether he respected Fed chair Arthur F. Burns’s independence, he responded, “I respect his independence. However, I hope that independently he will conclude that my views are the ones he should follow.” Such coercion was not easy for the Fed to resist. But Powell has now made it clear that central banks can and should take responsibility for delivering low and stable inflation, thus signaling that the Fed will resist any potential political pressure. 2. “The second lesson is that the public’s expectations about future inflation can play an important role in setting the path of inflation over time.” Powell understands the enormous risk long-term high inflation poses to the US economy. The Fed’s experience during the Great Inflation is instructive. Under Martin, the Fed had the opportunity to extinguish inflation in the late 1960s. It failed to act, and its inaction did not go unnoticed: Market participants began incorporating higher inflation expectations into their future plans. Once higher inflation was entrenched in the economy, it became much more difficult to unwind. Indeed, Fed chair Paul Volcker had to raise interest rates all the way to 20% in 1981. History shows that lowering inflation expectations requires much more aggressive and sustained monetary tightening. That’s why it is critical to prevent higher inflation expectations from taking root in the first place. Powell’s statement shows the Fed is aware of this risk and recognizes that time is running out. 3. “That brings me to the third lesson, which is that we must keep at it until the job is done.” “Keep at it” evokes Paul Volcker, the Fed chair who triumphed over the longest lasting inflation crisis in the nation’s history. This reference reveals that Powell understands the severe consequences of the Fed’s half-hearted efforts to tighten monetary policy under Martin and Burns. The truth is that the Fed’s leadership in the 1960s and 1970s understood that inflation was damaging; they were just unable (or unwilling) to bear the costs of ending it. Each time they engaged in monetary tightening, they prematurely reversed course in response to rising unemployment. The public correctly interpreted the Fed’s lack of resolve as a sign that high inflation would continue. By the time Volcker announced a new strategy in October 1979, it required several years of pain to convince the public that he was serious. Powell’s recognition that the Fed “must keep at it until the job is done,” sends a clear message that a potential recession or uptick in unemployment will not stop the Fed from further monetary tightening. The Fed’s primary goal is to reduce inflation to its 2% target. An economic recession and job losses are, in Powell’s words, “unfortunate costs of reducing inflation.” These costs are worth it, however, because “a failure to restore price stability would mean far greater pain.” Those who recall the stagflation years of the 1970s can attest to the fact that one day we will be thankful for the Fed’s resolve. Future Outlook Powell’s statement at Jackson Hole reiterated that the Fed leadership understands why the

Risk is an inherent part of both investing and career growth. While being cautious can protect against losses, avoiding risk altogether comes with its own set of dangers — missed opportunities, underperformance, and stagnation. Historically, women are perceived as more risk-averse in investing and professional decision-making. Taking calculated risks is essential for success, however, whether it’s investing in alternative assets, negotiating compensation, or making bold career moves. In today’s competitive landscape, professionals who embrace risk thoughtfully are better positioned to drive innovation, achieve financial independence, and create lasting impact. Last month, I moderated a discussion at the Inspirational Women Forum & Leadership Awards, “The Risks of Being Risk Averse,” hosted by the Los Angeles Times. In this blog post, I’ll share insights (lightly edited) from two of the panelists, Amber Ortiz and Lara Shortz, about women and risk. Why have women historically been risk-averse? Barbara Stewart, CFA: We earned this stereotype, honestly. Historically, “risky” in the world of investing was defined by investing in equities versus fixed income or cash. Thirty years ago, over 60% of US men invested in stocks compared to only 40% of women, leaving an investment gap when it came to stocks. But times have changed. In the 2001 to 2008 period, 65% of men and 59% of women owned stocks. By 2009 to 2017, the gap narrowed further: 56% of men and 52% of women invested in equities. The 2024 Gallup data shows that in fact 63% of women own stocks versus 62% of men. In what situations do women continue to show an aversion to risk? Lara Shortz: One case in point is that many women executives are apprehensive about having tough conversations around pay increases/promotions. They often have a harder time with these conversations. Pay equity has improved for younger professionals, but at the senior level, particularly for women executives, the pay gap often widens over time and becomes much harder to bridge. This is not usually the result of intentional bias. It’s more about systemic factors. For example, women tend to change jobs less frequently, which limits opportunities to renegotiate pay. Yet, when hiring new talent, companies often offer higher salaries to attract candidates. The net effect is this: If women aren’t making career moves, they’re missing out on crucial pay discussions. Over time, this dynamic makes conversations about raises or promotions even more challenging. Amber Ortiz: Risk is multifaceted and can be influenced by several factors. I would argue that women are not risk averse but instead risk aware. Women take the time to understand the risk and evaluate all the potential drawbacks and how a decision might affect the those they care about most families, companies, and society.  What are the risks of being risk-averse? Barbara Stewart, CFA: In my most recent research “Women & Alts: A Global Perspective” commissioned by private equity firm Kensington Capital Partners, my key finding was that globally men have double the exposure to alternative investments than women. This is largely due to structural barriers in place such as lack of a network effect for women and macho-themed sales and marketing around alts. Whether low-alt exposure is actually due to risk aversion or other factors, what is clear is that underexposure to what is traditionally seen as a higher-risk asset class is a risk for female investors. Lara Shortz: In an increasingly competitive market, organizations need to foster a culture of innovation and experimentation. Why? Because in a competitive market you need to constantly think about ways to retain your talent. This requires a lot of creativity. It also depends on the environment. For example, in my business of law — a traditionally risk-averse business — having an entrepreneurial environment focused on professional development is not common for law firms. We are creating a very positive, forward-thinking cultural environment. In industries with fast-moving and highly creative environments, it is also important to provide clarity and stability for your team. In my view, being intentional and transparent about your business’s goals and the culture you’re building is key to helping people feel supported and motivated. Amber Ortiz: Underperformance and regret. This is true for both investment performance and business success. Risk is