Thursday, May 27, 2010

What IS risk-free?

I'm conducting a review of a client's performance reports. When reporting by country, if there is no risk-free rate for that country, a zero value is used (e.g., for Sharpe ratio, Jensen's alpha). Why?

Risk-free rates can be quite complex; perhaps more than they need to be.

I'm a US-based investor. My risk-free rate is the U.S. Treasury bill. I can put my money there or invest in something more risky, such as Vietnam equities. Vietnam, to my knowledge, has no risk-free rate. But why should I care; would I invest in them? No, if I'm looking for a risk-free rate it's treasuries.

Well, what about the investor in Vietnam; what if he's your client, what do you show? I'd pick a risk-free rate that this investor could invest in; since there is no rate for Vietnam, perhaps one from Australia, the UK, or the USA? Pick something that could be used, but don't look for a collection of rates, one per country. The rationale behind this is lost on me. If you have a good argument for it, let me know.

Non-marketed need not apply

I recently conducted a "mini verification" for a client wanted us to do a high level check on a manager who both claimed compliance with the Global Investment Performance Standards (GIPS(R)) and had been verified.

As I always do, I asked to see all their composite presentations. While they could provide most, they couldn't for the "non-marketed" ones. And while they "knew" they are supposed to have them, their verifier never asks for them so they hadn't bothered to prepare them.

Their verifier never asks for them?

Well, I'm not surprised as there are some verifiers who believe that verification only deals with "marketed composites," and that the firm has no obligation to do anything with the "non-marketed" ones. To me, this is shameful. Verification is a "firm wide" exercise, not limited to only the "marketed composites."

I've addressed this point with this particular verifier on multiple occasions but clearly they have their own rules which they live by (GIPS rules be damned). To me, they're doing a disservice to their clients. First, they are claiming to conduct a "verification," but are actually doing only part of the job. This expeditious approach may have appeal, but it puts the client at risk. What if I were the SEC asking for these presentations? Might the firm's claim of compliance be questionable, posing the possibility of a sanction?

To this verifier and others who argue in favor of only worrying about the marketed composites I ask a simple question: what page in the standards do the words "marketed composites" appear? I have yet to find it.

p.s., As an aside, to make up for not verifying all the composites the verifier was able to talk this firm into examining ALL of the marketed composites: you know what I have to say about examinations.

Wednesday, May 26, 2010

PMAR VIII Highlights

Our 8th annual Performance Measurement, Attribution & Risk conference was held last week in Jersey City, NJ. And while Jersey City might not seem like a "dream location" for a conference, the Hyatt turned out to be a superb venue. From our conference room we could see the Manhattan skyline and the Statue of Liberty. On the second day many of the attendees chose to eat their lunch outside, taking in the warm weather and the delightful views.

The event also provided a great venue for the sharing of insights, information and ideas. Risk was a major theme throughout the event. With the market continuous volatility and recent downturn, ways to wrap our arms around risk remain an important topic.

For me, two of the highlights came from conversations I had with a couple attendees. One, a verifier for a "big four" firm, acknowledged his frustration with GIPS(R) (Global Investment Performance Standards) firms that conduct remote verifications. He is a reader of our blog and voiced support for my stand opposing this practice. The second, a quite knowledgeable industry veteran, voiced opposition to the heightened attention examinations are receiving. And while some believe these audits are of value, many of us see little relation to the GIPS standards. It's gratifying to hear support for ones ideas from others in such a candid fashion.

Speaking of GIPS, Jonathan Boersma, Executive Director of GIPS at the CFA Institute Centre for Financial Market Integrity and member of the GIPS Executive Committee, delivered a presentation on the upcoming changes (GIPS 2010). We could have allowed an hour for Q&A and still would have needed more time, no doubt.

As always, we had a handful of new speakers as well as several PMAR veterans. We welcomed back David Tittsworth of the Investment Adviser Association, who provided us with our regular session on regulatory matters. We've been fortunate that every time we've had this topic, we've enjoyed a speaker who is both a skilled orator as well as one who interjects humor into their presentations.

