FEATURING:
Dr. Richard Sandor
Chairman and CEO of the American Financial Exchange

05
Incentivize Good

November 20, 2019 | 42:21

Known as the father of financial futures, Dr. Richard Sandor, chairman and CEO of the American Financial Exchange, joins us for an in-depth conversation about his journey to becoming a financial innovator. He discusses creating the Chicago Climate Exchange; his newest venture, Ameribor, an alternative to LIBOR; and why doing well and doing good don’t have to be exclusive.

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Hugo Scott-Gall
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SHOW NOTES
03:04 Innovation is the commercialization of an idea.
05:11 Richard created a new substitute for LIBOR, knowing it would take a decade to work on.
07:53 You know you are right when you are a contrarian.
09:43 Never ever surprise a regulator.
10:33 The challenge with the original members of the Ameribor exchange was that there was no peer-to-peer FinTech.
13:34 The name of the game is how to minimize transaction cost.
14:00 Spot a big trend, make sure you create a tradable instrument and evidences of ownership, then create a central marketplace, build an exchange, design the contracts, and prepare for deconstructions of the same into OTC-like swaps.
15:40 There are first movers, fast followers, slow followers, and “I’d rather die than change” people.
16:27 Success or failure isn’t as useful as thinking of things as a clinical trial.
19:15 Blockchain was invented in 1990 by a professor at Princeton.
20:00 The success of climate markets is directly proportional to the distance from Washington, D.C.
21:21 Look to California and China where all environmental change occurs.
27:15 There’s no more powerful signal than price.
29:00 You can do good and do well; they are not mutually exclusive.
31:24 There are not many free markets in America.
36:58 Richard shares the timeline of his life.
Transcript
Hugo Scott-Gall: Today I am delighted to have joining me Dr. Richard Sandor. We are in his office, and I have to say he has one of the most impressive photographic collections I’ve ever seen. I think the best way to describe Richard is a serial innovator and a relentless problem solver.

Here are some things you need to know about him: he has a PhD in economics from the University of Minnesota. He was a professor at the University of California at Berkeley. He was chief economist at the Chicago Board of Trade where he was the key person in the invention of financial futures. You heard that right, he invented interest rate futures.

In the 1980s, having turned future money into a tradeable commodity, he set about turning air into a tradeable commodity, specifically polluted air. He designed emissions trading systems and created the Chicago Climate Exchange in 2003. As a result, Time magazine named him as a hero of the environment. His latest venture is the American Financial Exchange, created to trade Ameribor, which is designed to be an alternative to LIBOR. He solves problems on a grand scale via creating market incentives and price discovery.

I can assure you that was just a truncated version of his resume. Believe me, there is plenty more in terms of impressive accolades and achievements that I left out. Not least, beating Bobby Fischer at chess. Richard, I want to say thank you for joining us.

Richard Sandor: It’s my pleasure to be here with you and the listeners today.

Hugo Scott-Gall: Also, with me from William Blair is Blake Pontius. He is the Director of Sustainable Investing, and he never got to play Bobby Fischer at chess.

Blake Pontius: Thank you, Hugo. That’s factually correct.

Hugo Scott-Gall: We’ve done the intro, so let’s get going. So, first question to you. You’ve created Ameribor. Can you tell us why you did it? Why you created it and what’s the problem you’re solving? And how does it work?

Richard Sandor: I created it in 2011. And maybe we can talk about a broader subject, because it might address some of your listeners’ other questions that they have. Where does a new idea emanate from? What sparks it? How do you innovate? Innovate means make it commercial. Invention is coming up with the idea. Innovation is the commercialization of the idea. It was pretty simple. We sold our last exchange, the Climate Exchange, in 2010 to ICE (Intercontinental Exchange, Inc.).

And we were going to pursue water markets, and we were furiously working on basin trading in New Mexico, preserving the Great Lakes in Chicago. Picked up the FT in 2011 and saw a small article that the Royal Bank of Scotland had fired four people for manipulating LIBOR. I think 40 years in the finance business taught me that if you’re going to manipulate, it takes two to collude. So, if there were four, it was likely to be 40 or 400. And this was a structural event in my mind.