relative, and your tolerance continues to shift and shape as time passes. People evaluate potential risk and return differently. Risk can be highly subjective and dependent on the influences surrounding the decision. Not only should we spend time evaluating the negatives aspects of risk, but we also need to talk about how opportunities, creativity, growth, and resilience come from taking risk. There have been multiple studies that conclude that women generate better investment performance than men. Men tend to be more decisive and confident when making decisions due to their ability to compartmentalize, while women evaluate all angles and impacts an investment or decision might have on their family, business, liquidity, or even society. We need to remember that we face risk in almost every decision and as leaders we must inspire confidence and encourage risk-taking while also maintaining a prudent approach to decision-making. How can women replace risk-aversion with risk-awareness? Amber Ortiz: Take space and be involved. I suggest that you build a team of advisors you trust and respect and who listen and communicate effectively. Building a relationship with those who are advising you and your family is key. Surround yourself with like-minded women. I hold intimate all-women conversations (10-15 people) where we dive into a specific topic like estate planning, investing in real estate, and generational gaps. These all-women sessions provide space to ask questions, share stories of failure and success, and build a community of people that might have experienced a similar situation or have similar concerns. Lara Shortz: My best advice is to focus on what you do best and outsource the rest. For example, when it comes to negotiating compensation, having a lawyer handle it for you can create a completely different dynamic. It removes personal bias like questions about being too assertive and focuses attention on the terms

Demographics Unravelled: How Demographics Affect and Influence Every Aspect of Economics, Finance and Policy. 2021. Amlan Roy. Wiley. Demographics are destiny. This cliché will cause some investors to nod their heads in agreement, yet it provides little meaning. Demographics are often used to bolster an investment narrative, yet the rich details on their link with asset returns are often missing. Amlan Roy, an economist working on the intersection between demographics and investments, provides a comprehensive review for how the study of population affects many of our core investment and policy decisions. This volume covers all issues associated with population dynamics, from aging to geographical movement, and can serve as a comprehensive guide on how demographics affect asset pricing, pension management, health, retirement, and policy. Rather than just a problem of birth, deaths, and aging, Roy frames demographics as a driving factor on returns from the combination of tastes and numbers. Population numbers count, but tastes and the changing behaviors of different age groups drive markets. The book is divided into six major topic areas: core demographic foundations; population dynamics; the impact of demographics on the macroeconomic environment; the link between demographics and asset prices; problems of health and longevity across populations, pensions, and retirement; and the effect of demographics on quality of life, gender, governance, and sustainability. Each topic is linked to long-term returns and relative prices across asset classes and market sectors. The core population issues, which are the base for demographic analysis, are all well presented. Aging, life expectancy, fertility, and dependency generate economic problems that must be addressed by both investors and policymakers. Population changes generate headwinds and tailwinds for policy and asset prices that cannot be escaped and do not have simple solutions. Roy discusses how decisions made more than a generation ago will support or plague future generations, forcing countries to transition between population shortages and excesses. One country may face birth excesses while another grapples with aging. Each affects capital allocations and returns. Roy, through clear graphical analysis, highlights the dynamics of these core issues. The demographics and macroeconomics chapter drives home the core observation that population dynamics create market constraints. Demographics affect economic growth, living standards, inflation, public debt, capital flows, and exchange rates. The dynamics of population influence relative country growth as consumers age and move through their life cycles. The population mix sets policy preferences through voting and drives policy choice constraints. Bulges in population will constrain opportunities for both older and younger citizens. Roy dusts off the core consumption theory (the life-cycle and permanent income hypotheses) and links population changes with asset price behavior. As populations move through the aging process, their behaviors switch from spending to saving and thus influence the demand for risky and safe assets. Whether it be the equity premium or real interest rates, population dynamics will always pressure returns. As is well-documented for China and India, population dynamics coupled with tastes also drive commodity markets. Roy emphasizes the critical point that age by itself does not drive markets. The combination of population and tastes generates demand pressure on markets. Populations desire to survive and extend longevity, so health becomes a core focus with respect to expenditures. Just as fertility drives demographics, life extensions stretch the population with new demands. As incomes rise, there is a corresponding change in the composition of populations, and the demand for better health services increases. Longevity changes tastes and marches headlong into issues surrounding quality of life. Longevity and the aging of the population focus on the key investment issues of retirement and pensions. Flowing back to consumption models, Roy explains how if you expect to live longer, retirement planning and health care costs become even more important. When aggregated across generations, pension decisions weigh critically on returns and the asset management and insurance businesses. Trillion of dollars are being allocated to address a highly uncertain problem. Who will pay and at what costs are critical pension issues that are only exacerbated when the population structure bulges for older generations. The book ends with a discussion on such core issues as quality of life, gender, governance, and sustainability. Views toward gender and work upend many past demographic assumptions. Longevity shines a spotlight on happiness and life quality, while intergenerational transfers represent more than wealth and include the state of the world. These issues are hard to quantify, but Roy provides a holistic approach through connecting these topics to the core assumption that demographics coupled with tastes define our future. Demographics Unravelled provides an extensive and well-documented review of the finance and economic research influenced by demographics. This allows the reader to be exposed to the key topic research; however, it makes for a lengthier and less lively work that at times reads like an academic literature review with an author citation and conclusion approach. The graphics are extremely helpful in visually telling the demographic story, but these complex graphs are at times hard to read in their black and gray template. Roy does provide in one volume everything an investor should know about the impact of demographics on investing; nevertheless, connecting the research to core investment questions would have resulted in a more compelling story. Given the author’s long history of consulting in this area, it would have been helpful to show readers how to integrate the background research with investment decisions. For example, how should a pension investment committee use this information to improve allocation decisions? The answers are not immediately obvious. While demographics are destiny, our future can change with the right thinking. Demographics drive demand and pricing, but with the right lens, we can see these trends better and adapt to these headwinds and tailwinds. If a reader wants to be up to speed on demographics, this is the book to read. Demographics Unravelled should generate deeper discussions on the integration of demographics with investing, and if investment committees take the time to integrate this thinking, the result may be better performance. If you liked this

