Revaluing fixed income ...

Recall that effective 1 January 2010, GIPS (r) compliant firms must revalue portfolios for large cash flows. This may be an issue, a costly one, for fixed income managers who today only value bonds weekly or monthly. I specifically asked, during last week's GIPS conference, whether this rule will apply, and it will. While I'm not surprised, I could have seen some flexibility, given what happened with real estate last year.

Direct real estate managers now have to value quarterly. But this rule seemed to soften a bit, in that they can carry over the same value from the prior quarter ... at least that's my understanding. And so, if a fixed income manager has a policy whereby they value weekly, they may argue that the market isn't liquid and therefore the value stays roughly the same week-to-week (or at least, day-to-day); also, since many of the assets are matrix priced, they don't expect to see much of a change.

However, the word is that firms will have to revalue whenever a flow occurs; translation: figure you'll have to value daily. This means added costs. Further clarity on this may come, but I'd plan on more frequent revaluations unless we here something "official" to the contrary.

Writing ... trying to improve

If you were to speak with virtually ANY of my English teachers you'd quickly learn how much I didn't like being in class...I was a "math" guy early on and developed a firm belief that my general dislike for all things relating to writing was attributable to an irrefutable fact that there exists an inverse correlation between math and writing: that is, you're either good at one or the other, but not both. (talk about a run on sentence!!!) It wasn't long after I left school that I realized that one HAS to write, and so I grudgingly gave in. Over time, I found that I liked to write. And, I realized that to become better, I had to (a) read regularly and ( b) read about writing.

It's probably no surprise that in the blogosphere there are many who devote their time and effort to improve the writing of others. One such site is managed by Susan Weiner, who also happens to write in the investment space. I encourage you to visit her site and sign up so that you learn of new postings that you will no doubt find of interest. Whether you write regularly or not, you're sure to learn a few things.

Dealing with prospects below the minimum

Recall that the GIPS 2010 "exposure draft" proposed a requirement that firms be prohibited from giving a GIPS (R) composite presentation to prospects below their stated minimum. While this was characterized as a change from a "recommendation," this appeared to be much more given the language as it currently appears in the standards (see paragraph 3.B.3). Putting this semantic disagreement aside, the GIPS Executive Committee responded favorably to the overwhelming opposition to this proposed change (my count had more than half saying "no," with but a few saying "yes").

During last week's annual GIPS conference we were told that this will stay a "recommendation." Given the wording in the draft, it isn't clear to me if this means that the EXISTING wording will stay (that is, recommending that compliant firms "not market" to prospects below) or if it'll change to the previously proposed change, but with "must not" replaced with a recommendation (that is, to not SHOW a presentation to a prospect below the minimum). I'm fine either way, and suspect many, if not most, of those who opposed the original change will be fine with this, too.

Terminology: Plan Sponsor

Last week I had an "a ha" moment when during a meeting, discussion turned to the meaning of the term "plan sponsor." I always considered it a broad expression, that refers to institutional clients (e.g., pension funds, endowments, foundations). But at least one of the participants restricted its meaning to pension funds. Interestingly, a pension fund representative at the meeting shared my view!

Well, I have concluded that the term is a tad ambiguous, though the formal definition DOES seem to limit it to pension funds. I did a quick "Google search" and found two definitions:

"An employer who sets up a pension plan."
(http://www.investorwords.com/3711/plan_sponsor.html)

"While some plan sponsors will take matters into their own hands and handle all the investment decisions for retirement plans, most of them outsource the fiduciary management of the assets in the plan to one or more third parties. This way, multiple investment options run by different money managers may be offered to suit various risk profiles among the company's employees."
(http://www.investopedia.com/terms/p/plansponsor.asp)

It is evident that I'm not alone and even among those who know what the term is intended to mean, they often use it in a broader context, too. And so we can add this term to the growing list of words and expressions that often have multiple meanings.

Annual distribution to clients

One proposed change to the GIPS(r) standards that garnered a great deal of attention was to recommend that compliant firms annually send the appropriate composite presentation(s) to their existing clients. While this was merely a recommendation, many folks opposed it. In fact, by my count roughly one-third took the trouble to say "no," while no one said "yes" to this item.

The GIPS EC decided to move forward with this change. There appears to have been a belief that some of the opposition stemmed from the prior practice or suggestion that "recommendations" often become "requirements." This is no longer the case.

Because recommendations mean "best practice," only time will tell whether firms are virtually forced into delivering these reports. It will be interesting to see what costs result from this move.

Annualized standard deviation ...yes!

Okay, so the decision has been made: effective January 2011, GIPS compliant firms must report a 36-month annualized standard deviation, on an annual basis (that is, for all years starting with 2011). Further clarity is in order.

First, is standard deviation risk? There is hesitation to call it that, because a lot of folks don't consider it risk. But if it's not risk, why show it? Granted, not everyone thinks of volatility as being a risk measure, but most firms report that they use standard deviation as a risk measure. If volatility isn't risk, then is volatility such a valuable measure that we need to see it reported?

I think it's a mistake NOT to call standard deviation risk: the fact that not everyone agrees shouldn't be a reason not to. There is disagreement about much of the standards, but that doesn't stop these items from being included. It's even more confusing not to call standard deviation risk. Is someone going to be offended if we call it "risk"? I think not.

Is the Sharpe ratio a risk measure? Technically it's a risk-adjusted return. And, what risk measure is used to adjust the return? Yes, you're right: standard deviation. But if standard deviation isn't risk, then I guess the Sharpe ratio can't be a risk-adjusted measure. Who's going to tell Bill?

Okay, and so HOW do we calculate standard deviation? First, use 36 months ... not days, not quarters, not years: months! You will also be required to include the annualized return for each 36 month period. What if you don't have 36 months' of composite returns? Then don't show this until you do (well, actually, you arguably can show a standard deviation for the period you have, but you're not required to until you reach 36 months).

Do we divide by "n" or "n-1" (where "n" is the number of months (i.e., 36))? No decision has been made yet, though it appears from comments at this week's conference that "n" might win out. We use "n" for the population and "n-1" for a sample; some might argue that it would be wrong to use "n," while others would argue that it's wrong to uses "n-1." This is debatable and controversial, no doubt. And, no doubt more details will follow.

Oops!

One great benefit from conferences is the questions that are posed ... they sometimes identify things that weren't previously considered.

Effective 1 January 2010, firms must revalue portfolios for large cash flows. Okay, fine. AND, unless you revalue for ALL flows, you can't then revalue for SOME that fall below what you define as large. Example: you use Modified Dietz on a monthly basis; your definition of large is 10%; you get an 8% flow in, you cannot revalue. Okay, clear enough.

What happens if you have a composite, that is made up of mutual funds and separate accounts, where the funds are valued daily and the funds use monthly Modified Dietz? Looks like we have a problem :-(

Clearly, some guidance is needed. I would favor an amendment whereby in these cases, where you have some funds that you value daily and some that you value monthly, then the "large" rule will only apply to those that are valued monthly. There may be some holes here ... we'll have to see.