Thursday, December 29, 2011

"We are the agents of change"

One of my Christmas presents this year was the book, The Language Wars, by Henry Hitchings. Not surprisingly, I have already discovered some great insights which translate well to our profession.

Hitchings quotes American linguist William Dwight Whitney: “‘Every existing form of human speech is a body of arbitrary and conventional signs...handed down by tradition.’ Crucially, therefore, change is ‘the fundamental fact upon which rests the whole method of linguistic study.’”

Hitchings points out how “we may experience a kind of amnesia about what the words we employ used to mean and where they came from.” Sound familiar? See any relevancy here?

“Change happens” Hitchings proclaims, and “We are the agents of change...Needs alter, values shift, and opportunities vary.”

To say that some of our rules are arbitrary would be inaccurate and unfair; but many are due to convention, and perhaps “handed down by tradition.” Why not open our eyes to the possibility that some changes are in order?

As to the book, if you’re an avid reader, writer, or merely interested in language, you are sure to find it of interest. It was reviewed in the WSJ recently, and placed on my list of books I’d like to receive, and my wife was kind enough to include it with my other gifts. I think you’ll like it!

Tuesday, December 27, 2011

New Year's Resolutions

It's that time of year when folks begin to think about things they want to change come the new year.

It occurred to me that wisdom from one of the most renowned and powerful Jedi Masters, Yoda, might serve us well. After all, he was known for his legendary wisdom and mastery of the Force, not to mention his skills in lightsaber combat!

You must unlearn what you have learned

This is a tough one, I must confess. We tend to hold on to beliefs that we learned early on, without regarding the possibility that there could be any other way. And, I must confess that I have been guilty of this shortcoming too many times, myself.

I hardly expect that we will all agree on one set of beliefs, and there is always room for different approaches. But to at least be open to why one approach might be better than another would be wise. Here is an abbreviated list of areas where one might consider exploring the alternative(s):

Rates of return: be open to employing money-weighted returns. Why must time-weighting dominate?

Attribution: arithmetic versus geometric. Here is one area where I must try to see the benefit of geometric.

GIPS(R) (Global Investment Performance Standards): I invite others to see that the two broad approaches to derive composite returns (using beginning market values (with or without weighted flows) versus the aggregate method) yield two completely different results, meaning two different definitions for this value. In addition, for more PMPs (Performance Measurement Professionals) to see that equal-weighting is superior to asset-weighting.

Risk: be open to exploring alternative metrics, both ex post and ex ante.

Saturday, December 24, 2011

Season's Greetings

When I was 15 I met  Ian Harvey when I joined the Order of DeMolay (a Masonic-sponsored group for young men). We became friends and remained very good friends until his death from cancer, five years ago. Ian was Jewish, and he said how he really liked it when Chanukah and Christmas overlapped. While they obviously don't always, they do this year.

And so, I wish my Jewish brothers and sisters, a very Happy Chanukah.

And, to my fellow Christian brothers and sisters, a very Merry Christmas.

And to all, a safe, happy, healthy, and prosperous New Year! May 2012 be a great one for us all. God bless.

Wednesday, December 21, 2011

The 10 Best Things About GIPS

As I explained in yesterday's post, I would balance out my 10 "not so good things" about GIPS(R)" (Global Investment Performance Standards) with my "10 best."


#10 3-year annualized standard deviation: Okay, so I'm not a huge fan of standard deviation as a risk measure, and voted against it in my comments on the 2010 exposure draft. But, I realize, too, that getting agreement on a risk measure is quite a challenge. And the need for a risk measure in the Standards justifies something, almost anything. Standard deviation is easy to calculate and understand. And firms can always augment it with other risk measures, and probably should.

#9 The GIPS Help Desk: Arguably, one could simply say the CFA Institute, but we'll just focus on the individuals who respond to questions that come in on "all things GIPS-related." They work very hard to respond quickly to requests, and attempt to be as clear as possible. No doubt they are often inundated with inquiries. Where would the Standards be without them?

#8 The GIPS Country Council: This group represents the 30+ countries who endorse the standards. And while they do not dedicate the same level of time as the EC, they are still extremely important, and worthy of our praise and thanks.

