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!

Simplifying a data problem

We have a GIPS(R) (Global Investment Performance Standards) verification client who uses Advent's Axys portfolio accounting system. Most of their clients are at Schwab, and they have a direct feed from Schwab to Advent. However, they had a couple accounts elsewhere, and hadn't included them in their composites, because they hadn't added them to Advent. This was a problem that had to be addressed.

They reached out to Advent, and were apparently told that they would have to add everything for each account for each time period, meaning market values and transactions. This would be a monumental task for our client. But, life doesn't have to be so challenging. Before you continue to read, reflect on how you would handle this. [pause]

For GIPS, we don't care about subportfolio activity; just market values and external cash flows: that's it! But how can we get this onto Advent?

SIMPLE!!!

For each account, assign a unique dummy (fictitious) security, with them owning just one share. The security's starting value is ...

[drum roll]

...the starting value of the portfolio! For example, if the portfolio begins with $513,078.22, then the security is worth $513,078.22, and they have one share, meaning their market value is $513,078.22.

What happens when a cash flow occurs? Enter the flow on the date it occurs.

Subsequent months, whatever the broker/custodian tells you is the market value becomes ...

...the price for the security! And so, if the next month the portfolio is worth $538,135.78, then this is the price of the security. And since the portfolio owns only one share, that's what they're worth. The only caveat here! Since they may have brought cash in, then the price of the security has to be the market value, minus the cash amount. Likewise, if there is a cash outflow, they will have to adjust the security's price, so that cash is handled properly.

[i.e., the market value from the statement must equal the price of the ficitious stock, minus the value of cash, meaning (algebraically derived) the share price equals the market value of the statement minus the cash value!]

Two issues remain!

(1) As of January 1, 2010, GIPS compliant firms must revalue their portfolios for large external cash flows, even those firms who use the aggregate method to derive composite returns (which Advent uses), even though this method doesn't use the underlying portfolio returns. So what must they do? IF they discover that large flows occurred, then they would have to revalue the portfolio on those days, and consequently set the fictitious security to this value (plus or minus the cash flow amount).

(2) ALSO, the "large cash flow rule" applies to the composite, too, meaning that if the composite has a large flow, the entire composite is revalued. HOWEVER, given the size of their composite, the likelihood of it (the composite) experiencing a large flow is infinitesimal.

Make sense?
Can you think of a better way or a flaw in my method? Let me know!

When random isn't so random

In conducting research studies, we often want to introduce a degree of randomness, to avoid the potential bias that might creep in if we select our cases directly. There are random number generators available to assist us, although many of them have been challenged for their "true randomness." I know that in research I'm doing on transaction based attribution, I sometimes question whether the random number generator I've chosen is truly producing random results.

While sitting at the boarding area in Oslo, Norway this past Saturday, after conducting a GIPS(R) (Global Investment Performance Standards) verification for a client, one of the officials mentioned that there would be security checks done on a random basis. Well, I soon learned what random meant.

A young man, probably in his mid-to-late 20s, was the security person charged with "randomly" selecting passengers. I observed as he walked up and down the rows of passengers who were seated, awaiting word to board. A couple rows across from me was a very attractive young lady; and sure enough, she was his first "random" selection. While at first I thought this was humorous, when I observed that he was the one who carried out the full body search (and I want to emphasize the word "full"), I became a bit disturbed. But I became even more upset when I saw that his second "random" passenger was another young, attractive woman. This time the girl's father came rushing over, when he learned that she was to be screened. But this didn't deter the security man from once again carrying out the full body search.

Shortly thereafter we boarded, and this episode continued to bother me, to the point that I mentioned it to the attendant in charge, who suggested I contact United when I got home. Well, I decided to go up to some of the passengers who were forced to undergo what I saw as an embarrassing ordeal. I went first to the father of the young girl, who expressed his upset at what had occurred, and how he was reluctant to say much, fearing the result (thinking that  he might even be arrested); i.e., he was intimidated by security. I ended up speaking with several of the young  ladies (and there were several; all attractive) who were randomly picked. I wanted to see if I could get their contact information, in the event United wanted to speak with them.

