The Global Investment Performance Standards (GIPS(R)) now require compliant firms to include the 3-year, annualized standard deviation for the composite and its benchmark. And while this was a somewhat controversial move, it's here, so we live with it. But, why stop there?
For example, while conducting a recent GIPS verification for Reams Asset Management, a division of Scout Investments, I found the following shown for their Unconstrained Fixed Income Composite:
Okay, the composite had a significant out performance relative to the index (more than 200 bps); but, look at that standard deviation; looks like a lot of risk was taken! If one truly believes in the value of standard deviation, might it be a good idea to move to the next step? That is, to require a risk-adjusted measure, such as (what seems to be the logical choice in this case, given that the risk measure is standard deviation) the Sharpe ratio?
But also observe that we are showing a one-year return and a three-year standard deviation, meaning the match up isn't perfect (and is arguably misleading), and so, let's report what isn't required (but perhaps should also be?): that is, the three-year annualized returns!
In this particular case, the benchmark is an absolute index, so the differences are a bit more pronounced than they might otherwise be. But the point is, I believe, still valid: to compare one-year returns with three-year risk statistics is, as we like to say, mixing apples and oranges. And, showing returns and a risk measure doesn't quite do the job.
And so, I encourage the GIPS Executive Committee to:
- Require, in addition to the 3-year annualized standard deviations, the corresponding 3-year annualized returns
- Require the Sharpe Ratio.