What if we were wrong all along?

Funny what we can do with Google: type in just about anything and you'll be whisked away to one or more potential sites to provide you with information related to your inquiry. I entered the title for this post and was sent to a Yahoo site that addresses this topic from a creative writing / English lit perspective. This has little (make that no) relevance to my reason for using it.

Rather, I've begun to hint at this for some time, with my various rants and analyzes.From my questioning the almost universal love affair we have with time-weighting (at the expense of money-weighting), to my questioning of the acceptability of the aggregate method for composite returns, and most recently my challenge of asset-weighting of composites (versus equal-weighting) (the last two, of course, relate to GIPS(R) (Global Investment Performance Standards)), I've clearly been asking this question, though not necessarily with these words.

I don't set off with the intent of upsetting the apple cart, but rather innocently stumble upon these epiphanies. The word "epiphany" has a variety of meanings, with one being "a sudden, intuitive perception of or insight into the reality or essential meaning of something, usually initiated by some simple, homely, or commonplace occurrence or experience." This one fairly accurately describes how I've come upon the realizations that what we do, sometimes, appears wrong. Because I arguably have no skin in the game, that is, I never came up with any of these approaches, I am not required to say "heh, I was wrong." But, the reality is that at one time I supported all of these approaches but of late have come to question them. And so, yes, I have been wrong in supporting them.

This being my last blog post for 2010 I thought it fitting to close out the year by simply reminding you of my questioning. There are some in our industry who, for whatever reason, refuse to even consider a fresh look at what we have done for years and have accepted as perfectly acceptable ways of operating. I know there are some, too, who grow frustrated and impatient when some, such as I, raise these issues. But many others find these ideas refreshing. 

Just this past week I was asked to opine on a client's presentation where they, independent of my analysis, decided that the aggregate method was inappropriate for what they were doing: I was ecstatic to see this and so of course enthusiastically supported their work product. Others, too, have joined me in my crusade to see that money-weighting achieve its rightful place in our industry. 

I sent a letter to the GIPS Executive Committee a couple months ago, challenging the employment of the aggregate method. Although I understand they have discussed my paper I have yet to hear what their reaction is. And while I don't hold out much hope of seeing the method either removed from the standards as an acceptable approach (my preference) or at least carry a "warning label," anything is possible. None of the EC's members were involved in sanctioning this method, and so there should be no "pride of authorship" to influence them. 

I may send them another letter requesting a fresh look at the weighting approach for composite returns. Steve Campisi's support in response to my recent post enhanced my confidence that I was perhaps on to something. Here, too, the EC has no members who championed this approach when introduced by the FAF in the mid-80s and AIMR in the early '90s, so there should hopefully be complete objectivity and a willingness to step back and ask, "what if we were wrong all along?" That's my hope. 

Gross or net???

A client recently suggested that whenever a firm shows money-weighted returns (with the possible exception of private equity and direct real estate) the returns should always be net-of-fee, since they're representing how the client is doing. I think this makes sense.

When to show net, when to show gross, are, in general, good questions. I have suggested in the past that when marketing ones services, gross-of-fee is probably best, especially if the net-of-fee return is a mix of fees, making interpreting the returns a challenge. With a gross-of-fee return the prospect can always back into the net-of-fee return they would have had. With clients reporting, I think that net-of-fee is, in general, best.

I recently commented how the idea of accruing fees appears to make little (or should I say, "no") sense; recognizing the fees when they occur is, to me, preferable.

Perhaps more discussion is needed on this topic. Your ideas and thoughts are invited.

Holiday Greetings

Our office, like many, will be closing early today, and we won't be open tomorrow. And so, I want to take this opportunity to express my wishes that you and your family have a Merry Christmas. Our country remains at war and we have many brave service members who are away from home, protecting our freedom. I pray for them almost daily and hope that they are safe and able to enjoy the spirit of the season.

Rethinking equality...

You may recall that the only major controversy regarding the AIMR Performance Presentation Standards (AIMR-PPS(R)) was the use of asset-weighted returns, rather than equal-weighted. Two groups in particular, the Investment Management Consultant's Association (IMCA) and the Investment Counsel Association of America (ICAA) (now the Investment Adviser Association), opposed asset-weighting, partly because they felt that larger accounts would have greater influence on the return, which could cause "special handling" of these accounts. The reason for the asset-weighted approach was to have the composite look like an account. Not surprisingly the GIPS(R) standards adopted asset-weighting, too. Until today I hadn't given this much thought.