The debate about private market fund valuations and volatility has returned to center stage. To quote Mohamed El-Erian, some private equity managers believe “their asset class would avoid the reckoning that stocks and bonds have been exposed to this year because they were structurally immunised against disruptive changes in the investment landscape.” El-Erian says that this “may prove to be misplaced self-confidence,” while Cliff Asness describes it as “volatility laundering.” From a capital market perspective, how can investors price net asset value (NAV) valuations and efficiently transfer their eventual risk? We have developed an actionable framework. The best way to offer investment commentary is to walk the talk and take a side in a trade. If you think that a NAV’s valuation is low, you should buy at that price. If you think it’s high, you should sell. There should be a proper mechanism in place to reward such forward-looking, relative value trades. As a consequence, an investor could monetize a higher or lower return — a positive or negative risk premium — versus other allocations over a given time horizon. The Problem Private market valuations are still opaque, which makes it difficult for investors to determine the value of private assets. Unlike in listed markets, private market prices are not publicly available and the methodologies by which valuations are derived are often a mystery. Still, private market investments can’t ultimately conceal their true results. Their self-liquidating structures are intrinsically objective. Volatility can’t be laundered indefinitely. In the end, the total value produced over time will be converted to cash. Before liquidation, even when private market returns are measured with an accurate methodology, they are heavily influenced by the on-paper gains and losses of the estimated interim NAVs. General partners have different philosophies about what is a fair NAV valuation. Some have a mark-to-market outlook, while others take a less sensitive stance on market risk. Not all private market fund valuations are born equal. Indeed, the International Private Equity and Venture Capital Valuation (IPEV) Guidelines dictate several valuation methodologies for deriving the fair value of private funds. These run the gamut from comparable transaction multiples to discounted cash flow methodologies to quoted investment benchmarks. Nevertheless, the Financial Accounting Standards Board (FAS 157 – ASC 820) places the focus on fair value, with an emphasis on the exit value, or the expected proceeds from the sale of the given asset. While private market investments tend to be held for the long term, their fund’s liquidation mechanism gives their mark-to-market the final say. Only when portfolio assets are sold does the seller discover what the market is willing to pay. If the paper valuations of those assets do not reflect their corresponding secondary market price, the buyer may seek to negotiate a discounted price and thereby increase their probability of a positive risk premium. The Way Forward Our research has sought to explain and maximize the value of time-weighted metrics in private market investments. Why? Because private market assets should be comparable to all other asset classes and easier to comprehend. This will make the asset class more usable, improve portfolio and risk management, and reduce the idiosyncratic inefficiencies of the undrawn cash or overallocations. Our investigations have yielded many first-of-their-kind private market solutions. Valuation Transparency Through our duration-based calculation methodology, we measure the time-weighted performance of private market investments and establish a real-time valuation link with the public markets that makes volatility explicit and eliminates delays or lack of estimates. This rules-based probabilistic framework is grounded on a robust benchmarking approach. Investors can nowcast and objectively assess the mark-to-market quality of the NAV of their private market investments. Price Discovery With real-time, time-weighted indexing techniques, the duration-adjusted return on capital (DARC) methodology constructs a curve of forward returns for private market funds that ties ex-post performance to forward-looking expectations. Only time-weighted returns can be traded over time, and the DARC makes private funds tradable over future maturities. With our Private Fund Forward Exchange (PRIFFE), investors can test the potential of current NAVs to deliver equivalent cash in the future, anticipate the expected forward returns over the targeted time horizon, and manage the volatility of the mark-to-market. The premise behind our approach is that money on the table can take advantage of the staleness of misplaced private market NAVs — hence the PRIFFE acronym, which plays off of “priffe,” or money in the 19th-century Roman dialect, and priffe, a traditional Swedish card game with bids and contracts. Leveling the Playing Field for Private Market NAVs A conventional rationale for private market investments is that their “stale” valuation profile reduces the volatility of a typical multi-asset portfolio and provides return stability. But this is only true for short-term declines in valuations. Private market fund reporting has a lag of several months and may benefit from hindsight. Since the global financial crisis, we have yet to see a prolonged period of asset repricing. Hopefully, we won’t see one again, though that may be wishful thinking given the current economic framework. If such repricing occurs, private market investments have no way out. Market conditions will always influence the exit values and returns of private investment portfolios. Even assuming stable valuations, the liquidation process may take time, reducing returns. In uptrend cycles, like that of the last decade, duration and market risks are often neglected, but they track private market investments through the ups and downs. Mark-to-market just makes them more visible. Going forward we need to anticipate and manage the mark-to-market adjustments to increase transparency around private fund investments. Private market funds that adopt a mark-to-market approach may exhibit more volatility and seemingly even underperform in certain market conditions. But they offer investors three important advantages: Despite the usual reporting lag, investors can calculate more robust now-casted NAV estimates. The more consistent the starting point, the lower and more random the estimation error. Such NAV data makes investors’ balance sheets more resilient and eliminates the negative performance spiral that results from the artificial denominator