Kyle Ringrose delivered a challenging talk, in that he was the late Damien Laker's stand-in for the keynote address. Damien won the 2009 Dietz Award; each year the recipient is given the opportunity to give a keynote address at PMAR, in order to share their ideas from their winning article. Obviously, Damien couldn't make it and so we called upon Kyle, a colleague of Damien's.

On June 8-9 we will hold our first PMAR conference in Europe. At this event Carl Bacon will take on the task of delivering the keynote address on behalf of Damien. For Carl, that will no doubt be easier than his other chore, which will be to debate me on money vs. time-weighting at our Battle Royale! We are expecting a very good crowd for this inaugural event and are looking forward to crossing the pond to join them for this program.

Tuesday, May 25, 2010

Lost lessons

This week has seen the conclusion for the six-year run of the television show, Lost. My wife and I have been avid viewers for some time and anxiously awaited this final episode. I like the show so much that I am a "fan" of the show on Facebook. And this past week has shown a considerably disparate collection of opinions regarding what actually occurred with the cast as well as the success of the last episode.

This made me think about our chosen field of endeavor, where there are often widely divergent views on approaches and methods. This past week saw Steve Campisi compete against Mark Elliott on the value of including the "income effect" in a fixed income attribution model. And next month I  have the pleasure of taking on Carl Bacon on the subject of time- versus money-weighted returns. Our Battle Royale has been a standard part of our annual Performance Measurement, Attribution & Risk conference since the event's initiation, and it serves to show how not only are there different views, but that they often engender strong passion on the part of the participants. And while these events have never resulted in profanity-laced name calling, such as what appears in some of the Lost comments, participants can clearly see how opinions can be strongly held and well entrenched. These events, as with the Lost commentary, provide the opportunity to gain additional insights into controversial topics.

Standards are great, but it's good that not everything is standardized, so that firms and institutions have the opportunity to select the approach(es) they feel best suit their needs.

Thursday, May 20, 2010

Necessary or not?

A GIPS(R) (Global Investment Performance Standards) client asked if a certain disclosure is needed. They, like a few firms, include language such as:

The collection of fees produces a compounding effect on the total rate of return net of management fees.  As an example, the effect of investment management fees on the total value of a client’s portfolio assuming (a) quarterly fee assessment, (b) $1,000,000 investment, (c) portfolio return of 8% a year, and (d) 1.00% annual investment advisory fee would be $10,416 in the first year, and cumulative effects of $59,816 over five years and $143,430 over ten years.

I am unaware of any reason to include such language. I know that some verifiers request (or require) firms to include this, but unless they can provide a reference for such a demand I'm at a loss as to why this is needed. I think that with all that's required, why invent new disclosures?

Tuesday, May 18, 2010

Too much information can be counterproductive

I'm listening to Malcom Gladwell's Blink: The Power of Thinking Without Thinking. I've read two of his other books (The Tipping Point: How Little Things Can Make a Big Difference and Outliers: The Story of Success) and enjoyed them considerably, and so am not surprised that I'm finding this book to be quite good, too.

Gladwell gives some examples of situations where decision makers are overwhelmed with information, which actually both slows them down and fails to improve their decision making. In the case of cardiac doctors, their old methods of addressing lots of details about a patient's history slows the process down and proves unnecessary (we actually learn that less is better at diagnosing patients); the same applies to psychologists and military commanders.

Can we learn something from Gladwell when considering what we give to clients? What is the point of our reporting? Can we provide them with the information they truly need in a more succinct manner? Something to consider, yes?

Monday, May 17, 2010

One size fits all...not when it comes to reporting

Occasionally we hear a call for "reporting standards." Personally, this is far from the top of my priority or wish list. Guidance is often appreciated, but standards? No thank you!

Okay, and so for a little guidance consider that reporting should very much take into consideration the needs of the recipient, the conditions under which investing is being done, and the likely questions the individual may have. For many, time-weighting is the panacea of returns; unfortunately, it isn't quite that simple. Recall that time-weighting eliminates or reduces (in the case of approximation methods) the impact of cash flows. And why in the world would we want to do that? For just one single purpose: when evaluating the performance of managers who don't control the cash flows! That's it. Nothing more. And yet, time-weighting appears everywhere, more often than not where it doesn't belong. Firms need to avail themselves of money-weighting to complete the picture to ensure they report properly.

