Performance examinations: when should you have them done (and when absolutely not)?

By now, if you're a regular (or even infrequent) reader of this blog and/or The Spaulding Group's newsletter, you know of my dislike for GIPS(R) (Global Investment Performance Standards) performance examinations. I have commented at length as to how compliance with the Standards and having annual verifications done are investments, but that in most cases, examinations are an expense or cost that should be avoided. But are there times when they should be done?

Yes, of course!

• If the firm believes they have value! To put it simply, if the firm disagrees with me and feels that this exercise provides them with benefits, then by all means, have them conducted.
• If a prospect virtually mandates that the composite(s) that align with their strategy have them done, and you feel that by having them conducted, you'll stand a better chance of winning the business
• If you find that for your primary composites the market fairly often inquires into whether or not examinations are done.

We've told our verification clients that we'll come in immediately, even over a weekend, if they require an examination to be performed (no one has yet taken us up on this offer). Until that time, most of our clients avoid the expense.

Are there times when they should absolutely NOT be done? Well, one particular case comes to mind:

• For non-marketed composites.

Note that the GIPS standards do not speak of "marketed" and "non-marketed" composites, but the industry surely understands the concept. We see absolutely no need to have examinations performed for non-marketed composites. By sheer virtue of their status, any possible benefits are nonexistent, are they not?

We know that some firms do have them done, but don't understand why. If you do, please let me know the reason(s) why. If you're a verifier and conduct them, chime in, too! And, if you have them done but don't know why, ask your verifier and tell me what they report, as I am curious as to the benefits they provide you for the costs involved. Thanks!

The Five Ways You May Be Wasting Money in Performance Measurement (#4)

#4 GIPS Performance Examinations

We have always been big supporters of GIPS(R) (Global Investment Performance Standards) verifications: given the Standards' complexity, it is very easy for firms to make mistakes.

At one time it was expected that verifications would become mandatory, but this idea was met with much opposition and was (fortunately) derailed. However, the importance of verification has been heightened as a result of the rewording and expansion of the "claim of compliance" statement in composite presentations, and the market has, in fact, made it a de facto requirement.

Examinations are a totally different matter. They are GIPS' version of the AIMR-PPS' Level II Verification. The following schematic summarizes the history of these reviews:

Examinations test to see if the firm is "cooking its books," and has little to do with the standards themselves.

While it's true that firms (a) move to compliance and (b) undergo verifications primarily for marketing purposes, the rationale behind examinations is less clear, especially since most RFPs fail to ask about them. We believe that for many firms they are simply a continuation of their Level II verifications, that were done when many large verification firms wouldn't do Level I's. And while this is no longer the case (i.e., these same verifiers will do GIPS verifications), the practice has continued.

We discourage our verification clients from having them done, and very few do (even those who used to, have, for the most part, stopped). This has resulted in tens of thousands of dollars in savings each year for our clients.

If a firm IS going to have examinations done, they should only be for those composites for which they have seen interest in having them done by their prospective clients. We have seen cases where verifiers perform them for all of the firm's marketed AND non-marketed composites: the only one who benefits from this is the verifier.

If yours is like most firms, chances are you're spending a lot of money on examinations each year. Do yourself the favor of asking "why?"

Should the GIPS EC learn from the SEC?

Yesterday’s WSJ  carried an interesting op-ed piece (“SEC Smackdown”) regarding the U.S. Securities & Exchange Commission’s attempt to alter the way committees are voted on, an idea that was called “unutterably mindless” by the D.C. (District of Columbia) Circuit Court of Appeals. The panel sided unanimously with plaintiffs (who challenged the new rules) because “the SEC didn’t ‘determine the likely economic consequences’ of the rule and its effect on ‘efficiency, competition and capital formation.’” The SEC is required to do this by law, and the piece mentioned that this was the “fourth time in recent years that the court rejected SEC rules on similar grounds.” And so, what does this have to do with the Global Investment Performance Standards (GIPS(R)) and the Executive Committee (EC)?, you might ask.

