Liquidity risk

In a recent comment (see "Waltzing through the blogospher," November 28, 2009) Steve Campisi wrote about the need to measure liquidity risk, citing the difficulties that the Yale Endowment fund had. It just so happens that this month's Institutional Investor's cover story deals with the huge drop in assets major colleges have seen in their endowments, effective the fiscal year ending this past June 30. The drops have been quite staggering, with the average loss being roughly 20 percent.

I'm intrigued by the notion of liquidity risk, but I can see huge challenges with it, too. How does one properly assess this risk, especially when the variables that can impact it can be quite significant. It was probably a lot easier selling your Dubai World bonds a few weeks ago than it is today, right? During a flight to quality liquidity dries up. If you don't have to sell an asset that is down, you can perhaps afford to wait around to see if it recovers its value. But, there are times when you must sell, thus you encounter liquidity risk and lower prices. Long-Term Capital Management WAS able to recover the value of just about all of their assets...the problem was they couldn't afford to hang around and had to be bailed out. Perhaps stress testing your portfolio would be one way to determine what your risk is.

More details will help, and we hope to see this topic explored in greater detail.

Calculating returns ... the wrong way

We got a call recently from a firm that wants us to review their method to derive returns. They take their beginning market value plus cash flows to determine an average capital base; they then determine their account's appreciation for the period and calculate a simple average to derive the return. Extremely intuitive, yes?

But sadly wrong, too. (Hopefully you agree).

This isn't the first time we've encountered firms who employ a proprietary approach to derive returns. Not long ago during a conference lunch I was sitting next to an attendee who told me of the approach they had developed. Again, quite intuitive ... one that surely no one would find objectionable. Unfortunately, it, too, was invalid.

Long ago, before the publishing of performance books and various standards, individuals were often compelled to figure out a return methodology on their own. Fortunately, this is no longer the case. So, if you have such a formula in your shop, perhaps you should have it checked out.

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.

Waltzing through the blogosphere

I guess it's not surprising that as a blogger, I occasionally wonder around looking at other blogs ... I regularly visit about a dozen and am always looking for new ones to add to my list. Today I've visited several new sites and have picked up a few ideas.

As far as I know it, my blog remains unique in its focus, addressing topics such as the GIPS(R) standards, rates of return, performance attribution, and risk on a regular basis.

To date we've attracted some 500 visitors, which I guess is pretty good as a start. Our newsletter has several thousand subscribers, so perhaps we have a bit to go to get to that level. Visitors have come from every continent and many different countries. And while only a few have signed up as "friends" so far, we know that many circle back regularly. The idea of being a "friend" is that you are notified when a new post is added.

Photo by chrismar

I'm pleased that we've had a few comments regarding posts, as this suggests that some agree while others not with what has been offered.

I've now been blogging for six months and am open to your ideas, thoughts, suggestions. Feel free to contact me directly (DSpaulding@SpauldingGrp.com) or by posting a comment. Thanks!

Rates of return ... come again?

I stumbled upon a website today that provided the following brief explanation about returns:

"To evaluate the performance of a portfolio manager, you measure average portfolio returns. A rate of return (ROR) is a percentage that reflects the appreciation or depreciation in the value of a portfolio or asset"

We measure "average" returns? I don't think so. Average returns have been shown to have zero value. A classic example: Year 1 +100 return, Year 2 - 50% return, average= (100 - 50) / 2 = 25 percent. Now, let's use some dollars: start with $100; at the end of year 1 you're at $200, then at the end of year 2 you're at $100, meaning zero percent return.

In addition, while there are times when a return will reflect the appreciation or depreciation, once we introduce cash flows, forget about it! Recall that time-weighting can yield funny situations, like having a positive return but losing money.

I guess the lesson is: be careful about what you read on the Internet ... may not always be correct.

Happy Thanksgiving!!!

While we in the United States celebrate Thanksgiving today, everyone should no doubt be able to reflect on the things they give thanks for. My list is so very long. It includes our management and staff, our clients, our vendors, and colleagues. My wife and family are blessings in my life. The fact that I'm fortunate to live in a country that affords us so many freedoms is also something to give thanks for.

The fact that our firm managed to weather this severe market downturn offers us something to give thanks for. We know that this past year has been a challenging one for just about everyone, with many who suffered greatly. We're seeing a turnaround and look forward to much improvement in the coming year.

Perhaps this year I'm most thankful for the birth of our grandson, Brady, who will turn four months old this coming Tuesday.

We wish you and your family a blessed and wonderful Thanksgiving.

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.