Thursday, December 27, 2012

What to do with the cash that you just created for your client

We often get questions about a problem all asset managers face: a client requests you to sell some of his/her/their securities, to free up cash that they plan to withdraw. Between the time that the cash is created and it's finally taken by the client, it's sitting in the account, impacting the portfolio's return. What options does the manager have? There are a few:
  1. You can leave the cash there and accept the impact. When reporting to the client, you can explain that the cash diluted the return and that you would have invested it if you could have, but at the client's request, it was created for them.
  2. You can move the cash out immediately into a "temporary account." This account would be on YOUR system (i.e., the custodian doesn't know about it), and would segregate the cash you raised from the account and any other cash that may be there (i.e., cash you can invest).
  3. You can move the cash into a different cash "bucket" (or pseudo security), which you would flag as being "unmanaged," so that it isn't included in the returns.
Once the cash is created it's nondiscretionary, is it not? When it was invested it was under your control, but once you create it for the client, you cannot invest it, and so it should arguably be segregated. By moving it into a temporary account, you accomplish this. Also, if you can move it into a different security category and simply give it a different name ("non-discretionary cash") which you've flagged as unmanaged, your return calculation will exclude it.

Some of our clients raise cash for clients who say they'll take it immediately, only to find that the cash is still there weeks (or months) after it was raised. It's unfair for the cash to impact the return when the manager can't invest it. It's just like any other unmanaged or nondiscretionary asset: it should be excluded from the return. Have some other thoughts? Please share them.

Wednesday, December 26, 2012

Having a risk policy is only part of the solution

A recent WSJ headline referenced one major bank's problems as regulators challenge its risk management practices. This made me think of comments I usually make during our firm's Fundamentals of Performance Measurement course, when I touch on risk management: having a risk policy can be risky!

This comment is based on a consulting assignment we had several years ago, that involved a plan sponsor's challenge of one of its managers risk management policies. They felt that the manager had failed to live up to their documented control procedures, and we were asked to conduct an analysis to discover what we could regarding this matter.

Of course, a policy has to be sound and as complete as possible. The point here is that having one on paper but not in reality can be hugely problematic. Not having one is also a problem, as more and more clients expect to see some risk management in place. I recall a NYC asset manager client who contacted me one day about establishing one: their largest client had asked what their policy was, and the reality was that they didn't do any risk measurement or management.

Policies, procedures, and controls cannot reside only on paper; they must be exercised and validated occasionally, to ensure they are performing as expected, and from time to time enhanced, too.

Monday, December 24, 2012

Seasons' Greetings from The Spaulding Group

This has been quite a year. We've had our ups, and our downs, just like all years. Overall, The Spaulding Group had a great year. Our verification practice continues to grow, and our GIPS(R) verification clients now number more than 100. Our PMAR conferences both had record attendance, and our training numbers were on the rise. Our new software certification service has been well received, and we will shortly award certifications to two of our clients. We are grateful for those who have hired us to serve them, as well as our the many professionals we have the pleasure of working with. On a personal note, I am thankful for the team we've assembled.

A dear friend, who I met almost 50 years ago when, as young men, we were members of the Order of DeMolay, and who passed away 6+ years ago, told me how he always liked it when Chanukah and Christmas overlapped. While the holidays have nothing in common other than their proximity, I agreed that having them occur at roughly the same time was especially nice. This year they are separated quite a bit, and so our Jewish brethren have already exchanged their holiday gifts.

Our pastor's letter in this weekend's church bulletin referenced two events which have taken away from the holiday season for many of us: Hurricane Sandy, which smacked our region a few weeks back, and those horrific killings which struck a nearby Connecticut school 10 days ago.

Yesterday was the last Sunday of Advent, and just like the prior Sunday, the four candles in our Advent wreath were changed to black, as a sign of mourning for those who perished in Newtown. The song we began the mass with brought tears to my eyes, and the tears appeared again yesterday, as I reflected upon those candles. Our hearts continue to ache for those who perished and the loved ones they left behind.

Our family will celebrate Christmas tomorrow, though tonight we will go to church with our sons, our daughter-in-law, and our grandsons. We will also exchange gifts this evening, since this year our grandchildren (and their parents) will be "at the other grandparents" for Christmas day.