In today’s data-driven investment environment, the quality, availability, and specificity of data can make or break a strategy. Yet investment professionals routinely face limitations: historical datasets may not capture emerging risks, alternative data is often incomplete or prohibitively expensive, and open-source models and datasets are skewed toward major markets and English-language content. As firms seek more adaptable and forward-looking tools, synthetic data — particularly  when derived from generative AI (GenAI) — is emerging as a strategic asset, offering new ways to simulate market scenarios, train machine learning models, and backtest investing strategies. This post explores how GenAI-powered synthetic data is reshaping investment workflows — from simulating asset correlations to enhancing sentiment models — and what practitioners need to know to evaluate its utility and limitations. What exactly is synthetic data, how is it generated by GenAI models, and why is it increasingly relevant for investment use cases? Consider two common challenges. A portfolio manager looking to optimize performance across varying market regimes is constrained by historical data, which can’t account for “what-if” scenarios that have yet to occur. Similarly, a data scientist monitoring sentiment in German-language news for small-cap stocks may find that most available datasets are in English and focused on large-cap companies, limiting both coverage and relevance. In both cases, synthetic data offers a practical solution. What Sets GenAI Synthetic Data Apart—and Why It Matters Now Synthetic data refers to artificially generated datasets that replicate the statistical properties of real-world data. While the concept is not new — techniques like Monte Carlo simulation and bootstrapping have long supported financial analysis — what’s changed is the how. GenAI refers to a class of deep-learning models capable of generating high-fidelity synthetic data across modalities such as text, tabular, image, and time-series. Unlike traditional methods, GenAI models learn complex real-world distributions directly from data, eliminating the need for rigid assumptions about the underlying generative process. This capability opens up powerful use cases in investment management, especially in areas where real data is scarce, complex, incomplete, or constrained by cost, language, or regulation. Common GenAI Models There are different types of GenAI models. Variational autoencoders (VAEs), generative adversarial networks (GANs), diffusion-based models, and large language models (LLMs) are the most common. Each model is built using neural network architectures, though they differ in their size and complexity. These methods have already demonstrated potential to enhance certain data-centric workflows within the industry. For example, VAEs have been used to create synthetic volatility surfaces to improve options trading (Bergeron et al., 2021). GANs have proven useful for portfolio optimization and risk management (Zhu, Mariani and Li, 2020; Cont et al., 2023). Diffusion-based models have proven useful for simulating asset return correlation matrices under various market regimes (Kubiak et al., 2024). And LLMs have proven useful for market simulations (Li et al., 2024). Table 1.  Approaches to synthetic data generation. Method Types of data it generates Example applications Generative? Monte Carlo Time-series Portfolio optimization, risk management No Copula-based functions Time-series, tabular Credit risk analysis, asset correlation modeling No Autoregressive models Time-series Volatility forecasting, asset return simulation No Bootstrapping Time-series, tabular, textual Creating confidence intervals, stress-testing No Variational Autoencoders Tabular, time-series, audio, images Simulating volatility surfaces Yes Generative Adversarial Networks Tabular, time-series, audio, images, Portfolio optimization, risk management, model training Yes Diffusion models Tabular, time-series, audio, images, Correlation modelling, portfolio optimization Yes Large language models Text, tabular, images, audio Sentiment analysis, market simulation Yes Evaluating Synthetic Data Quality Synthetic data should be realistic and match the statistical properties of your real data. Existing evaluation methods fall into two categories: quantitative and qualitative. Qualitative approaches involve visualizing comparisons between real and synthetic datasets. Examples include visualizing distributions, comparing scatterplots between pairs of variables, time-series paths and correlation matrices. For example, a GAN model trained to simulate asset returns for estimating value-at-risk should successfully reproduce the heavy-tails of the distribution. A diffusion model trained to produce synthetic correlation matrices under different market regimes should adequately capture asset co-movements. Quantitative approaches include statistical tests to compare distributions such as Kolmogorov-Smirnov, Population Stability Index and Jensen-Shannon divergence. These tests output statistics indicating the similarity between two distributions. For example, the Kolmogorov-Smirnov test outputs a p-value which, if lower than 0.05, suggests two distributions are significantly different. This can provide a more concrete measurement to the similarity between two distributions as opposed to visualizations. Another approach involves “train-on-synthetic, test-on-real,” where a model is trained on synthetic data and tested on real data. The performance of this model can be compared to a model that is trained and tested on real data. If the synthetic data successfully replicates the properties of real data, the performance between the two models should be similar. In Action: Enhancing Financial Sentiment Analysis with GenAI Synthetic Data To put this into practice, I fine-tuned a small open-source LLM, Qwen3-0.6B, for financial sentiment analysis using a public dataset of finance-related headlines and social media content, known as FiQA-SA[1]. The dataset consists of 822 training examples, with most sentences classified as “Positive” or “Negative” sentiment. I then used GPT-4o to generate 800 synthetic training examples. The synthetic dataset generated by GPT-4o was more diverse than the original training data, covering more companies and sentiment (Figure 1). Increasing the diversity of the training data provides the LLM with more examples from which to learn to identify sentiment from textual content, potentially improving model performance on unseen data. Figure 1. Distribution of sentiment classes for both real (left), synthetic (right), and augmented training dataset (middle) consisting of real and synthetic data. Table 2. Example sentences from the real and synthetic training datasets. Sentence Class Data Slump in Weir leads FTSE down from record high. Negative Real AstraZeneca wins FDA approval for key new lung cancer pill. Positive Real Shell and BG shareholders to vote on deal at end of January. Neutral Real Tesla’s quarterly report shows an increase in vehicle deliveries by 15%. Positive Synthetic PepsiCo is holding a press conference to address the recent product recall. Neutral Synthetic Home

