CFA Institute

The latest earnings results for banks include words like “record,” “outstanding,” and “doubles.” So far, 2023 has been a banner year for the sector, at least from an earnings perspective. But bank stock prices have yet to eclipse their previous highs. The KBW NASDAQ Global Bank Index, which tracks global banks, has barely grown since the current rate-hiking cycle began in early 2022 and generally has not exceeded its pre-COVID-19 peaks. Other bank indexes haven’t outperformed either. The S&P Regional banks index is trading at 2016 levels. Banking is a complex sector with many influences. So, to understand the mid- to long-term outlook, we need to understand the three key drivers at work in the industry today. 1. The Transition to a Higher Rate Environment The US Federal Reserve’s hiking cycle has been the fastest in decades, and the banking sector has profited from it. As rates rise, a bank’s assets tend to reprice faster than its liabilities and thus a bank’s net interest income, which constitutes the bulk of its earnings, increases. That is what has happened in the current rate cycle, which has created a tailwind for the industry’s financials. But higher interest rates are a double-edged sword. Many banks loaded up on sizable portfolios of long-duration securities during the easy money era, and their prices have plunged as rates have risen. Held-to-maturity — or hide-’til-maturity — accounting has shielded bank financials from the impact, but should these portfolios be unwound, the losses will materialize and the bank’s capital will take a hit. This is a sector-wide concern, as W. Blake Marsh and Brendan Laliberte observe in “The Implications of Unrealized Losses for Banks.” Indeed, the switchover from a low or negative rate environment to one with a positive but inverted yield curve occurred quite quickly. Could this spell trouble for banks? According to financial theory, banks engage in term transformation — they borrow in the short term to lend over the long term — so the answer to the question may very well be yes, theoretically. But in practice, banks borrow and lend at different points on the curve, and the average maturities of loans and securities tend to be below five years. Additionally, assets and liabilities are well matched, so the banks may still make money with an inverted yield curve. In fact, in “How Have Banks Responded to Changes in the Yield Curve?” Thomas King and Jonathan Yu find evidence that banks actually increase their net interest margin with a flat curve. 2. Reduced Competition from Neobanks Neobanks and fintechs are the offspring of low rates and technological disruption. Low rates forced banks to look for alternative sources of income amid historically low spreads on their bread-and-butter products, which meant charging higher fees for credit cards, cash transfers, etc., to generate non-interest income. This combined with old technology stacks and start-ups financed with cheap money created fierce competition for traditional banks. That is, until the fintech winter settled in. With easy financing rounds a thing of the past, most neobanks will have trouble surviving. The vast majority have yet to achieve profitability, and they won’t have cheap funding to fill the gap any longer. Moreover, as banks revitalize their reliance on conventional sources of revenue — interest income — the pressure to increase service fees will fall. For all the hype about customer experience and digital disruption, neobanks will have a hard time retaining customers if their fees are more or less the same as traditional banks. Some banks may even be tempted to go on the offensive and cut their commissions now that their interest income offers a financial cushion. 3. Market Multiples So, how are the market variables moving for banks? Not very well. The sector is still underpriced relative to other industries. Price-to-book is banking’s universal multiple, and many banks are still below the magic value of 1. There are several reasons for this. Even though earnings are improving, clouds are gathering on the horizon. Unilateral government action through direct taxes as in Italy, increased regulation, and additional capital requirements are all possibilities. Bank compliance departments are growing ever larger and constituting an ever greater drag on profitability. A further headwind is the unrealized losses on securities portfolios. How large are they? Large enough to trigger a liquidity event? We don’t know, and that poses an additional risk for the sector. New production — slower credit growth due to tighter conditions and a deteriorating economy — is another challenge. Germany and Holland are already in technical recession, and whether the United States can avoid one in a higher rate environment is unclear. The latest GDP readings have been robust, and the labor market is resilient, which helps explain why US banks trade at a higher price-to-book ratio than their more-subdued European peers. But even in the United States, credit card and auto loan delinquency rates have started to swing upwards, and the housing market’s outlook appears cloudier the longer rates stay elevated. Looking Forward The banking sector is in better shape now than during the last decade of low or negative rates. The fintech winter will ease competitive pressure and give some banks the opportunity to buy out neobanks and appropriate their technology stack. However, latent losses in banks’ securities portfolios, the political temptation to overtax and overregulate the sector, and the damage higher rates may inflict on the economy could take a toll on an otherwise bullish outlook. So, the next few quarters should present both considerable challenges and opportunities. If you liked this post, don’t forget to subscribe to 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 / sakchai vongsasiripat 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

Now that individual investors can access direct real estate investments, what should they keep in mind regarding the main US commercial real estate (CRE) sectors and their respective outlooks? To conclude our series, we analyze the prevailing perspectives on the US CRE market and four of its key segments, specifically residential — multifamily, industrial, retail, and office.* Residential — Multifamily  The United States faces a significant housing unit shortfall. Pre-COVID-19, Fannie Mae data estimated a shortage of 3.8 million homes. New estimates range from 2 to 3 million. While construction starts rose through most of 2021, according to Green Street analysis, the estimated influx of 1.3 million net units after subtracting obsolete properties will not be enough to accommodate the projected 4.7 million household formations. Real wages have increased across the wealth spectrum, but suitable, affordable housing that costs less than 30% of household income is still out of reach for much of the US population, particularly in leading primary markets. At 63.1%, the US homeownership rate is at a record 53-year low, as millennials, who are of prime age to start families and purchase homes, face far steeper costs than prior generations.  Given the recent surge in housing prices as well as the high (mortgage) interest rate environment and ongoing economic uncertainty, the affordable housing shortage should further fuel near-term demand for rental properties. This could benefit sub-asset classes, such as single-family rental, as an alternative to ownership and, at the most affordable end of the spectrum, manufactured housing. The US population today is also more mobile than previous generations. Remote and hybrid work and changing family and community structures have prompted greater geographic movement. Knowledge workers may relocate to secondary metros, suburbs, and exurbs at increasing rates in search of lower rent and lower cost of living as well as more space and more favorable tax regimes.  