Thursday, July 30, 2009

Knightian uncertainty

In 2004 Alan Greenspan offered the following: "When confronted with uncertainty, especially Knightian uncertainty, human beings invariably attempt to disengage from medium to long-term commitments in favor of safety and liquidity." I stumbled upon this quote in an article by Ricardo J. Caballero and Arvind Krishnamurthy in the October 2008 issue of The Journal of Finance. Their article deals with the common flight to quality events that occurs during severe market jolts and the role that the lenders of last resort (LLR) typically have. My intent at bringing this up isn't to address their subject, although it's quite an interesting one and one that we will be addressing more formally at a later date, but rather to touch on this term "Knightian uncertainty."

If you're like me, it's one that you're not familiar with. It is derived from a book by Frank H. Knight (Risk, Uncertainty, and Profit) that was written in 1921. I was able to find a 1965 edition and haven't yet read it, though I intend to at least skim through to see what gems lie between its covers.

The term "Knightian uncertainty" wasn't coined by Knight (just as "Sharpe ratio" wasn't coined by Sharpe), but probably not by Greenspan, either. A "google search" brought me to the often times reliable Wikipedia site which informs us that Knight distinguished risk and uncertainty. It involves the presence of immeasurable risk. To further quote Wikipedia, "Knightian uncertainty is risk that is immeasurable, not possible to calculate."

The site specifically references the book and provides the following: “Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated.... The essential fact is that ‘risk’ means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating.... It will appear that a measurable uncertainty, or ‘risk’ proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.”

When it comes to measuring risk, many will recognize that most of our common risk measures (e.g., standard deviation, beta, tracking error) are measures of volatility or, if you prefer, variability, which many argue isn't risk. This causes one to ask, "well what IS risk?" The most commonly cited definition deals with the inability to meet an objective, while the potential for loss is also often used. I've seen uncertainty referenced in the past, though on my own wondered how one would measure it. Well, Knight pointed out almost 100 years ago that you can't measure it! I wish someone had told me.

Moving further along I came across, which offered the following: “Economists distinguish between ‘Risk’ and ‘Uncertainty’: the former can be priced by financial markets while the latter cannot. The distinction between the two was made by the famous economist Frank H. Knight in his seminal book, Risk, Uncertainty, and Profit (1921). In brief, ‘Risk is present when future events occur with measurable probability’ while ‘Uncertainty is present when the likelihood of future events is indefinite or incalculable.’”

Why the need to qualify the term "uncertainty" isn't clear to me, though it's worth understanding a bit more about the term, in general. It is interesting, isn't it, that the basis for much of what we do was addressed years, decades, or perhaps even a century ago, but unfortunately isn't always known to us, for a variety of reasons.

Wednesday, July 29, 2009

Interpreting the IRR

I recently stumbled upon an article that I found quite interesting: "What Does an IRR (or Two) Mean?," by David Johnstone (Journal of Economic Education, Winter 2008). David is the National Australia Bank Professor of Finance at the University of Sydney School of Business. I found two things in particular quite insightful.

First, you may be aware that with the IRR we run the risk of having multiple solutions. And although there are techniques to help identify the number of potential solutions, the process is still fraught with challenges. David pointed out that multiple solutions will only occur "when the balance in the investment is at one or more times negative. That is, at some stage in its life, more is taken out than exists in the account." (page 79) I found a second article by Eschenbach, Baker & Whittaker ("Characterizing the Real Roots for P, A, and F with Applications to Environmental Remediation and Home Buying Problems," The Engineering Economist, 2007) which supported this claim. Clearly there are cases when the multiple solutions problem will be an issue, but how frequently will we find an investment portfolio go into the red? Dare I say virtually never?