On February 27, 2024, Investing in U.S. Financial History was published, capping off my exhaustive four-year effort to document the financial history of the United States. The book begins with Alexander Hamilton’s brilliant financial programs in 1790 and ends with post-COVID-19 inflation in 2023. Now that the book promotion process is winding down, I am returning to my second passion, which is serving as an advisor to institutional investment plan trustees. This blog post draws from several chapters of my book, as well as on my more than 12 years’ experience as an investment consultant. It is framed around five quotes that relate to the fulfillment of a trustee’s fiduciary duties. If you serve as a trustee of an institutional investment plan, these quotes may help guide your decisions for the benefit of those who depend on your stewardship. Quote 1: “A trustee may only incur costs that are appropriate and reasonable in relation to the assets, the purpose of the trust, and the skills of the trustee…Wasting beneficiaries’ money is imprudent.” — Uniform Prudent Investor Act (1994) A trustee’s scarcest asset is rarely found in the portfolios they oversee. In fact, their scarcest asset is their time. Trustees typically convene quarterly for a few hours, which forces them to depend heavily on advice provided by investment consultants, professional staff, and asset managers. Over the past several decades, these advisors have encouraged trustees to add actively managed funds and expensive alternative asset classes. The Uniform Prudent Investor Act (UPIA) requires fiduciaries to evaluate whether these incrementally higher costs are worth it, but few pause to consider their obligation to make such determinations. Perhaps, reciting this quote before every decision — especially those that result in substantially higher fees — may serve as an inexpensive but powerful hedge against unintentional financial waste. Quote 2: “More often (alas), the conclusions can only be justified by assuming that the laws of arithmetic have been suspended for the convenience of those who choose to pursue careers in active management.” — Nobel Laureate William Sharpe (1991) Investment consultants and investment staff frequently recommend heavy use of active managers without considering the preponderance of evidence demonstrating that active management is highly unlikely to add value. Skeptics of this approach need only review the exceptional performance of the Nevada Public Employees’ Retirement System (PERS) to validate their concerns. Employing only two staff members and allocating roughly 85% of the portfolio to index funds, Nevada PERS boasts 10-, 15-, and 20-year returns that exceed roughly 90% of public pension plans with more than $1 billion in assets. When presented with these exceptional results, consultants and staff may deny the reality of the fundamental mathematical principles underpinning them or argue that they are exceptions to the rule. Trustees, in turn, often accept such explanations at face value even though the arguments are rarely backed by credible track records. This being the case, as a rule of thumb, if consultants or staff fail to demonstrate convincingly why they are uniquely capable of choosing the best fund managers repeatedly and sustainably for decades to come, the most prudent action is to assume that they are not. Quote 3: “You don’t want to be average; it’s not worth it, does nothing. In fact, it’s less than the market. The question is ‘How do you get to first quartile?’ If you can’t, it doesn’t matter what the optimizer says about asset allocation.” — Allan S. Bufferd, former treasurer Massachusetts Institute of Technology (2008) In 2000, David Swensen, the former CIO of the Yale Investments Office, published Pioneering Portfolio Management. The book detailed many techniques that he employed to produce returns that far exceeded those of his peers. The key to Yale’s success was the presence of an extremely talented CIO, stable and prudent governance, and a unique learning culture that enabled team members to replicate Swensen’s talents. The critical importance of these oft overlooked capabilities is covered in a subsection of Investing in U.S. Financial History entitled “Pioneering People Management.” Relying on this rare ecosystem, Yale repeatedly chose the best fund managers — especially in alternative asset classes like venture capital, buyout funds, and absolute return funds. After reading Pioneering Portfolio Management, rather than concluding that Yale’s ecosystem was exceptionally rare and difficult to replicate, investment staff, consultants, and OCIOs mistakenly assumed that mere access to alternative asset classes was a reliable ticket to Yale-like returns. The problem with that assumption is that even 15 years ago it was well established that Yale’s returns depended on consistent and sustainable selection of top-quartile fund managers. Without a Yale-like ecosystem in place, accomplishing this feat in the dangerous and expensive realm of alternative asset classes is highly unlikely, and failure to generate top-quartile returns is a recipe for mediocrity or worse. Therefore, before establishing or continuing to allocate to alternative asset classes, trustees should ask whether they and/or their advisors possess Yale’s capabilities. An honest answer in almost all cases is, “No.” Quote 4: “You either have the passive strategy that wins the majority of the time, or you have this very active strategy that beats the market…For almost all institutions and individuals, the simple approach is best.” – David Swensen, former CIO of Yale Investments Office (2012) Nobody understood the difficulty of outperforming ruthlessly efficient markets and dangerously opaque alternative asset classes better than Swensen himself. This is why he concluded that nearly all institutional and individual investors would produce better long-term outcomes by investing entirely in low-cost index funds. Sadly, the main reason this message never reaches boardrooms and investment committee meetings is because the people who advise trustees almost always suffer from a deep-seated fear that it will result in their own obsolescence. One of the greatest tragedies is that the opposite is true. Once advisors rid themselves of the hope and dream that they are among a tiny subset of investment professionals who can outwit the ruthless efficiency of markets, they can refocus trustees’ scarce time on addressing real financial challenges that are