#7 The GIPS Executive Committee: Where would we be without this body, to manage the standards' development? Eight of its nine members are unpaid volunteers, who devote countless hours to the standards, on our behalf. We are in their debt and gratitude. While we may not always agree with them, we recognize that they do what they believe is best for the industry.

#6 Significant cash flows: I take pride in pushing the introduction of this provision, along with Neil Riddles and a few others, who felt that to force managers to keep accounts in their composites when they experienced very large flows made no sense. While many firms don't avail themselves of this option, many do, and at least firms have this opportunity.

#5 Verifier independence guidance: Having seen some verifiers go to great lengths to obliterate any semblance of independence, the introduction of a formal guidance statement on this matter was an important step, in at least memorializing some rules. Granted, some verifiers still manage to cross the boundaries, but at least we have rules.

#4 Dispersion: In 1970, Chevrolet introduced the Vega (I bought one (model year 1972) in November 1971: my first new car). It was a nice car for its time, but the initial edition (model year 1971) was missing something: a glove box! An acknowledged oversight which was quickly corrected with the 1972 version. Well, the initial version of the AIMR-PPS was missing something: dispersion! This was corrected in 1997, and provides a great deal of insight into a composite's management: a return by itself just doesn't say enough. Does the manager consistently apply the style across all clients, or are they "all over the map" with their investments? This is important information, which is a necessary and required disclosure in the Standards, by way of standard deviation (not to be confused with the required 3-year annualized, which is a risk measure; here, it's a measure of dispersion), high/low, range, or quartile dispersion, for any composite with six or more accounts present for the full period.

#3 The composite: To me, the bedrock of the standards is the composite. They're powerful, and yet flexible, too. Yes, they can be quite complicated, but at the heart, they're quite simple, at least to understand. They provide the prospective client with a thorough understanding as to how the manager managed the style/strategy they're interested in. What a concept!

#2 The globalization of the standard: AIMR, back in the mid 1990s, had the forethought to create a global committee, which ended up crafting GIPS. They could have allowed each country to "do their own thing" (as many began to do, following the introduction of the "PPS" in 1993) but they chose to be proactive, assemble a team of international performance professionals, and create what became a single global standard: what an accomplishment!

#1 The standards, in general: I believe we owe a huge debt of gratitude to the gentlemen who were on the "blue ribbon committee" back in the mid 1980s who crafted the first performance presentation standards: a great idea that has seen worldwide support. And the fact that this was taken up by AIMR (now the CFA Institute) is a huge commitment, responsibility, and service to the industry.

Anyone involved with the Standards could obviously craft their own list. And I do not expect you to agree with everything I've written. If you have ideas, thoughts, reactions, please let me know! But reminder: please do not do it "anonymously," as it then won't appear in the blog.

Tuesday, December 20, 2011

The 10 "Not So Good" Things About GIPS

Over the past several months, I've had conversations with other PMPs (Performance Measurement Professionals) about the GIPS(R) Standards (Global Investment Performance Standards). And while we are in agreement that the standards are exceptional, necessary, and highly successful, and something we all support, we're also in agreement that there are some shortcomings (as one might expect with such a complex document). And, of course, there are many things about these standards we like a lot. And so, I thought I'd put two lists together, representing both sides.

I first thought of referring to this first list as the "10 worst things" about GIPS, because I will identify the "10 best things" about the Standards tomorrow, but thanks to feedback from colleagues I decided that the word "worst" might engender some ill feelings among some folks (which is not my intent or desire), and perhaps sounds really negative. And so, what to call the list?, I wondered. Someone suggested making it like Santa's "naughty and nice" list, but I thought that didn't fit well. How about the "10 could be better" list?, but that wasn't very crisp. After much thought, I settled on this "euphemismistic" title: "The 10 'Not So Good' Things About GIPS."

And so, here is my list of the 10 "not so good" things about the standards, and in David Letterman style: 

#10 Performance Examinations: The GIPS draft didn't include examinations, but somehow they were introduced when the first edition was published. They have virtually nothing to do with the standards, and cost managers tens (and in some cases, hundreds) of thousands of dollars a year. The Spaulding Group is happy to do them for our clients, as we are a for-profit company, but discourage our clients from having the expense (compliance is an investment; verification is an investment; examinations are usually an expense). And most of the clients we've won from other verifiers, who previously had them done, have ceased; and none of the clients we were the first verifier for have them done.