And I had seen things like this and studied things like this, where there’s a particular event. And that goes back to the Dutch East India Company in 1605, the birth of wheat trading in Chicago in 1848, the birth of the mortgage market in ’70, and acid rain and emissions trading in 1990. And one looks at this and then has to make a judgement. And the judgement is, what’s the next 10-20 years going to look like? And we called a team in and said, “Let’s put a new substitute for LIBOR.” It will take a decade to work on, but we made three assumptions, and four sort of, if you combine two of them.

Number one, that LIBOR would lose its preeminence. That this would lead to a cascading of difficulties in the market. Number two, that zero interest rates were not sustainable. Number three, that the world’s largest economy ought to have its own interest rate benchmark. Very strange that 22% of the world’s GDP was relying on international and multi-national indexes. And number four, the Fed had to relent on its policies on interest on excess reserves. That was a response to a catastrophic decline in GDP in ’07 and ’08.

Having said that, we called up the lawyers, got a patent application worked on, said, “Look, London has LIBOR, Europe has Euribor, Hong Kong even has HIBOR. America’s got nothing. So, let’s trademark Ameribor.” Since the goal was to develop an American benchmark, this meant American banks. And people who focused on lending to new businesses, small businesses, medium-sized businesses.

So, my life changed dramatically. I used to go to Shanghai and Singapore and London and Paris and New York, and now I’ve found myself in Bentonville, AR, Evansville, IN, Tupelo, MS. The birthplace of Elvis among other things. And so, I reacquainted my history at the Board of Trade when I was doing grain contracts and things like that. Got criticized and said, oh, we don’t really need an overnight unsecured lending market. We borrow from the government, we lend to the government. Interest rates are zero, go back to Chicago.

You know you’re right if you’re a contrarian when most people don’t think that what you’re talking about is realistic or is the right time. And so, my standard retort was, if you want to be on time, you have to be early. You can’t get a solution when it’s apparent there’s a problem. You have to be anticipatory. So, we continued for two years and then we got some sails, wind in our sails, when the Fed announced it was forming an alternative rates committee. And people started saying maybe this is not such a bad idea, and maybe LIBOR will continue to have problems and investigations and fines and things of that nature.

2015, we went to the CBOE. Said, “You’ve got a great set of products, you invent, you’ve got volatility, you don’t have an S&P 500, But you don’t have an interest rate complex. And if you’re going to compete with other big exchanges, you need to be diversified. You serve as our compliance. We want a regulated market, we want it to be transparent. We’ll develop the index, then you can put up futures, options, ETFs, ETNs and service the community.”

They agreed, summer 2015 and it’s very important as an inventor, one proposition over the last 40 years, is never ever surprise a regulator. Not even on Christmas. It’s a non-starter. So, we went down to Washington with a gentleman by the name of Rodgin Cohen. He’s the chairman of Sullivan & Cromwell. Briefed the Fed, the OCC, the FDIC, the SEC, the CFTC, and launched the exchange on December 11, 2015. We had four members, and they were the biggest bank in Wisconsin, the biggest bank in Indiana, one of the biggest banks in Chicago, and the biggest independent bank in Texas.

The problem and the challenge that we faced at that time is that none of these banks had lines to each other. There was no notion of peer-to-peer fin-tech. And they had to get reacquainted with their neighbors. We started with four, we averaged $13 million a day, we’re up to 163 members. 30 non-banks and 133 banks. And then 1,000 correspondents. So, we represent about 20% of America’s banks. And in asset terms, cumulatively, over $2 trillion in assets.

We have as our tagline very important to us, commercial logic with social value. And we had a Native American bank join and we have every FDIC minority bank in America. And we’re making a special nod to diversify at the CEO level and to get women CEOs. And we’ve accomplished and have a number of woman CEOs.

