One possible reason for the reluctance to hear different views

The weekend WSJ often provides fodder for this blog, though this is the first that I recall it came from Peggy Noonan. Her assessment of Thursday's Vice Presidential debate ("Confusing Strength With Aggression") in this past weekend's edition was quite insightful. But the source for today's post can be seen as independent of the debate critique. She offered the following:

"Age can seem reactionary, resistant to change in part because change carries a rebuke: You and your friends have been doing things wrong, we need a new approach." [emphasis added]

A few of the new ideas that I and others have championed have met with resistance from some in our industry. For example:

• My call to eliminate the aggregate method to calculate composite returns (for the Global Investment Performance Standards (GIPS(R))
• Our desire to see broader acceptance and employment of money-weighted  returns.

It had never occurred to me before that some may interpret these suggestions as rebukes, as this was never our intent. But surely we can rise above this, can we not?

The irony is Noonan's linking of the resistance to change to age, as if those who don't want it are older. In spite of my youthful appearance, the reality is that I am one of the oldest folks in our industry!Those who oppose the ideas put forward are in all cases younger than I am. Why must they be so wedded to their ideas that they resist being open to new ones? Can our industry advance when some (and sometimes those who hold positions of authority) refuse to even consider change? 

Valuing securities with stale prices for GIPS compliance

I am preparing to meet with a hedge fund client who wants to comply with GIPS(R) (Global Investment Performance Standards). As part of this preparation I am revisiting the recently published Guidance Statement on Alternative Investment Strategies and Structures.

This guidance makes it clear from the start that what is set forth within it applies to all asset classes.

When the GS was being discussed by the GIPS Executive Committee, I inquired into one particular section:

This essentially gives firms the opportunity to use stale prices, if those prices are deemed "the best estimate of the current fair value of the investment."

I asked (in order to confirm) whether this could be applied to fixed income securities, for example, and was told "yes."

This is a HUGE change. I recall individuals at the annual GIPS, conference around the time the 2010 edition was introduced, asking about the need to revalue for large cash flows, when their portfolio might contain less liquid securities (e.g., municipal bonds) that do not price daily. While I don't recall the specific response, I do not believe it was what is stated here.

If a GIPS compliant manager who has such assets finds that they may need to use historical prices, they need to document this in their valuation policy and indicate that they do so when they believe it's the "best estimate of the current fair value of the investment." Alternatives, such as the use of matrix pricing, can also be used, but it's good to know that firms can also use historical prices.

Mixing currency returns

A software vendor client of ours described a situation involving one of their clients. Until a certain date, the portfolio's return was in US Dollars (USD). After that date, it was in Japanese Yen (JPY). The question: can we link these periodic returns?

My initial reaction was to distinguish between local and base returns. The local return is the return of the assets. For the initial period, my guess is that the portfolio was invested in USD denominated securities, so the local return was USD. And more recently, it appears the portfolio was invested in Japanese denominated securities, so the local return is JPY. To paraphrase my friend, Steve Campisi, you can't eat local returns.

Further, as Denis Karnosky and Brian Singer wrote in their monograph, Global Asset Management and Performance Attribution, "Because of the unavoidable impact of interest rate differentials in controlling exchange rate exposures, local Eurodeposit returns are an inseparable component of currency returns." I.e., investors cannot achieve local returns.

My initial reaction was that you wouldn't want to link these different currency returns and that the investor should be more interested in their base return, which is reflected in their currency.

However, upon further reflection (which occurred in the wee hours of this morning, while attempting to remain asleep), I was once again reminded of the fundamental principle that one should always keep in mind when discussing returns: what's the question? That is, what question does the investor wish to get an answer to?

If they're interested in how the manager(s) performed at the local currency level, before the impact of currency movements (as well as any hedging which may have been employed) is taken into consideration, then to link these returns is fine. We often mix different currencies together to obtain our local return, so to link them is acceptable. The why behind the question (that is, why would they want to know this?) may have value, perhaps at a minimum from an academic perspective, but in the end, if the client asks that the two period returns be linked, this is okay. But again, "what are they hoping to gain from this information?" is a valid point to raise.

True or False: Verification verifies a firm's claim of compliance with GIPS?

In The Spaulding Group's Fundamentals of Performance and GIPS(R) Fundamentals courses, I often pose this question to attendees:

Verification verifies a firm's compliance with GIPS:

true or false?

Simple question, right? What does it mean to be verified?

Is it not intuitive that verification would verify compliance with GIPS (Global Investment Performance Standards)? It's probably not surprising therefore that many, if not most, of those attending will respond "true."

Therefore, it's also not surprising that when they learn that the statement is false, they appear a bit perplexed.

If you check the Standards' glossary you'll learn that verification is "a process by which an independent verifier 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."

Going through the Standards we also find that it "tests the construction of the firm’s composites as well as the firm’s policies and procedures as they relate to compliance with the GIPS standards." And while it "is intended to provide a firm and its existing clients and prospective clients additional confidence in the FIRM’S claim of compliance with the GIPS standards," and that it "brings additional credibility to the claim of compliance" [emphasis added] it does not specifically verify compliance.

