You are there! The risk measure designers' annual dinner ...

Imagine for a moment that the designers of the various investment risk measures have gathered for a dinner; perhaps this is an annual event (may as well have it annual, since we like to annualize risk measures, right?). And imagine that you have the opportunity to witness what occurs; perhaps someone videotaped it and placed it on YouTube for all of us to view. We find Bill Sharpe (Sharpe ratio), Leah & Franco Modigliani (M-squared), Jack Treynor (Treynor ratio), Brian Rom (Sortino Ratio), Michael Jensen (Jensen's alpha), Fischer Black (who, along with Jack Treynor, came up with the Information Ratio), and others.

During the pre-dinner cocktail hour a debate ensues, as one after the other guests begins to argue that their formula is the most appropriate to measure and evaluate investment risk. Suddenly, Sir Francis Galton, at 188 years of age, slowly rises from a chair and boldly proclaims that it's quite evident that his is the far superior measure, and he can prove it! After all, his and his alone has been "endorsed" by GIPS(R) (Global Investment Performance Standards). And what, pray tell, is his measure? Well, if the name Francis Galton is unfamiliar to you, his measure surely isn't: standard deviation.

With the 2010 version of the standards all compliant firms must include the three-year annualized standard deviation; what further proof is needed to elevate his metric above the rest. And even if a compliant firm argues that this measure is inadequate for their strategy, they must still show it, along with an explanation as to why it isn't effective and the measure they feel is.

Well, I remain unconvinced, and will (hopefully) soon pen an article that will address this measure's weaknesses at great length (sorry, Frank!).

p.s.,With all due respect to Sir Francis, even the GIPS EC would, I believe, gladly explain that its adoption of standard deviation falls well short of an endorsement for it being numero uno when it comes to risk measures. A recommendation to include a risk measure has been part of the standards since its introduction, and the EC took it upon itself to identify a measure to be used across the board. They, no doubt, recognize many of its shortcomings but also recognize that its an easy measure to calculate and is, in reality, used by most asset managers (as shown in surveys that our firm has conducted). And so, please accept this blog's boldness (and Sir Francis' claims) as a bit of hyperbole.

A different way to measure ROR

While "risk" seems to be a more commonly found topic in the Wall Street Journal, I was pleased to see this advertisement appear in this past weekend's edition. First, it's wonderful to see a focus on diplomas, especially for inter-city children; as a former "inter-city" child myself (though we didn't use the term in the '50s and '60s), I have an appreciation for such achievements.

What strikes me about this ad is the personalization of the return; something we've been trying to get folks to identify with for some time. Again, it has to do with perspective. Returns often are multidimensional, and to solely view them through the lens of time-weighting does them an injustice. Perhaps this piece can serve to wake more folks up to the importance of money-weighting.

p.s., we hope you'll consider donating to this worthy cause. Go here for the full size ad and details on how to contribute.

Index funds ... designed to outperform?

Jason Zweig's piece in this weekend's Wall Street Journal serves many purposes, one being a clue as to why it's so difficult to beat indexes. It occurred to me some time ago that the index designers must be exceptionally talented at constructing them, but perhaps their mere existence serves as a device for "above average" performance, since any changes to them typically result in buying frenzies which, of course, cause stock prices to rise (and of course selling of the tossed out issues).

There is probably plenty of room for research into this phenomenon, and perhaps much has already been done (I haven't yet investigated this). But Jason's insights offer, as usual, good reading material and ideas to ponder.

Thanksgiving greetings

Happy Thanksgiving to our blog readers. Hope it's a happy, healthy, and blessed one for you and your family.

GIPS isn't that hard for hedge funds

We often get contacted by hedge funds who are considering GIPS(R) (Global Investment Performance Standards) compliance. For some reason they see this as being a monumental task; but it really isn't. Here are some key attributes of hedge funds which make the task a lot easier for them than long-only managers:

1. Hedge funds typically establish separate partnerships by strategy, so they're normally looking at a one-to-one relationship between funds and composites. In other words each composite will likely have only one (or only a few at most) fund(s). Meaning the composite is the fund's return, the composite's assets are the fund's assets, and there is no measure of dispersion.
2. Hedge funds typically limit cash flows to once a month, normally at the end of each month. This means that the funds are valued at month-end before the flows are applied. Therefore, their returns are usually pretty simple to deal with. And, they automatically meet GIPS requirements.

A hedge fund manager's policies will no doubt be easier to implement than for a long-only manager who is more likely dealing  with a lot more diverse accounts.

While it's true that in the institutional, long-only space, one can no longer claim a "marketing advantage" by complying, because virtually all of the firm's peers already comply, this isn't true in the world of hedge funds. Here there is clearly an advantage to make the effort. The investment to comply isn't going to be as great as you'd think, so why not make it?

p.s., for more information on how we can help, please contact Christopher Spaulding at 732-873-5700.

Do I have to???

I got a call from another verifier who was wondering if GIPS(R) (Global Investment Performance Standards) 2010 requires firms that object to the use of annualized standard deviation to still show this measure, even though they have (a) documented why standard deviation doesn't apply and (b) provided a substitute. And the answer is (drum roll, please)....yes.

I objected to this new requirement, as did many others who commented on the "exposure draft," but it remained. In addition, it requires firms that feel that standard deviation is a poor risk measure to employ for their composite's strategy to explain why and provide the measure they feel IS appropriate; but it STILL requires firms to show the three-year annualized standard deviation.

Why do we multiply returns?

I'm teaching our Fundamentals of Performance Measurement course for a client this week and have been asked some interesting questions by the students. One asked why we multiply returns in order to link them. Questions like this require, I believe, a bit of detail in their response, so let's discuss it here.

Let's say that our first quarter returns are as follows:

The rule we apply to compound is to add one to each return, multiply them together, and then subtract one, which results in:

But why? Why is this the right return? And again, why do we multiply?

Well, we are multiplying in order to compound our returns. January sees a return of 10%, which adds 10,000 to the account's market value. February's return is applied to both the starting or base amount (100,000) as well as January's gain (10,000), and March's return goes against the base, January's gain, as well as February's (5,500). This might help:

Questions like the one this student posed requires some thought, and I believe I've represented what happens, though will expand upon this further in our December newsletter.

p.s., to learn more about our training, please contact Patrick Fowler or Chris Spaulding.