Consider the current proposed changes to the Performance Examination Guidance Statement, which is open for comments until August 31. Included are suggestions that verifiers should not rely upon external records (e.g., custodial statements) provided by their client, but rather go directly to “independent external parties” for these records. We discussed this in a prior post, our July newsletter, and yesterday’s monthly webinar. I am opposed to these suggested changes because of the added cost and complexity they would bring.

Leading up to the release of GIPS 2010, I chaired a meeting where we discussed some of the changes. During the session I voiced strong opposition to the then proposed (since adopted) recommendation that compliant firms provide their existing clients with copies of the composite presentation(s) they’re in on an annual basis. My objections were based on the anticipated excessive complexity and added cost that would result, since roughly half of a firm’s clients have returns below the composite’s average, who therefore might be inclined to require their manager to explain why. One individual who attended, who isn’t affiliated with any asset manager, responded “well, isn’t that just too bad.” I’ll admit that such a response was far from expected and wasn’t well received by many of the others in the room.

I believe that just as with the SEC, the GIPS Executive Committee should determine the likely economic consequences of changes to the standards, as well as their effect on the efficiency of compliance. In my years of involvement with the standards I am unaware of anyone voicing these concerns (as I’ve shown above) as loudly as I have, and perhaps my concerns are thought of by others as being a nuisance, or perhaps “just too bad,” but the standards were never intended to be overly burdensome on a compliant firm’s budget.

Perhaps the GIPS EC could learn from the recent Court of Appeals ruling and consider taking these points into consideration with future changes. Perhaps make them a formal part of their own rules for introducing change. It would be nice to see some sensitivity in this regard.

By all means, if you feel differently (or, perhaps agree), please chime in; thanks!

A graphical history of verifications

In preparing for today's webinar on GIPS(R) (Global Investment Performance Standards) Performance Examinations, I constructed, what I believe to be, the first graphical depiction of the confusing history of verification:

A brief explanation is in order:

First, we can consider Level I to be analogous to today's "verifications," while Level II is akin to today's "performance examinations." Now to the figure:

• In the beginning, under the "old" AIMR-PPS(R), we began with the requirement that firms MUST undergo a firm-wide Level I verification before commencing with a (composite level) Level II verification.
• Things got a big awkward when the large accounting firms declared that they would not do a Level I, but would do a Level II. And so, a "Modified Level II" verification was added, which was at the composite level, but incorporated the elements of Level I.
• The 1997 edition of GIPS changed the original Level II to its Modified form, but dropped the qualifier.
• Moving onto GIPS, the draft did not reference performance examinations, but only firm-wide verification.
• However, when the first edition was presented in 1999, performance examinations appeared.

And so, briefly, this is what has occurred. Oh, and it's not too late to sign up for today's webinar, which will be at 11:00 AM! Contact Patrick Fowler (732-873-5700) for details. We already have quite a crowd showing up!

Expanding ones vocabulary

I don't know about you, but often when I learn a new word I want to take ownership of it, by using it in sentences and making it part of my lexicon. To do this I often have to search for opportunities, which perhaps aren't as elegant as they might otherwise be.

In submitting my comments regarding the proposed changes to the Performance Examination Guidance Statement, I couldn't recall one particular word that would have worked, but then saw it in a front page article in yesterday's WSJ. The subheading: "Authors Who Crave Verisimilitude Learn Secrets of Bodice Ripping"; you can probably guess which word I am referring to.

Well, I came to know the word quite some time ago, but hadn't really taken ownership of it, but my comment letter provided me the opportunity, but I failed to take advantage of it. And "how exactly" you might ask? Well, the GIPS(R) (Global Investment Performance Standards) Executive Committee has suggested that perhaps verifiers should seek out documentation for the client being examined from independent parties, such as custodians and brokers. In my response I suggest that it's possible that to save the verifier the hassle, they could perhaps ask the client to contact these parties and ask them to provide the materials. However, who's to say that the client, who might be committing fraud, might not "go the extra mile" and fabricate what appears to be legitimate materials from these parties? And so, the verisimilitude they present might fool the verifier, right? This, to me, suggests that one cannot possibly rely upon the money manager as doing this on behalf of the verifier, but rather that the verifier must do all the "leg work" themselves.