Well, the compliant has been filed, and we'll see what becomes of it. But so much for randomness, right? What good is this extra level of security when most of those selected are young, attractive women (the heck with the older guy with explosives strapped to his body!).

Randomness: a great concept that offers much value, but only if it really is random.

p.s., In the unlikely event you're wondering what my issues were: first, it wasn't random, which defeats the purpose of the exercise; second, a woman should have done the body checks of women; third, when checking "private" areas, the back of the hand should be used, not the front. Need I say more?

Who benefits from quarterly verifications?

The Spaulding Group is sometimes asked if we do quarterly GIPS(R) (Global Investment Performance Standards) verifications. We would be happy to, but strongly recommend against it. And why is this?

Well, we firmly believe that the only one who benefits from quarterly is the verifier; and this is for two reasons:

1. They can charge more, because they increase the frequency of visits
2. It keeps their staff busy all year round!

We oppose it because:

1. It's disruptive to the client
2. It costs more
3. There are no added benefits from more frequent verifications

What benefit does it provide? Does the client really think that they are going to fall out of compliance within a quarter, or a few quarters? Recall that verification does two things; it "assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm’s policies and procedures are designed to calculate and present performance in compliance with the GIPS standards." Even though the Standards encourage firms to reflect quarterly and/or monthly returns on their presentations (see ¶ I.5.B.2.c), we don't feel this means they need to immediately get those quarters verified.

As verifiers, we focus on the firm's policies and procedures, and its composite construction. Chances are the P&P won't change very much during the year, so that leaves the composite construction. Why must we monitor clients monthly? If we give interim reports rather than an annual, will it really help them?

During the year we often engage with our clients. Our clients frequently contact us with questions or seek advice. Our clients are invited to participate in our monthly webinars at no cost. And, we share information with them in other ways. And so, why bother them with quarterly visits?

Interestingly, of the numerous firms who have switched to The Spaulding Group from verifiers who required quarterly, none have continued at this frequency: all have been happy to move to annual.

Disagree? Think quarterly is a good idea? Let me know why! I'd love to hear your reasons. And the competing verifiers who read this blog are invited to chime in, too, but not anonymously, otherwise they won't be posted.

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?"

Getting the basics right

I stumbled upon an asset manager's website this week, which served as a good example of some of the problems that exist within the world of firms claiming compliance with GIPS(R) (Global Investment Performance Standards).

This firm apparently has undergone a recent verification; granted, not by a firm that many have heard of, but nevertheless, one that holds itself out as being capable and qualified to conduct verifications. Very quickly I identified three problems:

1. This was an SEC-registered firm, meaning that it must comply with the SEC's advertising rules. The SEC requires that net-of-fee be of equal or greater prominence to the gross-of-fee returns. They only reported gross-of-fee results. (Strike one)
2. Their website page announcing compliance failed to contain the GIPS required advertising disclosures. Granted, compliant firms aren't obligated to adhere to these guidelines unless they reference GIPS; but since this firm did, it was required to include them. It was missing virtually all of them. (Strike two)
3. Their site includes a composite presentation. This presentation was missing at least one required disclosure, and had other items which looked suspect. (Strike three).

Of these three items, the verifier is technically only responsible to look into the third; their apparent failure to catch the missing disclosure(s) is a problem. The verifier should also provide their client guidance on advertising (from both a GIPS as well as SEC perspective); this was clearly not done here. The verifier should educate their client so as to avoid actions which might put them at risk or negate their compliance. Bottom line: this firm is not compliant and part of the blame belongs with the verifier.

Nearly 20 years ago I encountered similar problems, and requested a mechanism to verify the verifiers (I believe I coined the phrase). This has been an ongoing theme for nearly two decades. I suspect that nothing will ever be done.

We all make mistakes; as the saying goes, "no one is perfect." But the gravity of these errors is of such a magnitude that their existence reflects serious problems. I am confident that this asset manager had no intention of being out of compliance. They are most likely quite proud that they "achieved compliance." It appears to me that they picked an unqualified verifier.