Are examinations necessarily a "bad" thing? No, perhaps not; perhaps they fulfill a need that some folks have, to undergo an independent review of the underlying data, to enhance the credibility of their presentation. But, I believe they're overdone, and that too many firms have ALL of their composites examined, or ALL of their "marketed" done, when this isn't really necessary.

#9 Model fees: GIPS 2010 introduced a term: "model fees." But, there is no definition for it! I've asked for one, but am still waiting. You would think that if a new term is introduced, it would have a definition, but this did not occur. Maybe we'll see one in the 2015 edition.

#8 The recommendation that compliant firms annually give their existing clients a copy of the composite(s) their account is in. This idea, when introduced in the 2010 Exposure Draft, was met with strong opposition. But rather than listen to those opinions, the EC decided to make this part of the standards: and since recommendations are, by definition, "best practice," someone thinks that all firms should do it. 

I am curious to know how many members of the EC, who work for asset managers, send these reports to all of their clients annually; I suspect few, if any. Reporting to existing clients is arguably "out of scope" for GIPS. This was a bad idea, but unfortunately it's with us.

#7 Introducing a rule disallowing intra-month additions of accounts in a Q&A: There is no doubt that the recent addition of this rule was in response to my vocal opposition to the aggregate method, as several of my examples pointed out how the aggregate method could yield nonsensical results when accounts were added during the month. However, after further reflection, and the realization that the aggregate method, by definition, isn't supposed to look like the asset-weighted methods, since it's measuring something completely different, it turns out that intra-month additions for the aggregate method are perfectly fine; they shouldn't be allowed for asset-weighted methods. But more importantly, introducing a rule, in a Q&A, no basis for it, with no opportunity for public comment, and with no effective date? One might suggest (as a colleague did to me) that the concept is good, but it's lacking (a) a clear definition of the concept of a "performance measurement period," and (b) a basis for the Q&A in the existing provisions and guidance, which would justify the requirement. I recommend retracting the Q&A and treating this rule change as any other would be: by putting it out for public comment, with sufficient supporting language to make its application clear.

#6 No GIPS Handbook. We still do not have a GIPS Handbook, which is odd/unfortunate, because GIPS 2010 has been in effect for a full year, and so many rely on this important document. Having worked on the current handbook, when I was a member of the Investment Performance Council and Interpretations Subcommittee, I know how challenging revisions can be, especially following major changes to  the Standards. But I also know how important the document is. We have had several inquiries from our clients about it, and its absence is a problem. Hopefully it will be here soon.

#5 Dropping after-tax. The 2005 edition of GIPS included after-tax provisions for the U.S. and Italy. It was decided to drop them completely from the 2010 edition, rather than (a) allow them to stay, (b) encourage other countries to offer rules, or (c) come up with generic rules. This has resulted in a great deal of confusion, at least here in the U.S. In addition, it has removed an important element: after-tax performance. 

Perhaps the EC could have, and perhaps should have, made more of an effort to come up with something here. And perhaps a USA-bias was the problem, and a feeling that a global standard would need to be as specific as the existing U.S. guidance, causing people to think any global tax provisions would be bogged down with accounting details. But, the right answer may have been to become more principles-based (with the necessary disclosures) rather than rules-based, with respect to after-tax provisions and guidance. Perhaps something to take up with the 2015 version. My colleague, John Simpson, CIPM, has worked on these rules for many years, and would be a great candidate to lead such an effort. And, I will toss in Douglas Rogers' name, too, as he, like John, is a recognized expert on this subject, and could contribute greatly to the assembly of such a document.

#4 The Error Correction Guidance Statement: It would be a bit unfair (and not my intention) to label the entire GS as a bad idea, especially since I crafted the initial working draft several years ago (which was based on an article Stefan Illmer and I wrote). But the version that went into effect in January 2010 was poorly handled: it introduced several changes to the earlier draft (which had been approved by the IPC), including requirements, which arguably should have been put to the public for comment. Once the EC saw how the ideas were, received they were when made part of the standards (in the 2010 exposure draft), they (the EC) pulled them from the standards. But, since they were in the GS, they would still be required! 

The most recent GS edition is much improved, save for the third level of the recommended error correction hierarchy, which is a requirement to disclose immaterial errors, for an indefinite period! There's a reason the public is asked to comment! Oh, and to clarify: the concept of the guidance is both great and necessary, and we fully support it (heck, it may have been my idea, come to think about it!); the problem is how it was introduced.

#3 The aggregate method for composite returns. I have commented on this before, but it's clearly in my top (I mean, bottom) list. The aggregate method tells us how the composite did: who cares? Who manages the composite? Why wouldn't we want to know how the average account did? Okay, while I'd prefer the equal-weighted average, I'll take the asset-weighted average any day over the composite's return, which I believe is useless information.

But perhaps more importantly, the GIPS EC needs to define what "composite definition" means, as I have suggested in the past, as the two broad calculation areas  (asset-weighted methods vs. aggregate) produce two very different numbers, representing two very different things.

#2 The use of asset-weighting to measure performance. Back when the Association for Investment Management & Research (CFA Institute's former moniker) were crafting the AIMR-PPS(R), two groups (the ICAA (now the IAA) and IMCA) opposed the use of asset-weighting of portfolio returns, as it could skew the results in favor of the larger account(s). But AIMR refused to budge, and asset-weighting remains. Over the past year or so I've learned that they (the ICAA and IMCA) were right: equal-weighting is a much better way to assemble the returns. For example, a very large mutual fund's return can dwarf the returns of a few smaller accounts, such that the composite's return is essentially that of the mutual fund. 

Perhaps the best solution is to require both asset- and equal-weighted composite returns. One could argue that prospects should have some sense of returns for larger versus smaller portfolios in the strategy. 

#1 The decision to eliminate the opportunity for firms to allocate cash to carve-outs. Back when the earlier (2005) version of GIPS was being crafted, the rule change was already planned to occur in 2005. But the IPC (Investment Performance Council; the predecessor group to the GIPS EC (Executive Committee)) listened to the overwhelming opposition to the change, and agreed to push it back five years. But when the 2010 edition was being considered, rather than again open this point up for comment, the EC refused; how unfortunate. As a result, most firms that had been using carve-outs have had to stop, which was an unnecessary inconvenience; this isn't a desirable outcome.

Please do not get me wrong: there is SO much more good about the standards than bad (sorry, I mean not so good); and, with any such document, there is bound to be disagreement. And, being the somewhat opinionated person that I am, it's not surprising that I could craft such a list. To balance them out, I will post my "10 best things" tomorrow!

Oh, and if you (a) have your OWN list or (b) wish to comment on mine, please let us know!

Monday, December 19, 2011

Announcing a new service!

We are very excited about a new service The Spaulding Group announced last week: "Software Certification."

While the type of work isn't new for us, as we've reviewed many firms' performance systems for close to 20 years, the formalizing of it is. We provide an independent review of a firm's performance system, addressing the system's:
  • Functionality
  • Calculations
  • Completeness
  • Screens/User Interfaces
  • Reports
  • Usability
  • Controls
  • Workflow.
Software products or areas that are eligible for certification include:
  • Rates of return
  • GIPS(R) "Basic"
  • GIPS Real Estate
  • GIPS Private Equity
  • Equity Attribution
  • Fixed Income Attribution
  • Risk, ex post 
with other areas planned.

The review is intended for software vendors, custodians, and asset managers with internally developed systems. It is both rigorous and comprehensive. John Simpson, CIPM and I designed and developed the process we will use to evaluate systems. For firms to have their system declared "TSG Certified" it must meet the tests we've developed. 

The certification
  • provides software vendors with a "competitive edge"
  • affirms the system's capabilities
  • gives the firm's clients and prospects greater confidence, reduces their concerns and risks, and increases the vendor's likelihood of a sale.
To learn more about the service, please contact Christopher Spaulding (732-873-5700).

Friday, December 16, 2011

Who to get net, who to get gross?

Okay, so yesterday we touched on the calculations for gross- and net-of-fee returns. But who should get what?

Prospective clients should get gross-of-fee returns, unless the net-of-fee returns are net of the same fee. The problem with most net-of-fee returns is that they're net of a mix of fees: how can one easily understand what the number represents? If you're going to show net-of-fee, provide helpful information so that the reader can better interpret it. Under the "old" AIMR-PPS(R), firms were required to show their weighted average fee, which could be helpful to interpret the return; but this is neither required nor recommended in GIPS(R) (Global Investment Performance Standards). In some cases, regulators (think SEC) require net-of-fee under certain circumstances, so it becomes a requirement. To me, gross-of-fee should be a requirement for marketing to prospects. Showing both is probably the ideal, even given the NOF's shortcomings.