Tech hubs have emerged outside of San Francisco, Seattle, Boston, and other knowledge capital strongholds. With their robust educational institutions, affordability, and business-friendly climates, Salt Lake City, Utah; Phoenix, Arizona; Memphis, Tennessee; Raleigh, North Carolina; and other ascendant cities are attracting knowledge workers and tech businesses. These trends will provide fertile ground for multifamily investors. Demand for affordable rental housing will grow given the underlying scarcity and elevated inflation. This dynamic accounts for recent growth in real rents — 14% nationally and 20% to 30% in some markets. Since residential leases are usually of shorter duration — often one year — relative to other asset classes, they better capture a portion of inflation, and rents recalibrate more quickly. Despite an estimated 20% decline in apartment values compared with 2022, according to Green Street’s Commercial Property Pricing Index (May 2023), as rent growth normalizes in the near term, residential units in robust markets may still see additional rent growth. Industrial Industrial today has diverse and persistent demand drivers. The COVID-19 consumption boom spurred e-commerce sales growth of almost 40% in 2020, generated nearly 250 million square feet in warehouse demand, and led to global supply chain disruptions. As a result, US industrial is coming off the best two years in its history. Thanks to COVID-19 quarantines, e-commerce experienced perhaps decades of evolution in two or three years. In the new normal, e-commerce has greater penetration than traditional brick-and-mortar retail and requires three times the square footage, according to Green Street estimates. As such, national market rents grew by more than 40% in the last two years, more than in the previous seven years combined.  Industrial has had historically low vacancy rates — below 5% since 2016 — and sustained elevated demand: Retail sales are up 17% over pre-COVID-19 levels despite inflation, according to Green Street. These strong fundamentals augur well for future performance. Geographically, coastal markets, particularly on the East Coast and Gulf Coast, should have the most valuable investments. Thanks to port expansions and supplier diversification, they have gained 8% in market share over the last five years, according to the American Association of Port Authorities, and US imports are almost evenly divided between both coasts. Many importers shifted volume from West Coast to Gulf Coast and East Coast ports during the pandemic, to the benefit of the latter. But population growth in secondary West Coast markets, California’s large population base, and continued market capture of e-commerce mean there is still significant opportunity for industrial operators in certain West Coast markets. Orange County and the Inland Empire were both in the top five markets for revenue per available square foot (RevPAF) growth in 2022. This was driven by per capita industrial square footages for Amazon fulfillment centers that still lag other key markets throughout the United States. Southern California markets, in particular, also benefit from more stringent barriers to entry for new supply.  Fundamentally, the current capital-constrained market has reduced new construction, with 15% fewer deliveries in 2024 and 2025, according to Green Street estimates. That adds up to approximately 100 million square feet. The sector should be on pace to produce enough new supply to roughly match new demand, with occupancy remaining stable, and otherwise support continued rent growth. Real e-commerce sales remain 50% higher over year-end 2019, and firms are building out traditional and last-mile warehouse facilities to meet increased online sales. This should further help demand keep pace with supply. While industrial values declined by an estimated 15% compared with 2022, according to Green Street’s Commercial Property Pricing Index (May 2023), industrial investors should look for appealing assets in robust coastal markets with strong rent growth potential. Among the in-demand sub-categories are third-party logistics and last-mile industrial facilities that cater to e-commerce. Lease structures that index to CPI/inflation could become more common — again, following a prolonged period of low inflation resulting in fixed rent steps — and offer investors a means to offset inflation. The cold storage sub-sector is worth paying attention to as consumers trend towards fresher, healthier, and better-quality foods delivered in shorter timeframes and as food producers continue to ramp up their production

Investors often choose diversified, multi-factor strategies to overcome the limitations of traditional cap-weighted benchmarks. These benchmarks are overly concentrated on companies with the largest market capitalization and expose investors to idiosyncratic risks that are not rewarded over the long term. Moreover, cap-weighted benchmarks incorporate no explicit objective to capture exposure to those risk factors that have been documented in the academic literature to offer a long-term reward. Significant deviations from the traditional cap-weighted benchmark are required, therefore, to deliver stronger risk-adjusted performance over the long term. Namely, choosing stocks that target explicit exposures to rewarded factors and applying a well-diversified weighting scheme to manage stock specific risks. However, deviations from the benchmark create unintentional exposure to economic risks. For example, if a factor portfolio is too heavily tilted toward low volatility stocks, it may behave in an overly “bond-like” manner and accordingly exhibit strong sensitivity to Treasury yields and movements in the yield curve. Ideally, your factor portfolio will deliver factor premia in a systematic and reliable fashion without such undue sensitivity to economic risks that create additional tracking error for no additional long-term reward. In this article, I outline a methodology — which we call EconRisk — to mitigate economic risks of factor-driven equity strategies and eliminate unnecessary tracking error by keeping strong exposures to rewarded factors and preserving diversification benefits. Getting Exposures to Rewarded Factors There are six consensus rewarded factors that emerge from academic literature and that have passed sufficient hurdles to be considered robust, namely size, value, momentum, volatility, profitability, and investment. Their long-term reward is justified by economic rationale. Investors require compensation for additional risks brought by factor exposures in bad times when assets that correspond to a given factor tilt tend to provide poor payoffs (Cochrane, 2005). For instance, to build the value factor sleeve of our multi-factor index, we first select stocks with the highest book-to-market ratio adjusted for unrecorded intangibles to acquire the desired exposure. When doing so, we might select value stocks with negative exposures to other rewarded factors such as profitability, for example (Fama and French, 1995), Zhang (2005). This could be problematic when assembling the different factor sleeves into a multi-factor portfolio, since it will lead to factor dilution. To account for this effect, we screen out from the value selection the stocks with poor characteristics to other rewarded factors. This approach enables us to design single-factor sleeves with strong exposure to their desired factor but without negative exposures to other rewarded factors. The goal is to build multi-factor portfolios with strong and well-balanced exposure to all rewarded factors. Reducing Idiosyncratic