Operations & Compensation Survey

The Advent Users Group is hosting a compensation survey, which is open to all. We invite you to join in.

Our firm regularly does surveys ourselves, so we know how important it is to encourage individuals to participate. And we're happy to support the AUG in their effort to gather this information.

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.

Keys to success for a software search

Although I'm technically on vacation this week, I came into the office to wrap up a report for a client I visited last month. I did a review of their entire performance operation, which resulted in a recommendation that they move forward with a software search. Since they wanted some help in getting pointed in the right direction, I included a schematic we developed some time ago, which identifies what see as the "keys to success" for such an undertaking:

As you can see, we believe there are several “keys to success” for software search projects.

• Performance measurement & GIPS expertise: it is no doubt obvious that an in-depth knowledge of performance, the GIPS standards, and attribution is paramount to having a successful search.
• Software development and design experience: We believe that a solid technical background is also paramount as it assures you that the analyst is intimately familiar with the other side of the equation.
• Exceptional analytical skills: software searches are very much an analytical activity; therefore, it’s critically important that the individual who heads up the effort be skilled at analysis, which includes the ability to know what questions to ask, detail the requirements, evaluate how the competing products meet these needs (micro level), and compare vendors along broader perspectives (macro level).
• Familiarity with the vendors: having an awareness of the “major players” is important to assure that the most appropriate vendors are considered. Ideally you will want to narrow the field down to the vendors you think are most likely to meet your needs.
• Recognized expertise: ideally the analyst should be recognized for their knowledge so as to establish credibility with the vendors being considered, though this isn’t a requirement.
• Proven success: it’s also ideal to have past success with these projects. A software search and selection is a huge investment in resources, both time and money, so success is critical, as you don’t want to repeat the process soon after a selection is made.
• Independence & objectivity: if the analyst is biased, it is likely they will favor one vendor over another, even though there may be a better solution available for the client.

We use the term "analyst" to represent the team leader, his or her designee, a group of individuals chosen for the task, and/or a consultant. I'll touch further on this topic shortly.

A brain teaser's solution

Recall that on Tuesday I posted what I described as a "brain teaser," involving the allocation of flight costs across three clients in two cities. The total cost is $710.10. Let's begin with some suggested solutions.

Allocate evenly: one-third to each

This is clearly the easiest solution to apply, but is it the most equitable? Let's say that the normal flight to and from Boston is $300, while it's usually $900 to Chicago. If we divvy up the $710.10 evenly, everyone's cost is below what it normally would be, but the Chicago client saves a much larger amount, from a proportionality perspective: is this fair? I don't think so.

Allocate based on the number of days

We're at Clients A and C one day each, and Client B for two days, thus Client B gets to pay half the fee, while the other two pay one-quarter each: rather simple to apply. However, what does it matter how long we're on the ground at each city? Let's say that I'm flying to Boston, and the normal cost is $300, and I'm there for four days; I then fly to London, and the normal cost there is $700, and I'm there just one day. And so, the Boston client pays four-fifths of the cost, even though a normal cost there is much lower; again, the other client benefits greatly while the other seems to be penalized.

Split the leg costs up

Here, the specific response was as follows:

• I would charge the Boston client the cost of the ticket from Newark to Boston
• I would charge the Chicago client the cost of the ticket from Chicago to Newark
• I would split the cost of the ticket from Boston to Chicago between the two clients

This requires finding out the one way costs from Newark to Boston, Boston to Chicago, and then Chicago to Newark. The charging of these fees seems fairly equitable, yes? And splitting the costs between the two legs also seems fine. I would say that this is an acceptable approach, though not what I do.

Allocate based on the normal relative round trip costs 

We find out what the normal round trip cost is to and from each city. We then add these together, and determine a ratio of what they would normally pay relative to one another. We apply this ratio to the actual costs. The following table shows the details:

I think this provides an equitable allocation of the costs, but agree that the third method, too, seems worthy of consideration.

Happy 4th

We wish all of our U.S.A. readers a Happy 4th of July!

Compounding problems with hurdles

Some folks in a Linkedin group I'm a member of have been discussing the challenge of dealing with hurdle rates when calculating returns. As I showed in a December 2010 newsletter, you cannot compound these rates, as their rate of compounding is proportional with the monthly returns they're added to. In the examples I provided, where the annual hurdle rate is 1.00%, compounding can result in the actual annual hurdle rate ranging from 0.53% to 1.36 percent. So much for the agreed to 100 basis point hurdle.

And so, what is one to do if you want your compounded returns with the hurdle rates to tie out to what you've contracted to, or to track your hurdles on a monthly basis? The "simple" solution:

1. Take your annual hurdle and divide by 12 to arrive at the monthly rate
2. For each month that's being linked, add a multiple of the monthly hurdle rate to the linked return value.

That is, we link the returns first, then add the hurdle. Let's take an example. We'll begin with the way most firms do it, which we can call the "geometric" approach, since we are compounding the fee, along with the return. As you'll see, with this approach we add the hurdle, then link.