Despite the difficult times, we will try to focus on the happiness that the holiday brings. I am blessed that my wife of 40 years and I will share it with family.

We hope our Jewish friends and colleagues had an enjoyable Chanukah, and wish our Christian friends and colleagues a happy and blessed Christmas.

Friday, December 21, 2012

Spreadsheet-based systems: a case in point

The Spaulding Group's December newsletter deals with the use of spreadsheets, and their all too frequent use as "systems." I point out, as I've done countless times elsewhere, that they are:
  • time-consuming
  • error prone
  • cumbersome
  • not databases
and so should be avoided, if possible.

Earlier this year I was asked to develop an attribution model for a client that employs option writing along side its long stock positions. It's a global firm, so the model has to also be sensitive to currency movement, though since the client doesn't employ a hedging strategy, naive multi-currency attribution works.

I completed the assignment, and delivered the spreadsheet. Because of its complexity, the firm will most likely not employ it, which I can fully understand.

I do see the exercise as a way to prototype a model, so as to gain confidence in the approach, formulas, assumptions, etc. From such an effort a programmed system can be built.

This exercise will also likely result in an article for The Journal of Performance Measurement(R), to explain the model as well as to further support the use of spreadsheets to prototype models, but not to turn into "systems."

Wednesday, December 19, 2012

Attribution is part of our daily lives

When I teach our fundamentals of performance or attribution classes, I often mention how we adopt ideas from other segments of society. Measuring performance, for example, is found in many areas, with sports perhaps being the most thorough (with baseball leading the way).

Attribution, too, is found in many places. Police departments conduct attribution when attempting to ascertain the cause(s) of an accident, and fire departments do the same when investigating a fire.

The recent horrific massacre at the Sandy Hook Elementary School is causing a rash of attribution analysis, as the contributing causes are being analyzed. How much did mental illness play a part, should gun control laws be examined, does violence on television lead to violence in real life, etc.? And just as performance attribution is controversial, so are many of these discussions.

I'm conducting a study which demonstrates how some approaches to performance attribution or flawed, and can lead to incorrect conclusions (an article summarizing preliminary results will be published shortly). This, in spite of the fact that we're talking numerical attribution. In the case of analyzing a crime, much of the work will be subjective, which can be influenced by various factors, including political and public pressure. To avoid flaws in the results, objectivity must be complete and the evaluation unbiased.

David Kopel wrote an interesting piece in Monday's WSJ titled "Guns, Mental Illness, and Newton." He points out how we've seen a significant increase in random mass shootings over the past 30 years. Some are quick to "rush to judgement," while many admit they "haven't a clue." President Obama wants action taken to make these events an impossibility, which is admirable and something we all would support, though how realistic this goal is is yet to be determined.

My heart continues to ache for those who died and the loved ones they left behind. The attribution analysis has begun, and hopefully action can be taken to reduce the risks of similar attacks taking place.

Saturday, December 15, 2012

No answers for this one

Almost every day I receive questions from clients and others about various aspects of performance and risk. And for the most part I am able to respond, either with my opinion or an answer based on fact.

What occurred yesterday in Newtown, CT leaves me, and no doubt you, too, with no answers. How anyone could commit such a heinous crime baffles us to no end. How anyone can kill small, frail, innocent children, as well as innocent adults, is something that none of us can give a good reply to, other than perhaps madness. This young man was set on a journey of destruction; his motives or the basis for such action will probably never be known. Man's inhumanity to man is still shocking to me. But it's difficult to think of anything that can compare to this horror.

One of my friends expressed being somewhat at loss as to how to pray for the parents who lost their young children; I suggested that to pray that they be given peace and comfort is an okay thing to do. They will forever, probably every single day, be reminded of their loss. Nothing I can think of can compare to such a loss, especially at this time of year, as most of these young folks were awaiting the arrival of Santa in less than two weeks, and others just wrapping up the festival of lights, a time that no doubt brought them much joy.

Two weeks from yesterday is the Feast of the Holy Innocents, when we remember those victims of Herod's pursuit of the newborn Christ child. Those youngsters who died yesterday are holy innocents, too.