The second insight I gained from David's piece was his "simple but intuitively meaningful interpretation of the notion of IRR." He uses the following example:
  • at time = 0 (the starting point), we begin with$1,200
  • at time = 1 (end of year 1), the client withdrawals $500
  • at time = 2 (end of year 2), the client withdrawals $850
  • at time = 3 (end of year 3), we end with $500.
The IRR is found to be 25 percent. So, what does this 25% represent? It's what we earn throughout the period. The following table should help convey this:

t = 1 t = 2 t = 3

Balance at (t-1) 1,200 1,000 400
Period t interest (25.00%) 300 250 100

1,500 1,250 500
Cash flow at t -500 -850
Balance at t 1,000 400 500

We can see that with the IRR, we're able to reconcile our values throughout.

This, of course, is something you can't do with time-weighting. I expect to discuss this at greater length in the August issue of Performance Perspectives.

Tuesday, July 28, 2009

Jim Johnson, age 68, succumbs to cancer

Jim Johnson, Philadelphia Eagles Defensive Coordinator, died today of cancer (see What, you may ask, does this have to do with performance measurement?

On January 28,2005, the Home News Tribune (a NJ paper) ran a story titled "New Challenge for Defense," which discussed the Eagles' victory over the Atlanta Falcons in the NFC Championship game. The article attributed much of the Eagles' success to Johnson's tactical prowess.

I have used this headline in our attribution classes since that time as an example of attribution. I just learned of Johnson's death when visiting the ESPN website, and felt it appropriate to acknowledge this in light of my regular use of the article and the citing of Johnson's exceptional skills.

We ALL know folks who have died from cancer, be it parents, spouses, other relatives, or friends. It's a dreaded disease that touches us all. As an Eagles fan, I know the team will miss him, as will his family and friends.

VaR...not as hard as one might think

This past week I spent a day dealing with the single topic of Value at Risk (VaR). This was in a class I'm taking in my doctoral program. Our professor, Aron Gottesman, did a fantastic job showing how VaR isn't nearly has challenging as one might think. As a result, we will be holding a webinar dedicated to the topic and will also have this as a topic at our upcoming PMAR VIII.

Just about everyone in the industry has heard of VaR, but not everyone understands much about it. Concepts first: it reports the most money that can be lost, for a specific time period, at a specified confidence level. For example, the most your portfolio can lose over the next ten days is $100,000, at a 98% confidence level.

At PMAR VI I debated Robert Mackay on this topic, arguing that VaR is "voodoo," while he took the position that it has value. While I lost the debate, I still question the accuracy of the results given the way VaR works. Robert returned this year to PMAR VII and acknowledged that the results, as predicted last fall, were somewhat optimistic, given the significant downturn we saw. That's the challenge with VaR: it bases its predictions on past performance, which can often be met with a shock. And while these "one in a thousand year" events don't happen all the time, they clearly occur a lot more often than once every thousand years.

When using VaR, one must be careful as to how much credibility they place in the results. I'd argue that one thing we know is true: that the results are in error because of the faulty assumptions. However, they do provide valuable information. The recipient should understand what the assumptions were in providing the information and recognize that it's an estimate that may under or overstate reality.

If VaR is important or of interest to you, please join us when we hold our VaR webinar. And, consider joining us for PMAR VIII, when we'll go into a bit more detail on the topic. The webinar date will be announced soon.

Monday, July 27, 2009

Discretion...does this help?

GIPS(R) compliant firms are required to include all actual (i.e., a REAL account, not a model), fee-paying (i.e., that the account pays fees, though this may change with GIPS 2010 to mandate the inclusion of non-fee paying accounts, too), discretionary accounts into at least one composite. Let us turn our attention to the word, "discretionary." What is meant by this?

First, the term is admittedly confusing. We are already aware of the legal definition: that is, a firm is legally discretionary if they have granted the portfolio manager the right to trade on their behalf. Great! Is that what we mean here? NO! Then what DO we mean?

We mean GIPS discretionary. In order to know if an account is discretionary from a GIPS perspective, it already has to be legally discretionary. And here we're speaking of the cases where accounts have placed certain restrictions on the manager (e.g., no "sin" stocks). The manager gets to decide if the restriction has impeded their ability to execute their strategy.

While teaching a class recently I came across this metaphor (or analogy, if you prefer), which I think may help. Let us turn our attention to the world of cooking.