Risks The second objective is the diversification of idiosyncratic risks. Indeed, we want to avoid the performance of our multi-factor indices, which should be driven by exposure to the market and rewarded factors, being significantly impacted by stock-specific shocks, since they can be mitigated by holding diversified portfolios. Typically, an investor would not want the performance of their multi-factor portfolio to be negatively affected by a profit warning made by a single company. The reasons is this unexpected shock is not related to the premium of the market of rewarded factors and is only company specific. Hence, we combine four different weighting schemes that are proxies of the mean-variance optimal portfolio (Markowitz, 1952). Each weighting scheme implies some trade-offs between estimation and optimality risks. For example, one of the four weighting schemes that we use is the Max Deconcentration. This has no estimation risks because it assumes that volatility, correlations, and expected returns are all identical across stocks. Given this strong assumption, this weighting scheme will be far from the mean-variance optimality. To mitigate the estimation and optimality risks of each weighting scheme, we simply average them together into a diversified multi-strategy weighting scheme. Unintentional Economic Risks Both sources of deviations discussed above are necessary to achieve the objective of long-term risk-adjusted performance improvement compared to the cap-weighted benchmark. Nonetheless, they create implicit exposures to economic risks that can affect the short-term performance of factor strategies. A low-volatility factor portfolio, for example, tends to overweight utilities companies, which are more sensitive to interest rate risks than the stocks in the cap-weighted benchmark. This is illustrated in Table 1. The sensitivity of each single-factor sleeve of our Developed Multi-Factor Index to each of the economic risk factors that we have in our menu. Each factor sleeve has different sensitivity to the factors.    Table 1. As of June 2024 Single-Factor Sleeves of Developed Multi-Factor Size Value Momentum Low Volatility Profitability Investment Supply Chain 0.08 0.13 0.09 0.05 0.06 0.09 Globalization -0.16 -0.17 -0.05 -0.22 -0.08 -0.19 Short Rate 0.02 0.13 0.13 0.04 0.05 0.07 Term Spread -0.01 0.07 0.07 -0.11 -0.02 0.00 Breakeven Inflation 0.12 0.14 0.14 0.02 0.03 0.07 The sensitivity of a factor sleeve to a given economic risk factor is the weighted average (using the stock weights within the sleeve) of underlying stock-level betas. These stock-level economic risk betas capture the sensitivity of stock returns more than the cap-weighted reference index to the returns of five market-beta neutral long-short portfolios that capture the five economic risks. Our menu of economic risk factors is designed to capture recent economic disruptions that are likely to continue in the future, such as increased supply chain disruptions, surging trade tensions between Western countries and China, changes to monetary policy by central banks to manage growth and inflation risks, and increasing geopolitical risks such as the war in Ukraine or tensions in the Middle East. Given that these economic risks are not rewarded over the long term, investors might benefit from trying to get more neutral exposures to them relative to the cap-weighted benchmark, while still trying to maximize the exposures to consensus rewarded factors. EconRisk to mitigate unintentional economic risks To preserve the benefits of our diversified multi-factor strategy, we introduced a weighting scheme we call EconRisk. The weighting scheme is implemented separately on each factor sleeve. Weights of each single factor sleeve are allowed to move away from the diversified multi-factor strategy

FTX is simultaneously the biggest fraud and the culmination of the largest banking crisis in the history of the crypto industry. But the FTX debacle has very little to do with crypto itself: It is merely another episode in global finance’s long history of such catastrophes. Despite extensive regulation and central bank activity, traditional finance is littered with shocks, panics, bank runs, and other disasters of which FTX is just the latest iteration. But unlike traditional finance, crypto offers a pathway to a sounder financial system. If crypto is going to deliver on this, the principles of decentralization, immutability, and verifiability need to be adopted by more centralized institutions. Financial Crises Are Symptoms of the Opaque Fractional Reserve Banking System Fraud is as old as humanity, and banking crises are as old as banking itself. But the ubiquity of such excesses has increased ever since banks evolved from depository institutions that held client deposits on reserve to fractional reserve banks. Fractional reserve banks only keep a small share of client deposits on hand. Hungry for returns, they prioritize profits over client safety, leveraging up their balance sheets by investing client capital in longer-duration, less-liquid, and less-credit-worthy assets. This dramatically boosts the sector’s profitability, but it makes banks susceptible to runs and insolvency.* If clients seek to redeem their deposits en masse, the banks won’t have the necessary capital available to meet the demand. The FTX collapse is an outgrowth of this system. FTX CEO Sam Bankman-Fried allegedly bailed out his own trading firm, Alameda Research, with FTX client capital, effectively turning FTX into a fractional reserve bank and executing the typical financial fraud. Regulation and Monetary Policy Don’t Fit with Crypto Traditional finance attempts to counteract the inevitable excesses of fractional reserve banking with regulation and monetary policy. Neither of these are likely to work effectively in crypto. Let me explain. The FTX scandal highlights crypto’s ongoing regulatory arbitrage potential. Bitcoin, Ethereum, and other crypto-assets are decentralized, internet-based financial technologies. They facilitate the movement of capital among various parties throughout the globe, no matter their jurisdiction. Exchanges are easy to set up in more far-flung jurisdictions as a means of evading restrictions and growing market share away from the hawkish eyes of developed market regulators. In fact, this is exactly the path FTX pursued, opting to conduct its operations in the Bahamas. Perversely, the stricter developed market regulators become in the wake of the FTX collapse, the greater the incentive among crypto operators to migrate to more permissive jurisdictions. Enron, Barings Bank, and Theranos all demonstrate that complex banking regulations solve neither banking crises nor frauds. In fact, FTX’s Bankman-Fried cultivated close relationships with US regulators in Congress and the SEC in recent years. He was hiding in plain sight, and regulators didn’t see a thing. Thoughtful crypto regulations may help rein in crypto intermediaries in the future, but history shows regulation is no silver bullet. Central banking does lower the risk of bank runs in traditional financial markets. A central bank’s status as lender of last resort reduces the incentive to flee insolvent institutions. But with crypto, monetary policy is both undesirable and not especially applicable. Effective monetary policy requires supply elasticity. The US Federal Reserve can manipulate the US money supply, but nobody can just print bitcoin.