These Are the Plunderers: How Private Equity Runs — and Wrecks — America. 2023. Gretchen Morgenson and Joshua Rosner. Simon & Schuster. In 1970, Milton Friedman penned an influential editorial in The New York Times stating that business had one social responsibility: to increase profits. The Friedman doctrine focuses on managers in their role as agents for owners. As Friedman points out, managers, as individuals, may have many responsibilities to their family, country, and community. However, in such cases, individuals are principals, not agents, and do not represent the interests of others. The exception to profits as the sole responsibility, Friedman points out, is when a group sets up a corporation for charitable purposes, such as a hospital or school. In These Are the Plunderers: How Private Equity Runs — and Wrecks — America, Gretchen Morgenson and Joshua Rosner attempt to pull back the curtain on the opaqueness of the private equity industry. Morgenson and Rosner contend that private equity (PE) has gone far beyond the Friedman doctrine and has even applied the goal of maximizing profits to formerly not-for-profit organizations. The book’s title indicates that the authors are not interested in presenting the industry’s good, bad, and ugly sides — just the latter two. Morgenson, a 2002 Pulitzer Prize winner, is the senior financial reporter for the NBC News Investigative Unit and has extensive experience in the financial markets, having worked as a stockbroker and reporter for the Wall Street Journal and the New York Times. Rosner, likewise, is a veteran of Wall Street and is the managing director of research at the consultancy Graham Fisher & Co. The two previously collaborated on a book on the 2008 financial crisis, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon. These Are the Plunderers is well researched and comprises 17 chapters and 52 pages of notes from the popular press, academic research from such sources as the NBER and the Journal of Financial Economics, court filings, legislative hearings, and author interviews. Although the book covers the private equity industry as a whole, much of it traces the misdeeds of Leon Black’s Apollo Fund. Other PE funds that receive significant coverage include Stephen Schwarzman’s Blackstone Group, Kohlberg Kravis Roberts (KKR), and the Carlyle Group. After a brief introduction to Michael Milken, junk bonds, and the art of leveraged buyouts, the book’s first half sets the stage for the rest of the book by focusing on the Apollo Group’s foray into the purchase of insurance company Executive Life. Although no one would view an insurance firm as one with charitable goals, insurance serves a more essential societal role than many other businesses. Much of this part of the book focuses on the victims — most notably, Vince and Sue Watson. The couple used a malpractice award for brain damage suffered by their toddler, Katie, to purchase a policy from Executive Life to fund her care. In painstaking detail, the authors describe how Black’s Apollo Fund acquired the firm, enriching Black and his partners and leaving policyholders with a fraction of what they were promised. Readers are likely to find this eye opening because most of us would expect that a structured settlement funded through an insurance annuity would provide guarantees to the recipient. However, the financial promises made by the original insurer do not apply to the acquirer. This calamity was made possible by the political ambitions or incompetence of California’s insurance commissioner at the time, John Garamendi. Garamendi chose to seize Executive Life even though many experts believed the firm would survive. In an affront to policyholders, Garamendi allowed Executive Life’s bond portfolio to be sold at fire sale prices to Black and his colleagues, even though Wall Street consultants believed the price was too low. Later research by Harry DeAngelo, Linda DeAngelo, and Stuart C. Gilson in the Journal of Financial Economics found that the company’s bond portfolio would have recovered in a year. To add insult to injury, a California judge approved a request to destroy all court documents and filings in the Executive Life case. The authors weave a compelling tale of greed and misdeeds throughout the book. We are introduced to a cast of characters on both sides of the issue. These stories dispel the myths about private equity that the profession promotes. That narrative holds that PE represents the best of capitalism, an industry that takes on the risks and receives the rewards for turning around companies on the verge of extinction. But Morgenson and Rosner offer examples of for-profit and not-for-profit organizations bled dry by PE, leaving employees, pension funds, taxpayers, and other stakeholders holding the bag. Readers might ask, “Did the authors cherry-pick a handful of egregious cases that do not represent the norm?” Throughout the book, the authors point out their attempts to obtain comments from PE funds that are discussed. In most instances, their requests were ignored; in others, they were given canned responses that painted the firm and industry in the best possible light. The PE playbook is always the same: Borrow money to acquire the firm, saddle it with debt, and extract exorbitant management fees. The fees sometimes continue long after the PE firm has already sold off the entity, a gambit that the authors call “money for nothing.” The authors illustrate that principle with the industry practice of charging pension funds for cash committed but not yet under management. In some instances, when the PE firm cannot identify a viable buyer for an exit, it may sell the entity to one of its other funds at an inflated price, leaving investors in the first fund with a nice profit and investors in the acquiring fund holding the bag. Elaborating further on plundering by private equity, Morgenson and Rosner provide cases of PE’s stranglehold on the health care industry. The authors recount stories of physicians and nursing home employees who were fired after speaking out about safety concerns and individuals who were banned from visiting loved

The number of environmental, social, and governance (ESG) benchmarks and indexes demanded by the asset management community has grown at an unprecedented rate over the past two years. That’s according to our latest survey of Index Industry Association (IIA) members. Unpacking these high-level numbers, ESG indexes have expanded beyond more traditional areas of integration into new asset classes and strategies. The IIA queries our membership each fall in our annual benchmark survey to understand where the index industry’s growth is coming from. Last fall, the IIA found the number of ESG indexes increased 85% over the last two years. In response, we conducted additional surveys of the global asset manager community in 2021 and 2022 to confirm that index providers are meeting the ESG needs of the investment community, assessing the impact, and monitoring potential impediments to growth. That’s what makes the results of our most recent ESG Global Asset Manager Survey so interesting. Conducted earlier this year, the survey queried 300 investment fund companies across Europe and the United States. It found that amid geopolitical conflict, rising interest rates in many countries, a 40-year high in inflation, and now recession fears, the influence of sustainable investment factors on the global market ecosystem has continued to accelerate. In fact, our survey found that ESG factors are even more important to global asset managers today than they were a year ago. A full 85% of asset managers reported that ESG has become a larger priority within their company’s overall investment strategy in the past year. Overall, Has ESG Become More or Less of a Priority within Your Company’s Overall Investment Strategy over the Past 12 Months (By Geography) To be sure, given extensive media coverage of ESG and its aggressive promotion by asset managers, these results may not be all that surprising. So, we dug deeper on our next question and asked asset managers to quantify the integration of ESG considerations into their portfolios. We wanted to understand what asset managers believe the future state of asset management will look like. Expectations around ESG portfolio percentages within the next 12 months jumped more than 13% over last year’s survey. Moreover, within 10 years, asset managers expect 64.2% of their portfolios will contain ESG elements. These double-digit percentage increases over last year’s results extend across every time horizon surveyed. Approximately What Percentage of Your Asset Management Portfolios in Your Firm Do You Expect Will Contain ESG Elements in the Future? Weighted Average 2021 Survey 2022 Survey 12 Months from Now 26.7% 40.0% 2 to 3 Years from Now 35.0% 48.2% 5 Years from Now 43.6% 57.4% 10 Years from Now 52.3% 64.2% Base: All Respondents (300) ESG integration has become so widespread that sustainable investment approaches have expanded beyond equities into other asset classes. The percentage of investors implementing ESG factors in their allocations to fixed income shot up to 76% this year, from 42% just a year ago. In fact, ESG integration in all asset classes grew year-over-year, with the most expansion in fixed income. This trend shows no signs of slowing: Over 80% of global asset managers expect the use of ESG criteria in all major asset classes to increase in the next 12 months.  