For roughly 35 years I have had the responsibility to make the stuffing whenever we have turkey. And each year I turn to my wife's trusty Betty Crocker Cookbook for the recipe. And each time I prepare the stuffing, I do it the same way.

Now let's suppose that I've been asked to prepare the stuffing for someone else and they ask me to substitute wheat bread for the white bread, or perhaps to add a cup of chicken broth to the mix. Can I do this? Yes, of course. But, can I predict what the result will be? Am I comfortable taking the praise (or criticism) for the result? Maybe not. You've altered my normal normal strategy for executing my process to prepare the stuffing. And so, I may say "yes, I can do this, but you get the credit for this idea." Thus, I might say that it's nondiscretionary.

Returning to investing, I wouldn't say that the client gets the credit. Clearly, I've agreed to do something for the client and the result is influenced by whatever that was. But, I may not feel that the result matches what would have occurred had I not had the adjustment made and thus declare it nondiscretionary for GIPS purposes.

Hope this helps! Please let me know your thoughts.

Friday, July 24, 2009

Standard deviation: dispersion vs. risk

Standard deviation is a commonly used statistic, well known by many long before they enter the world of performance measurement, which serves multiple purposes and thus engenders confusion.

The GIPS 2010 draft proposed a requirement that a 36-month annualized standard deviation be shown by GIPS(R) compliant firms. While it remains unclear whether this will stick (because of the opposition expressed by those who commented), it remains a commonly used risk measure. It reports the volatility in returns over some time period.

GIPS requires compliant firms to report a measure of dispersion when there are six or more accounts present for the full time period (e.g., if reporting for 2008, you're required to show a measure of dispersion if there were six or more accounts in the composite for the full year). Standard deviation is often used for this purpose. It shows the dispersion of the returns across all of the accounts for that period. For example, if for 2008 the firm reported a return of 13.04%, we would look at all of the individual account's annual returns and compare them.

Hopefully, the accompanying graphic helps contrast the uses of standard deviation.

Thursday, July 23, 2009

Peter Dietz and the Modiglianis

While I doubt that they were aware of it, when Franco and Leah Modigliani developed their risk-adjusted return measure, M-squared, they were extending an idea first promulgated by Peter Dietz in his 1966 thesis, from which we obtained the notion of time-weighting and the Dietz return formulas.

Peter recognized that return without risk didn't show the full picture. But, if we are comparing two managers or a manager with his benchmark, even when risk is shown it's difficult to draw any conclusions when the two return and risk measures are different. For example, if Manager A has a return of 3.00% and the benchmark has a return of 2.95%, and the manager's standard deviation is 1.02% vs. 0.98% for the benchmark, what can we conclude? We must somehow bring these numbers together.

Dietz felt that if the portfolio and benchmark had the same return, then we can compare their risks, or vice versa, but as long as they were different we had a problem. Well, since then we've seen the development of numerous risk-adjusted measures that are able to handle this situation.

Franco and Leah, however, implemented Dietz's idea, so to speak, by equalizing the risk measures so that we end up with a simple comparison of returns. Theirs is the most intuitive of all the risk-adjusted measures and the one I champion the most.


To learn more about risk-adjusted returns, join us on August 19 for our next webinar. And, to learn more about M-squared, I suggest you read my article: "M-squared: A Double-take on Three Approaches to a Primary Risk Measure," The Journal of Performance Measurement, Summer 2007.

Wednesday, July 22, 2009

Friends of MWR & IRR

Our friend, Stefan Illmer of Credit Suisse, has launched a new group on Linkedin: Friends of MWR & IRR, and John Simpson and I are two of its early members. We are very pleased that Stefan has done this, as it's another way to provide increased attention to our efforts to encourage folks to adopt the MWR/IRR approach to calculating returns. Arguably, Stefan, along with Steve Campisi and I, have been the three most vocal supporters on this topic, and each of us have penned at least one article addressing this topic.