** An inelastic supply of the primary assets is a major constraint to any lender of last resort. Moreover, recent events demonstrate why central bank bailouts are both pernicious and undesirable. FTX itself effectively acted as a lender of last resort in the crypto space in May and June: It bailed out troubled centralized lenders BlockFi and Voyager, as well as its trading arm, Alameda. But these actions only hid the underlying risk in these institutions and led to a larger crisis down the road. Binance, crypto’s largest exchange, looked like it might step in as FTX teetered on the edge, but wisely stayed on the sidelines. Healthy Economies Reveal Failures. They Don’t Hide Them. Bad business practices, poor risk taking, overly leveraged companies, and outright frauds need to be uncovered and put out of business. That is how a healthy, functioning economy works. Central banks can help conceal these challenges in the short-term and delay the final reckoning, but that creates economic inefficiency and damages productivity over the long term. So, where does crypto go from here? Apply the Principles of Verifiability and Transparency to Centralized Finance Like any nascent technology, bitcoin is volatile, but it is robust. Bitcoin and Ethereum continue to process transactions and smart contracts, delivering financial freedom to underserved people around the world. They provide these services without the need for regulators and central banks. Centralized institutions like FTX have failed to live up to the principles that make bitcoin, Ethereum, and other cryptoassets valuable: transparency, openness, decentralization, etc. To take this industry to the next level, crypto advocates need to impose these principles on centralized financial institutions. Crypto intermediaries like FTX cannot be allowed to succumb to the age-old shenanigans of traditional finance. Self-custody of assets and decentralized exchanges are two great solutions because they don’t expose users to the vagaries of centralized custodians and their penchant for fractional reserve banking. Proof of reserves can also make centralized institutions more transparent. After all, centralized intermediaries aren’t going away. Not everyone has the wherewithal to fully transition into crypto’s decentralized universe. Traditional financial institutions need to integrate crypto’s first principles into their operations. A simple on-chain proof of reserves that allows the public to view company assets and liabilities would be a good first step. It wouldn’t prevent all malfeasance, but it would dramatically reduce risks by fostering accountability, openness, and transparency. Regulators wouldn’t be required to audit exchange balance sheets. Instead, crypto can automate the audits through code and on-chain transparency. That information could be disseminated in real-time and be available to everyone. Crypto Isn’t Going Anywhere Bitcoin has declined 78% since its October 2021 peak. It also fell 92% in 2010 and 2011, 85%

Introduction  A global black swan event — COVID-19 — followed by record inflation and the sharpest upward interest rate trajectory in three decades has bedeviled markets over the last three years. Moreover, the financial markets have undergone structural shifts that call into question the effectiveness of traditional portfolio construction techniques. No one can predict the future, but the next phase of the market cycle will not look like that of the last decade, when investors enjoyed the longest bull run in US history. So, investors should consider adjusting how they build their portfolios. Here we examine alternative portfolio construction methods that supplement the traditional 60/40 stock/bond portfolio with allocations to alternatives, or alts. These include private equity/venture capital; hedge funds; and real assets, including private real estate, commodities/natural resources, and intellectual property. We explore the theoretical basis for going beyond the 60/40 portfolio and consider the present and future market conditions that could make alternative portfolio allocations useful to institutional and individual investors alike. The State of the 60/40 Portfolio  The year 2022 was historically bad for the average 60/40 portfolio, which fell by 16%. So why stick with it? Because, for most of the last century, bonds’ low or negative correlation to stocks protected portfolios from stock market volatility. Unfortunately, this relationship tends to fall apart amid high inflation. During “quasi-stagflationary” periods, stocks and bonds often exhibit higher correlations. Their correlations have tended to be negative or minimal — below 20%, for example — since 1998, when the five-year inflation CAGR generally fell below 3%, according to Blackstone. The current higher, 3%-plus inflation regime has pushed the stock-bond correlation to more than 60%, a level reminiscent of the 1970 to 1998 era. This has contributed to the traditional 60/40 portfolio’s third-worst annual return since 1950. Public equities have recovered somewhat in 2023. Through the end of the third quarter, the 60/40 portfolio delivered a 7% rate of return. Still, the public markets have been volatile: The S&P 500 ended September down more than 7% from its July highs, with more volatility expected. While the stock market has performed well lately, seven major tech stocks account for much of the gains and price-earning ratios are high. Simply put, a rising rate environment impedes growth, potentially devalues bonds (and stocks), and injects uncertainty into the market. With renewed geopolitical tensions and ongoing public health threats, sentiment-based swings in stock values may be inevitable, and while future US Federal Reserve moves are unknowable, inflation may remain a fixture and constitute a headwind to dividend stocks and bond yields for some time to come. So volatility will probably be the rule rather than the exception in the months and years ahead. Year-over-year (YoY) CPI inflation has fallen in recent months amid one of the most aggressive rate hike cycles ever. But the path to the Fed’s 2% annual inflation target remains fraught. While the Fed did recently signal possible rate cuts in 2024, nothing is guaranteed and a “higher for longer” policy is still possible if inflation persists. The stock-bond correlation has continued to hover around 60% since the start of the year. The 60/40 portfolio showed considerable diversification benefits in recent years and generated enviable returns through the pandemic. But the current moment requires a paradigm shift. Investors must consider different portfolio compositions if they want to drive risk-adjusted returns, decrease cross-asset correlations, increase appreciation potential, and diversify into alternative income sources. Infusing Alternatives (Alts) into a Portfolio The rationale for changing or optimizing portfolio allocations rests on Harry Markowitz’s modern portfolio theory (MPT). Bundling assets with low correlations can help maximize returns given the specific risk/return characteristics of the assets themselves. In MPT, pairing a risk-free asset with a “market portfolio” to create optimal portfolios should maximize anticipated returns for various levels of anticipated risk (downside variance). These allocation decisions, in turn, improve the “efficient frontier,” or the opportunity set that realizes the highest expected returns at the lowest volatility or standard deviation.  