My heart aches as I think of what occurred. As a parent and grandparent, perhaps this event is more hurtful, though I don't believe we need to have any children to know how horrible this crime was.

I pray for the parents, family, and friends who suffered the loss of a child yesterday. And, I pray for the victims; it is my hope that they are at peace, resting in the arms of a loving God.

Friday, December 14, 2012

Getting control of ancillary systems

At this month's Fall (Autumn) Performance Measurement Forum meeting, which was held in one of my favorite cities (San Francisco), one member posed a question about ancillary systems (i.e., those systems that sit aside the packaged or programmed systems that most asset managers use, including manual and spreadsheet). The reality is that EVERY FIRM just about has at least one spreadsheet-based system to support their performance measurement needs. This discussion raised a question about "best practices" for such systems.

Interestingly, this past weekend's WSJ had an article ("Ex-Trader's Gambit Bites Goldman") which discusses how a former Goldman and Morgan Stanley trader "using a manual system typically for trades done over the counter or those handled by a floor broker, entered 60 false 'sell' trades to make it look as if he was reducing his position." Does this not speak to the need for some form of "best practices"?

At our Spring Forum meeting (which we expect to be held in Boston) we will address this subject. Here are a few quick thoughts (you're invited to chime in with your own):
  1. Avoid having manual or spreadsheet based systems when packaged software can accomplish what you require
  2. KNOW what systems exist within your organization. Construct an inventory of all systems, who built them, who's responsible for their maintenance, who uses them, and what they're used for
  3. Know what data is used by these systems and what data comes out of them, to be used by other systems
  4. Identify the controls that are in place to ensure integrity of the information
  5. Put in place a process by which such systems must go through a testing process before they can be implemented...
  6. ...also, for changes!
  7. Identify systems that are used as an alternative to programmed/packaged systems
Give me time, and I'll come up with a few more, but this is at least a start.

As you might expect, this is one of the areas we look at when we conduct our operational reviews. It's not uncommon to find spreadsheet based systems that pose huge threats to the integrity of the firm's data.

Thursday, December 13, 2012

Feeling lucky?

Jason Zweig often provides inspiration for a blog post, and his article in this past weekend's WSJ ("Are You Brilliant, or Lucky?") has done just that. The subject of luck versus skill has been one that academics, as well as practitioners, have wrestled with for decades, but this is not the time to try to address this in any detail.

What actually grabbed me was his opening statement: "Have investors finally learned that past performance doesn't guarantee future results?"

The answer, sadly, is NO!

We're approaching that time of year (January) when several magazines  (e.g., Money) will identify the "top money managers of 2012." And how will many investors react? They will flock to whoever holds the #1 spot.

My response: sorry, but you're a year late.

Often the #1 fund managers have a minimal amount under management, and perhaps are concentrated in a few stocks that simply performed in an OUTSTANDING fashion. But investors don't care...they'll be sending their money their way once the manager's been id'd.

Investing is clearly not the only industry that falls victim to this. We see it in sports all the time, do we not? Professional athletes often receive very lucrative signing or resigning contracts, because the GM (General Manager), manager/head coach, and/or owner(s) expect past performance to predict future results.

Of course, this begs the question, if past performance ISN'T an indication of future results, should it be banned from being reported?

The answer: no. Because, it still tell us how the manager did in the past, and this information can have value. To have no such track record would, I suspect, be MUCH worse.

Imagine, for example, me, David Spaulding, putting up a shingle on January 1 offering my investment management service with absolutely no track record, because past performance is no predictor of future results. I suspect that folks would want some indication as to my prior success, in spite of my inability to say that what I had done could be done again.

In whatever endeavor we choose, we cannot guarantee that our past accomplishments will be matched in the future. Fortunately, this some times works where the individual had previously failed multiple times but then succeeds (Abraham Lincoln comes to mind). Knowing about one's past should always be part of the evaluation.

Tuesday, December 11, 2012

GIPS Standards Handbook Now Available; The Spaulding Group to Provide Copies to GIPS Verification Clients

The long-awaited third edition of the Global Investment Performance Standards (GIPS(R)) Handbook is now available.

This book is a companion whenever I do a verification. I find it to be an invaluable compendium to the Standards, and a valuable resource that helps provide clarity to various aspects of the Standards.

