Significant cash flows ... so easy to get wrong

Perhaps it's partly because "significant" and "large" can be viewed synonymously that we find confusion regarding how firms can handle these within GIPS(R). One of our clients was clearly thinking that "significant" means the same as "large" when it comes to the standards, but it doesn't. Significant flows deal with the opportunity to temporarily remove portfolios from composites in the event of large (sorry, I mean significant) cash flows...the idea being that all of a sudden you get a lot of cash and it may take time to invest it, so remove the account while you get the cash invested. On the other hand, effective 1/1/10, GIPS compliant firms will be required to revalue portfolios for large flows.

I'm at an outsourcing client who has a client who NETS cash flows during the month to determine if the account should be removed. NETS cash flows? And why do they do this??? Hopefully we'll find out, but let's think about this.

Their level to remove the account is >25% of the beginning market value. And so, we start with $1 million. On August 3 a $300,000 contribution is made. Then, on August 24, the account withdraws $250,000. Net = 300,000-250,000=5,000; 50,000/1,000,000 < 25%; therefore, don't remove the account. WHAT???

If the firm actually wishes to take advantage of the optional significant cash flow provision, they should have removed the account because of the August 3rd contribution (because presumably there's a bunch of cash they need to get invested). The fact that a few weeks later the client decided to withdraw funds has nothing to do with the earlier flow. In my opinion, they are confused!

Also, in my opinion: this is (a) wrong and (b) shouldn't be permitted by the firm's verifier.

Still trying to get my arms around the error correction rules

I'm still a bit befuddled by the GIPS(R) error correction guidance, which goes into effect in three weeks. I guess I'm relieved that I'm not alone, but I'd feel a lot better if it was crystal clear. The guidance provides for four levels of errors:

1. Non-material: ["Take no action"] error is so minor that no action is needed. 
2. Non-material: ["Correct the presentation with no disclosure of the change"] you'll (a) correct the error, but (b) not document it (i.e., disclose it in your GIPS presentation) nor (c) not tell anyone
   
3. Non-material: ["Correct the compliant presentation with disclosure of the change and no distribution of the corrected presentation"] you'll (a) correct the error, (b) document it, but (c) not tell anyone
4. Material: ["Correct the presentation with disclosure of the change and make every reasonable effort to provide a corrected presentation to all prospective clients and other parties that received the erroneous presentation"] you'll (a) correct it, (b) document it, and (c) tell anyone who got a copy of the previously erroneous copy that an error was corrected.
   

Recall that the disclosure draft included the requirement to document any material errors for 12 months (as is written in the guidance). Also recall that the recently issued Q&A says that you don't need to do this, at least in all cases. It reads: "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 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. This may result in the preparation of two versions of the corrected compliant presentation to be used for a minimum of 12 months following the correction of the presentation." 

At last week's Performance Measurement Forum meeting in Orlando we discussed this issue at some length. It appears that you don't have to have rules for all four cases. My advice regarding the four levels (by level):

1. Identify the kinds of errors that you'd not bother correcting (immediately spelling and grammatical errors come to mind; you get to decide what else)
2. Identify the level that you feel needs to be fixed but is so minor that you don't need to tell anyone (an example here might be a correction that increases your return).
3. I don't see a need for this level. I base this on the Q&A, which basically says you don't have to document the error unless you can't determine if you gave a prospect a copy of the prior version. If this is the sole condition, since this level doesn't require redistribution, why would you document it?
4. I'd establish the rules that would cause this to happen, but ensure that I've got records of who gets copies of what presentations, so that if a material error IS discovered, I can get them a copy of the revised presentation, if appropriate.
   

The big question that you need to decide on: what's material? We've heard an error as high as 100 basis points, which I happen to think is pretty darn high. I think it depends (a) on the asset class (I'd have different levels for bonds than stocks, unless you adopt an approach like I suggest below) and (b) the relative size of the returns. For example, a 100 bp difference of 2% vs. 1% is a lot different than a 51% vs. 50%, right?

I'm thinking that perhaps a relative rule might be workable. For example, a 5% error of the return itself (example: if the return was 2% and has been corrected to 1.89%, that's 11 bps, which is 11/200 = 5.5%, so it's material). Perhaps at returns > 10% I'd say the level is 10% (again, of the return itself; example: if my return was 12% but corrected to 10.78%, that's a 122 bp drop, and 122/1200 = 10.17%, so it's material).

This approach might be better than simply saying "100 bps" or "50 bps." I'm not saying to adopt these thresholds ... you decide what works for you. But perhaps this approach would provide the necessary flexibility so that the rules will make sense? Your thoughts are, as always, invited.

Value at Risk Article

The current issue of the NYSSA's (New York Society of Security Analysts) journal contains an article I wrote on Value at Risk. I invite you to view it.

