Performance & ethics

Calculating rates of return really isn't that difficult. And while we may debate whether returns should be calculated using money-weighting or time-weighting, such issues pale in comparison with the broader aspect of ethics.

I must confess that I initially thought that the Certificate in Investment Performance Measurement (CIPM) Program's emphasis on ethics seemed a bit excessive. And perhaps the exam questions could be geared more to the issues and situations that performance analysts and performance heads are more likely to encounter. But the issue of ethics shouldn't be ignored. We seem to be reminded of this on a fairly regular basis.

Yesterday's Wall Street Journal has an article on Raj Rajaratnam and his Galleon hedge fund. Recall that Mr. Rajaratnam has been accused of trading on inside information. His prowess at building relationships, which allegedly resulted in him gaining access to confidential information, allowed him to build a successful business and amass a fortune of more than a billion dollars.

Galleon's returns were apparently quite impressive. And one might not find any fault with the accuracy of the valuations or the return methodology employed. But what is the value of the returns if, as has been suggested, they reflect the results of illegal activity?

What is the responsibility of the performance analyst or manager, should they have reason to believe that the returns reflect illicit activity? Perhaps questions like these should be added to the CIPM program. What would YOU do, if you had reason to believe that the firm's results were arrived at through illegal means? Something to ponder, yes? 

p.s.,We are investigating another fraud case which might involve a firm that claimed compliance with the Global Investment Performance Standards (GIPS(R)). We will provide details once we've done further vetting of the information we've seen so far.

Active vs. Passive Voice

When commenting on someone's writing I often recommend using the active voice. A recent example may help.

A client sent us their GIPS(R) Policies & Procedures document to review. It included the following: "there are few industry-accepted standards for calculation and presentation of after-tax returns"; clearly a statement in the passive voice.  I suggested changing this to the active voice; for example, "there are few industry-accepted standards to calculate and present after-tax returns." It's shorter, more direct, and arguably reads better.

I, like most people, used to write almost exclusively in the passive voice, but eventually learned the difference and try to use active as often as possible. It's fine to include some passive voice, but most of the writing should be in the active mode. When I review client documents, such as their firm's policies to support their compliance with the Global Investment Performance Standards, this is one of the items I'll comment on. Clearly, it's up to the client to switch, but most recognize the benefits and seem to appreciate the suggestions.

In a piece for today, Susan Weiner commented at length on this topic, and provides additional resources to support one's transition to the active voice. I suggest you check it out!

Good news for 2010, as predicted by the yield curve

In a recent blog piece, Larry Kudlow discussed how the yield curve is portending a positive economic environment for 2010; here's part of what he wrote: 

"The Yield Curve is Signalling Bigger Growth 

"What’s a yield curve and why is it so important? 

"Well, the curve itself measures Treasury interest rates, by maturity, from 91-day T-bills all the way out to 30-year bonds. It’s the difference between the long rates and the short rates that tells a key story about the future of the economy.

"When the curve is wide and upward sloping, as it is today, it tells us that the economic future is good. When the curve is upside down, or inverted, with short rates above long rates, it tells us that something is amiss -- such as a credit crunch and a recession.

"The inverted curve is abnormal, the positive curve is normal. We have returned to normalcy, and then some. Right now, the difference between long and short Treasury rates is as wide as any time in history. With the Fed pumping in all that money and anchoring the short rate at zero, investors are now charging the Treasury a higher interest rate for buying its bonds. That’s as it should be. The time preference of money simply means that the investor will hold Treasury bonds for a longer period of time, but he or she is going to charge a higher rate. That is a normal risk profile.

"The yield curve may be the best single forecasting predictor there is. When it was inverted or flat for most of 2006, 2007, and the early part of 2008, it correctly predicted big trouble ahead. Right now it is forecasting a much stronger economy in 2010 than most people think possible."

Good news for investors and everyone else, too!

Standard Deviation ... a risk measure or not?

Standard deviation is a much misunderstood measure, in spite of its common use.

First, is it a risk measure? It depends on who you ask. It's evident that Nobel Laureate Bill Sharpe considers it to be one, since it serves this purpose in his eponymous risk-adjusted measure. Our firm's research has shown that it is the most commonly used risk measure.

And yet, there are many who claim that it does anything but measure risk. What's your definition of risk? If it's the inability to meet a client's objectives, how can standard deviation do this? But, for decades individuals have looked at risk simply as volatility.

As to volatility, is it a measure of volatility or variability? In an e-mail response to this writer, Bill Sharpe said that the two terms can be used in an equivalent manner.

The GIPS(R) (Global Investment Performance Standards) 2010 exposure draft includes a proposed requirement for compliant firms to report the three year annualized standard deviation, which appears to have survived the public's criticism and will be part of the rules, effective 1 January 2011. But, will it be called a "risk measure"? This remains unclear.

Interpreting standard deviation is a challenge, since the result's value will vary based on the return around which it's being measured. Example: your standard deviation is 1 percent; is this good or bad? If your average return is 20%, then to know that roughly two-thirds of the distribution falls within plus-or-minus 1% doesn't seem bad at all, but if your average return is 0.50%, then doesn't 1% sound a lot bigger? In reality, it's better to use it to compare managers or a manager with a benchmark. Better yet, as part of the Sharpe Ratio, as this brings risk and return together.

I could go on and on, but will bring this to a close. Bottom line: it's easy to calculate (if we can agree on how (didn't address this today)), in common use, and has a Nobel Prize winner's endorsement. Will it go away? Not a chance. If you're not reporting it, you probably should be.

First ten years of the 21st century are already done?

In last week's Wall Street Journal, there was an entire section dedicated to revisiting the end of the first decade of the 21st century. But, on this one, the WSJ has it wrong: they're a year too early.

The first century (A.D.) began in year 1 and ended in year 100 (thus, the end of the first century or first 100 years). The second century began 101 and ended 200 (the second century's conclusion). Fast forward: the 19th century began in 1801 and ended in 1900 (the 19th 100 years). And, the 20th century began in 1901 and concluded in 2000, not 1999! Yes, I know that MANY, MANY people thought that they welcomed in the new millennium January 1, 2000 but they were a year early as the 21st century began January 1, 2001. Therefore, the first decade ends December 31, 2010, not December 31, 2009 as the WSJ (and unfortunately, others) are trying to persuade us to believe.

Time marches on quickly enough without our news media trying to rush it along even faster.

p.s., Think I may be wrong on when the new millennium began? Check this out (towards the bottom)! Looks pretty official to me!

A holiday break

I decided that this week will be a break from blogging. And so, I wish all of our Christian readers a blessed and very Merry Christmas; to our Jewish readers, a somewhat belated Happy Chanukah; and to everyone, a prosperous, healthy, safe and Happy New Year! May 2010 be a wonderful one for all of us.

And finally, as Tiny Tim offered, God Bless Us, Every One!

Inflation...an interview with John Longo, PhD

Our friend and colleague, Rutgers University professor John Longo, was recently interviewed on CNBC. We suggest you have a look & listen: