More on the aggregate method

Fear not!

I haven't given up on my arguments against the use of the aggregate method to derive the extremely important composite returns (which are the bedrock of the Standards).

I was conducting a GIPS(R) verification earlier this week, and stumbled upon the following on page 6 of the 2010 edition of the Global Investment Performance Standards:

"The composite return

is the asset-weighted average

of the performance

of all portfolios in the composite."

[emphasis added]

But, as I have pointed out repeatedly, this does not hold for the aggregate method, which calculates the return of the composite, which can yield a hugely different result. And so, IF this IS the definition, why allow the use of a formula that violates it? We have two measures which DO satisfy this definition, and should be the ONLY ones permitted.

Can I get an "amen" on this?

Now, in reality, I favor equal-weighting, but asset-weighting won't go away. But we can at least adhere to the intended definition and calculate it properly, can't we?

p.s., I learned this form of writing from reading NBA Hall of Famer Dennis Rodman's autobiography (yes, I read it).

p.p.s., Well, actually, Susan Weiner was my inspiration.

Best practice for composite construction

One of our GIPS(R) (Global Investment Performance Standards) verification clients called to ask what's the best practice for composite construction. Interesting question, I think.

We first touched on the meaning of "best practice," as it relates to the Standards, which is arguably an unknown, though I have concluded that it's what the Executive Committee thinks is best, which is fine by me; it's just important to know the context of the term. In the case of our conversation, though, I suspect the client meant what the industry might deem best, or best for ones clients or prospects.

If we turn briefly to the Standards, we know there are a host of recommended criteria available in the Composite Definition Guidance Statement. In reality, the standards afford the firm a great deal of latitude when it comes to construction. As is often stated, one can define their composites broadly, which allows more accounts to be included, with the likely result being more dispersion, or narrowly, meaning fewer accounts, with the anticipation of tighter dispersion.

Let's consider a brief example. Let's say that you have a U.S. large cap growth strategy, which you implement in two ways: with separate securities for your larger accounts, and mutual funds for your smaller ones. The "instruments used" can be a criteria for composite construction, and so you could have two composites: USLCG with separate securities and USLCG mutual funds. Or, you could combine them and have a single composite.

The advantages of a single composite are (a) more assets and (b) having to deal with just the single composite from a maintenance perspective; it also probably means wider dispersion. Going the dual composite route means tighter dispersion; it also means you'll have lower assets and have to work with two composites. Which is best practice? Well, if we're speaking from the standpoint of the firm it really depends on what they wish to accomplish. If you are disappointed that you'll have lower assets if you go with two composites, you can still show prospects the other composite, too, in order to demonstrate that your presence in that strategy is broader than one might conclude by looking at the single composite. From the prospect's perspective, to me it's clear that the dual composite approach makes more sense, because it means that they will see the one that aligns more accurately with their objectives and what you'll be doing for them. In the end, though, it's up to the firm. If you decide to have one large composite, then its description needs to indicate that mutual funds or (or possibly, "and/or") separate securities may be employed.

There are always trade-offs, and the firm gets to decide how they wish to deal with them. I was pleased that our client takes this so seriously, and wishes to do what is best for their prospects. It may mean more work for them, but it will allow them to better represent their success. There is more to be said on this topic, and we'll likely take it up again in the future. Your thoughts, ideas, and reactions are always invited.

Equal-weighting ... can it be done?

I had a call yesterday with a client who wanted to know if they can show equal-weighted composites. Recall that GIPS(R) (Global Investment Performance Standards) requires composites to be asset-weighted (something which I have grown to consider perhaps not to be appropriate, but that will be taken up at length in an upcoming article). And so, is it permitted to show an equal-weighted composite?

Yes! Provided (a) you have an asset-weighted version which is your actual presentation, (b) that you don't use the equal-weighted version as the presentation, but rather, (c) label it as "supplemental information."

Firms can use supplemental information to go well beyond the requirements of GIPS. The rules deal with the materials GIPS requires, but not items outside of GIPS, other than provisions as outlined in the Supplemental Information Guidance Statement, which you should familiarize yourself with.