What does it mean to be a "Friend" of MWR & IRR? This hasn't yet been defined, though I suspect it includes:
  • supporting the use of MWR and IRR for most reporting scenarios
  • a desire to promote the use of MWR and IRR
  • the recognition of the MWR's superiority over TWR in most cases.
Does it mean a total abandoment of the TWR? Absolutely not! We believe that the TWR serves a valuable role: to show the portfolio return of managers who do not control external cash flows; but that's about it.

If you, too, embrace MWR's role and want to see its use increased, please join!

Monday, July 20, 2009

Tom Watson & performance measurement

I can't allow the almost history making weekend in Turnberry, Scotland go by without trying to tie it to investment performance. Well, how's this?

Tom Watson once accused fellow golfer Gary Player of cheating. This was during the first "skin's" game, when Tom said that Gary had plucked out a weed that was sitting near his (Gary's) ball. Such an act violates one of golf's rules. Gary insisted that he hadn't cheated and offered to pay $1 million to anyone who could provide video showing that he had. This wasn't the first time I had heard of players being accused of cheating. For example, Ken Venturi accused Arnold Palmer of cheating during the '58 Masters.

And so, what does this have to do with investment performance? Plenty!

You may recall that in the movie The Legend of Bagger Vance, the young boy, Hardy, explains why he loves the game of golf. One of his reasons is that it's the only sport in which the player calls a penalty on themselves.

Well, aren't investment managers obligated to "call a penalty" on themselves, too? Firms should have "error and correction" policies, which dictate when they are to correct and report errors they discover. And, if the firm claims compliance with the GIPS(R) standards, we would expect that they would take steps to ensure that they follow the rules. And, if they discover an infraction, that they would correct it. Even if a firm undergoes a verification, we expect the firm, in the end, to be the one that mindfully tracks their status vis-a-vis these standards.

Weekend golfers are habitual breakers of rules, either consciously or out of ignorance. But professionals are obligated to adhere to these rules. And even if no one else notices their error, they are to announce it and take the appropriate penalty, even if it means that they lose or, in some cases, are removed from the tournament. That's a lot of pressure, especially when there's a lot of money at stake. But without such expectations we'd have to have an army of "verifiers" following players around, watching every step they take, every action they make (and also, every action of their caddie, as Gary Player was accused another time of cheating when (supposedly) his caddie dropped a ball after they couldn't find the one that Gary had hit). Investment firms should have similar ethics and obligations, yes? No one likes to be called a "cheater," so we must be mindful of the rules and ensure we follow them.

Friday, July 17, 2009

Outliers on the positive end of the curve

Last night I had the privilege to participate in a panel discussion, organized by Rutgers University Professor Jim Bicksler, at the Dow Jones facility in Princeton, NJ, titled "Investment Principles Revisited." You're no doubt not surprised that the principle I dealt with had to do with how returns are calculated.

During the Q&A session an attendee referenced John Paulson, the hedge fund manager you may recall who made billions of dollars on shorting credit default swaps. I saw his success as being a “black swan,” in the words of author Nassim Taleb, but one at the positive end of the curve. And while Taleb tended to focus more on the black swan events on the negative end, we can identify many that are at the positive. At the time Paulson made his bet, would many have said that it was a shrewd one, guaranteed to generate tremendous returns? Clearly this is a purely academic question for which no answer is known. But we do know that there were many others, such as AIG, who (incorrectly, as it turned out) were long CDSs.

Can we attribute skill or luck to the extreme success that was received by this bet? Again, we simply do not know. What we do know is that those who have big successes often have big failures, too. For several decades Baseball Hall of Famer Babe Ruth held (without the help of any performance-enhancing drugs) the records for most home runs in a year and career. But he also was the holder of the record for most strikeouts in a year and career for a long time. Was his strategy to swing hard and hope that the bat made contact with the ball in such a manner as to cause the ball to leave the park? I don’t know, but what we do know is that he had “outliers” at both the long and short ends of the curve. Today, Ryan Howard of the Philadelphia Phillies is paid US$15 million a year because of his prowess at hitting the baseball a long way. But he, too, has held the record for the most strikeouts in a year as well as the most home runs.

