More on Error Correction

We held a webinar on Monday devoted to the GIPS(R) (Global Investment Performance Standards) Error Correction Guidance Statement. As I pointed out in the session, this GS is one of the most confusing that has been offered, though the newest version is definitely much improved of the prior edition.

A verification client sent me a question, which is one that perhaps is worth commenting on here:

The Guidance Statement on Error Correction indicates that disclosure of the change must be included In the respective compliant presentation for a minimum of 12 months following the correction of the compliant presentation.  In what situations would the firm be required to continue to disclose the change to the erroneous presentation for a minimum of the following 12 months if the firm has already provided all persons that received the erroneous presentation with a corrected presentation that contains disclosure about of the change?

There are two possible scenarios when it comes to the disclosure of "material errors":

1. The firm has kept track of the recipients of their presentations
2. The firm has not kept track of the recipients of their presentations.

If the client has kept track, then this 12-month rule doesn't apply, since they will have two versions of their presentations (one with the disclosure, which they will give to those prospects who are (a) still active prospects or (b) have become clients in the interim; the second with no disclosure, which will be given to new prospects who didn't see the version with the error).

If the client failed to keep track, then they have a single version of the presentation, which will contain the disclosure, and which they will give to everyone (both new prospects as well as any prospects that saw the version which they know of).

Hope this makes sense!

Wondering about your error correction policy?

Here's an opportunity to gain some insights into the proper way to construct your policy. (If you claim compliance with the Global Investment Performance Standards (GIPS(R)), you are required to have a written policy!).

Join me on Monday, December 5, from 11 AM to 1 PM (EST), for our delayed November Webinar. We will go through the guidance statement, clarify some key points, and address:

• Understanding the requirements
• Common mistakes
• Dealing with materiality

To register or for further information, please contact Jaime Puerschner or Patrick Fowler (732-881-5700).

Note that a modest site fee will be charged (and you can have as many people on the line as you'd like!), except for our verification clients and members of the Performance Measurement Forum (who can participate at no cost!).

Error correction, made perhaps TOO easy!

As of January 1, 2010, any firm claiming compliance with the GIPS(R) standards (Global Investment Performance Standards) must have a documented error correction policy. The policy that the firm comes up with should cover all aspects of their compliant presentations, both numeric (covered in section I.5 of the standards; e.g., returns) and non-numeric (i.e., disclosures, covered in section I.4; e.g., composite descriptions). Many firms fail to address the latter, and often only address returns when it comes to numeric errors, even though all numeric values (required and recommended (that appear); e.g., assets under management) need to be noted, too.

As for the non-numeric disclosures, what needs to be said? Well, some firms have taken the easy route and simply stated that any errors in this category will be treated as "non material." I have to object to this because materiality should include anything, found to be in error and then corrected, that might cause the recipient of the previous non-corrected version to possibly draw different conclusions. And surely there are required disclosures that fall into this category. For example, the composite description. Granted, a spelling error is probably non-material, but if the wording has to be changed, might that not constitute a material change? It would be very difficult to craft rules that could somehow distinguish between material and non-, when it comes to disclosures, (i.e., to bifurcate your rules into "material" and "non-material" for each disclosure) other than for spelling errors.

And so, I think firms have two choices:

1. Review every required (and recommended, if they appear in the presentation) disclosure to identify which ones would fall under the "material" category, and list these (you could state that the balance are non-material), or
2. Indicate that any error, other than spelling to disclosures will be deemed material.

Is the second option onerous? Well, it could be, so #1 would be perhaps better. But if your diligent in ensuring that your wording is correct, you'll never encounter an error, and so won't have to worry about it.

To me, these are the only choices available to you. But, if you have other ideas, please let me know!

Is it "material"?

GIPS(R) (Global Investment Performance Standards) compliant firms are now required to have an error correction policy. This calls for firms to establish rules for materiality, something many struggle with from a definitional perspective.

The CFA Institute's Standards of Practice Handbook provides a definition of this term in relation to "material nonpublic information": "Information is 'material' if its disclosure would likely have an impact on the price of a security or if reasonable investors would want to know the information before making an investment decision. In other words, information is material if it would significantly alter the total mix of information currently available regarding a security such that the price of the security would be affected."

Might this not serve as the basis for a definition of materiality relative to errors? Perhaps "Errors are 'material' if their disclosure would likely have an impact on the assessment of the composite or strategy, or if reasonable investors would want to know the information before making an investment decision. In other words, errors are material if they would significantly alter the total mix of information currently available regarding a composite, such that the assessment of the composite would be affected."

Thoughts?

Error Correction Policy ... some ideas and clarifications

The revised GIPS(R) (Global Investment Performance Standards) Error Correction Guidance Statement provides clarity over the earlier version, though I suspect that many individuals whose firm claims compliance with the Standards haven't read it (but should!). This topic is one that is often confusing and sometimes results in policies which are lacking in substance and clarity.

Next Month (Friday, May 27, to be exact) I will host a webinar that will touch on many of the policies we expect to see a GIPS compliant firm to have. But given some recent questions that have arisen about error correction, I thought it would be a good idea to touch on this topic here, though in cursory fashion. I may take this up in greater detail in next month's newsletter.

