Monday, October 14, 2013

A week about timing, starting with returns

It occurred to me that we could spend some focused time on the issue of time (pun intended). Let us begin with rates of return.

One of the ironies of performance measurement is that the term "time-weighting" has really nothing to do with the weighting of time; it's a term that was carried over from the 1968 BAI (Bank Administration Institute) performance standards. But time is an important component of rates of return.

We can speak of the issue of frequency of valuations. At one time it was not uncommon for firms to value their portfolios annually. Today, that may seem quite odd, but given the lack of computer power and absence of any performance systems, asset managers relied primarily on manual calculations. Over time (that word again), we saw a shrinking of the valuation frequency to quarterly, than monthly, and now it's typically either (a) daily or (b) whenever a large cash flow occurs. Some occasionally speak of "real time" valuations, but I think that would take this topic to an extremity that is ill advised.

When should you begin to report your performance?

But for the purpose of this discussion I am not speaking of such things. Rather, my focus is on how much time is needed before one should begin to REPORT PERFORMANCE!

Let's say that you've begun a new strategy or just opened shop and have your first client. When do you begin to report your rates of return (internally, to your client(s), or to prospective investors)?

The Global Investment Performance Standards (GIPS(R)) have, in a way, answered this, at least for prospective investors, because they now require the reporting of "stub periods." That is, returns for periods less than a year. And so, if you've begun a strategy in October, we probably expect to see returns for the end of the year, starting with November or December (depending on your timing to add an account to your composite).

It seems to be fairly common practice to report monthly returns, and so, if we have a new client we will most likely be reporting returns to them almost immediately.

As far as internal reporting, many firms report daily, weekly, and/or month-to-date returns. This is fine, as it is a way to "keep your finger on the pulse" of what is going on. What is done with the information is important to consider. That is, how much importance is placed on it, how is it being interpreted, and what actions may be taken as a result?

Short-term reporting of returns is all perfectly well, provided we understand that this information has very little meaning. It would be wrong to draw much from just a month or even a few months' of returns. If they are extremely bad, perhaps we look to determine what is going wrong; but if they are extremely good, don't start celebrating just yet. You need more time to properly assess skill.

A gambling analogy

I hope I am not disparaging our profession by bringing up gambling; it seems to fit, at least in this case.

What's the worse thing that can happen to someone the first time they visit a casino? I think it's to win a lot of money. And why? Because this may make them think that
  1. They're pretty good at gambling
  2. It's pretty easy to win
  3. They have a secret strategy that no one else ever figured out.
If they win big, they'll be back. And, eventually they will lose. But, given their earlier success, they may believe that the loss was an aberration (odd, because their win was probably the aberration), and so they will continue to gamble, knowing that another big win is just around the corner.

If they were to record their wins and losses over time, chances are they'd find that, on average, they lost. But they may not realize this unless they gamble over a period of time. The casinos know the odds; they want to keep gamblers in their casinos (thus, the typical absence of windows or clocks) and to keep them coming back (thus the "comps"), knowing that the winners will, on average, become losers. This has to be true; otherwise, where did the money for the fancy and lavish buildings come from?

How much reliance should be placed on short-term investment performance?

The same can be said for investing. Perhaps over a short time someone does extremely well with their investing. There's a reason the industry generally disallows annualizing returns for periods less than a year: it's because a good month or two, annualized, will present a return that is based on the assumption that their performance will continue, when there is no assurance that it will (thus the standard line, past performance is no indication of future results).

If a manger has a good month, two, three, or even several more, it is probably still too early to celebrate, at least too enthusiastically. There's also a reason why institutions typically want at least five years of performance before bringing a new manager on: because a short period of success may be non-sustainable.

We have, on occasion, been contacted by folks who have invested their own money for a few months; they've decided they want to become GIPS compliant. And while we encourage early adoption of the Standards (we'll discuss this later this week), it may be too early for these folks to quit their day job to enter the world of professional money management.

A benchmark for timing may be the requirements for a normal distribution: in general, we want at least 30 observations. We often "round this" to 36 months, which is often the basis for risk measurement (we'll discuss this, too, this week).

In some firms, a new manager who does extremely well in a short time may be prematurely rewarded; this is partly done out of fear that this individual may go elsewhere. But will the success continue? Only time will tell!

Warning labels

Should there be a disclosure with initial short period returns? Perhaps. Something to the effect that this performance is for a short period, and may not yet reflect the true skill of the investor or the strategy; that additional time will be needed to fully gauge this success. And, that success relative to the strategy's benchmark may fluctuate over time, and that by no means should the reader expect continuous out-performance.

Time matters, even with time-weighting; it's just a matter of how much it matters.

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