We only know if a strategy is a good one after the fact. In the 18th century I bet most people would have guessed that Antonio Salieri had a better chance of long-term success than Wolfgang Amadeus Mozart. And yet, had it not been for the 1984 movie, Amadeus, it is likely that very few today would know who Salieri was.

The wealthiest man in the world, Bill Gates, is applauded for his business acumen and keen insights into the world of software. And yet, many don’t recall that early on he offered to sell IBM his DOS operating system for the lofty sum of $85,000, a deal for which IBM was criticized for passing up. But what does this offer say about the man, Bill Gates? His interest at the time was to develop compilers (software that converts programming languages into the code that makes them run). Had IBM taken Mr. Gates up on his offer, it is highly likely that we wouldn’t know who he was today.

In his best seller, Outliers, Malcom Gladwell discusses the reasons for much of the success we find today. In reality, it’s not always (or often, for that matter) purely skill, but much of the time has a degree of luck attached to it. Individuals who make big bets, who try to hit the ball out of the park, are often met with failure. John Meriwether, of Long Term Capital Management fame, is in the process of shutting down his second hedge fund. For a number of years he was hitting the balls out, but in the long term, his success appears somewhat mixed.

There is clearly a degree of risk associated with any long ball hitter. When the individual goes to the plate, we have no way of knowing what the outcome will be. The same holds true with investors, especially those who make extreme bets. Even though their decisions may be made on sound and thorough analysis, we won’t know if they were right or wrong until afterwards. Only at that time can we look back and applaud them.

I used as an analogy this year’s Kentucky Derby Winner. At the time the race began, very few believed that Mine That Bird would be the winner...had they, the odds would have been quite different. And that day, a few believers won a lot of money by betting correctly on the outcome. But betting on longshots is, in most cases, a poor investment strategy. Granted, you only need one Mine That Bird to make your long-term performance a good one. But at the time anyone making such a bet was no doubt thought of as being somewhat foolish. A sports radio personality, who is highly regarded for his horse racing knowledge, didn’t make such a prediction. Likewise, in this year’s U.S. Open no one would have guessed who the final four golfers would be. In fact, only one of the final four (Phil Mickelson) had been identified as a potential winner. I was at the Open for the third round and picked up a program that didn’t even bother to mention Lucas Glover (the winner); nor did it mention David Duval or Ricky Barnes (the gentlemen who were tied with Phil for second place).

All of this has to do with predictions. No one knows what’s going to work, who’s going to win, or what the outcome will be. Outliers at the positive end deserve their recognition and applause, no doubt, but surely there must be some degree of luck involved to go along with their skill

Thursday, July 16, 2009

GIPS 2010 ... the people have spoken II

Continuing our discussion on some of the key findings from the feedback to the proposed changes to GIPS(r) ...

Recall that the Executive Committee proposed a new recommendation, 0.B.2, that compliant firms provide their existing clients with a copy of their corresponding GIPS presentation on an annual basis. More than a third of the individuals who offered comments at all specifically commented on this proposal. And, of the 36 who responded, I only counted one that supports this idea...the rest said "no." This was, as you'll recall, one of those "hot button" items that I was especially concerned with. And even though this is merely a recommendation, individuals pointed out that since there's another recommendation that compliant firms comply with all recommendations, and further since recommendations are "best practices," this idea wasn't deemed a good one. Hopefully it will be dropped from the final version.

Paragraph 4.A.20 is to be expanded, as per one of the proposals, to include a description of risk in the composite description within the presentation. I counted more than 70 responses. And these responses tended to be of three types: "yes," "no," and "need more guidance." Almost half voted "no." As one who also offered this response, I'm obviously hoping that the requirement gets dropped, but we'll have to wait to see how the EC handles this "mixed bag" of comments.

And speaking of risk, paragraph 4.A.29 is a proposed requirement that firms provide 3-year annualized standard deviation. I've addressed this topic at length, indicating how I had been "on the fence" and then "fallen off," to conclude that this isn't a good idea. (As for "falling off the fence," I used language like this in our June newsletter, which caused a response from my friend Carl Bacon, which will appear in our upcoming July issue). Close to 70 folks commented on this, with roughly two-thirds saying "no." With such an overwhelming opposition, I am hopeful this will be dropped and replaced with a requirement for A risk disclosure, but of the firm's choosing. I think this would be much more welcome by the GIPS and investment community.