Suppose that we have an annual hurdle rate of 3.00 percent. If we intend to include the hurdle with our returns as they're compounding (i.e., to add the monthly hurdle first, then compound) we would take the hurdle rate (3.00% or 0.03), add 1 to it, raise it to the 1/12th power, and then subtract one, which gives us 0.2466 percent. This is our monthly hurdle rate. We add this amount to each monthly return, and geometrically link these values. The following table provides our data:

 I've labeled the columns to make the explanation hopefully clearer:

• (A) is our monthly return (just numbers I made up for this exercise)
• (B) shows the inclusion of the hurdle rates, on a monthly basis. Since we're doing this geometrically, we add the hurdle to each monthly return, and then link them. I'm showing the cumulative effect of this linking, so that February is the two-month linked return, March the three-month, and so on.
• (C) is the cumulative hurdle rate (since it's for the geometric approach, I linked the monthly hurdles). You can see that by themselves they link to the agreed to 3.00 percent.
• (D) shows the cumulative returns, based on the values in (A) (i.e., without the hurdle rate)
• (E) is the difference between (B) (the linking of the returns with the inclusion of the hurdle rates) and (C) (the linked hurdle rates)
• (F) is the difference between (B) and (D) (the cumulative returns without the hurdles included).

First, we notice that our return for the year with the hurdle is 21.3556%; when we compare this to our annual return without the hurdle (17.87%), we see that our hurdle isn't the 3.00% we would have expected, but significantly higher (3.49%). The additional 49 basis points makes success more challenging for the manager than what they had agreed to, yes?

I included columns (E) and (F) to show that on a monthly basis the numbers don't tie out as we might expect. Column (E)'s values should equal the cumulative returns, but we see that they don't match what's in column (D). Column (F)'s values should equal the cumulative hurdles (C), but here, too, the numbers fail to agree.

The problem with this method is that the resulting annual return, with the hurdle compounded along with it, will not agree with what your contract or client calls for (i.e., what you've agreed to), and will either be lower (and therefore easier to obtain) or higher (therefore more of a challenge), but in neither case correct. Who would agree to a hurdle that will vary, depending on market conditions? If I'm expected to deliver a return 300 basis points above the LIBOR rate, for example, isn't it reasonable to expect that at the end of the year, the compounded benchmark would be exactly 300 basis points higher than the compounded LIBOR rate?

Now let's consider the arithmetic approach. With this method, we will compound or link the monthly returns first, and then add the hurdle. To derive our monthly hurdle rate we take 1/12th of the 3.00% annual rate, which gives us 0.2500 percent. The following table provides us with the data for the full application of the method:

The column's meanings are consistent with the geometric table version. First, notice that in this case our annual return with the hurdles (20.8682%) is 3.00% higher than our linked return (17.87%; the return without the hurdle), meaning we reconcile to the agreed upon annual hurdle rate. In addition, on a monthly basis, our column (E) matches the cumulative returns in column (D), and column (F)'s values match the cumulative hurdles shown in (C).

While most firms no doubt utilize the first method (the "geometric" approach), I would argue that it's flawed, since the annual hurdle will only equal what the agreed upon value is, if the return for the year is 0.00 percent; otherwise, it will be higher or lower than the hurdle, which to me justifies a switch in methods to the recommended approach (arithmetic), where we tie out exactly on both an annual as well as a monthly cumulative basis. Certain numbers aren't supposed to compound, and you can include in this group returns with hurdles; compound the returns, then add the hurdles to them.

If you'd like a copy of the spreadsheets, send me a note.

Even the Bible encourages IRR ...

"Men have had recourse to many calculations"

Ecclesiastes 7: 29

What's the interpretation of this line? Sadly, my bible doesn't reference which return formulas the writer was referring to, but one with an open mind can conjecture that it's a verse that recognizes that many return calculations are available and that one would be remiss not to consider them all.

To rely solely on time-weighting, for example, would provide us with limited knowledge. And since Ecclesiastes falls within the "wisdom" books of the bible (along with Job, Psalms, Proverbs, Song of Songs, Wisdom, and Sirach), clearly we're looking for ways to enhance ones wisdom; ones knowledge. A multi-dimensional view can only be obtained by considering alternatives, with each serving a purpose; fulfilling a role.

And so, what further evidence is needed that IRR (internal rate of return; money-weighting) should be part of ones arsenal?

p.s., While I knew that the bible was a source of comfort, insight, and guidance, I didn't realize it could also be a source of support for money-weighting!

A brain teaser?

For today's post I'm taking a different tact, and  presenting a situation we're facing this week, to see what ideas you can provide. I'm visiting two clients in Boston over a three-day period, and then a third in Chicago. Here's my itinerary:

• Monday morning: Departed Newark for Boston
• Monday: Visited Client A to conduct a pre-GIPS(R) verification
• Tuesday & Wednesday: Visiting Client B to conduct a non-GIPS verification
• Wednesday night: Flying from Boston to Chicago
• Thursday: Visiting Client C to review their operation
• Thursday night: Return to Newark from Chicago

And so, there are three legs to the flying: from Newark to Boston, from Boston to Chicago, and from Chicago to Newark. Some salient points:

• Living in New Jersey, I typically fly out of Newark
• Each client has agreed to reimburse us for travel
• The total cost for the airfare is $710.10.

And so, how do we allocate the travel equitably across all three clients? I believe I have identified the best answer, and will share it on Friday. In the mean time, if you'd like to, reflect on it yourself and feel free to post it as a comment, or send your answer directly to me. Thanks!