What IS risk-free?

I'm conducting a review of a client's performance reports. When reporting by country, if there is no risk-free rate for that country, a zero value is used (e.g., for Sharpe ratio, Jensen's alpha). Why?

Risk-free rates can be quite complex; perhaps more than they need to be.

I'm a US-based investor. My risk-free rate is the U.S. Treasury bill. I can put my money there or invest in something more risky, such as Vietnam equities. Vietnam, to my knowledge, has no risk-free rate. But why should I care; would I invest in them? No, if I'm looking for a risk-free rate it's treasuries.

Well, what about the investor in Vietnam; what if he's your client, what do you show? I'd pick a risk-free rate that this investor could invest in; since there is no rate for Vietnam, perhaps one from Australia, the UK, or the USA? Pick something that could be used, but don't look for a collection of rates, one per country. The rationale behind this is lost on me. If you have a good argument for it, let me know.

Non-marketed need not apply

I recently conducted a "mini verification" for a client wanted us to do a high level check on a manager who both claimed compliance with the Global Investment Performance Standards (GIPS(R)) and had been verified.

As I always do, I asked to see all their composite presentations. While they could provide most, they couldn't for the "non-marketed" ones. And while they "knew" they are supposed to have them, their verifier never asks for them so they hadn't bothered to prepare them.

Their verifier never asks for them?

Well, I'm not surprised as there are some verifiers who believe that verification only deals with "marketed composites," and that the firm has no obligation to do anything with the "non-marketed" ones. To me, this is shameful. Verification is a "firm wide" exercise, not limited to only the "marketed composites."

I've addressed this point with this particular verifier on multiple occasions but clearly they have their own rules which they live by (GIPS rules be damned). To me, they're doing a disservice to their clients. First, they are claiming to conduct a "verification," but are actually doing only part of the job. This expeditious approach may have appeal, but it puts the client at risk. What if I were the SEC asking for these presentations? Might the firm's claim of compliance be questionable, posing the possibility of a sanction?

To this verifier and others who argue in favor of only worrying about the marketed composites I ask a simple question: what page in the standards do the words "marketed composites" appear? I have yet to find it.

p.s., As an aside, to make up for not verifying all the composites the verifier was able to talk this firm into examining ALL of the marketed composites: you know what I have to say about examinations.

PMAR VIII Highlights

Our 8th annual Performance Measurement, Attribution & Risk conference was held last week in Jersey City, NJ. And while Jersey City might not seem like a "dream location" for a conference, the Hyatt turned out to be a superb venue. From our conference room we could see the Manhattan skyline and the Statue of Liberty. On the second day many of the attendees chose to eat their lunch outside, taking in the warm weather and the delightful views.

The event also provided a great venue for the sharing of insights, information and ideas. Risk was a major theme throughout the event. With the market continuous volatility and recent downturn, ways to wrap our arms around risk remain an important topic.

For me, two of the highlights came from conversations I had with a couple attendees. One, a verifier for a "big four" firm, acknowledged his frustration with GIPS(R) (Global Investment Performance Standards) firms that conduct remote verifications. He is a reader of our blog and voiced support for my stand opposing this practice. The second, a quite knowledgeable industry veteran, voiced opposition to the heightened attention examinations are receiving. And while some believe these audits are of value, many of us see little relation to the GIPS standards. It's gratifying to hear support for ones ideas from others in such a candid fashion.

Speaking of GIPS, Jonathan Boersma, Executive Director of GIPS at the CFA Institute Centre for Financial Market Integrity and member of the GIPS Executive Committee, delivered a presentation on the upcoming changes (GIPS 2010). We could have allowed an hour for Q&A and still would have needed more time, no doubt.

As always, we had a handful of new speakers as well as several PMAR veterans. We welcomed back David Tittsworth of the Investment Adviser Association, who provided us with our regular session on regulatory matters. We've been fortunate that every time we've had this topic, we've enjoyed a speaker who is both a skilled orator as well as one who interjects humor into their presentations.

Kyle Ringrose delivered a challenging talk, in that he was the late Damien Laker's stand-in for the keynote address. Damien won the 2009 Dietz Award; each year the recipient is given the opportunity to give a keynote address at PMAR, in order to share their ideas from their winning article. Obviously, Damien couldn't make it and so we called upon Kyle, a colleague of Damien's.