And so, while I missed out on the opportunity to employ said word in my letter (and for that matter, our July newsletter which is about to be published), I got to here AND hopefully provided you with some insightful information about this document; more to follow!

p.s., if "verisimilitude" is a new or perhaps forgotten word for you, it means "the appearance or semblance of truth; likelihood; probability; something, as an assertion, having merely the appearance of truth."

Tests: too hard, too easy, and the world of cheating

This past week saw a few articles appear dealing with test taking. The WSJ reported on teachers who cheat for their students, so that the students' scores on standardized tests are higher, presumably so that the teachers can qualify for monetary benefits (or perhaps to avoid being terminated). The article cited one student who refused to take the test, but somehow managed to pass! Sadly, even in the Garden State (New Jersey), home of some of the most corrupt politicians in the States, apparently is also home of some corrupt teachers, as we are seeing evidence of cheating, revealed in last Saturday's Home News Tribune.

At the other end of the spectrum we learned of EU Bank exams that are apparently so easy that too many banks refused to fail them, as reported in this past weekend's Wall Street Journal.

An exam that's near and dear to many of us in GIPS(R)-land (Global Investment Performance Standards) is the Performance Examination, which can be done alongside, or after a firm undergoes, a verification. The GIPS Executive Committee has presented us with a proposed revised version of the Examination Guidance that suggests that verifiers perhaps should get the required account details (holdings and transactions) from an independent external party (e.g., custodians or brokers), offering three levels for your consideration:

• “preferable” to obtain from independent external parties
• “must make every reasonable effort” to obtain from independent external parties
• “must” obtain from independent external parties.

I consider these rather extreme measures, that appear to be aimed at the likes of the currently incarcerated Bernard Madoff; must we all suffer as a result of his misbehavior?

In this month's soon-to-be-published newsletter, I go into some detail on the exposure draft (the draft is available for public comment until August 31). In addition, I will discuss performance examinations in general, as well as the exposure draft, at this month's webinar (Monday, July 25, @ 11:00 AM, EST). If you're interested in participating in the webinar, please contact Patrick Fowler. And please review the draft so that you can comment; this document affects both verifiers and asset managers.

Examination Guidance ... it's time to be heard!

There is little doubt in my mind that if Bernie Madoff were to be given a copy of the proposed changes to the Guidance Statement on Performance Examinations he would pat himself on the back, and be quite proud that his nefarious actions have extended so far.

At the beginning of the document we find a few specific questions that the GIPS(R) (Global Investment Performance Standards) Executive Committee (EC) would like comments on, including:

Regarding performance examination procedures" we're asked if "you believe it also needs to be indicated that:

a. it is  preferable that verifiers obtain appropriate documentation directly from independent third parties;
b. verifiers must make every reasonable effort to obtain appropriate documentation directly from independent external parties; or
c. verifiers must obtain appropriate documentation directly from independent external parties?"

Also, regarding the existence and ownership of client assets we're asked if "it needs to be indicated that:

a. it is preferable that verifiers obtain appropriate documentation directly from independent external parties; or
b. verifiers must obtain appropriate documentation directly from independent external parties?"

Within the document itself we find on page 6: "Beginning- and end-of-performance measurement period portfolio positions are supported by sufficient documentation such as custody statements and custody reconciliations. The verifier must make every reasonable effort to obtain these documents directly from independent external parties (e.g., custodian, broker)."

The references to "independent external parties" trouble me, as it could possibly require the verifier to reach out to brokers and/or custodians to obtain documents, which in itself can be a challenge, and would likely add further complication and cost to the process. While I can understand why the EC would "float" such ideas, I would hope that they do not make it into the final document.