There are many ways to optimize a portfolio. The “Endowment Model” pioneered by the late David Swensen at Yale University is a prime example in the alternatives spaces. The perpetual nature of endowments and their smaller liquidity needs make their increased exposure to alts, which tend to be less liquid than publicly traded stocks, intuitive. Some endowments have alts allocations of more than 50%. Swensen believed in a strong equity focus but felt the bond portion of a portfolio should provide yield while also offsetting the volatility contributed by the portfolio’s stock component. Under Swensen, the Yale Endowment did not invest in corporate bonds because of their inherent principal-agent conflict — company management has to drive value for both stock- and bondholders — and because they display a minimal premium relative to government bonds after factoring in defaults. Swensen also avoided non-US bonds because, despite potentially similar/offsetting returns, the associated currency risk and uncertain performance in volatile times did not align with his long-term investment goals. As he explains in Pioneering Portfolio Management, equity generates superior long-term returns, a well-diversified portfolio requires investing in non-publicly traded/private/illiquid securities, active managers can extract alpha in less-efficient markets, and patient investors with longer horizons have a relative advantage. During his 25 years managing the Yale Endowment, Swensen achieved a 12.5% annualized return and outperformed the S&P 500 by 280 basis points (bps). So, what is it about alternatives portfolios? Alts are generally less correlated to public stock and bond investments. Private equity and hedge funds, for example, may correlate with public equities, but MPT holds that adding less correlated assets may improve a portfolio’s overall risk/return profile. Alts tend to be more illiquid, perhaps because they trade less frequently than their public counterparts or because they lack liquid prices. Valuations for alts are often based on periodic private valuations. For privately owned real estate, valuations depend on appraisals, so changes in value may have a lag and, in turn, smooth returns/volatility. The alts-trading markets may not be as efficient as

In this Research Foundation book, edited by  Alfonso Ricciardelli, CFA, and Philip Clements, CFA, practitioners introduce the key features of the alternative credit asset class. They spotlight leading transactions to evaluate those features and their implications for investors. They also discuss the market’s anticipated continued growth and potential evolution. Net zero requires transformational changes and significant investment, Roger Urwin, FSIP, asserts. This guide aids industry leaders in implementing net-zero investing. Based on interviews with more than 20 industry leaders, it offers practical guidance that stresses the importance of mindset shifts and highlights strategies for success. In this report, Serena Espeute and Rhodri G. Preece, CFA, examine how young investors use content from financial influencers on social media platforms, such as YouTube, TikTok, and Instagram, to gather information and make investment decisions. Access to powerful LLMs like ChatGPT is reshaping roles in the investment profession. In this report, Brian Pisaneschi, CFA, discusses how to ethically build investment models in the open-source community. He defines alternative data and presents an ESG investing case study. Winnie Mak and Andres Vinelli explore actions investors, asset managers, corporations, and policymakers may consider to improve the disclosure of transition plans, provide clarity on transition activities, and mitigate risks associated with transition finance. Innovations such as smart beta exchange-traded funds (ETFs) and direct indexing go beyond traditional capitalization-weighted strategies and incorporate varying levels of active management. In this paper,  Jordan Doyle  and Genevieve Hayman offer an updated framework for active management to capture the full range of index-based strategies and to support informed investment decision making. Climate-related data are critical to assessing and managing the financial risks and opportunities posed by climate change, yet the data are often inconsistent and unreliable. This paper by Andres Vinelli, Deborah Kidd, CFA, and Tyler Gellasch, discusses how regulations to enhance transparency are evolving and suggests how investors can make effective use of the data available to them. Private markets have ballooned since the Great Financial Crisis. While advocates hail their efficiency, critics call for more regulation, Stephen Deane, CFA, writes. This report illuminates how private markets function and uses the results from a CFA Institute global survey to inform recommendations for investors and policymakers. The cost of capital is the expected rate of return that the market requires to attract funds to an investment and is one of the most important concepts in finance, write James P. Harrington, Carla Nunes, CFA, and Anas Aboulamer. This paper provides a good understanding of this, which is essential for making global investment decisions. CFA Institute Research and Policy Center convened net-zero thought leaders and investment luminaries to break down the big ideas around achieving net zero. These Voices of Influence provide practical guidance for investors, asset managers, investment professionals, and regulators. More than 50 authors from the United States, Europe, and Asia collaborated on 16 research projects that we are delivering on a staggered publishing schedule. 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 / Ascent / PKS Media Inc. 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

Reminiscences of a Bond Operator: A Guide to Investing in Corporate Debt. 2024. Mark A. Rieder. Independently published. New and seasoned corporate bond investors will be delighted to get acquainted with Mark Rieder’s conversational narrative and clear presentation of complex analytical ideas in Reminiscences of a Bond Operator. When asked about the top reference work in bond investing, I refer my colleagues and students to Frank J. Fabozzi’s The Handbook of Fixed Income Securities.[1] As comprehensive a magnum opus as Fabozzi’s book is, Rieder’s book, released in 2024, adds value as a highly technical guide enhanced by personal insight into analyzing corporate bonds and private credit, as well as structuring and managing a debt portfolio. Rieder maintains that anyone can assemble a corporate bond portfolio, but only a skilled investor can consistently select the correct bonds to generate alpha without incurring significant losses. After reading this book and having 30 years of experience in analyzing individual corporate bonds and managing fixed-income portfolios, I can say that I learned fresh methods of analyzing individual issues and structuring total portfolios that will immediately influence my investing activities. Mark Rieder is not a household name to analysts and portfolio managers the way Frank Fabozzi is. Still, his book deserves a place in the universe of corporate bond practical guides as issuers come and go and the world of credit changes, such as it did with the explosion in private credit after the 2008 Financial Crisis. He has a rich background in the analysis and management of fixed income, from his early days at Deloitte & Touche and Goldman Sachs to his tenure as Managing Director and Lead Corporate Bond Portfolio Manager at GIC, the sovereign wealth fund of the Government of Singapore. In 2023, he founded La Mar Assets, a global multi-strategy credit manager. Based on his long tenure through the Financial Crisis and beyond, he confidently speaks from a deep experience in the trenches of corporate credit. Keep in mind that Reminiscences is not a primer in corporate fixed-income investing, yet it begins with an Overview of the Financial Markets (Part I). Subsequent parts of the book consist of The Research Process (Part II), Portfolio Management (Part III), Advanced Topics in Portfolio Management (Part IV), and lastly, Lessons Learned and Concluding Thoughts (Part V). As rudimentary as the Overview may seem in its description, it provokes much useful thinking about the size and performance of the bond market, the largest issuer — the United States — and its growing financing needs, the demand for corporate debt in a zero-interest rate