Existing clients should get net-of-fee reporting. This represents the manager's performance after the fee they're charging has been removed. This seems best for the client.

Arguably, both prospective and existing clients should also see net-of-taxes (i.e., after-tax) returns, too. And, net-of-risk (i.e. risk-adjusted) returns.

p.s., The 2010 edition of GIPS now requires firms to indicate whether their NOF returns are net of actual or "model" fees (see ¶ I.4.A.6.b).

Thursday, December 15, 2011

Deriving net rates of return

There has been a bit of a debate on one of the Linkedin groups lately, regarding the proper way to derive net-of-fee returns, when the fees come out of the corpus of the account. I happen to like this topic, and wrote an article on it for the CFA Institute some time ago.

To put it simply, fees are technically cash flows, but when it comes to calculating net- or gross-of-fee returns, we need rules on what to do with them. When we calculate gross-of-fee returns, we treat the fees as a flow; when we calculate net-of-fee return, they're ignored (i.e., they do not show up in our calculation at all).

The Linkedin question was simply whether one should always include the fee (as a cash flow) in the denominator, regardless of whether you're calculating a net or gross return. One individual suggested that since the manager controls the timing of the flows (recall that in the Modified Dietz formula, cash flows are weighted based on timing, and this weighting is done in the denominator), that they should always be included (sorry about the run-on sentence...quite a mouthful!). I failed to see the logic behind "controlling the timing" and whether to include them. My interpretation of the statement was that this "control" might be used to advantage them somehow, even though one never knows how the month will end, so why would this matter?

Anyway, I stick by my simple rule:
  • Gross-of-fee: treat fees as a cash flow (in the denominator AND numerator)
  • Net-of-fee: ignore everywhere.
This, of course, is for fees taken from the corpus; fees paid from outside the account are treated differently. We'll address this at another time.

Wednesday, December 14, 2011

Doing transaction-based attribution? Don't forget about the benchmark!

I am working on a research project, where I am creating a variety of portfolios to compare the implementation of transaction-based attribution versus holdings-based. I began this study more than a year ago with my first test portfolio, and am now putting several more together. I chose the S&P 500 index for this project.

To avoid complicating the matter, I began by selecting months where the S&P 500's constituents saw no changes, as I didn't want to be bothered with worrying about capturing those transactions (one or more securities leaving during the month, and being replaced by other securities, possibly altering the weights of the various sectors). The problem is that it's often difficult to find such a month.

And so I decided to discard this requirement, and select any month, even if changes had taken place. The problem was that when I made this decision, I forgot about the need to capture the transactions on the index side.

Almost immediately residuals appeared when no portfolio transactions had occurred: they weren't terribly large (usually only one or two basis points), but when there is supposed to be no residual whatsoever, this posed a dilemma. At first I thought the fault lied with my spreadsheet somehow: that perhaps in loading the data, I had altered a cell's formula. But after some reflection it hit me: the benchmark's composition had changed, and I hadn't accounted for it (ironic, because my initial intention was to avoid this situation, but somehow forgot about it when I decided to forgo the original constraint). In other words, the benchmark sector weights used in the formulas were based solely on what they looked like at the start of the period, without accounting for the changes that occurred during the month. And so, the formula:
fails. And yet, the sector returns are the result of changes in their weights, which aren't captured here. The result: we have a residual.

The solution? Well, in "real life," one would want to make sure you captured the changes in the sector weights that resulted from securities leaving or entering the sector during the month. In my case, because I am evaluating changes to the portfolio, not the benchmark, I will simply alter the benchmark's overall return so that the formula is satisfied: something I have the luxury of doing in my analysis, and arguably a "must" to properly assess what the study is all about. Hopefully, you'll read more on this in an upcoming article.

My point? Make sure that your implementation of a transaction-based model properly captures the benchmark's changes, too; i.e., not just the ones to your portfolios!

