Materiality ... and what DOES it mean?

The term "material" or "materiality" appears several times within the Global Investment Performance Standards (GIPS(R)). Perhaps the most recent addition that requires attention is its use in the new Error Correction Guidance. It seems odd to me that so many firms don't have an error policy since errors occur quite a bit...who doesn't make a mistake? Without a policy, how do you decide or know what to do?  Did we actually need to require firms to have a policy? Apparently we did, given the many cases where they don't exist.

What "is" materiality? From a definitional standpoint it occurred to me recently that it is a change that would cause someone to respond to something differently.  President Obama won the U.S. Presidency with roughly 53% of the vote: what if an error was discovered and it turned out it was actually 54 percent, would that matter to most people? I think not. How about 55 percent? Probably not. But, as the number rises we reach a point where we're bordering on landslide territory, so there would clearly be a reaction. Well, what if it had actually been 52 percent? Chances are not much of a change in view; but, if it had been 51 percent, then it's close to 50/50, which would likely cause a response. And, if he had won but with less than 50% (i.e., a plurality but not a majority, as President Clinton won in '92 and '96), then no one could suggest that he "had a mandate."

We're of course dealing with materiality from a performance perspective, but should still take into consideration those differences where we believe someone would respond differently if they saw the revised number. While the guidance has three levels devoted to dealing with errors which are deemed "not material," there's one that deals with errors that are "material." And when we talk about defining materiality for your error policy, we're not really speaking about a definition, because there are plenty of sources for definitions, but rather the objective numerical indicator that alerts you that you have a material error and must take certain action. I suggest you don't use former U.S. Supreme Court Justice Potter Stewart's statement that he knew pornography when he sees it as your model (i.e., "I know materiality when I see it" doesn't cut it).

I've been trying on Linkedin to get a sense of where people stand with this topic and have gotten, as you'd expect, mixed results so far. I do believe that errors mean different things at different levels: that is, rather than an absolute level of materiality, a relative level is better. For example, while we might say that an error of 50 basis points (bps) is "material," is it always? If your return for 2009 was reported as 57.60% but it turned out it was 57.10 percent, do you think you'd get much of a reaction when you alert your clients of the error? But, if your return was reported as 1.60% but it was really 1.10 percent, I suspect that you'd have a better chance of getting a response.

Defining relative levels of materiality can be tricky, however. One of our clients defined it in two steps: first, the number (e.g., 50 bps) and then as a percent (e.g., 10%) of the originally reported return. For example, if the error is 50 bps or more and is > 10% of the original return. And so, in our earlier case, while we meet the 50 bps threshold it isn't > 10% of 57.60% (which, of course, is 5.76%). (Please note that this example is provided solely for illustrative purposes and isn't intended as an endorsement of a method.)

To me, relative definitions (again, from a numeric perspective) of materiality have much greater value than absolute. And while the GIPS Interpretations Subcommittee provided us with this "GS," it would be helpful if it included some examples. Perhaps over the next few weeks we'll get enough responses to the Linkedin poll to warrant a presentation here. If you haven't joined in, please do! You can provide your thoughts directly to me, if you wish, anonymously. Thanks.