So, this is a massive project that takes a decade. It probably cost, and it has me, over the last 40 years, it’s generally a decade to get to it. Zero to two is kind of a toddler. Two to five is infancy, five to ten is young adult, and ten to twenty is full adulthood. And it generally—you have to raise about $40—$50 million to implement it and you have to be laser-like focused and make sure that you don’t ever lose that focus in what you’re doing. That’s a sure long-winded answer, but I wanted to cover some things because people often call and say, “I have a new idea. How about cannabis futures?” I said, great, then you’ve got a half-percent done. Now get $40 million and figure another ten years and you’re going to be on your way.

Hugo Scott-Gall: One of the things you said which really stuck out was sort of the social benefits of this. Could you talk a little more about kind of you’re 40% of where you want to get to? But when you get there, what would be the social benefits and how would you categorize them?

Richard Sandor: Well, we trade between $190 and $195 for overnight benefit. The bid offer market at the Fed and at larger alternatives is $180 bid at $225. So, we think we’re going to increase the profits to the banks and reduce the costs of borrowing by cutting down the bid-ask spread. And that’s really the name of the game. How do you minimize transaction costs? How do you build the network of users and keep transactions low so that the buyer and seller is cheaper to operate? And it doesn’t much matter if it’s bond futures or acid rain permits or sustainable markets in water.

The idea is to spot a big trend, make sure you create a credible instrument and evidences of ownership. Then try to create a central marketplace, then build an exchange, and then design the contracts, and then prepare for deconstructions of the contracts into OTC-like swaps and things of that nature.

Hugo Scott-Gall: And do you think this is a less esoteric product than some of the others you’ve launched before. You were generally creating new markets that didn’t exist. This does exist around the world, it’s just an American version of it. So, therefore, can the adoption and the growth be faster and quicker? Maybe your ten years is a little too bearish.

Richard Sandor: Well, we started in ’11. 2021 I think it’s 2019 already. We’ve got eight years in it, you know? It’ll begin to be a college kid in 2021 and maybe get into the workforce. But it doesn’t much matter. I think that people don’t recognize that they were using typewriters in 1980 in journalism schools five years after the personal computer was adopted. Power steering and television were invented in the ‘30s and didn’t become ubiquitous until the ‘50s. So, if we look at industrial inventive activity, financial inventive activity, it’s a generation any way you count it.

Hugo Scott-Gall: Yeah.

Richard Sandor: There are, fundamentally, and the reason it doesn’t come, because I’ll give you and I’ll share with you what one person’s theory of the case is. There’s first movers. And maybe that’s 15% of the population. There’s fast-followers, there’s slow-followers, and then there’s “I’d rather die than change.” Right? So, you’ve got, ultimately, to go through that process, you have to critically identify who the first movers are, who are the opinion leaders, and no matter how obvious the product, not every – our job is to embrace change. And to recognize that failure doesn’t matter.

All the young people that you see around – this is only a clinical trial. You don’t get it right, you do a second. You don’t get it right, you do a third. And so, we don’t really think about things in terms of success or failure, we think of clinical trials. And it’s hard to shrink the process, or at least, I’m not smart enough to figure out how you reduce it to two years. And try to really, especially if you’re in the business that we’re in. And we’re in the business to find transformational change. We want to make a big difference; we’re not playing a game where it’s marginal. And when you’re trying to effect worldwide behavior, I don’t think there’s a shortcut. Or maybe if you guys can tell me about it—I’ll be quick to say I got it wrong.

Hugo Scott-Gall: I’ve got one more question on this topic before we move on to environmental and ESG-related things. So, where else in financial markets do you see problems that need solving? And maybe a strand of that, maybe this is an over-stated solution that blockchain technology can actually solve quite a few frictional problems. Maybe they’re more hidden, they’re not quite front-and-center, but they exist. So, would you include blockchain, blockchain technologies within a suite of solutions of financial markets? Or are there some other big problems in financial markets that you are going to get your teeth into without giving away?

Richard Sandor: The only constraint is time. I see more change in the next 20 years than I do in the last 20 years. And I think it’s a dangerous idea to ever go short mankind and womankind’s ability to invent. It’s a bad short. Never get short creativity. It’s a bad trade and so, you’ve got water problems, you’ve got blockchain, you’ve got a question of, what’s the role of a clearinghouse? If you have a trusted network? Will exchanges exist, not exist, what form will they take, will they be ethereum-based under the theory of the case?

