Saturday, February 6, 2010

doveryai, no proveryai

Today marks the 99th anniversary of Ronald Reagan's birth. And so it's fitting to recall one of his signature lines: "trust, but verify" (the Russian version is in this entry's title). Perhaps it's a coincidence that Jason Zweig chose to address this topic in today's WSJ: "Will we ever again trust Wall Street?"

Wall Street has always been an easy target for politicians, and we're seeing this occurring with increased vigor of late. But with the shenanigans of folks like Bernie Madoff, one can't really be too surprised by this attention. Clearly, the bad guys number in the minority, with most portfolio managers and investment firms exercising a high degree of ethics and proper action for their clients. But, as we know, it only take a few bad apples...

Perhaps this is also one of the reasons why the Global Investment Performance Standards (GIPS(R)) is seeing performance examinations rise to a level its original framers probably wouldn't have envisioned. If one looks at the draft that was first published for GIPS, there is no reference to such a review: only firm-wide verification. By the time the first edition was published in 1999 examinations (equivalent to the AIMR-PPS(R) Level II verifications) had been added. But while firms were encouraged to indicate in their presentations that they had undergone a verification, no such recommendation appeared for examinations; if anything, the opposite. But the 2010 version (to go into effect in January 2011) has a special disclosure for firms to include if they've undergone an examination. Is this a good thing? I think not. This addition wasn't part of the original exposure draft, so the public didn't have the opportunity to offer an opinion.

My views on examinations have been expressed here before, as well as in our newsletter. Examinations, in my opinion, have little to do with GIPS, per se. They're an audit of the numbers to ensure that the reported returns are accurate. Our research shows that most RFPs don't inquire about examinations, although most do ask about verifications. No doubt many verifiers are pleased to see this increased attention because it may result in pressure for more firms to undergo costly examinations. But for what benefit? Most clients of asset managers receive, in addition to reports from the manager, custodial statements (and possibly statements from consultants, too). If their mangers are playing fast and loose with the numbers, surely the client can see this when they compare the reports. Why must a manager put their composites through these very costly exercises?

Some unethical (in our opinion) verifiers talk their clients into having ALL of their composites examined, even the ones they don't market. While this brings thousands of dollars of added revenue to the verifier, it's a waste for the most part for the manager.

We favor trust, but verify and strongly encourage managers who claim compliance with GIPS to be verified. As for trust, but examine? Nah.


  1. Stephen Campisi, CFAFebruary 8, 2010 at 8:29 AM

    It seems to me that the two really significant problems that need to be checked out before accepting a firm's claimed investment performance are: a) whether there is outright fraud (there are no assets, the assets are wrongly classified, the asset values are overstated, etc.) and b) the accounts shown are not representative of the product being offered (the manager cherry picked the accounts, the calculations are incorrect as in using inflated values or other manipulation.) Once these hugely significant problems are corrected, the performance is likely to be "in the ball park" even though the results may not be mathematically perfect. As an example, what would you rather see: a) a report where end of period weights were used (obviously skewing performance up a bit) or b) a composite of only winners and perhaps c) a composite where there are no assets at all. Clearly, these errors increase substantially as you move from option "a" to option "c." It's a little strange that after two decades of performance standards we encounter a world where severe errors and misrepresentations of performance exist in spite of claimed and affirmed adherence to the standards. Seems we need to put more effort into verifying that the obvious and material things have been truly confirmed while we worry less about the small details. We seem to have things backwards; we're pointed in the wrong direction and we are picking up speed.

  2. We agree! (always like it when this happens)

    As has been stated by various folks, verification isn't designed to detect fraud. That being said, there is a new requirement for verifiers to determine that the firm's policies and procedures to ensure the existence and ownership of client assets are appropriate and consistently applied. Clearly this is a Madoff scandal driven addition. Since this wasn't (as I recall) part of the original disclosure draft, it will be interesting to see how verifiers respond and what guidance is offered. This is a positive step towards including some of this important checking, without putting the burden of fraud detection on verification. However, the newly included strong emphasis on examination is problematic to me.

  3. When a public company blows up, since investor relied on the financial statements, auditors are blame. What happened if a GIPS verified company was in negligent? Who do you think will get the blame?

  4. Actually, depending on what you mean by "blows up," the firm's management also shares in the blame. As for a "GIPS verified company," the verification firm does not opine on the firm's compliance with the standards; they merely opine on whether the policies and procedures are proper, as well as the composite construction. If the GIPS verified company was "negligent," it would depend on what is meant. If they were negligent from a GIPS compliance perspective, one would hope that the verifier caught it.

    I take from your question that you suggest that verifiers should encourage their clients to undergo examinations as a way to cover the verifier's butt, right? That is, if there's a problem, we might as well have the firm spend as much as possible on the work we do, so that we can protect ourselves? That doesn't sound like a good argument in favor of examinations.

  5. I would recommend that firms conduct an internal survey of all RFPs received since the firm's date of compliance with the Standards to determine exactly how many RFPs required that the firm have a performance examination conducted on a specific composite. My own experience has been that this "actual" number is much lower than the "assumed" number. The result can contribute to a more precise cost/benefit analysis of the value of specific performance examinations as to which composites should be prioritized or whether or not the additional work is justified at all. Especially in the non-U.S. arena, the demand for specific performance examinations is practically nil.

  6. Thanks for your comment. Many U.S. firms only have examinations done because they were used to having Level II Verifications when they claimed compliance with the AIMR-PPS (at that time, the larger CPA firms wouldn't do a Level I). When these firms made the switch to GIPS, they continued to have the equivalent work done (i.e., examinations) as well as verifications, as these same CPA firms now offer GIPS verifications.

    Unfortunately, this heightened focus on examinations might cause even more firms to have this work done, which, unless there is a sound business reason for it, is highly questionable to us.

  7. Contrary, if there is no 100% assurance, I don't believe an examination is needed. People familiar with GIPS guidance understand the purpose. Others not familiar could mistakenly believe the intended purpose. What's the purpose of expressing a negative opinion when there is no 100% assurance from an auditing firm is something I'll never understand. I believe verifiers / GIPS society need to inform the general public that a verification or examination does not insure 100%. Yes, I know new disclosure language is in 2010 guidance, but I don't feel its enough.

    You're right that negligent is soemthing difficult to prove. This is secondly. Legal fees is probably the first idea that hits me.

  8. If you ask most folks what verification does, they'll say it verifies compliance: wrong. The assumption is that examinations have something to do with GIPS; I'd say, no, or at most, very little: it's an audit to check if the firm is "cooking their books."


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