What explains these results? Based on conversations with market participants, I believe better data has led to better ratings and more research and development in fixed income, which in turn has created greater impetus to incorporate sustainable investing across asset classes and portfolio holdings. In Which Asset Classes Does Your Company Currently Implement ESG Criteria? 2021 2022 Fixed Income/Bonds 42% 76% Equities/Stocks 53% 74% Commodities 37% 47% Base: All Respondents (300) That conclusion isn’t purely anecdotal: More than 9 out of 10 survey respondents agreed that environmental impact, social sustainability, and corporate governance tracking tools, metrics, and services were either highly or fairly effective. That’s up significantly from 66% in 2021. Of course, given concerns about greenwashing and disparate data across the E, S, and G, this result seems optimistic. To date, environmental data is more quantifiable and directly measurable than social and governance data. Within “E” ratings, agencies can standardize how emissions are measured across various jurisdictions, for example. By contrast, privacy issues make some social data difficult if not impossible to collect. More fundamentally, not every country or culture, let alone individual, agrees on what the specific social priorities ought to be. But the survey responses do indicate something of a paradox: Fund managers are giving broadly equal weight to the E, S, and G components even as their attitudinal comments suggest that environmental concerns are more top of mind at this stage of ESG development. In fact, 78% of respondents said that “environmental criteria should always be given priority over social and governance criteria.” Which of the Following Best Describes How Each of the Elements of ESG Are Incorporated into Portfolios? Even in a year of economic and geopolitical challenges, global asset managers believe demand for ESG investing will accelerate and expand further into more asset classes. This raises a number of questions: Will there be enough data to support rising demand for ESG-oriented indexes and tools? Will a global consensus develop on more than just the “E” in ESG? That is, will sufficient insights be developed on social and governance criteria? These are issues we will be sure to monitor in our discussions with global asset managers in the coming years. This is the sixth installment of a series from the Index Industry Association (IIA). The IIA is celebrating its 10th anniversary in 2022. For more information, visit the IIA website at www.indexindustry.org. If you liked this post, don’t forget to subscribe to the Enterprising Investor. All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Image credit: ©Getty Images/enjoynz Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits

In golf, a hole-in-one is a remarkable feat. The odds? Roughly one in 850,000 from a distance of 150 yards – practically a statistical anomaly. Yet, the 2023 LPGA tour recorded 20 such occurrences. How can this be? Simple: a low probability doesn’t necessarily translate to low frequency. Hold on to that thought for a moment. Now, let’s switch gears. Imagine two coin-toss games. In the first, the coin is fair, offering an equal chance of winning or losing. In the second, the coin is flawed: there’s a 60% chance of losing and only a 40% chance of winning. Both games, however, offer an expected return of 25%. At first glance, most would claim that the flawed coin presents a higher risk. But consider this carefully. Both games are equally risky if we don’t know the outcome in advance –particularly when playing only once. The next flip could easily defy probability. Therefore, risk isn’t merely about the odds of winning. It’s about the severity of loss when things go wrong. Let’s add a new layer. Suppose the fair coin offers a 150% return on a win but a 100% loss on failure. The flawed coin, meanwhile, offers a 135% return on success but only a 50% loss on failure. Both scenarios result in an expected return of around 25%, but the flawed coin lets you live to play again — a crucial factor in investing. In investing, risk is not defined by probability or expected return. True risk is the likelihood of permanent capital loss when the odds turn against you. Risk, therefore, should always be viewed in absolute terms, not relative to return. Simply put, as a minority equity investor, there is no return level worth the risk of a permanent loss of capital. Since the future is unpredictable, avoiding extreme payoffs is paramount. Rational investing doesn’t involve betting on binary outcomes, no matter how enticing the potential upside. While this sounds simple, in practice, it’s far more nuanced. Theory to Practice Consider a chemical company that has just completed a major capex cycle, funded primarily through significant debt. The management is optimistic that new capacity will triple cash flows, allowing the company to quickly repay its debt and become net cash-positive in two years. Additionally, the stock is trading at a deep discount relative to peers and its historical average. Tempting, right? But the prudent investor focuses not on the potential upside but on the bankruptcy risk inherent in a commoditized, cyclical industry, especially one vulnerable to Chinese dumping. Now consider another example. A branded consumer company with a historically strong cash-generating legacy business. Recently, the company has taken on debt to expand into new related products. If the new product flops, the company’s core portfolio will still generate enough cash flow to pay down debt. It would be a painful setback, but far less catastrophic. For a long-term investor, this investment might still result in a profitable outcome. In both cases, the difference isn’t in the probability of success but in the severity of failure. The focus should always be on managing risk. Returns will follow naturally through the power of compounding. Empirical Evidence: Leverage and Long-Term Returns To reemphasize this principle, let’s turn to a more practical illustration. I analyzed the performance of US stocks over the past 10 years by creating two market-cap-weighted indices. The only distinguishing factor? The first index includes companies with net debt to equity below 30%. The second index comprises companies with net debt to equity above 70%.Index 1. The results speak for themselves. The low-leverage index outperformed the high-leverage index by 103% over the decade and surpassed the broader S&P 500 by 23%. Repeating similar exercise for emerging markets (EM) highlights similar trends, albeit in a narrower range. The low-leverage index outperformed the high-leverage index by 12% over the decade and surpassed the broader MSCI EM by 6%. These outcomes underscore a simple truth: companies with lower leverage — less risk of bankruptcy — are better equipped to weather downturns and compound returns over the long term. Key Takeaway Investing isn’t about chasing improbable victories or betting on binary outcomes with alluring upsides. It’s about safeguarding your capital from permanent loss and allowing it to grow steadily over time. By focusing on companies with strong balance sheets and low leverage, we minimize the severity of potential failures. This prudent approach enables us to weather market downturns and capitalize on the natural power of compounding returns. Remember, managing risk isn’t just a defensive strategy. It’s the cornerstone of sustainable, long-term investing success. source