Friday, December 9, 2011

More on Error Correction

We held a webinar on Monday devoted to the GIPS(R) (Global Investment Performance Standards) Error Correction Guidance Statement. As I pointed out in the session, this GS is one of the most confusing that has been offered, though the newest version is definitely much improved of the prior edition.

A verification client sent me a question, which is one that perhaps is worth commenting on here:

The Guidance Statement on Error Correction indicates that disclosure of the change must be included In the respective compliant presentation for a minimum of 12 months following the correction of the compliant presentation.  In what situations would the firm be required to continue to disclose the change to the erroneous presentation for a minimum of the following 12 months if the firm has already provided all persons that received the erroneous presentation with a corrected presentation that contains disclosure about of the change?

There are two possible scenarios when it comes to the disclosure of "material errors":
  1. The firm has kept track of the recipients of their presentations
  2. The firm has not kept track of the recipients of their presentations.
If the client has kept track, then this 12-month rule doesn't apply, since they will have two versions of their presentations (one with the disclosure, which they will give to those prospects who are (a) still active prospects or (b) have become clients in the interim; the second with no disclosure, which will be given to new prospects who didn't see the version with the error).

If the client failed to keep track, then they have a single version of the presentation, which will contain the disclosure, and which they will give to everyone (both new prospects as well as any prospects that saw the version which they know of).

Hope this makes sense!

Thursday, December 8, 2011

Dealing with zero weights

I got an email from a client recently, asking how one should treat the case where a manager has zero exposure to one of the sectors in the benchmark.

If you are using one of the Brinson models and simply use the formulas as written, you'll find that the interaction effect gets most of the credit (or blame) for the decision. But does this make any sense? No!

And so, you may want to shift the interaction results to one of the other effects: selection or allocation.

Now, which do you think it should be? [pause, to allow you to reflect a moment] I think allocation, since the manager made the decision to go void in the sector. Thus, I would move the entire interaction effect there.

I'll address this in greater detail in this month's newsletter.

Monday, December 5, 2011

What happens when our firm's name changes, and we're "GIPS compliant"?

One of our GIPS(R) (Global Investment Performance Standards) verification clients may be changing their name soon. What is the requirement for dealing with this?

Well, technically there is nothing explicit that I have found which deals with this matter: a quick check of the Q&As turned up nothing, and the Firm Definition Guidance Statement only states that changes in the name alone do not qualify for a firm "redefinition" (which has its own required disclosures).

A name change falls under the broad category of a "significant event," and requires a disclosure (see ¶ I.4.A.14). Our advice: include the date and previous name in the Firm Definition paragraph of all presentations. For example, "Effective January 1, 2012, XYZ Investment Advisors changed its name to ABC Investment Management." If a merger or acquisition occurred which formed the basis for the name change, include a disclosure about this, too; for example, "Effective January 1, 2012, XYZ Investment Advisors changed its name to ABC Investment Management, as a result of the September 1, 2011 acquisition of XYZ by ABC."

Thursday, December 1, 2011

How to implement transaction-based attribution

I got an email from someone today asking how to calculate transaction-based attribution. I addressed this during our recent Attribution Week, but will touch on it briefly here, and in greater detail in this month's newsletter.

Recall that attribution relies on returns and weights.

The Weights

With a holdings-based appraoch we use the weight at the start of the period. For example, if the portfolio's initial value is 100,000, and Technology has 10,000 as its starting value, then its weight is 10% (10,000 / 100,000).

To have a transaction-based approach, we need to adjust the weight for any buys/sells/income that occur during the month. For example, if we bought another 2,000 at the middle of the month, then we weight the transaction the same way we do with Modified Dietz [(CD-D+1)/CD] and multiply this by the value (and so, 0.5 x 2,000 = 1,000). We add this to the starting value and get a revised weight [(10,000 + 1,000)/100,000 = 11%]
We use this weight in our formula.

The Returns

With holdings-based, we can simply account for the starting values to derive our returns. With transaction-based, I suggest you use Modified Dietz, so that you capture the activity that occurs. And so for our example above, if we ended with Technology being valued at 14,000, we'd have R = (VE-VB-CF)/(VB+w*CF)=(14,000-10,000-2,000)/(10,000+0.5*2,000).
[I'll let you do the math]

That's it! Again, I'll spend a bit more time on this in the newsletter.