People—sloppy research is bad. Let me conclude on this topic and we can get to other topics. The conventional wisdom is the blockchain and bitcoin was invented in 2008 by Nakamoto. That’s wrong. Okay? It was invented in 1990 and it was by a professor at Princeton and he wrote an article in the Journal of Cryptology, and ultimately started a blockchain-based network in 1994. And the published third-force was the Sunday ad in The New York Times, which is published today. Under the 20-year theory that we spoke about earlier, the blockchain should bloom by 2022. It doesn’t begin in ’08 and 2028.

Blake Pontius: So, just shifting gears back to the environmental aspect of your work, I think when you were launching the Chicago Climate Exchange, the people referred to it as global warming, which has now kind of evolved, unfortunately, to a climate emergency. Is sort of the common – the way that investors and society are framing the problem. Do you think that a broader policy response is becoming increasingly inevitable to this climate emergency that we’re facing?

Richard Sandor: Two things come to mind. Number one, it’s very important to recognize that the United States is a federal republic, and the success of climate markets and cap-and-trades is directly proportional to the distance from Washington D.C. The further you go, the more you find local solutions. So, perception and reality. Perception is, no public policy on climate change. Reality: open interest in North American carbon, including the state of California, RGGI (Regional Greenhouse Gas Initiative), the 10 states, renewable energy, is over 700,000 contracts, which means North American’s carbon open interest is 40% bigger than gold. And everybody thinks nothing is happening in the U.S. Couldn’t be further from the truth.

Blake Pontius: And then in China, I know you’ve done some work there as well, I mean, it’s amazing the progress that we’re seeing and the commitment to reforms.

Richard Sandor: It’s game-over as far as I’m concerned. If you want to look at the future now, and your investors do, or stuff like that, it’s my humble opinion, you look to California where all change occurs. Good or bad. And China. Both of these have cap-and-trade; or are well on the way. In 2020, China’s going to have a national system. We set up, or introduced, the idea of environmental markets in China and I would go around lecturing there in 2007. And I gave a talk at Peking University, the Harvard of China, and I started doing basic ABCs. What is an environmental market? The dean looked at me like I was insane and raised his arms, and said, “Jack up the level. You’re talking down.” Every university student was bilingual, and in 2007, there was an undergraduate emissions trading club at Peking University.

So, lest we think this communist country doesn’t get it, they have a trade-off. They have 500 million poor people and they’re just going to get around to it and, like they do everything, when they change, it will be massive. You’ll get 1.4 billion people moving in the same direction. And I think a lot will change when the world’s largest emitter institutes cap-and-trade.

Blake Pontius: So, I think 20 years ago, when you helped launch the Dow Jones Sustainability Index (DJSI), you were clearly witnessing, or you had a belief in the link between corporate performance and positive ESG management. Do you see that link strengthening over time as environmental and social issues become increasingly material?

Richard Sandor: Yeah, I do. And I think it was just an educational—you know, the folks who get to leadership positions, CEOs, are very savvy people. It’s very wrong-headed to think, and I think we’re seeing vast changes going on. Our particular belief is society and its norms are changing dramatically. Go down to the University of Chicago, look at the student body, listen to the student body. Understand what they want, and gender issues are irrelevant, and certainly racial issues are long-gone, and I think the world is changing dramatically.

And I think that as shareholders speak out, managements will pay attention. Stockholders, after all, own the company, and if they see the SEC worrying about environmental liabilities that are hidden in balance sheets, they see stockholders, they see movements to diversify their board, they will get the message. And then you will hit a turning point. And so, I tend to be very optimistic about these issues.

I think there are challenges. I think the biggest one is water. Okay? And all you need to do is look at Europe today and imagine if you had water problems in the subcontinent and you had 300 million people on the march and what would happen to borders and what would happen? We have enormous challenges in front of us, but I’m optimistic. Whether it’s William Blair and its customers, its investors, its principals, capital markets really change quickly because the assets go up and down in elevators and you don’t have a 40-year fixed piece of plant and equipment. And people are incredibly capable of pivoting when they have to.

