Wednesday, September 8, 2010
Consistency doesn't necessarily make things right
We generally want to see firms employ consistency when it comes to performance measurement. GIPS(R) (Global Investment Performance Standards) is one source for this desire. For example, firms need to be consistent in how they employ their rules for discretion, for their timing of adding and removing accounts, and for composite compositions. But if what you're doing is wrong, doing it consistently doesn't make it right.
Case in point. We have a client who employed a non-standard method to calculate performance; by "non-standard" I mean that it was invalid. The results would be often erroneous. Although they recognized the flaw in their method, they felt that by employing it consistently, somehow the error would be eliminated. Unfortunately this line of reasoning is invalid: consistently employing an invalid formula will only yield an invalid result.on a consistent basis (which might, in fact, mushroom!).
I do find it a bit odd that with all the documentation on how to derive returns, that individuals and firms will still come up with their own return method. And if they do derive their own approach, they should at least have it validated by an independent third party. Twenty-five years ago there wasn't a great deal that was readily available on how to calculate performance; today there are dozens of books and probably hundreds of articles, and loads of websites that can be referenced.
This wasn't the first time we've encountered firms who use their own formula. Often the methods that firms come up with seem quite intuitive; unfortunately, they're invariably wrong, however. What may seem to make intuitive sense often fails mathematically.