The requirements to be a verifier today are the same as they were roughly 20 years ago: call yourself a verifier. Technically, we and the standards would expect a lot more, but since there is no test, no oversight group, no verifier of verifiers, anyone wishing to can become a verifier in a matter of minutes. I think there's room for improvement.

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!

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.

Providing performance results in a "non-GIPS" world

We have been in discussions with a firm that doesn't claim compliance with GIPS(R) (Global Investment Performance Standards), but still wants their returns "verified." They wanted to know what they need and what their options are.

The introduction of GIPS doesn't mean that firms can't show prospects performance results; granted, GIPS is considered "best practice" within our industry, but there can be a variety of reasons why a firm isn't able to comply. And so, what can they do? Here are three approaches:

1. Hypothetical or model results. With this option, the firm doesn't use real portfolios but a model portfolio to represent their strategy. This would be the least attractive option, but is permitted. Adequate disclosures are needed. (Steve Stone and I wrote an article on this topic for the CFA Institute, which you might find of value).
2. A representative portfolio. This is probably more attractive than a model, but less attractive overall, because it suggests "cherry picking," and you'd also have to deal with cases where an account may terminate. However, it's an option nonetheless. It would require appropriate disclosures as to what the returns represent.
3. A composite of all accounts in the strategy. This could be just like what GIPS requires (e.g., asset-weighted returns) or not completely (e.g., to use equal-weighted returns). This is preferable to the other two options shown (but obviously not as preferable as GIPS compliance), and will require your rules for composite construction to be identified, and preferably written down. Some form of disclosures would be needed, but perhaps not as many as the other options.

We conduct "non-GIPS" verifications for several firms, and so this option (to get your returns verified by an independent, third party) exists in this arena, too. We obviously encourage all managers to comply, but recognize this isn't always possible. This doesn't mean you can't have your numbers reviewed.

Oh, and when it comes to firms that fall under their country's regulator(s) (e.g., the Securities and Exchange Commission (SEC)): you will want to ensure that your materials conform with their rules, just as GIPS requires.

Is compliance enough?

A firm we consulted to a few years ago responded to one of our marketing pieces about verification, wondering if they should make the investment to undergo this exercise. They have claimed compliance with the Global Investment Performance Standards (GIPS(R)) for some time, but have noticed that they aren't getting the business that they thought they'd get, especially their above average returns.

To put it simply, YES! Verification is not an expense but an investment, that serves multiple purposes.

Claiming compliance is critically important today, especially when marketing in the institutional space. However, these institutions want some assurance that your claim has a degree of validity, and verification does just that. Granted, contrary to common belief, verification doesn't verify compliance. Rather, as GIPS 2010 points out, "Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm's policies and procedures are designed to calculate and present performance in compliance with the GIPS standards." But for many this is seen as being tantamount to affirming, though not in so many words, that the firm's compliance is correct.

And given that both our research and experience have shown that most firms who have not undergone a verification but claim compliance are falling short of the requirements (i.e., not really complying), the claim without the verification doesn't carry a lot of weight.

Another advantage for SEC registered firms: while the SEC offers "free verifications," you don't want to fail them (i.e., you don't want them to be the ones to tell you that you're not actually in compliance). Therefore, isn't it better to make the investment to avoid having these problems?

How frequently should you have a verification done? We recommend annually; we don't in any way support quarterly. Not because we don't like to visit our clients, but because there is no benefit for this level of frequency, other than to keep the verifier's employees busy throughout the year. We believe that quarterly visits are also disruptive to the client. Granted, some of the firms that do these verifications don't actually visit their clients, but we do, and none of ours has the need for us to see them that often (unless, of course, we're engaged in some other work for them).

Our research has also shown that most firms that claim compliance do have verifications done. And so, firms like the one cited above are in the minority. Yes, it's nice to be able to "tick off" the box in the RFP (Request for Proposal) that asks "Do you claim compliance with the GIPS standards?" But if you can't also tick off the "Have you had a GIPS verification done?," then the likelihood of being hired, or even considered, is significantly reduced.