Hugo Scott-Gall: If you were looking at a company and analyzing it and trying to work out whether through an ESG lens, do you think all the things you would want to know could be measured and quantified? And the second part of my question is, do you think there is a risk that companies change their behavior to look good on the things that can be measured and quantified? As in, the metrics inform the behavior, rather than the behavior informing the metrics?

Richard Sandor: Yeah. I think the whole notion that I have with regard to (and it may be a wrong hypothesis) is you can’t look at this as a negative filter. The job is not to punish the bad, it’s to incentivize good. And this is really the issue, and much of the environmental movement began with “punish the bad.” Thus, I got into DJSI and in inventing and playing a role in something like that. You can’t say it’s bad behavior. You know? There’s no more powerful signal than price. Whether it’s the price of a stock, the price of pollution, and once you put the idea in place that it pays financially not to pollute, it pays not to pollute in financial terms, you’ll change behavior.

I think there are some people who grain wash. I think they ultimately will be out of business, that they will not be able to—you can fool some of the people all of the time and all of the people some of the—you know, all of that stuff. And it’s not a long run. If we can, as a society, take a look at this country, how it’s transformed itself in the last 20, 30 years, it’s remarkable. If you would have ever said that an exchange in Chicago like the CME and ICE, the CME alone is going to be—which was a—CBT was, butter and eggs, pork bellies, that it would have a 40% higher market cap than the auto industry? Than General Motors? You would have said, “Put the guy away.”

Hugo Scott-Gall: Yeah.

Richard Sandor: That can’t happen. There’s no way a futures exchange is going to be 40% bigger than General Motors, which was the largest company in the world. Right? And so, I think you have to really get transparency and get out a price and you’ll change behavior.

Hugo Scott-Gall: So, you pretty firmly believe that green is both a moral color and an economic color?

Richard Sandor: I think you can believe that, and what I say to students in my classes is, you can do good and do well. They’re not exclusive. The idea is not to be on the negative side. We all know what the problems are. It’s to provide a solution that makes rational, economic behavior. That’s the job of an inventor, is how do I make it rational for you as a profit-maximizer to provide commercial logic and social value?

Hugo Scott-Gall: So, one of the things I was thinking about, reading some of your work and some of your interviews, is I think you—and please do correct me if I’m wrong—I think you believe in markets. And you believe that markets via price discovery incentives can lead to good solutions. I would argue in the current political environment, markets as doing good are under some pressure. That core belief that markets provide, ultimately, good solutions for a greater number of people, is maybe being tested. Maybe markets don’t lead to good outcomes. So, as someone who has used price discovery leading to markets as the key vehicle for effecting change, are you prepared to stick up for markets and make the defense for them? And some are saying, actually, market-based solutions don’t always work and there needs to be an intervening hand above that?

Richard Sandor: Well, two answers. In 90% of the case, what you call a free market is not a free market. Economists call rent-seeking, the ability to exact monopoly profits, not through competitive behavior in the marketplace, but because you get a special niche in some bill that’s 2,000 pages long. And it weakens the fundamental ideal of symmetrical information, pure and perfect competition, because advantages are gotten politically, not because of efficiency and being a low-cost reducer. So, the notion that—we don’t really have a lot of free markets in this country. There’s a lot of regulatory and institutional efforts and legislative efforts to corrupt the markets.

I think we have a very unfortunate situation in the West, and I include Europe and the U.S., in which the political leadership has not made the case for free markets. And the amount of money that’s spent on elections—you think of $5 billion to elect somebody—and people say to me, “Well, that’s ridiculous.” And I say, well, I’m an economist. If I think I’m going to get more than $1 million in benefits by supporting a candidate, it’s quite rational. This is a cost-benefit thing. So, if it costs $7 billion to elect a CEO, then it’s likely that $7 billion, these are investors. They’re not political contributors.