policy (ZIRP) environment, and the refinancing of such low-interest debt. The point of the book is summarized on page 40: “Savvy investors adjust their portfolios by increasing credit exposure when spread and yields are wider, then reduce exposure when spread and yields tighten.” If only bond investing were so simple. That is why the author provides in-depth exercises and case studies in the heart of the book. Within The Research Process (Part II), I found that Chapter 9: Analyzing Company Cash Flows and Chapter 10: Rieder’s Matrix keeps analysis on track for one purpose: minimizing unknown information about the potential investment to make the best-informed decision at the time the trade is executed. Within Portfolio Management (Part III), Chapter 13: The Difference Between Coupon, Yield, and Bond Returns provides sound insight into selecting issues based on moves in benchmark rates and credit spreads. It addresses hybrid securities at length, raising a topic that rarely enters discussions of fixed-income instruments. Rieder encourages investors to consider hybrids for higher yields, acknowledging all their risks compared to alternatives in the fixed-income market. The following chapters (within Portfolio Management) are explicitly geared toward institutional investors: Chapter 17: The Rise of Credit Trading Widgets and Chapter 18: Private Credit Opportunities and Challenges. The latter explores an asset class that potentially creates situations with no limits on leverage. Rieder raises many important questions related to private credit’s surge over the past decade: • Does private credit have a lower default profile than public debt? • Will defaults increase as interest rates climb? • Can companies that utilize private credit restructure ad infinitum? • Could there be systemic risk stemming from the rush of life insurers into private credit? • Are there any liquidity concerns? The author suggests that the evolution of private credit markets will lead to a significant convergence between liquid and private credit. More than a decade of rapid growth in private credit issuance and investment could be explored in a future book on this issue. Advanced Topics (Part IV) applies to investors and analysts in all asset classes. It addresses topics such as financial engineering, bankruptcy, reorganization, and, my favorite, credit portfolio risk management. It also deals with a subject many of us have experienced but rarely gets mentioned: inheriting a portfolio. I do have one criticism of this comprehensive book. An index should have been included. Despite the author’s inclusion of extensive notes and my bookmarking of numerous pages, I frequently found myself searching for specific topics and individuals referenced. To conclude, Reminiscences is an attractive guide to corporate bonds that is professionally focused but accessible to analysts and portfolio managers of all experience levels. It also serves as a launching point for deeper analysis of fixed-income topics that could be affected by increased market volatility. 1.  Frank J. Fabozzi, et al., The Handbook of Fixed Income Securities, 9th ed, (McGraw Hill, 2021). source

The most-read blogs published on Enterprising Investor between April 1 and June 30 captured a profession in motion, grappling with disruption, uncertainty, and legacy. While the topics varied, several themes emerged: AI and the analyst’s edge: Investment professionals are thinking seriously about how to work with, rather than be replaced by, AI. Q2’s top reads explored bias, prompting, model performance, and what it means to stay competitive in an AI-driven world. Rethinking portfolio construction: From stretched market concentration to small-cap rotation and Bayesian frameworks, readers dug into smarter ways to diversify and position portfolios amid regime shifts. Learning from the long view: History, macro forces, and global politics loomed large in Q2 content. Readers looked to the past, not for nostalgia, but for data-driven insight into future risks and returns. 1. Vices, Virtues, and a Little Humor: 30 Quotes from Financial History Mark J. Higgins, CFA, CFP, and Rachel Kloepfer deliver a sharp, unsentimental reminder that financial folly is nothing new. These quotes from centuries past expose the recurring misjudgments, overconfidence, and occasional brilliance that continue to shape markets today. 2. Market Concentration and Lost Decades With the top 10 US stocks now representing more than a third of market cap, Bill Pauley, CFA, Kevin Bales, CFA, and Adam Schreiber, CFA, CAIA, explore what history tells us about such extremes. Elevated concentration and stretched valuations have often preceded long periods of underperformance, underscoring the need for a more intentional approach to diversification. 3. Small Caps vs. Large Caps: The Cycle That’s About to Turn Daniel Fang, CFA, CAIA, draws on market cycle history, rate-driven migration dynamics, and relative valuations to make the case for a small-cap comeback after more than a decade of underperformance. 4. How Tariffs and Geopolitics Are Shaping the 2025 Global Economic Outlook Kanan Mammadov examines how inflation, economic divergence, and a surge in protectionist policy are reshaping global markets in 2025. With trade tensions escalating and market volatility rising, he argues that investors must adjust forecasts and strategies to account for cross-border risks and policy shocks. 5. Two Enduring Legacies, One Oracle’s Exit, and “Buffett’s Alpha” This post reflects on Warren Buffett’s retirement and how the award-winning Financial Analysts Journal article “Buffett’s Alpha” helps explain his long-term success. I weave together the legacy of a legendary investor with the 80-year history of the Journal, reminding readers that outperformance may be rare, but it’s not necessarily mysterious. 6. AI Bias by Design: What the Claude Prompt Leak Reveals for Investment Professionals This forensic look at a leaked Claude system prompt reveals how embedded instructions can distort financial analysis by reinforcing bias, overstating fluency, and simulating reasoning. Dan Philps, PhD, CFA, and Ram Gopal argue that without explicit safeguards, investment professionals risk mistaking AI-generated coherence for insight and inheriting flawed assumptions at scale. 7. Tariffs and Returns: Lessons from 150 Years of Market History Drawing on one of the most comprehensive long-term datasets available, Guido Baltussen, PhD, Joshua Dekker, Michael Hunstad, PhD, Bart van Vliet, CFA, and Milan Vidojevic, PhD, explore how tariffs have historically influenced growth, volatility, and asset class performance. Their analysis reveals that while protectionism often raises macro risks, equity style factors, especially low volatility, have consistently provided resilience across high-tariff regimes. 8. Outperformed by AI: Time to Replace Your Analyst? In a head-to-head test, top AI models outperformed human analysts in generating detailed SWOT analyses — especially when guided by advanced prompting. Michael Schopf, CFA, argues that the future of investment research belongs to those who can combine model selection, prompt engineering, and human judgment into a competitive edge. 9. AI in Investment Management: 5 Lessons From the Front Lines Markus Schuller, Michelle Sisto, PhD, Wojtek Wojaczek, PhD, Franz Mohr, Patrick J. Wierckx, CFA, and Jurgen Janssens outline five key lessons on how AI is reshaping investment workflows. From boosting early-career productivity to raising ethical and regulatory concerns, this post emphasizes the need for critical thinking, explainability, and intentional integration to unlock AI’s value responsibly. 10. Bayesian Edge Investing: A Framework for Smarter Portfolio Allocation Sandeep Srinivas, CFA, introduces a dynamic, evidence-updating framework that helps investors calibrate conviction, detect mispricing, and allocate capital more intentionally.Rooted in Bayesian reasoning, the approach reframes rationality as adaptive judgment — where clarity, not certainty, gives investors a lasting edge. Looking Ahead These were the most-read blogs published on Enterprising Investor between April 1 and June 30, a quarter that reflected a profession balancing innovation with insight. Whether wrestling with the implications of AI or revisiting the lessons of financial history, our readers show deep curiosity and a continued hunger for rigor. source