And so to these firms I have to ask: you made the investment to achieve compliance; isn't it worth the investment to undergo a verification, too? We (and most of the industry) would say "yes."

p.s., a point of clarification is in order. The SEC doesn't actually offer "free verifications." They do freely come in once in a while to check registered investment advisors out, and in the course of their work may conduct tests to validate a firm's compliance, but aren't in the business of conducting verifications. Please don't call them and say "Dave Spaulding said you offer free GIPS verifications and we'd like you to come in and conduct one for us." I have used this line about "free verifications" in a number of talks I've given, thinking that surely everyone understood it was meant as a joke, but apparently some in attendance believed me.

p.p.s., while the suggestion that verification become mandatory has died away, the new requirement (as part of the 2010 edition) to declare whether or not the firm has undergone verification should encourage more firms who haven't made the investment yet to do so. That's at least the expectation.

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.

What to expect with a GIPS Verification

We decided to create an animation for our GIPS(R) (Global Investment Performance Standards) verification clients, to prepare them for the actual verification. We thought it would be helpful, and thought you might find it of interest, too.

It also demonstrates how these animations can serve many purposes.

And the reason you're having quarterly verifications done is why exactly?

One of our GIPS(R) (Global Investment Performance Standards) verification clients recently mentioned that they may be under pressure to move to quarterly verifications. I found this of great interest, because we, and most other verification firms, recommend annual verifications. What possible benefit is there to have quarterly, other than:

• you get to see your verifier's smiling face more often (if they show up, that is, as opposed to doing "remote verifications")
• you get to keep your verifier's employees active throughout the year
• you get to pay more money for the service?

We have heard from a number of firms who undergo quarterly verifications that they are still waiting for their 2nd quarter 2010 (or earlier!) verification report!!! So, what's the point? We have already conducted 2010 annual verifications  for some of our clients. To recommend quarterly suggests that the client might suddenly somehow stop doing what they know they're supposed to be doing procedure-wise. Firms should not confuse quarterly verifications with the recommendation to update presentations quarterly; in fact, we believe that most firms don't (update their reports quarterly), adding even further justification to ask why not just do them annually? We will be happy to do quarterly if a client wants us to, but none of ours do; and this includes our clients who were previously undergoing quarterly verifications with their prior verifier.

Annual is sufficient. But what is also important is that the verifier keeps in touch throughout the year and is willing to respond to questions as they arise. We, of course, do this. We have been extremely proactive with the standards, by:

• sending letters to clients detailing upcoming changes
• hosting webinars on the standards (which are complimentary to our verification clients)
• commenting in detail in both this blog and our newsletter about the standards.

We consider our verification clients, make that all of our clients, to be friends, and we enjoy their company. However, we don't believe in wasting their time or money: visiting quarterly means that quarterly they need to prepare for our visits: heck, annual is tough enough! Why disrupt their operation?

If someone has a good reason for quarterly, please share it, 'cause I surely don't know of any.

A dozen tips to picking a GIPS verifier

How does one go about choosing their GIPS(R) (Global Investment Performance Standards) verifier? There is little guidance provided and it's very easy to use criteria which is less than ideal. I've compiled this list and hope you find it of value (as always, your thoughts are welcome):