Having said all of that, I couldn’t be more bullish on America, on Europe, on the Western ideals of democracy. I think it’s up to the academic institutions, to those of us who are practitioners, to identify market failures. And to try to curb them. To identify rent-seeking and try to eliminate it. And by-and-large, the Western democracies have had 500 years of hegemony, and I think it’s because of free markets and social innovations and democracy. Whether it’s the Magna Carta or whether it’s double-entry bookkeeping, or the U.S. Declaration of Independence and Constitution. These social and financial innovations dominate things like the steam engine or anything like that.

And that’s why financial innovation is so challenging. Because you can affect the well-being of lots of people by allowing fairness in markets.

Hugo Scott-Gall: One of the things that I find fascinating, and Blake and I were discussing on the way over, is process. So, to do what you do, you’ve got to have a process. You identify things that need solving, or problems, or opportunities. Then you’ve got to make them happen. Do you consciously think around your process for how you do it? Or do you just kind of subconsciously gut-instinct it? Do you say, okay, first of all, I want to create interest rate futures? Now I’m actually going to think about emissions trading. Now I’m doing Ameribor.

And these are—at their core, they’re similar things that they’re doing. We need a solution to something, design it, execute it, build it. So, there must be a process there. I was wondering if you could just talk a little around, kind of, have you ever codified your process, and what is it?

Richard Sandor: Yeah. I’ve talked about, there is a process. And as I alluded to at the outset, that there are seven stages that you go through. And one is a structural change. The second is the standardization of whatever you’re speaking about. The third is creating evidence of ownership. The fourth is informal exchange. The fifth is organizing exchanges. The sixth is futures markets and the seventh is deconstruction into OTC products. 1848, mortgages, sulfur trading, they all follow the same thing.

I always – one thing that keeps me straight and one thing that I say, and it’s kind of the great hockey tradition in this town. You’ve got to skate where the puck is going, not where it’s been.

I always try to look 10-20 years from now and imagine the change that has occurred over the last two decades and extrapolate that into the future and say, okay. Do we want to lose 5,000 small banks in the United States? Who is going to lend to the dairy farmer in Minnesota? Is it going to be a multi-national bank? Who’s going to lend to a 50-person feeder company to Walmart in Bentonville, AR? Is that going to be a French bank? Who is going to provide the local services? You can have economies of scale, but credit is very much, very important. And the more we rely on a systemic group of organizations to deliver a homogenous commodity to a heterogenous consumer, it’s not going to work. It’s just not good for the republic.

Blake Pontius: Yeah, we were hoping to just talk a little bit about where your innovative mindset came from in terms of your earlier years at—going from Minnesota out to the west coast, reading your book Good Derivatives, it seemed like a very influential moment for you when you arrived in Berkeley.

Richard Sandor: Look, I’ve been honestly blessed. You know, I grew up in Brooklyn, NY and played competitive chess and looked at a world that was out of my scope. That, unless I had done things, I lived in an exciting environment, I was stimulated. I watched growing up, as I said, I’m 700 years old, so I grew up as a pre-war baby.

Hugo Scott-Gall: Pre-which war?

Richard Sandor: Second World War. So, I’m a pre-war baby. I’m part of the silent generation, if that would make any sense to you. I lived in the 50s, went to college and watched Allen Ginsberg and beat poets in the 50s and I went from that environment, in the beat generation, to an entire Midwestern, plain-vanilla world. And I got to know and love the Midwest. I ended up in Berkeley in ’66 and said, “Oh, my God! Free love!” Women’s rights, drugs, you name it. And I watched six years of social issues being born. And I arrived in Chicago in ’72 and ’73, the great grain crisis begins, the Arab oil embargo, and I ended up being in the commodities business.

And so, I’m just lucky. And I don’t for a second, nor should your listeners, think that right time and right place and being fortunate isn’t a very important part of anybody’s success. There’s lots of people that have many ideas that don’t get a chance. And I happened to end up, through a set of circumstances to live in Chicago, then, in the ‘80s watched the derivatives and worked on acid rain, because somebody said, could you commoditize acid rain? I said, sure. You did it in interest rates. And then I got to do a lot in Europe and in China. And so, you know, it’s been a series of blessings. And I’m thankful for it.