Wednesday, July 15, 2009

Negative Sharpe ratios

In our newsletter I've commented on the perceived problem with negative Sharpe ratios: that the results appear to be counter intuitive. When excess returns are positive, if the portfolio did a better job of managing risk, it will show a higher Sharpe ratio; however, when returns are negative, the inverse occurs. While some find no problem at all with this, others are challenged by these results.

Craig Israelsen has written a couple of articles on this topic and, at our request and urging, provided one for The Journal of Performance Measurement, and will appear in our upcoming (and unfortunately delayed) Summer issue.

Until the last year or so, although this problem was known by many, it didn't seem to be much of an issue because the bull market often meant that the long-term excess returns were positive. However, because of the devastation that was wrought upon the investment community last year, many are seeing negative excess returns and the accompanying oddity with the Sharpe ratio (and, by the way, the Information Ratio, too!).

Space doesn't permit me to go into detail on this topic in one sitting, so I'll return to it again. I encourage you to become familiar with Israelsen's piece, as well as the writings of others who have chimed in on this subject.

Tuesday, July 14, 2009

GIPS 2010 ... the people have spoken

I spent a few hours reviewing the 100+ comment letters that were submitted in response to the proposed changes to the GIPS standards, and want to give you an indication of what folks wrote, at least on a few key issues. I don't envy the CFA Institute staff who will no doubt have to go through these letters, line by line, to dissect what's been offered.

Paragraph 3.A.9 was presented as a change from a "recommendation" to a "requirement," but I've mentioned more than once that this isn't exactly correct. The current wording speaks of firms not "marketing" to prospects below their minimum, while the proposed requirement calls for firms not providing presentations to these prospects. While I'm very sure there was no intent to mislead anyone, the wording is still a bit confusing. Well over half the individuals who offered their thoughts on the standards took the time to comment on this provision, with an overwhelming majority opposing this proposed change.

Paragraph 0.A.7 alters the wording for the compliance statement, in that a reference is made regarding the firm's status vis-a-vis verification. Three statements were proposed: currently verified, not verified, and verified but not current (i.e., stale). Very few individuals opposed the introduction of this new statement, although a very large number preferred only having two status statements: verified or not. Interestingly, an accompanying provision defines "current" as being verified within the past two years. The comments here were quite mixed, ranging from a recommendation that the time period be narrowed to a single year, to dropping the qualification completely.

Roughly 25% of the respondents commented on the new proposed requirement to disclose if there were any material errors corrected in the presentation for a year (paragraph 4.A.28), and by far the majority opposed such a requirement.

I'll stop here for now, and will discuss other comments later.

Monday, July 13, 2009

Fixed Income Attribution...still a "hot" topic

This week is dedicated exclusively to fixed income attribution. Okay, maybe not everything about the week will be dedicated to fixed income attribution, but we will have a webinar every day on this topic.

For some time we've said that "attribution is the hottest topic in performance measurement," and we believe this is still fairly accurate. But more specifically, fixed income attribution is critically important and "hot." But why does it need a whole week of webinars?

We want to provide those interested in this topic the opportunity to really delve into it, in a way that isn't overly burdensome but that will also provide some great insights. We will have five days of five different models presented. Unlike equity attribution which is somewhat dominated by the "Brinson" models, there is no "Brinson-equivalent" in the world of fixed income. That is, there is no single model which is available from virtually every software vendor. While some of us expect this to happen at some point, it hasn't yet. And so, it's worth understanding some of the differences between the models. There are more than five models so we will have a similar session in the Fall.

Fixed income needs its own model. Why? Because attribution is supposed to assess how the manager's decisions impact their performance. And since fixed income managers tend to manage quite differently than equity managers, they deserve a model that is sensitive to their approach. And not all fixed income managers manage in the same way, so there's a need for some flexibility here, too.