1. Don't choose a verifier just because you already have a relationship with them. Occasionally we hear something like "oh, we picked XYZ Accounting Services," even though XYZ has never conducted a verification before. Yes, they're good auditors, but GIPS is a whole different animal and it requires a very different skill and knowledge set. Chances are, you'll be teaching the verifier all about the standards, meaning that you'll be teaching them what you understand, which may not be totally correct.
2. Ask the verifier how they keep up with the standards. Our firm, like several other verifiers, regularly attends and sponsors the CFA Institute's annual GIPS conferences. This affords us the chance to not only hear from speakers but also interact with others. This helps improve our knowledge. In addition, we're tuned in on what's occurring and participate in the opportunities to respond to changes to the standards. Is the firm you're considering truly engaged in this segment of the industry?
3. How does the verifier train their staff? The CFA Institute provides periodic training courses on GIPS (we've been teaching these classes since their inception, some 10+ years ago). While we see that some firms send their new hires here, many don't. Perhaps they offer their own training, which is fine, but you will want to know how they ensure that their staff is aware of the key aspects of the standards.
4. What level of experience are the individuals who will conduct the verification? If you're given new hires, chances are you'll be training them (see #1 above). And, chances are they won't be able to answer many of your questions. Ideally you want at least one senior, experienced individual who is engaged full time on the assignment, who will manage the project and be able to respond to your questions.
5. Speaking of questions, will the verifier answer your questions? We respond quickly to client (and even non-client) inquiries. If we're unsure about the answer, we'll let them know our initial thoughts and tell them we will do additional checking before finalizing the answer.
6. What kind of turnover can you expect in the verification staff? Ideally turnover should be kept to a minimum; hopefully you'll experience zero turnover. 
7. Will the verification be done at your site or remotely? We favor being on site, as we don't feel that we could do an adequate job from our offices. Most verifiers appear to feel the same.
8. How frequently will the work be done? Most verifiers, like us, recommend annual verifications. Trust me, it's not that we don't like visiting our clients, but quarterly is, in our opinion, too disruptive for them (and our clients seem to agree). But, if a client wants us in more often, we'll be happy to oblige.
9. How does the verifier keep their clients apprised of what's going on with the standards? Some firms, like us, provide periodic newsletters, host webinars, or provide letters detailing changes and other important information about the standards. While it's ultimately the client's responsibility to know what's expected, it's important to have a resource who will inform and provide counsel with the changes as well as other aspects of the standards.
10. Is the verifier truly independent? The independence guidance statement places the responsibility to assure independence on the shoulders of both the verifier and the client.
11. What do the verification firm's clients say?  It's important that you conduct due diligence when selecting a verifier. Ideally, speak with clients who have experience and knowledge about other verification firms, so you get a broad perspective. 
12. Is the verifier easy or are they thorough in their analysis? While there might be some appeal to getting a "rubber stamped" verification, one that doesn't require a lot of effort, you have to realize that this may put you at risk should the regulators come in. In addition, you might be exposed to reputational risk if your verifier is known for doing shoddy work. Yes, we all liked the professors who were easy graders, but we also realize we probably didn't get much out of their classes or for that matter our money's worth; the same holds true with verifications.

We have been on record opposing mandatory verification, and I fought strongly against it when I served on the GIPS Investment Performance Council. But, this doesn't mean we don't favor verification: we believe it's critical that GIPS compliant firms have annual verifications done.  However, in choosing a verifier it's important that you select a competent one: don't just pick one because they're easy or inexpensive. You and your firm should be concerned with the risks of a poorly conducted verification and the reputational risk that you may face as a result.

Feel free to chime in with your thoughts and ideas on this list.

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.

Fraud & GIPS

A couple recent and related blog posts have addressed recent suggestions about the Oppenheimer College Fund Fraud investigation. The Money Game actually points to Mish's site,  which is one that I have listed as a blog I periodically visit.

As Mish pointed out, this fund is alleged to be a hedge fund masquerading as a mutual fund. It appears that the firm also claims compliance with the Global Investment Performance Standards (GIPS(R)). While it isn't clear, yet, whether or not they were also verified, we nevertheless must be concerned that yet another "GIPS compliant" firm may have committed fraud. The details have not been provided such that we can determine to the extent that this infraction may have run afoul of any specific GIPS rules (of course, the requirement to abide by laws would clearly be in conflict with GIPS).

What makes this case all the more interesting (and challenging) is that there are actually two firms that carry the name "Oppenheimer," and both are located in New York City. They were apparently related at one time but no longer are. In addition, there are two funds with the same name! Talk about confusing.

I had the opportunity to speak with Mish last week about this topic. He explained (and noted as an addendum to his blog piece) that he pulled some earlier verbiage once he discovered the existence of the second firm.

One might think that these most recent problems might cause further discussion to ensue regarding a verifier's role in detecting fraud. As has been stated previously, verification isn't designed to detect fraud. In addition, we wouldn't want this additional requirement to be placed on a verifier. BUT, we would hope that verifiers would be sensitive to things that just don't look right.