When trying to decide which measure to use, consider the perspective from which the report will be reviewed. What questions will the recipient be asking? If they want to know how did my manager do?, then in most cases time-weighting is appropriate. If they want to know how did I do?, then money-weighting, by far, is the method of choice.

It amazes me to some extent that we still have time-weighting be the only method most firms employ for sub-portfolio returns, when regardless of the perspective, money-weighting should be the only approach.

We're making headway here, but there's a long way to go.

Thursday, May 13, 2010

What's significant?

Since 2006, the Global Investment Performance Standards (GIPS(R)) have required compliant firms to disclose "significant events." But what, pray tell, is a "significant event." In our lives we encounter significant events all the time, right? Births, deaths, baptisms, bar mitzvahs, weddings, and so on. But what are examples for an investment manager? The standards provide little guidance, so it's up to the firm to decide, though their verifier should offer some assistance, too.

A few obvious examples:
  • a new chief investment officer. Any major personnel change should be considered "significant."
  • acquisitions. Even if they don't meet the portability requirements (meaning you can't use the history), if they're part of your firm definition going forward, they are significant.
  • the hiring of a new head of performance. Okay, just kidding on this one ... probably not deemed significant to your prospective clients. (But it should be, right?)
The test is "would this information be of interest to your clients or prospects?" or "would knowing this provide additional insights into the information contained in the presentation?"

A verification client acquired several mutual funds and thought that this wasn't necessarily significant. However, since their introduction resulted in their assets under management during recent times to increase while those of many other firms dropped, I'd say this WAS significant, since without this information the reader might (wrongly) think that the firm had been able to avoid losing assets or accounts. The client has agreed with us.

More on the math ... start vs. end-of-day treatment

An observant reader identified an error in my math in yesterday's post, which I should have caught immediately. Long ago I realized that outflows should be treated as end-of-day events. Let's consider yesterday's post a bit more.

We started the day with $327,000; there was an outflow of $337,000 (i.e., $10,000 more than what we started with) and we had residual cash of $940. How could this be anything but an end-of-day event? If it was a start-of-day flow, we'd immediately put the account into a deficit, right?

The proper way to think about this is that we began with an investment, it grew in value because of the market, we sold out to capture the gain, and then we sent the client a distribution. The distribution, in essence, has nothing to do with performance and, in keeping with time-weighted returns, its impact should be eliminated or reduced. By ignoring it completely and simply treating it as an end-of-day event, we focus on the growth of the portfolio during the day, which yields a return of 3.35%.

I can't think of a more perfect example to demonstrate why end-of-day makes sense for outflows. More and more firms and software vendors are adopting this approach (and start-of-day for inflows) because they've seen the benefit it has.


Back to yesterday's original post for a moment.  The start-of-day return I came up with was wrong, but because it was one basis point away from the end-of-day return, I ignored it. It should have been suspect because of past problems I've seen, but I was lulled into thinking it was okay. That happens a lot, doesn't it? We tend to look at the outliers for errors, not considering that returns that look right may, in fact, be wrong! The real start-of-day return is -108.87%, which is totally absurd (losing more than we have?). That would have gotten my immediate attention, and I would have recalled the problem with such treatment. Goes to show that just because something looks right doesn't make it so.

Wednesday, May 12, 2010

Is the math REALLY that difficult?

I'm conducting a GIPS(R) (Global Investment Performance Standards) verification and encountered something somewhat unusual. The client uses a well known software package to calculate their returns and use a daily method. Here are the approximate details for one day that is behind this post:
  • Beginning market value = $327,000
  • Cash flow = -$337,000
  • Ending market value = $940.
Obviously, the portfolio grew in value during the day which allowed them to distribute more money than they started the day with. Okay, so what return does the system yield? Actually it doesn't provide ANY return and simply indicates in a footnote that a return isn't possible. BUT, why not? We can employ a simple Modified Dietz formula:

which will yield a return of 3.35%. Is it really that hard? I don't think so. Perhaps you would think so at first glance, but it really isn't.