We're aware of legal cases involving firms that had committed fraud and that had both claimed compliance with the Standards and had undergone verification. Questions arose whether or not it's the job of the verifier to "detect fraud," and while it's fairly clear that it isn't, some of us feel that there are cases when verifiers should be alert to possible problems. These changes would, in essence, put the onus on verifiers to do just that: detect fraud. Is this really the verifier's role? I think not.

Our firm is on record as not supporting examinations as we don't believe they add to the compliance process. We do conduct them for a few of our clients, but most recognize that they're an expense that usually cannot be justified.

Please take the time to read the draft guidance and send your comments in (you have until August 31, 2011). You don't have to read the entire document; by simply referring to the first few pages (that ask specific questions) you'll understand the key items that the EC wishes to hear your comments on.

Examinations...the whys and wherefores

No doubt you recall a time when we wouldn't tear off those tags on our mattresses, because to do so would violate the law! We were convinced that there was a special agency (the Mattress Police) who, unannounced, would appear at your bedroom door to inspect your mattresses: God be with anyone who foolishly removed their tags. And the reason why everyone behaved this way? Ignorance. The tag writers assumed everyone would know that the prohibition only applied BEFORE a mattress was sold ... who cared what you did once you got it home!

Well, I liken this behavior to GIPS(R) examinations: why do people get them done? By far, most U.S. firms that claim compliance with the Global Investment Performance Standards undergo examinations: but why? And because so many firms do, does that make this behavior correct?

Our firm is, perhaps a bit unusual in that when we meet with verification clients, especially ones that we won over from competitors, we ask them why they previously underwent examinations. I recall one NYC client who, at one time, had ALL of their composites examined (probably to the tune of tens of thousands of dollars). Then, a few years ago, they decided only to have their "marketed" composites examined. When we asked why they had this done, the basic answer was "well, we just always have; our verifier recommended it." Okay, and so how has this benefited them? Did prospects or clients regularly ask if they had their composites examined? Well, upon further review our client determined that no, this work hadn't been beneficial at all to them. And so, they decided to stop having them done.

Another client, who we won over a few years ago from a "big 4" firm, had previously undergone examinations; we encouraged them to think twice about spending the money (even though it would mean money in our pockets). They decided to stop and have continued to avoid having them done; and, apparently this hasn't cost them any business.

Outside the States, hardly anyone gets examined. And why is this? Well, let's consider the history of examinations. To put it simply, they are equivalent to the old, AIMR-PPS(R) Level II verifications. Recall that the "big 8" (now "final 4") wouldn't do Level I (firm-wide) verifications but would do the Level IIs. And so, if a firm wanted to be verified by one of the "big boys," they had to settle for Level IIs. When the GIPS draft came out, it only had firm wide verifications, but when the first version (1999) appeared, examinations were included. And so, U.S. firms who had always had Level IIs not surprisingly now had examinations done (and today the large CPA firms are willing to do GIPS verifications).

We are aware of at least one of our competitors who is actively trying to convince people to have examinations done. We will be happy to do examinations, too: we ARE a for profit company. But, we don't want to take our client's money if we don't feel that it's being well spent. We'd prefer that they become convinced that yes, they're necessary, and then engage us to do them.

No doubt that the Bernie Madoff scandal can be a justification for having examinations done, but I'd argue only when the client isn't getting reports from third parties (e.g., custodians): recall that Bernie did everything for their clients (how nice), including custody, trading (right!), and management.

If the basis for encouraging firms to undergo examinations is because so many other firms do them, then that's like saying "I won't remove the tag from my mattress because no one else does." Well, be a tag puller! Don't be a lemming! Be convinced that this expenditure truly is an investment and not merely an expense! (As your mother no doubt asked you, would you jump off a bridge just because your friends did?)

We're conducting a "mini survey" to determine what people see in RFPs. We believe that it's unusual to be asked if composites have been examined. The preliminary results suggest we're right; we'll provide more details once they're available.

p.s., Please do not construe this post as an attack at verification firms that offer, recommend, and conduct examinations. This is solely our opinion. I don't feel that verifiers who conduct examinations are unethical, charlatans, self-serving, or anything like that. They offer a service which there is clearly a market for; we just question its value.