The book is available as a PDF online for free. While I frequently use the PDF version of the Standards, I haven't taken advantage of this option with the handbook, but will give it a try. Hard copy versions are available for US$40.

The Spaulding Group feels that this book is so important that we are buying copies for all of our GIPS verification clients. Each client's verifier will provide a copy to them when we conduct their 2012 verification. A copy is also included in our GIPS Orientation Kit.

Monday, December 10, 2012

Getting our attribution right

In last Friday's WSJ, Cameron McWhirter had an article titled "To Quote Thomas Jefferson, 'I Never Actually Said That,'" in which he refutes many quotes that are incorrectly attributed to our America's third President (and one of our Founding Fathers, author of the Declaration of Independence, the country's first Secretary of State, and much more). He cites Anna Berkes, a librarian at the Monticello Jefferson Library who speaks of the "rampant misattribution" of such misassignment of quotes.

In performance attribution analysis, we must also be on the lookout for misattribution; what's the point of doing the analysis if it's going to result in figures pointing to the wrong cause?

For example, on a few occasions I've found global managers who fail to measure the impact of currency movement. This means that the selection effect is including it, and therefore possibly crediting selection decisions when the currency movement is the correct source.

I've written about the problems that holdings-based models can cause, especially when there's a fair amount of trading occurring within the portfolio: not only can we expect to see large single-period residuals (as opposed to multiple-period, that can result from the absence of a sound linking method), but also the misassignment of the effects (more to follow on this point).

The integrity of the attribution analysis depends on the model's alignment with the investment process, as well as the completeness and accuracy of the model's formulae.

Misattribution can result in giving credit where credit isn't due, failing to see problems that may exist within the investment process, and misleading clients and prospects about the sources of return. They can also call into question the value of the performance team. None of these are good things.

Saturday, December 8, 2012

The ever befuddling world of materiality

Today's post was inspired by an op-ed piece in this weekend's WSJ: "Madoff Got Away, But Netflix Won't," by Holman W. Jenkins, Jr.

Jenkins discusses how Netflix CEO Reed Hastings' Facebook post that the company's "customers had streamed a billion hours of video in the month of June" was determined to be worthy of scrutiny by the U.S. Securities & Exchange Commission. He suggests that one "ask just how crazy is the SEC in trying to extend its concept of 'materiality' to the news that Netflix actually disclosed."

In our industry, the Global Investment Performance Standards (GIPS(R)) calls for the disclosure of material items multiple times, including the requirement that firms define a level of materiality for a certain threshold of errors (which happen to be classified as "material").

Of all the things we wrestle with, defining materiality is probably one of the most challenging, because it is entirely subjective, and there is no real guidance or "best practices" to help.

My favorite word source,, offers definitions for "materiality" that refer to "material," which is of no real value, and so we're forced to check out what this latter term means. And while several definitions are offered, the one that applies here is "of substantial import; of much consequence; important." An example is included: Your support will make a material difference in the success of our program.

And so something is material when it's important and involves much consequence. Now, let's translate that into numbers; ah, there's the rub.

I tend to think that something is material if it causes us to look differently upon something than we would otherwise have.

An extreme example: Wilt Chamberlain, the late Hall of Fame National Basketball player claimed to have slept with 20,000 women; quite a tally. If we were to learn that the actual number was 19,000, or 21,000, would we think any differently about his achievements in this area? I think not. And yet, it would still be a 5% error over what he reported.

Interestingly, his actual height is unknown. He claimed to have been 7-foot tall, as I recall, but was apparently even taller (by a few inches, perhaps). Hardly a 5% difference from the actual height, but he was somewhat intimidated by his height and didn't want to share the actual figure, fearing, perhaps, that it might cause some embarrassment.

When trying to define rules for materiality, try to consider what others would consider a noticeable difference, which could cause them to rethink their prior conclusions based on the earlier result: would it cause someone to say something like "well, upon further reflection I must reconsider my earlier response"? If yes, then it's material.

As always, we're open to your thoughts and ideas on this subject.

Friday, December 7, 2012

Minimum requirements for Karnosky-Singer attribution

Many software vendors and custodians claim to offer the Karnosky-Singer multi-currency attribution model, but do they really?