Profitability metrics are often the main focus in the search for high-quality stocks. But Profitability is not a defensive factor and may expose investors to a company’s aggressive profit-chasing, among other unintended risks. So, how can such risks be mitigated? By incorporating an additional quality dimension that we classify as Conservatism. By combining Profitability and Conservatism, we can reduce a portfolio’s downside risk and enhance its risk-adjusted returns over the long run. Profitability Isn’t “Defensive” Profitability and Quality are often used interchangeably. That’s understandable. Several influential academic studies, including Eugene F. Fama and Kenneth R. French’s five-factor model, feature Profitability as an equity factor. Outside of academia, however, Quality has a broader definition that extends beyond simple Profitability. Thematically, Quality is a “defensive equity factor” that should provide downside protection during bear markets. This raises the question: Does Profitability offer similar downside protection? To answer this, we examined the historical performance of various factor strategies using several conventional industry Profitability metrics. These include Fama and French’s Profit, Return on Equity (ROE), Return on Invested Capital (ROIC), and Return on Assets (ROA). We sorted and ranked all stocks within the Russell 1000 universe according to their Profitability scores and then constructed factor-mimicking portfolios by taking the first quintile of stocks with the highest scores and weighting them equally. We rebalanced the factor strategies on a monthly basis and calculated their performance from January 1979 to June 2022.  Historical Performance of the Profitability Factor   Fama–French Profit ROE ROIC ROA Russell 1000 Annualized Return 14.2% 14.2% 14.0% 13.4% 10.1% Annualized Volatility 17.2% 17.4% 17.1% 17.3% 15.3% Sharpe Ratio 0.58 0.58 0.57 0.53 0.39 Maximum Drawdown –53.6% –55.3% –53.0% –61.6% –51.1% Upside Capture Ratio 1.12 1.14 1.12 1.08 – Downside Capture Ratio 1.03 1.05 1.03 1.02 – Source: Northern Trust Quant Research, FactSet, Russell 1000, January 1979 to June 2022 Our analysis shows all four Profitability strategies generated positive excess returns relative to the Russell 1000. But they all experienced higher maximum drawdowns than the benchmark and had a downside capture ratio over 1. As such, the Profitability strategies failed to provide downside protection.  The Case for Conservatism These results demonstrate that the profit-centric view of Quality can lead to higher downside risk. Why? Because the overemphasis on Profitability encourages firms to take on excessive leverage and conduct empire-building activities, among other profit-chasing pursuits. A profitable but highly levered firm may have greater default or bankruptcy risk when financial stress increases amid economic crises.  Minimizing such risks requires a multi-dimensional approach that incorporates Conservatism into the Quality design. We look for firms with high levels of profitability that also exhibit greater financial conservatism. That means lower leverage, stronger balance sheets, more conservative asset growth, etc.  To illustrate the process, we examined the performance of various Profitability and Conservatism metrics during the Global Financial Crisis in 2008 and the COVID-19 crisis in 2020. The following chart shows the annualized return spreads between equally weighted top and bottom quintile factor-mimicking portfolios during the market crashes. We found that Profitability metrics generated negative return spreads. For instance, ROE, ROIC, and ROA had return spreads of –25% to –37% during the recent COVID crisis. By contrast, all Conservatism metrics had positive return spreads during both stress events. Profitability vs. Conservatism during Crises Note: Prudent Capex Growth prefers low CAPEX growth over high CAPEX growth.Source: Northern Trust Quant Research, FactSet, Russell 1000 Next, we demonstrated the defensive characteristic of Conservatism with scatter plots and fitted polynomial curves for both Profitability and Profitability Plus Conservatism. The fitted curves illustrate that the convexity of Profitability improved from –0.11 to +0.04 when it was combined with Conservatism. The positive convexity, or smile effect, is the defensive feature that drives the factor’s outperformance in both up and down markets. Convexity of Factor Returns Note: Profitability is based on composite metrics of ROA, ROE, ROIC, and Profit. Conservatism is based on composite metrics of CAPEX growth, Leverage, and Cash Holdings.Source: Northern Trust Quant Research, FactSet, Russell 1000 Finally, we updated the first chart by adding our Profitability Plus Conservatism portfolio. We found that the composite factor offered much better downside protection and risk-adjusted returns than the more simplistic Profitability metrics. The Profitability Plus Conservatism portfolio had a lower maximum drawdown and higher risk-adjusted returns. The Profitability Plus Conservatism Factor   Fama–FrenchProfit ROE ROIC ROA Comp-ositeProfit-ability1 Profit-ability +Conserv-atism2 Russell1000 AnnualizedReturn 14.2% 14.2% 14.0% 13.4% 14.1% 15.0% 10.1% AnnualizedVolatility 17.2% 17.4% 17.1% 17.3% 16.9% 16.6% 15.3% SharpeRatio 0.58 0.58 0.57 0.53 0.58 0.65 0.39 MaximumDrawdown –53.6% –55.3% –53.0% –61.6% –51.8% –49.0% –51.1% UpsideCaptureRatio 1.12 1.14 1.12 1.08 1.10 1.13 – DownsideCaptureRatio 1.03 1.05 1.03 1.02 1.01 0.99 – 1. Composite profitability consists of equally weighted Fama–French Profit, ROE, ROIC, and ROA; 2. Profitability with Conservatism consists of equally weighted profitability metrics and conservatism metrics.Source: Northern Trust Quant Research, FactSet  Conclusion Academic literature may treat Profitability and Quality as synonyms, but our research shows they are far from analogous. High-Profitability stocks can suffer from excessive leverage, aggressive business models, and so on. When crises come, they may not provide much of a safety net. But Conservatism can add that extra dimension to Quality, one that can potentially deliver higher risk-adjusted returns. Further Reading Fama, Eugene F., and Kenneth R. French. “The Cross-Section of Expected Stock Returns.” The Journal of Finance. Novy-Marx, Robert. “The Other Side of Value: The Gross Profitability Premium.” Journal of Financial Economics. Hsu, Jason, Vitali Kalesnik, and Engin Kose. “What Is Quality?” Financial Analysts Journal. If you liked this post, don’t forget to subscribe to the Enterprising Investor. All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Image credit: ©Getty Images/ photonaj Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker. source