However, I recently did a GIPS (Global Investment Performance Standards) verification for a client who has a couple composites which are dominated by very large mutual funds. For example, one has a fund of roughly $250 million and individual accounts of around $500,000; suffice it to say, the composite return usually approximates or equals the fund return, even though the individual accounts may differ by several basis points (e.g., -2.38 vs. -2.11, the composite matches the fund (-2.38); 8.46 vs. 6.56; the composite matches the fund (6.56)). Granted, this is a very extreme example, but it does cause me to wonder if the asset-weighted approach truly is better.

What is the composite return supposed to represent? Clearly some sort of average, right? And so we have asset-weighting, but does this always make sense? While I understand the idea of the composite looking like a portfolio, in reality no one is managing the composite; the accounts are being managed. Something to ponder, perhaps?

Where does verification and compliance begin and end?

A client of ours asked us the following:

Is their a distinction between being a GIPS® compliant firm and claiming that our performance is GIPS verified? In other words, is the industry standard to have all advertisements and websites GIPS verified if your performance is GIPS verified?

First a firm can claim compliance with GIPS (Global Investment Performance Standards) without being verified. That being said, (a) verification is strongly recommended, (b) there is a new requirement to disclose whether the compliant firm has or has not been verified, (c) the institutional market virtually demands that firms are both compliant and verified, and (d) given the standards' complexity, firms that fail to be verified are probably not compliant.

Firms claim compliance with GIPS; they don't claim that their performance is GIPS verified; it is either verified or is not. Granted, there may be a question about the efficacy of the verification, depending on who did the review, but there still is no "claim" associated with verification.

There is no standard nor requirement to have advertisements or websites "verified." There is no formal review process. We recently offered to review our verification clients' advertisements, because we discovered an error with a firm who was previously not (but subsequently has become) a client, and so thought it worth alerting our clients that we would be happy to do such a review for them, at no additional fee. The reality is that many firms get the advertising guidelines wrong, too, so having a verifier review them isn't a bad idea.

Premature embracing?

In Tuesday's Wall Street Journal there was an article on heart treatments which have begun to be questioned because of problems that have arisen. It points out that this "reflect[s] a persistent phenomenon in medicine where doctors and patients embrace new technology onnly to find that it may not be good medicine once exposed to rigorous testing."

This statement reminded me of the similar case with the investment world, where certain models are adopted without sufficient testing. Just think about the model AIG used to decide which credit default swap contracts to enter into; the model had been developed by a Yale professor and apparently had a known shortcoming, but this didn't stop AIG from taking the risk side of way too many such instruments. Other models, too, that hadn't been properly vetted, through rigorous testing, failed once the sub-prime mortgage crisis hit.

Our industry tends to love complex models, especially when they've been developed by someone whose name ends with "PhD." I will credit Nassim Taleb for pointing out some of these problems (The Black Swan), though at times  I find his rants a bit excessive. But we can't question the shortcomings of many of the risk models when put to the tests of recent years.

When I was in the military we trained under situations that were designed to match very closely what we might encounter in battle; unfortunately, risk models aren't always put through such tests, perhaps because the future is so uncertain; thus Taleb's suggestion not even to bother to try to use any ex ante measures. But his advice and analysis will no doubt have little impact on what we do.

Calculating net-of-fee returns

Many firms provide their clients or prospective clients with net-of-fee returns. I happen not to generally like these in a GIPS(R) (Global Investment Performance Standards) presentation, as their value is questionable. If you use actual fees, these fees typically vary, so the result has little meaning to the recipient...it's the result of a hodgepodge of fees being removed and usually bears no resemblance to what the prospect would have paid. If you use highest fee, this will often make you look worse, even though the prospect may not be expected to pay this amount. Reporting to a client is different: they should see net-of-fee performance as this is truly applicable to them.

Let's say you want to calculate net-of-fee for a GIPS presentation: should you accrue your quarterly fees monthly? If you only report annual returns, is it okay to deduct the annual fee from the annual gross? Or, should you deduct fees as they would be charged (e.g., quarterly)?

I ran a quick test (with an annual fee of 1%) to see what might happen and discovered some interesting results.

I was surprised that the quarterly actual versus the monthly accrual would be essentially the same, as I expected the more frequent compounding would make it significantly lower; apparently the less frequent (quarterly) compounding of the higher fee balances out the more frequent compounding. This also begs the question, "why accrue?"

What I think is perhaps most important is that by only removing the fee annually, the net-of-fee return avoids the compounding. And while this is a handy and convenient way to accomplish deriving the net-of-fee return, it clearly overstates it, because of the absence of compounding.

In my opinion, if you charge your fees quarterly they should be deducted quarterly.

I will present additional examples in our newsletter which will show similar results.