The name has become synonymous with a robust approach to identifying the contributions from currency movements on a portfolio's excess return, and comes from the monograph Denis Karnosky and Brian Singer wrote for the CFA Institute. Though a relatively short piece (as monographs are intended to be), it covers a lot of ground. Carl Bacon has done an admirable job of describing the model in his books, which arguably should be considered a companion piece to the model, and present on all performance measurement professionals' bookshelves.

But when we speak of the K-S model, what do we mean? I discussed this recently with my colleagues John Simpson and Jed Schneider, and then confirmed our conclusions with Brian.

First, we expect to see currency's attribution effect bifurcated into two components (am I being redundant? how many components could BIfurcation create?):
  • the contribution that results from currency movement on the market; that is, as we take securities from the local to base currency, the change in value that's attributed to currency fluctuations
  • the contribution that comes from currency management; that is, the investments in currency futures in order to hedge the portfolio, or to expose the portfolio to other currency weights that differ from the portfolio's investments.
Second, that interest rates be broken away from the market side of attribution and included with the currency side, because, as Denis and Brian point out, interest rates have a direct bearing on currency movement.

We have observed some firms who claim to offer the K-S model, but who "lump" or combine the effects into a single value; i.e., the currency effect is shown as one, not two numbers. This fails to provide the highlights that the K-S model offers from an analytic perspective, robbing the recipient of knowing (a) how much was contributed from the currency movement across time on the underlying assets and (b) how much came from currency management (i.e., the hedging decisions that occurred). To lump them together converts the K-S model into a naive model, and should deprive the firm from claiming that they do, in fact, offer Karnosky-Singer attribution.

As always, your thoughts and insights are welcome.

Wednesday, December 5, 2012

Some portfolio managers are more erinaceous than others ... explained

One of the daily alerts I subscribe to is the "word of the day," from Many of the words are quite fascinating, and today's struck me as one that was worthy of being highlighted in a post. Chances are you've already guessed what the word is.

erinaceous \er-uh-NEY-shuhs\, adjective: Of the hedgehog kind or family.

Examples are offered, including "[Thoreau was] the most erinaceous of American writers. Ideas struck out from his writing like porcupine quills, guaranteed to prick the hide of even the most thick-skinned, reader."

You may recall that the late investor Barton Biggs brought us Hedgehogging, a book I enjoyed and have often recommended. And so, it was he that extended the term "hedgehogging" to the hedge fund industry, and thus it seems appropriate to carry this a bit further and suggest that those who take up this craft might therefore be thought of as being erinaceous. It seems to work, does it not?

Tuesday, December 4, 2012

Filling in the gaps of performance ... or not!

My son, Chris, and I had a preliminary meeting with someone who is looking to obtain compliance with the Global Investment Performance Standards (GIPS(R)). He left his prior firm and has recently created an account that is being managed in the same fashion as those he managed at the prior firm. The rules of portability apply. And so, he wishes to show a contiguous track record extending to performance he had at the prior firm.

The problem is that there is a two month gap between the time he stopped managing at the prior firm and began managing his new account. What can he do about it? Can he cross or fill in the gap?

Unfortunately, no; nothing can be done to link the two periods. He must show partial (aka "stub") period returns for the period leading up to the break (e.g., January-August, 2012) and the period since (e.g., November-December, 2012). The gap cannot be crossed.

Might he simulate the performance, by way of a benchmark's return, model performance, or backtesting? Nope!

I recognize that this is frustrating to those managers who have compiled a five or ten year track record, and wish to take advantage of and build upon it in their new endeavor. No doubt, they wish to report the return for the entire year they departed, as well as to link that year to prior and subsequent periods, so as to show rolling or fixed five and ten year cumulative and anualized returns. But when a gap occurs, it sadly cannot be crossed.

Individuals contemplating a departure from one firm to either start or join another, and who wish to continue their track record, must maintain at least one account in the same manner so as to avoid the creation of a gap. Of course, there are times when their departure is not of their own design but is forced upon them without notice. In these cases, nothing can be done. But, if someone anticipates a departure, willingly or otherwise, they can take steps to ensure their continuous and contiguous track record remains.

Have other thoughts? Please chime in!