This is one reason we don't conduct remote verifications: we don't believe a verifier can do an appropriate and adequate job by verifying a client from the comfort of the verifier's offices. Sorry. I've suggested before that I believe that the GIPS Verification Subcommittee should at least encourage verifiers to spent a large portion of their time doing the verification in the client's offices. Whether or not this will come to pass is, of course, open to speculation.

Field-work free verifications

As promised, I commented further on the topic of verification firms avoiding "field work" in our newsletter. A colleague from another verification provider responded with the following: "I was reading your most recent article regarding verifiers who do not conduct fieldwork.  I just wanted to let you know that I, too, am disheartened by this process.  I do not understand how you can do a verification without going to your client’s office.  I am talking to a prospect now that told me that their verifier had not been in their offices for more than 5 years, yet they still get a verification report (and, by the way, they are not compliant)."

So, we're not alone in our disdain for such a practice. And, as evidenced by this individual's experience and observation, the absence of field work can often mean that the firm is non-compliant.

Should field work be mandatory? Unclear. But it should be considered "best practice," at a minimum. 

Reflections on an old Chinese statistical joke

I've mentioned in the past the value I'm seeing in a design book (Measurement, Design and Analysis, by Pedhazur & Schmelkin) I'm reading for a course. The authors reference a book by H. Zeisel (Say it with figures) who "pointed out that, according to an old Chinese statistical joke, the rate of mortality among people who are visited by a doctor is much higher than among those who are not visited by a doctor."
 
Reflect for a moment on this joke. Once you get it, think about how this applies to the world of GIPS(R) verifications, when a non-random approach is used.

If the verifier selects only a certain group of composites to review (e.g., "marketed"), might it be quite likely that they will conform with the standards, especially if the firm being verified knows that there's a greater likelihood of only these being checked?

These non-random verifications can be likened to what Pedhazur & Schmelkin refer to as "quasi-experimental designs," "that suffer, to a greater or lesser extent, from serious shortcomings and pitfalls...[and] that utmost circumspection be exercised in the interpretation of the results, and in conclusions...based on them."

Perhaps I'm beginning to sound like a broken record (whatever a "record" is), but by continuing to periodically bring this subject up I am hopeful that the GIPS Verification Subcommittee will take action to come out in opposition to such practices as they are fraught with problems.

Canopy Financial ... another scam discovered too late

We are just learning of yet another firm that scammed millions from investors: Canopy Financial. They forged audit reports from KPMG, who apparently WASN'T their auditor. We haven't yet heard whether they also claimed GIPS(R) compliance,  so have no way of knowing whether their alleged chicanery extended quite this far.

Canopy had been featured in BusinessWeek and managed to be ranked #12 on Inc's 500 List.

Even though GIPS verifications aren't "designed to detect fraud," they can provide an extra level of confidence in the manager's credibility. We aren't advocating the verification be extended to include fraud detection, but believe that verifiers can serve as an extra level of scrutiny.

Who would have thought to call KPMG to check to ensure that they had, in fact, audited Canopy? Some additional checking may be necessary going forward, especially with certain firms, to help catch these guys quicker. Unfortunately, we can't control shameful behavior, but we have to figure out ways to catch it. In this case, their investment bank actually helped them raises tens of millions of dollars. Is someone asleep at the wheel? Unclear at this time, but we're sure more will be forthcoming. While this doesn't rise to the level of a Bernie Madoff scam, many were no doubt impacted by it.

No fieldwork necessary

I am putting the finishing touches on this month's newsletter, and am including comments regarding the revelation that certain GIPS(R) verifiers feel that it's not necessary for them to conduct "fieldwork." That is, they feel that they can conduct a thorough verification from the comfort of their offices.

In our verification advertising piece we state that we don't conduct "remote verifications." Sorry, but we're not quite that good. We feel we NEED to be in our clients' offices to review their records, investigate issues that might arise, and engage in spontaneous dialogue, when necessary. We also enjoy meeting with our clients face-to-face, in order to enhance our relationship with them. We consider our clients friends, and look forward to these visits.

The quality of verifications has been questioned for as long as the work has been done. We wanted a process to verify the verifiers back in 1992. We at least need some guidance regarding this matter: hopefully it will be forthcoming.