Wednesday, April 4, 2012

A word about discretion

One of the problems with our industry is that we often use the same word to mean multiple things (e.g., "alpha" can mean excess return (portfolio return minus benchmark return) and Jensen's alpha, which takes beta into consideration), and multiple words (e.g., excess return, active return) to mean the same thing.

The word "discretion" serves two different roles in investing and performance measurement:
  1. It describes a client relationship, whereby the client has granted the manager (or firm) the authority to trade on their behalf
  2. For the GIPS(R) standards (Global Investment Performance Standards), it is used to indicate cases where the client has not imposed restrictions such that the account would not be representative of the manager's strategy (in this context, a nondiscretionary account is one where the client has restrictions that cause the portfolio to not be representative of the firm's strategy). In the expression "all actual, fee paying, discretionary accounts must be included in at least one composite," we're speaking of THIS form of the word.
When I teach classes on the GIPS standards or meet with verification clients, this is often an area that they find confusing, since they are used to using the word solely in the context of the first definition; the second one is a new one to them. In reviewing firm's policies and procedures, it is quite common to find their wording relative to composite inclusion addressing the legal aspects of the relationship, only. So, what's the solution?

For a while I've advocated qualifying the term when it's used in terms of the GIPS standards, since WHENEVER the standards use it, it means the second definition noted above. And so we'd see "GIPS discretion." However, I've come upon an even better solution!

Use the word "unencumbered."

To "encumber means to "impede or hinder." Isn't that what we mean when we say "nondiscretionary" in "GIPS speak"? And so, "unencumbered" would indicate cases where there is no impeding or hindering the firm's management. GIPS would then replace the wording to be "all actual, fee paying, unencumbered accounts must be included in at least one composite."

By adopting this change, we'd eliminate one of those huge confusing aspects of the Standards. Just a thought.

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