Semantics? Perhaps, but we should be accurate in our claims.

We sometimes see statements such as "XYZ verified our compliance with the Standards." This is technically incorrect, since a verifier does not verify claims of compliance.

Under the AIMR-PPS(R), the verifier did verify compliance; however, this provision did not carry over to GIPS.

Confused? You're not alone.

Announcing Free One-Day Fundamentals of GIPS Workshops

The Spaulding Group has offered training for close to 20 years, including our one-day GIPS Fundamentals Workshop. To date we've trained over 3,500 individuals throughout the world (all over the United States, in several cities in Canada, various parts of Europe, in South Africa, as well as in the Middle East, and in several locations in Australia and Asia). In addition to open enrollment classes, which we hold in various cities throughout the year, we also regularly conduct in-house training.

The Global Investment Performance Standards (GIPS(R)) have become an important part of the investment performance area, but there is still a great amount of confusion and misinterpretation about the Standards. The course has been designed to educate individuals that work with the Standards, as well as to address some of the problem areas we see with many firms.

We have decided to offer this course for FREE, but there are a few catches:

• The course is free only to investment firms (i.e., money managers and plan sponsors)
• Each class is limited to only 20 participants, to make it more intimate: easier to share ideas and discuss issues and concerns
• Only one participant per firm may attend. (If a firm wants to send more than one, then a modest fee of $500 will be applied)

We've already scheduled the course for five dates and locations, with more to follow:

• Monday, November 19, 2012 (New York, NY)
• Monday, January 28, 2013 (Los Angeles, CA)
• Monday, April 15, 2013 (Toronto, ON)
• Wednesday, May 15, 2013 (Philadelphia, PA)
• Monday, June 10, 2013 (London, UK)

We have taught similar workshops for the CFA Institute for roughly ten years. This course is intended for those responsible for GIPS and performance measurement, chief compliance officers, marketing, sales, and others for whom the Standards have value and importance.

John D. Simpson, CIPM, Jed Schneider, CIPM, FRM and I will take turns conducting these courses. This means you will be taught by performance and GIPS specialists with more than 20 years' experience each, who work regularly with the Standards, through our verification work as well as consulting.

We are accepting registrations for the November 19th NYC and January 28th LA classes now. If you'd like to join us, please visit our special registration page. But hurry, as the spaces will fill quickly.

Rating the ways to present performance to prospective clients

I am conducting a "non-GIPS(R)" verification this week for a client who uses "rep" (representative) account performance for marketing purposes. This particular firm is not easily able to comply with GIPS (Global Investment Performance Standards) today, and so this seems to be a reasonable alternative.

Last week we held a meeting with the Universal Advisor Performance Standards  (UAPS) board, to continue our review of the draft. We briefly discussed the various approaches to create historical performance for marketing.

These events caused me to think that perhaps we should develop a rating scale, that ranks the various approaches, from "best practice" to "not best practice" (would we call the worst of these "worst practice"?).  The following graphic represents my current thinking:

Perhaps we should have numeric designations for these, too. I'd give composite returns that are derived using equal-weighting a ten (or maybe it should be a 9.9). Note that asset-weighted has three options; and these should get individual ranks. Perhaps 9.5 when beginning value plus weighted cash flows is used, 9.3 when beginning value, and 9.1 (or perhad 8.9?) when the aggregate method is used.

As an aside, I've addressed the asset-weighting issue in the past, and my basic question would be what value is it to an investor to see an asset-weighted composite return if they are not aware that the result may be skewed by one or two very large accounts? As for the aggregate method, I stand on my earlier position that this return fails to meet the definition of a composite return and can present nonsensical results.

I will have more to say on this in this month's newsletter. In the mean time, feel free to offer your thoughts.

Responding to a GIPS Composite Question

We were recently sent the following question, that relates to GIPS(R) (Global Investment Performance Standards) and composites:

What becomes of a composites performance if the strategy (value, growth, etc) remains the same, but a new team of portfolio managers and analysts take over the strategy but implement a new and different investment process and construction to the strategy composite?

Does a new composite need to be created? If not or so, what disclosure should be stated so that performance can be clearly indicated as to the differentiation?

Our reply:

It has to do with "materiality." Performance belongs to the "firm." There is an expectation that staff will change over time. If the change is materially significant, then creating a new composite may be justified; however, I’m thinking of changes of the magnitude of almost going from a fundamental to a quantitative style of investing. If the strategy, per se, hasn’t changed, to justify creating a new composite might be difficult.

Changes in management would be considered "significant events," requiring a disclosure. And so, to disclose that effective a certain date, management changed, will communicate to the prospect that the "firm" has managed the strategy for a particular period, and that since a certain date, the management changed. Likewise, if the benchmark changes, you would document this.

Agree? Have different thoughts? Please chime in!