It's intended as a basic introduction to how one can calculate VaR using the Variance/Covariance (aka Correlation) method, which was championed by JP Morgan's RiskMetrics, meaning it's in fairly common use. Although we haven't done any research on this, I suspect that this approach is the most used of the three.

At our recent Performance Measurement Forum meeting in Orlando a colleague volunteered to write an article for The Journal of Performance Measurement where he'll provide a broad benefits / shortcomings assessment. We've seen some harshly critical reviews done of late, so a more objective review will be welcome.

I still remain skeptical of VaR's usefulness, but am open to hearing other perspectives. Hope you are, too!

Abbreviations & acronyms

This post has NOTHING to do with performance. It's the weekend, and I simply want to comment on the use of abbreviations and acronyms. First, I fully support their use. In fact, I favor even more use of them. Let's first consider the difference: as www.dictionary.com points out, an acronym is "a word formed from the initial letters or groups of letters of words in a set phrase or series of words." Examples: RADAR, ASAP, and WAC. In the world of investment performance we have GIPS. Acronyms are abbreviations, but not all abbreviations are acronyms. For example, "PPS" (performance presentation standards) is an abbreviation, but since it isn't a word (i.e., you can't say it; you only say the letters individually) it's not an acronym. Understand, however, that there are a LOT of folks who would say that PPS IS an acronym, and even though they're technically wrong, society seems to be loosening the strict meaning of this term. But, we won't debate this here.

I happen to be a big fan of acronyms. We named our annual performance conference in such a way that it forms an acronym (PMAR = PeeMar). Our fall event was called TIA (Spanish for Aunt, but that's merely a coincidence and has no relevance).

I spent almost five years in the Army ... the military LOVES acronyms. TRADOC = Training Doctrine Command; USAFAS = You-sa-fas = United States Army Field Artillery School. We already cited WAC, which is Women's Army Corp.

Some military acronyms have become commonly used and often misused. Take, for example, FUBAR and SNAFU. They're actually somewhat profane, though I'll use the softer translations: FUBAR = fowled up beyond all recognition; SNAFU = situation normal, all fowled up. When Bill Clinton was President he once remarked that they "had a SNAFU." I would suggest that first, the President shouldn't use such a term. Second, I don't believe it was the proper way to phrase it, though I won't be a stickler on this point. To me, any time you use a word or expression you should know what it means, otherwise you may offend (take folks who regularly use the Yiddish word "schmuck." This is NOT a nice word and shouldn't be used in mixed company...sorry).

The "word" ASAP is often used and, in my opinion, carries more weight than it's full meaning. If I tell you "I need this report ASAP" versus "I need this report as soon as possible," which sounds more urgent? I suggest the former, even though their meanings are identical.

Three abbreviations that are in common use in the military but that haven't made it into the outside world are IAW, NLT, and COB (COB isn't usually pronounced as a word "cob" but rather is treated as an abbreviation: c-o-b). IAW = in accordance with; NLT = no later than; COB = close of business. For example, "I need your report IAW my memo of July 7th NLT, COB this Friday." Army guys use this wording ALL the time ... shouldn't it fit into our writing, too?

I rarely text on my phone and know that there is a host of abbreviations that folks use to save keystrokes. I am also aware that some young people now write reports for school using these abbreviations, which is causing some concerns: students need to know how to properly write before using shorthand notation. I don't intend to adopt these shorthand expressions in my writing, though I think a well placed abbreviation or acronym can be quite helpful. Hope you agree.

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. 

Dealing with breaks

A client recently asked about dealing with "breaks" in performance. First, what IS a break? We'd define it as a temporary loss of discretion over a client's assets, during which time no trading can be done. Breaks can be caused by changes in custodians as well as for other reasons. Another term for a "break" is a "gap." I opined on this topic a few years ago in our newsletter, regarding the calculation of returns (that is, can you link across gaps for returns). The client's question had to do with GIPS(R).

If you search the GIPS Q&A database you'll only find one item dealing with this topic, and it doesn't really address temporary breaks. I recall discussing this a few years back with a group and we couldn't arrive at any clear consensus. Some thought ANY break meant that performance stops, while others felt that there should be an assessment as to whether or not there would likely have been any trading during the break: if not, then what's the harm in linking across it?

I tend to be in the latter group's camp: that is, when one has a break, they should determine the likelihood of trading occurring. If, for example, the manager is very much a buy-and-hold manager, who trades infrequently, then a gap of even a few weeks might not cause a problem. However, if the manager trades almost daily, then even a short break would be problematic.

Ideally, the manager has other similar accounts that they can compare the account-with-the-break to, to determine if there truly was an absence of trading. This is where the verifier can come in...to provide an additional degree of analysis.

It would be nice to see something formal regarding this topic, but for now there is little guidance. Hopefully mine won't conflict with anything that comes in an official capacity.

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.