From what perspective?

Almost 40 years ago I came across a "management test" (of the faux variety) which presented a variety of scenarios which required the "test taker" to respond to. For example:

You're at lunch with your largest client when for some reason the subject of Michigan comes up. You remark that "only two things come out of Michigan: football players and hookers." Your client calmly mentions that his wife is from Michigan. Do you
  1. ask what position she played,
  2. ask if she's still "working the streets,"
  3. begin to speak incoherently, or
  4. fake temporary amnesia?
At this point you're probably wondering what this has to do with performance measurement, and I must confess I'm confused, too. Oh, yeah, perspective! In this scenario, the character's attitude shifted quite a bit once his perspective changed, yes? When it comes to performance reporting, one must always be conscious of the perspective in which the information is being presented.

I was in a conversation earlier this week with a prospect who is thinking of having us review their performance measurement system and processes, something we often do. The prospect mentioned that they held some private equity assets which are difficult to value, and therefore perhaps the internal rate of return (IRR) should be used. I commented that it's a matter of perspective. Since this firm isn't a private equity manager but simply an investor in private equities (i.e., a limited, not general, partner), they are not obliged to follow, for example, the GIPS(R) (Global Investment Performance Standards) requirement for since-inception IRR. And therefore, they need to know if they're reporting "how the client did" or "how the firm is doing." In the former case, time-weighted returns are probably best, since the manager chose to invest in these and we want to eliminate (or reduce) the impact of cash flows. In the latter, the IRR would be best, since the client controls the cash and so why would we want to eliminate its impact?

Always consider the perspective of the person who is seeing the reports in order to know what to show and how to calculate the returns.

p.s., I'm obliged to mention that the use of Michigan was by no means intended to suggest anything improper about this state; it was done simply at random, I'm sure. Some of my best friends are from Michigan. And while they have great football, I'm unaware that there are any hookers living there. Should I stop grovelling now?

Monday, May 10, 2010

GIPS 2010 questions getting answered

The long-awaited list of Q&As regarding the Global Investment Performance Standards (GIPS(R)) 2010 edition are beginning to be answered. Go here and limit the search to "after April 2010" to see the first batch.

I have only started to review them and must admit that I'm a bit confused by at least one, so am trying to get clarity.

I don't envy the CFA Institute's effort to provide additional clarity as firms begin to adopt these rather massive changes. I, personally, am grateful that they've begun to post these and am hoping to dissect them over the coming days.

Saturday, May 8, 2010

An invitation to see sample policies and procedures

I just posted this on Linkedin and so want to extend this invite to my blog readers, too.

Many firms struggle with their Global Investment Performance Standards (GIPS(R)) policies and procedures; and even for those who feel theirs are pretty good, there is always an opportunity for improvement.

Here's an invitation: if you send me a copy of your policies and procedures (either PDF or Word format), I'll include it with those of others who respond, and then send all participants a complete collection. I advise you to remove your firm's identity from you materials before sending it to me as I will not do any editing (you're free, of course, to include your firm's identity in the materials).

If you wish to participate, please send it to by May 31. Only those who participate will receive the complete set.

Friday, May 7, 2010

What to report

I got an e-mail from a software vendor client who wanted to know what the "standard" is regarding period reporting of benchmark returns. It seems they have a client who wants to see 3 1/2 year benchmark performance (because their portfolio is for 3 1/2 years) but the vendor shows 4, 5, 10 year returns (presumably in addition to 1, 2, and 3).

First, many vendors (and managers) report returns for periods for which no data exists: e.g., my account is only 3 years old but I get columns for 5 and 10 year returns ... why? In a case as described here, I would expect to see 1, 2, and 3 year returns, plus a "since inception" return which would cover the 3 1/2 year period (and 3 7/12, 3 8/ 12, etc. as we move forward). There's no need to show columns if there isn't data to load in. AND, it would be inappropriate to show 3 1/2 year return in a column labeled "5 years."