On June 8-9 we will hold our first PMAR conference in Europe. At this event Carl Bacon will take on the task of delivering the keynote address on behalf of Damien. For Carl, that will no doubt be easier than his other chore, which will be to debate me on money vs. time-weighting at our Battle Royale! We are expecting a very good crowd for this inaugural event and are looking forward to crossing the pond to join them for this program.

Lost lessons

This week has seen the conclusion for the six-year run of the television show, Lost. My wife and I have been avid viewers for some time and anxiously awaited this final episode. I like the show so much that I am a "fan" of the show on Facebook. And this past week has shown a considerably disparate collection of opinions regarding what actually occurred with the cast as well as the success of the last episode.

This made me think about our chosen field of endeavor, where there are often widely divergent views on approaches and methods. This past week saw Steve Campisi compete against Mark Elliott on the value of including the "income effect" in a fixed income attribution model. And next month I  have the pleasure of taking on Carl Bacon on the subject of time- versus money-weighted returns. Our Battle Royale has been a standard part of our annual Performance Measurement, Attribution & Risk conference since the event's initiation, and it serves to show how not only are there different views, but that they often engender strong passion on the part of the participants. And while these events have never resulted in profanity-laced name calling, such as what appears in some of the Lost comments, participants can clearly see how opinions can be strongly held and well entrenched. These events, as with the Lost commentary, provide the opportunity to gain additional insights into controversial topics.

Standards are great, but it's good that not everything is standardized, so that firms and institutions have the opportunity to select the approach(es) they feel best suit their needs.

Necessary or not?

A GIPS(R) (Global Investment Performance Standards) client asked if a certain disclosure is needed. They, like a few firms, include language such as:

The collection of fees produces a compounding effect on the total rate of return net of management fees.  As an example, the effect of investment management fees on the total value of a client’s portfolio assuming (a) quarterly fee assessment, (b) $1,000,000 investment, (c) portfolio return of 8% a year, and (d) 1.00% annual investment advisory fee would be $10,416 in the first year, and cumulative effects of $59,816 over five years and $143,430 over ten years.

I am unaware of any reason to include such language. I know that some verifiers request (or require) firms to include this, but unless they can provide a reference for such a demand I'm at a loss as to why this is needed. I think that with all that's required, why invent new disclosures?

Too much information can be counterproductive

I'm listening to Malcom Gladwell's Blink: The Power of Thinking Without Thinking. I've read two of his other books (The Tipping Point: How Little Things Can Make a Big Difference and Outliers: The Story of Success) and enjoyed them considerably, and so am not surprised that I'm finding this book to be quite good, too.

Gladwell gives some examples of situations where decision makers are overwhelmed with information, which actually both slows them down and fails to improve their decision making. In the case of cardiac doctors, their old methods of addressing lots of details about a patient's history slows the process down and proves unnecessary (we actually learn that less is better at diagnosing patients); the same applies to psychologists and military commanders.

Can we learn something from Gladwell when considering what we give to clients? What is the point of our reporting? Can we provide them with the information they truly need in a more succinct manner? Something to consider, yes?

One size fits all...not when it comes to reporting

Occasionally we hear a call for "reporting standards." Personally, this is far from the top of my priority or wish list. Guidance is often appreciated, but standards? No thank you!

Okay, and so for a little guidance consider that reporting should very much take into consideration the needs of the recipient, the conditions under which investing is being done, and the likely questions the individual may have. For many, time-weighting is the panacea of returns; unfortunately, it isn't quite that simple. Recall that time-weighting eliminates or reduces (in the case of approximation methods) the impact of cash flows. And why in the world would we want to do that? For just one single purpose: when evaluating the performance of managers who don't control the cash flows! That's it. Nothing more. And yet, time-weighting appears everywhere, more often than not where it doesn't belong. Firms need to avail themselves of money-weighting to complete the picture to ensure they report properly.

When trying to decide which measure to use, consider the perspective from which the report will be reviewed. What questions will the recipient be asking? If they want to know how did my manager do?, then in most cases time-weighting is appropriate. If they want to know how did I do?, then money-weighting, by far, is the method of choice.

It amazes me to some extent that we still have time-weighting be the only method most firms employ for sub-portfolio returns, when regardless of the perspective, money-weighting should be the only approach.

We're making headway here, but there's a long way to go.