Friday, July 10, 2009 say poe-tay-toe, I say poe-tah-toe

Back on June 22nd I commented about a discussion I had with a colleague regarding the use of the term "volatility" for standard deviation and whether or not "variability" was more accurate.

I sent a note to Bill Sharpe, who in his 1966 Journal of Business article ("Mutual Fund Performance") introduced his well known risk-adjusted measure, which he called "reward to variability" and what is better known today as the "Sharpe Ratio." In the article he referred to Jack Treynor's risk-adjusted measure as "reward to volatility."

Here's what I sent Bill: "Quick question for you: you referred to your risk-adjusted measure as "reward to variability" and Jack Treynor's as "reward to volatility." I stated in a recent newsletter that standard deviation is a measure of volatility. Do you find any objection to this? I know this is a nit-picky type issue, but a colleague found exception to my use of this term and felt that 'variability' is more correct. Just curious what you think. Thanks!"

And his response: "I think most people equate variability with volatility so not to worry. A better term for Jack's measure would be 'reward to beta.' No one seems to have followed my terminology for either measure, since mine is now termed the 'Sharpe Ratio' by almost everyone (including me)."

Since we've heard from "one of the true masters," I guess we can agree that the terms are interchangeable.

Wednesday, July 8, 2009

Idea pioneers ... criticized but critical

I'm responsible this week for posting questions on Blackboard for a class I'm taking: Blackboard is interactive software that supports the creation of threads for online discussions. The topic is mean variance portfolio theory, the capital asset pricing model, and arbitrage pricing theory. One source that I drew upon was Nassim Taleb's The Black Swan. Taleb's displeasure with models that rely upon normally distributed returns and ex ante measures is so extreme that he suggests that Harry Markowitz and Bill Sharpe should return their Nobel prizes.

Last night it occurred to me that while MPT and CAPM might have their shortcomings, their development allowed the creation of subsequent work, such as APT and Fama-French's 3-factor model. One might wonder if these later models could have been developed without someone like Markowitz and Sharpe to get the ball rolling with their earlier work, despite its shortcomings.

The same holds true with much of what we do in performance measurement. It's easy to criticize some of what was done previously, but without that earlier work it's likely we wouldn't be as far along as we are today. And, it's easy to criticize some of the ideas that have been put forward with the GIPS standards, but without someone willing to put these ideas out there, where would we be? Being a pioneer is challenging because it opens you up to being criticized; but someone has to be willing to take the risk and put forward ideas. We should be grateful for those who did and continue to do so.

Tuesday, July 7, 2009

Passion & Performance Measurement

"Well, no offense to Aristotle, but in my three years at Harvard I have come to find that passion is a key ingredient to the study and practice of law"
also sprach Elle Woods (Reese Witherspoon) in Legally Blond

I have come to find that passion is a key ingredient in the study of performance measurement.

Our firm's tag line is "Performance Measurement is our Passion," and rightly so. Rarely does a day go by when something I read, hear, or think about doesn't spark an idea that's related to our field.

Yes, some find performance measurement boring, but not I and perhaps not you, either. Okay, I AM a bit sick, this is true. But after close to 25 years in this industry I've come to find what we do quite interesting, challenging, exciting, important and, passionate! And, as we move forward there's only more to be excited about.

I write this as our firm begins its 20th year. Although 2009 remains a challenging one for many of us, we look forward to a brighter future.

Let me take a moment to thank my associates and clients for allowing us to serve this industry for so long.

p.s., hopefully you picked up on the "also sprach" part ... comes from one of my favorite pieces, Strauss' Also sprach Zarathustra made famous (or more famous) by 2001, A Space Odyssey, which I believe has the lowest note ever recorded; and, as a basso profundo, I love low notes!

Monday, July 6, 2009

GIPS 2010 ... you have spoken!

At last count there are almost 120 comment letters on the GIPS website regarding the proposed changes to the standards (visit Some are as short as a paragraph or two, while others exceed 20 pages. So far I haven't read them all but am making it through quite a number of them.

My unofficial assessment is that there are certain recommended changes that folks are very strongly opposed to:
  • the recommendation that compliant firms provide their clients with the GIPS composite presentations for the composite(s) they're in on an annual basis. Not much support here.
  • the requirement for 3-year annualized standard deviation. While many folks support having risk, there doesn't seem to be much support for the measure being standard deviation.
  • the requirement to disclose, for a year, corrections to any material errors on composite presentations. This has received a lot of "push back," which is interesting since the requirement goes into effect this coming January (because of the GIPS Executive Committee's approval of the revised Error Correction Guidance Statement). If this does get rejected from GIPS 2010, will this mean that the GS gets dropped? Hopefully so.
  • the requirement to disclose the percent of "proprietary assets." Some mixed views here. Some folks feel the definition is too broad (as it includes investments of senior management, as well as owners and the firm). Many others reject it entirely.
  • the requirement to not provide a presentation to prospects below the firm's minimum wasn't well received, either. A few correctly pointed out that this wasn't a change from a recommendation to a requirement.
I don't know if there will be more letters posted or not. I think it's very fair that the GIPS EC has (a) allowed us to comment and (b) posted these comments for everyone to read. I'm very pleased that SO many individuals and firms took the time to comment. I'm also thrilled by the comments from many country sponsors, especially from some of the newer ones (e.g., Pakistan). The EC welcomes these voices. The EC works hard to make the standards better and must consider lots of ideas. I'm aware that some of what has been presented isn't supported by 100% of this group, which shouldn't be surprising. The EC will, I'm sure, consider all the comments before finalizing what will end up in the next edition. And, I know they will be VERY busy over the next few months working on this. AND, I know that the CFA Institute's staff will be VERY busy, too, as they assemble these materials. We owe the volunteers and the CFA Institute our thanks and appreciation, as this isn't an easy task. We are all looking forward to learning more in the coming months.

One important point to know: this ISN'T a vote; that is, I don't expect the EC to tabulate the "pros" and "cons" and decide what to do based on what was sent in. But, I believe they definitely take into consideration what has been written.

Friday, July 3, 2009

Happy July 4th!

As we witness the struggles of many throughout the world who strive for freedom that we, here in the United States, and many others throughout the world have, we should be mindful of our own blessings. Achieving and maintaining freedom isn't comes with a cost. We should also therefore be mindful of the many who paid the ultimate sacrifice for the freedom that we today possess, as well as those throughout the world who continue to protect our freedom. We should also recall those brave heroes who, in Philadelphia on July 4, 1776, signed a document which very well could have been their death sentence.

While for many, July 4th is merely a holiday, we should remember that it's much, much more. May we forever count ourselves blessed, and celebrate the struggles of others who long for the day when they, too, can live in freedom.

Happy July 4th!

Thursday, July 2, 2009

Multiple solutions for the IRR

We were recently contacted by a client who had a scenario where the IRR produced multiple solutions. This isn't rare, but also isn't that common an occurrence in investing. Multiple solutions can arise when we have a series of in- and outflows. There is no guaranteed way to know that you have multiple solutions, but when you do have them the challenge is to know which of the solutions is the correct one. (Note that you can know that you don't have multiple solutions, and know when you might have them, but there isn't a way to know when you do have them).

Some time ago we formed an IRR Working Group to develop guidance on the IRR, as we're finding more firms realizing that it's usually the superior measure to employ. Multiple solutions is one of the topics we're tackling.

As I explained to our client, today there are no rules whatsoever regarding this topic. The easiest case to address, though, occurs when there are just two solutions, one positive and one negative. Here, you simply determine if you made or lost money during the period to decide which return to use: if you made money, you use the positive return; if you lost money, you use the negative return. (This is one of the advantages of IRR (money-weighting) over TWRR (time-weighted rates of return): with TWRR, you can legitimately have a positive return and lose money; something many find odd and counter intuitive. This doesn't happen with the IRR).

There may also be non-real (imaginary?) solutions, which would be discarded. But if you have multiple real solutions and they aren't in the form of the simple case noted above, further guidance is needed...we're working on it! [Note that we're having a meeting later this month and are hoping to make progress towards our eventual white paper].