But are there "standards"? No, and perhaps this is a good thing, though we would like to see guidance provided, I'm sure.

Wednesday, May 5, 2010

A pronouncement on pronunciations

I was in London this week and reminded about how two words associated with the Global Investment Performance Standards (GIPS(R)) each have two distinctively different pronciations:

GIPS: The abbreviation for the standards, which is a word because it's an acronym (as per a word formed from the initial letters or groups of letters of words in a set phrase or series of words) can be pronounced in two ways. The first, and perhaps most common, is when the "G" has a "gah" sound; the second is when it has a "jah" sound. The perfect word to clearly distinguish the two sounds is "gauge," where the two "Gs" exhibit both of these sounds.

Composite: The most important word in the standards, perhaps, has two different sounds, too, and they're very regional. In the United States most individuals pronounce the word "come-paz-it." In just about everywhere else it's pronounced "comp-uz-it." Being bilingual I adjust depending on where I happen to be at the time.

While we have more than 30 countries that agree on the standards (a huge and quite unique accomplishment), we don't agree on how to pronounce some of the words, but that's okay. As the song goes, "You say toe-may-toe and I say toe-mah-toe."

Tuesday, May 4, 2010

Annualizing Yield to Maturity

A client called yesterday asking about annualizing yield to maturity (YTM). Can this be done and if so, how?

One should recall that the Yield to Maturity of a bond is calculated by using the internal rate of return, thus YTM = IRR. IRR is often expressed across a multi-year period (i.e., not annualized) and so YTM would be, too. My first reaction was to suggest that we would use the same approach that we do to annualize time-weighted returns, but I first turned to my colleague John Simpson, who responded as follows:

The yield to maturity is calculated as a “raw” IRR based on the bond’s periodicity, and then the street method is to convert it to an annual yield by multiplying the raw IRR by the payment frequency.

For example, if a bond that pays quarterly has a raw IRR of 2%, then the annual yield to maturity is stated as 4 * 2% = 8%.  That is to say, we do not take 1.02 and raise it to the 4th power, even though this is, in a sense, more mathematically correct.

If they want an annualized yield to maturity, then what they want (not knowing the context) could be to just take their annual yield, divide by the frequency, and then convert the period IRR to a (compound) annual IRR.  Perhaps this is what they mean.  But, such a yield is not street method and not comparable to commonly quoted yield to maturity figures.

And so the answer is  "yes, we can" and here's the "street method," as summarized by John.

Why someone would want to annualize YTM is unclear to me, but it can be done and apparently is done.

Monday, May 3, 2010

Who's the client?

One aspect of the Global Investment Performance Standards (GIPS(R)) which can be a challenge to deal with is to identify who the client is. While this may seem to be a "no brainer," it isn't always.

Let's consider mutual funds. Are the shareholders clients? I believe the consensus opinion is that "no, they aren't." At least for GIPS purposes. That is, a mutual fund manager isn't obligated to provide prospective shareholders GIPS compliant presentations. The fund itself is the client.

What about private equity partnerships? At first glance it appears that they're analogous to mutual funds and therefore the prospective partners wouldn't constitute clients for GIPS purposes, but rather the partnership itself would be the client. However, this seems to be a bit of a gray area. A private equity manager is the general partner of the plan and is seeking limited partners to participate. There is a whole host of rules regarding private equity and so wouldn't we expect that potential partners to receive materials that align with the GIPS standards? Further clarity here may be in order.

In the case of wrap fees the asset manager actually has some flexibility when handling the accounts for GIPS purposes, but I'd say it's generally agreed that the sponsor of the wrap fee program is the client.  The participants themselves, even though they have their own accounts, wouldn't be clients for GIPS purposes.

We're working with a verification client who is the manager of some 401-K programs, and this question arose during the course of the review. At first, because each account is sitting on the manager's system, I believed that THEY should be the clients. However, as with wrap fee programs, the 401-K sponsor selected the manager, and therefore for GIPS purposes the sponsor is the client; the individual participants in the plan are not.

Guidance on client definition would, I believe, be a helpful addition to the GIPS materials ... perhaps after GIPS 2010 is done?