“In investing, only some roads lead to Rome – others just take you in circles” Investing in consumer products requires distinguishing between passing fads and sustainable market leaders. Some companies succeed through affordability and mass-market appeal, while others thrive on exclusivity and pricing power. The key question for investors is not just which products will dominate, but why. Is the company’s success rooted in functional utility, emotional appeal, or a mix of both? By classifying products into commodity, luxury, or hybrid models, investors can identify durable competitive advantages. Is it the right time for a commodity product to achieve mass adoption? How do companies sustain value? Can a commodity business develop pricing power? Are luxury brands as resilient as they seem? Answering these questions can guide smarter investment decisions. Paths to Value: Commodity vs. Luxury Consumer products typically solve two distinct sets of needs: Functional: Addresses practical concerns such as cost, convenience, and efficiency. Here, success hinges on mass adoption and economies of scale. Emotional: Caters to status, identity, and exclusivity that transcend a product’s basic function. These business command premium pricing through strong branding and controlled scarcity. Some companies, however, blur the lines, creating a hybrid strategy that integrates affordability with aspirational branding — the final goal for all paths is to create and protect value and stay relevant. Framework to Analyze Commoditized Offerings Commodity businesses thrive by addressing practical needs, and they scale through utility. This is reflected in the S-curve of commodity businesses, moving through three key phases: Slow Build: The product is niche due to high costs or lack of infrastructure. Accelerated Growth: A tipping point, often driven by falling costs or technological leaps, fuels mass adoption. Maturity: Growth slows as competition intensifies, forcing companies to innovate or consolidate. Investor Takeaway: Each phase bears unique valuation implications. In the early stages, excitement can fuel high multiples, while in maturity, valuations moderate materially as the brand’s durability is tested.   Functional Success: Clean Energy’s Exponential Rise Solar Energy: In 1977, solar cells cost $77 per watt. By 2024, that figure plummeted to $0.11 per watt, enabling mass adoption. Companies like First Solar and Enphase Energy capitalized on this shift, delivering substantial long-term returns for investors. Similarly, in Electric Vehicles (EVs), Tesla began with the high-end Roadster. It soon recognized the broader opportunity in more affordable models. As battery prices declined, Tesla scaled up the Model-3 and Model Y, pioneering an industry now teeming with contenders like BYD.This pivot from niche to mass market underscores how effective cost reductions can transform a once-premium product into a widespread commodity. Investor Takeaway: Watch for cost inflection points in commodity industries — when affordability crosses a critical threshold, adoption and valuations surge. Fading into Irrelevance Orkut dominated early social media in markets like Brazil and India, yet stagnation spelled its downfall. Limited updates, poor mobile user interface, and minimal corporate backing let Facebook iterate faster and deliver a superior user experience. By missing its chance at a mass-adoption S-curve, Orkut ultimately faded into irrelevance. Investor Takeaway: In rapidly evolving industries, consistent innovation is paramount. Even an early lead can vanish without ongoing product development and strategic investment. Framework to Analyze Aspirational Brands Hermès Birkin bags, Macallan Scotch, and Bugatti automobiles show how heritage, craftsmanship, and exclusivity create formidable brand moats. These offerings aren’t just products; they are experiences, tied to storied legacies or handcrafted production methods that resonate with affluent consumers seeking status. By limiting production, each brand amplifies its allure. From Birkin waitlists to single-malt maturation or limited-run hypercars, scarcity becomes part of the value proposition. Three pillars drive luxury success: Aspirational Branding: Strong storytelling, craftsmanship, and heritage. Exclusivity & Scarcity: Limited production ensures high perceived value. Ownership Experience: The brand extends beyond the product. Investor Takeaway: In luxury, controlling distribution and upholding exclusivity is critical. Maintaining tight brand narrative and scarcity is essential to preserving pricing power. Investors often pay a premium for companies that leverage brand loyalty to sustain high margins. Yet even legendary names risk dilution if they expand recklessly. Contrarian View: Are Luxury Brands More Vulnerable Than We Think? Pierre Cardin rose to fame in the 1960s with avant-garde designs but pursued an aggressive licensing model across a vast product range. Although lucrative initially, this approach eroded the label’s exclusivity. Over time, Pierre Cardin’s name became synonymous with discount-level offerings – illustrating how a luxury aura can dissolve when overexposed. Is Gucci encountering a similar challenge? Its focus on trend-driven, accessible products may have diluted its luxury image, especially as consumer preferences shift towards timeless and understated luxury. Investor Takeaway: Exclusivity hinges on strategic brand guardianship. Investors should be wary of luxury brands expanding aggressively to maximize short-term profits, as it may undermine long-term brand equity. The Hybrid Approach: Bridging Functionality and Status. Several brands have successfully combined commodity functionality with premium positioning, transforming everyday products into lifestyle statements. For instance, Voss Water elevated plain bottled water into a symbol of luxury through sleek design, selective distribution, and a narrative emphasizing Nordic purity. Dyson reimagined household appliances like vacuums and fans, turning them into premium products through innovative engineering and design. Similarly, Stanley, originally known for rugged outdoor gear, evolved into a lifestyle brand with its Quencher Tumbler. The tumbler gained viral popularity on social media due to its sleek design, vibrant colors, and robust functionality. These brands address practical needs while offering a sense of sophistication. Investor Takeaway: Hybrid brands elevate basic products into lifestyle essentials through compelling storytelling and strong consumer relationships. However, as they scale, these brands often face valuation volatility due to execution risks. Investors must assess growth strategies and market positioning to ensure that expansion efforts do not compromise the brand’s core value proposition. Why Brand Equity Matters According to Kantar, strong brands balance three mental connections — knowledge, feelings, and experience — to stand out meaningfully, remain different, and stay top-of-mind. This alignment correlates with tangible financial rewards: Kantar’s chosen brand portfolio significantly outperformed major equity benchmarks since 2006.