Hugo Scott-Gall: We could take another two hours of your time easily, but we shouldn’t and we mustn’t. So, I want to say thank you for giving us all this time, giving us such intriguing, fascinating answers. We’ve learned a ton, and I’m sure our listeners will. So, from me, thank you.

Blake Pontius: Thank you, Richard.

Richard Sandor: Oh, it’s my pleasure. Look, fundamentally, I have been teaching for 56 years. And it’s a great pleasure to have people like yourself ask informed questions. And that’s 90% of an interview. So, thank you for being informed and being prepared. It makes this job a lot more fun and I hope that your listeners have learned something as a teacher. And if they’ve learned something, then I’ve done my job.

Hugo Scott-Gall: Well they will do, for sure. So, thank you very much.

Richard Sandor: Thank you.

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Hugo Scott-Gall
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Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Statements concerning financial market trends are based on current market conditions, which will fluctuate. William Blair does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax questions and concerns.

Investing involves risks, including the possible loss of principal. Equity securities may decline in value due to both real and perceived general market, economic, and industry conditions. The securities of smaller companies may be more volatile and less liquid than securities of larger companies. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Investing in the bond market is subject to certain risks including market, interest rate, issuer, credit, and inflation risk. Rising interest rates generally cause bond prices to fall. Sovereign debt securities are subject to the risk that an entity may delay or refuse to pay interest or principal on its sovereign debt because of cash flow problems, insufficient foreign reserves, or political or other considerations. High-yield, lower-rated, securities involve greater risk than higher-rated securities. Currency transactions are affected by fluctuations in exchange rates; currency exchange rates may fluctuate significantly over short periods of time. Different investment styles may shift in and out of favor depending on market conditions. Diversification does not ensure against loss. Any investment or strategy mentioned herein may not be suitable for every investor. Past performance is not indicative of future results.

The MSCI ACWI IMI Index is a free float-adjusted, market capitalization-weighted index that captures large, mid, and small cap representation across developed and emerging markets. The MSCI ACWI ex-US IMI Index is a free float-adjusted, market capitalization-weighted index that captures large, mid, and small cap representation across developed and emerging markets, excluding the U.S. The Value and Growth Indices are a subset of the Index that adopt a framework for style segmentation in which value and growth securities are characterized using different attributes. Multiple factors are used to identify value and growth characteristics. The MSCI ACWI Small Cap Index is a free float-adjusted, market capitalization-weighted index that captures small cap representation across developed and emerging markets. The MSCI Emerging Markets Index is a free float-adjusted, market capitalization-weighted index that is designed to measure the equity market performance of emerging markets. The MSCI World Index is a free float-adjusted, market capitalization-weighted index that is designed to measure the equity market performance of developed markets. The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid ARM pass-throughs), asset-backed securities and commercial mortgage backed securities. The Russell 2000 Index is a market capitalization-weighted index designed to represent the small cap segment of the U.S. equity universe. Index performance is for illustrative purposes only. The indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly.

Alpha is a measure of an investment's return in excess of the market's return, after both have been adjusted for risk.

Beta is a measure of the volatility of an investment relative to the overall market, represented by a comparable benchmark.

Half-life is a statistical measure of the time required for the discrepancy between price and value to contract by half of its starting value. Fundamental value estimates are based on the Dynamic Allocation Strategies team's proprietary research.

P/E Ratio is a measure of valuation which compares share price to earnings per share, calculated using estimates for the next twelve months.

Standard deviation is a statistical measurement of variations from the average.

QUANTITATIVE MODELS—FACTOR DEFINITIONS

The William Blair Earnings Trend Model captures information about short- and medium-term changes in analyst estimates in an attempt to anticipate future estimate changes and stock performance. The score combines measurements of earnings revisions, momentum, and earnings surprise.

The William Blair Valuation Model combines varying metrics used to characterize the relationship between the stock’s trading price and its intrinsic value. By going beyond using only one or two measures, the model attempts to build a more holistic version of a stock’s worth vis-a-vis the market. The score combines measurements of earnings/cash flow based, asset-based, and model-based factors.

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