Levels of errors

A firm can have as many as four levels of errors, and perhaps more, if they wish to be creative. Here's what is included in the guidance statement:

1. Do nothing! We would expect this to exist for errors deemed so immaterial that there is no need to take any action at all. While this is an option, most of our verification clients don't avail themselves of it.
2. Correct only These errors are still deemed "immaterial," though they are of a level that at least warrants correcting them. 
3. Correct, and disclose the error Here the firm will not only correct it, but also indicate in their materials that an error was corrected. By the GS (guidance statement), this is still considered an immaterial error, which to me adds some confusion, as I'll touch on below.
4. Correct, disclose, and redistribute This is the only level of "material" errors the GS references. It is deemed to be of a level that warrants giving corrected copies to individuals who (a) received the prior version (with the error) and have since become clients and (b) are still legitimate prospects. And, in some cases, requires you to disclose the error for 12 months!

To disclose or not to disclose

Let's take up the subject of "disclosure" for a moment.  Recall that the idea of retaining a disclosure of errors in presentations for 12 months wasn't well received when it was included in the GIPS 2010 Exposure Draft, and was subsequently removed from the final edition. A Q&A was published to try to add clarity to the revised intent, following the decision to abandon the verbiage from the Standards. I, like many others I suspect, interpreted what was here to suggest that as long as the firm maintained a list of recipients of their presentations, the disclosure wasn't required. Well, the disclosure isn't required for new recipients, but is for those individuals who you gave the prior version to (this point was clarified in the revised GS).

Okay, so for material errors, as long as you track recipients, when you discover material errors you need only disclose the error in the corrected materials you give to prior recipients; new recipients don't need to know of your error(s). The wording from the GS:

"Firms are not required to disclose the material error in a compliant presentation that is provided to prospective clients that did not receive the erroneous presentation. However, for a minimum of 12 months following the correction of the presentation, if the firm is not able to determine if a particular prospective client has received the materially erroneous presentation, then the prospective client must receive the corrected presentation containing disclosure of the material error." (emphasis added)

Well, what about the 3rd case of errors: immaterial that warrant correction, not redistribution, but disclosure? First, there is no indication as to how long the disclosure must be included in the materials (and since for other required disclosures that have no sunset provision, "forever" is the implied rule) and second, there is no option (as with case #4) to not include the disclosure.

I can't think of a situation where one would want to go with option #3 (immaterial but worthy of letting future recipients know that you had made an error). I can see someone going with three (#1, #2, and #4) or two (#2 and #4) levels of errors. If you can think of why you'd want #3, please let me know.

Materiality ... what is it?

I think that like former U.S. Supreme Court Justice Potter Stewart's remarks about obscenity (not knowing how to define it, but knowing it when he saw it), the same applies with materiality. I heard someone once suggest that you should establish a level that wouldn't require you do make too many changes; sorry, but that isn't approaching the subject in the spirit that it should. Essentially, the level should be such that it would cause the recipient to think differently from how they previously did. Of course there is no way to know generally how this would be, so we should select a level that we feel is appropriate.

What to include? 

When developing your policy you should cover everything that is in your presentations: numbers and words. For numbers we mean returns (composite and benchmark), dispersion, assets, etc. For words, we mean disclosures, such as firm definition, composite definition, etc. Errors can mean forgetting something or stating something incorrectly.

This is a rather long post, but it only scratches the surface. Again, I'll touch on this at our upcoming webinar, and most likely in next month's newsletter. To learn about the webinar, please contact Patrick Fowler.

Love Story's link to the world of investing...who would have thought?

If you're old enough you may remember the 1970 movie Love Story, that starred Ryan O'Neal and Ali MacGraw. While today's movie-going audiences would probably not find the movie very appealing, it did meet with a great deal of success four decades ago. One of the most unforgettable lines was uttered by both of these actors: "love means never having to say you're sorry."

And while we might debate the wisdom of this proclamation, one of our verification clients, Daruma Asset Management's founder and CIO, Mariko Gordon, uses "Love Means Always Having to Say You're Sorry" as her March newsletter's headline. She points out that we make mistakes (who doesn't) and it's okay to admit them. I think an investment firm's clients appreciate a manager who can not only acknowledge a mistake, but also identify its source, as it demonstrates that they have their finger on the pulse and know what's happening in their clients' portfolios. As Mariko points out, "our mistakes are calculated in real time and down to the penny, blinking red on [our] computer monitor for extra emphasis."

Mariko also wrote that "In the financial world, investors performing due diligence may ask about investment mistakes, but they often do so in an anecdotal way. They're more interested in specific examples of mistakes rather than assessing how mistakes are tracked, analyzed and dissected. Personally, I think it's more useful to ask the question broadly and see what sorts of mechanisms firms have to systematically track and learn from mistakes." (emphasis in original)

When it comes to mistakes, the GIPS(R) (Global Investment Performance Standards) of course have a (recently revised, thank you very much) guidance statement on error correction, which deals with some of the categories of mistakes firms encounter.

I encourage you to read Mariko's newsletter. Her practical and sound assessment and discussion of this topic is one that all should find interesting and insightful.