For more insights on the equity risk premium from Rob Arnott, Cliff Asness, Mary Ida Compton, Elroy Dimson, William N. Goetzmann, Roger G. Ibbotson, Antti Ilmanen, Martin Leibowitz, Rajnish Mehra, Thomas Philips, and Jeremy Siegel, check out Revisiting the Equity Risk Premium, from CFA Institute Research Foundation. “There’s one aspect of MMT that I have some sympathy for: the notion that what we spend money on is far more important than how we finance it.” — Cliff Asness Amid resurgent and persistent inflation, much of the bloom, such as it was, is off the modern monetary theory (MMT) rose. The US Federal Reserve raised interest rates by 75 basis points (bps) on 21 September in what is just the latest step in its tightening cycle. In the face of the CPI numbers for August, which showed inflation at 8.3%, further rate hikes are hardly off the table. These developments couldn’t have been anticipated in October 2021, when the Equity Risk Premium Forum discussion was held; nevertheless, the perspectives on MMT and many other topics, shared by Rob Arnott, Cliff Asness, Mary Ida Compton, William N. Goetzmann, Roger G. Ibbotson, Antti Ilmanen, Martin Leibowitz, Rajnish Mehra, Jeremy Siegel, and Laurence B. Siegel, are still relevant. Their assessment of MMT was ambivalent at best. Arnott declared that far from having the redistributive effect envisioned by its proponents, MMT policies simply make the rich richer. From there, panelists reflected on their 10-year predictions from the 2011 forum for the realized equity risk premium (ERP). All their forecasts vastly underestimated the actual figure. Before concluding the forum, they returned to the nature of the ERP and whether it is an actual “risk” premium. Ibbotson suggests that “One possibility would be that stocks are perceived as being much riskier than they are,” while Jeremy Siegel theorizes that “It could be the Tversky–Kahneman loss aversion explanation. . . . People react asymmetrically to losses versus gains.” Below is a lightly edited transcript of the final installment of their discussion. Roger G. Ibbotson: Does anybody here have an opinion, a positive opinion, about MMT? It seems to have taken over the government and the Fed really. Does anybody think there’s something positive to that? Rob Arnott: We at Research Affiliates have a draft paper that Chris Brightman wrote a year ago, and he hasn’t published it because he was worried about upsetting clients in the middle of the COVID pandemic. The paper shows that there’s a direct link between deficits and corporate profits. That is to say, a trillion dollars of deficit spending goes hand in hand with a trillion dollars of incremental corporate profits over the next four years. This relationship has a theoretical basis that would take too long to get into right now. In any event, the implication is that if you pursue MMT, you’re going to be enriching the people who you’re ostensibly looking to “milk” with the intent of enriching the poor and the working class. Laurence Siegel: I think most of us knew that. We just couldn’t prove it. I’d love to read Chris’s paper. Cliff Asness: That’s the verdict on quantitative easing for 10 years now. Let me say something about MMT. There’s one aspect of MMT that I have some sympathy for: the notion that what we spend money on is far more important than how we finance it. The one good point in MMT, which they don’t stress enough, is this: If the government did much less and charged zero tax rates, so that there was a big deficit, the libertarian in me would think that’s a good world. And if the government spent a ton of money and fully financed it with taxes, I might think that’s a bad world. I think MMT does make that distinction. I just then make every policy choice opposite from them. Arnott: The level of taxation is not the taxes we pay. It’s the money that we spend. Because whatever is spent is either coming out of tax revenues or pulled out of the capital markets through running deficits and increasing the debt. The money is being pulled out of the private sector in both cases. So, spending sets the true tax rate and is what’s disturbing about a $3- to $5-trillion deficit. Remembrance of Forecasts Past Rajnish Mehra: Larry, after the last forum in 2011, you sent an e-mail with everybody’s forecast for the equity premium. L. Siegel: It was an e-mail with all the forecasts from 2001, so we could compare our then-current (2011) forecasts with the old ones (2001). I don’t have a record of the forecasts from 2011. Sorry. But I do remember that Brett Hammond gave a talk at the Q Group in 2011 where he said that all the 2011 forecasts were very close to 4%. Ibbotson: I missed the last forum because of a snowstorm, but I think markets exceeded almost everybody’s expectations. L. Siegel: They sure did. Ibbotson: So, it doesn’t matter what we said. Whatever the forecasts were, the market did better. The person who had the highest estimate, won. Jeremy Siegel: And, by the way, I would say that bonds did much better than everyone predicted. Stocks and bonds both exceeded expectations over the last 10 years. Martin Leibowitz: My recollection — I could be wrong, and you’ll correct me on this, Larry — was that the numbers ranged from a 0% risk premium up to around 6%, with an average of 3.5% to 4%. It’s very interesting how those forecasts correlate with a lot of the numbers we’ve been bouncing around today, with very different types of explanations for how we got there. L. Siegel: Marty, those were the forecasts in the 2001 forum, the first one. In the 2011 forum, the estimates were all very close to 4%. Looking at the 2001 (20 years ago) forecasts, the lowest was Rob’s, and it was zero. But these were not 20-year forecasts; they were 10-year forecasts. The highest forecast was that of Ivo Welch, but the highest forecast from among