A standard in name only?

One of our clients sent us a note recently, which stated that one of their clients told them there is a "standard to report alternative investments as net-of-fee, and to combine these with gross-of-fee returns." This "standard" apparently is not in writing, so perhaps the term was being used a bit loosely? Perhaps "a common practice" (although how common this is is open to debate) or "best practice" (though I would think it's not "best") might have been a better choice of words. In general I think "standards" should be written down somewhere; this is an example of one that isn't, though it's still worth discussing.

Mixing assets with net-of-fee returns with assets with gross-of-fee returns is never a good idea: what do you end up with? A hybrid, where you cannot make much sense out of what is being shown. If there is a "standard" (though again, it's probably a "best practice") it would be to not combine net-of-fee return assets with gross-of-fee, unless you have no choice. An example of how this used to be the case: in the early days of the AIMR-PPS(R), many U.S. firms included mutual funds in their composite, where the funds had net-of-fee returns (because at that time, firms were prohibited from "grossing-up" the fund returns) and separate accounts had gross-of-fee returns. The result was a composite gross-of-fee return that was lower than it would have been (had the fund been grossed-up). In 1996, the SEC issued a "no-action letter" which allowed firms to gross-up fund returns, so this is no longer a problem.

There are loads of things that mix well together, but net- and gross-of-fee returns aren't two of them.

Our performance numbers don't agree!

Last week I had a call from a client who said that the returns they calculate don't match those provided by the hedge fund. How can this be?

Hedge fund performance should be pretty easy to handle: once we have the monthly valuations, cash flows are typically restricted to being once a month (on the last or first day), so it's quite simple to do the math. And so, what might be going on?

Well, our client said that they recognize flows when they occur! This could be the problem, right?

In wanting to get the money to the hedge fund in time that it's available, many of their clients will wire funds a few days early, but the hedge fund pretty much (as I understand it) ignores the money; (i.e., just lets it sit outside the corpus of the fund), until they're ready to bring it in: as a partnership, they do partnership accounting, where they calculate an end-of-month NAV (net asset value), and then issue new shares based on this value and the money being deposited (or, in the case of withdrawals, reduce the number of shares). If our client treats a flow as an intra-month event, using either Modified Dietz or a daily measure (where they simply carry the fund value from the start of the month to every day in the month (since daily values won't usually be available)), differences can occur, yes? There can be other reasons for differences in returns, but this seems to be a likely candidate.

My advice: adopt the same method as the fund. For example, if a flow actually occurs on November 28, but the hedge fund won't recognize it until November 30, having the return reflect the flow on the 28th isn't going to help when trying to match up with the fund. The fund is not doing anything with this cash, so treat the flow as if it occurred on the 30th, just as the fund will. As with all of my posts, I welcome your thoughts.

"the sort of precision that gave one confidence"

My son, Douglas, gave me Rules of Civility by Amor Towles for my birthday. And while I don't often read novels, the review in the WSJ painted it as a book I should read (it likened it to The Great Gatsby, and after finishing it I can see why). Given that performance measurement is our passion, it's not surprising that I found inspiration within this text for a post.

In describing how a waiter poured three martinis, such that there was just enough to fill each glass with great exactitude (with not a drop too much, or too little), the narrator remarked how "It was the sort of precision that gave one confidence."

This line reminded me of something Roger Lowenstein wrote in his best seller When Genius Failed, about Long-Term Capital Management: "Long-Term did not merely concede the possibility of loss, it calculated the supposed odds of it occurring, and to precise mathematical degrees...The point was, Long-Term predicted the odds with precision." (emphasis in original) And no doubt, this precision gave LTCM's investors confidence in those who managed their money.

When a pilot informs the passengers that he expects to land at "about 5:17," the mere fact that he didn't round to the nearest five (i.e., 5:15) suggests a high degree of confidence, in spite of the qualifier, "about."

Precision implies accuracy and confidence, which isn't always valid. One should think about how far they want to go with the precision of their reporting, if the numbers are based on approximations, estimates, preliminary information, etc. Sometimes qualifying language is in order, to guard against confidence that might be misplaced.

Wondering about your error correction policy?

Here's an opportunity to gain some insights into the proper way to construct your policy. (If you claim compliance with the Global Investment Performance Standards (GIPS(R)), you are required to have a written policy!).

Join me on Monday, December 5, from 11 AM to 1 PM (EST), for our delayed November Webinar. We will go through the guidance statement, clarify some key points, and address:

• Understanding the requirements
• Common mistakes
• Dealing with materiality

To register or for further information, please contact Jaime Puerschner or Patrick Fowler (732-881-5700).

Note that a modest site fee will be charged (and you can have as many people on the line as you'd like!), except for our verification clients and members of the Performance Measurement Forum (who can participate at no cost!).

Taking advantage of "senior moments"

When I was an undergrad math major at Temple University, roughly 40 years ago, a professor, who was teaching a Numbers Theory course, mentioned that there were three things mathematicians should always remember: the Pythagorean Theorem, Fermat's Last Equation, and he said he couldn't recall the third.

I often cite this episode when teaching our Fundamentals of Performance Measurement course, when I suggest that there are three things performance measurement professionals should know (in my scenario, I recall all three).

I thought of my professor's admonition when I heard about one of the Republican candidates for U.S. President, who said there were three departments he would eliminate, but failed to recall the third. His apparent stumbling didn't go over well. It seems that he hasn't learned the art of self-effacing humor, and turning moments like this into something funny.

Now that I am in my 60s (you're shocked to hear this, I know; people tell me all the time I don't look that old), I have the benefit of referring to episodes of forgetfulness as being "senior moments," something that always results in a laugh. And while my age probably has little to do with temporary memory lapses (given that everyone is subject to them), it's a line that fits well (at least for folks my age). Had the candidate made a similar statement, perhaps he would have gotten by without the negativity that has resulted.

Humor works, but only if the speaker is adept at pulling it off. This topic came up at a conference I was at this week; many of the attendees liked the humor I interjected during the session I moderated. Later, during dinner, I discussed this with a fellow dinner guest, and said how there is an art to telling a joke, and mentioned the joke about the fellow who walks into a bar, sits down and orders a beer. A few minutes later someone calls out "52," and everyone there began to laugh. A few minutes after that, someone called out "67," and the same thing occurred. Next, someone yelled "18," and the crowd again laughed loudly.

Turning to the bartender the fellow asked what was going on, since he didn't see any humor in numbers being called out. The bartender explained, "we have had the same neighborhood folks come in here for many years. And as you might expect, the same jokes kept getting told, over and over again. So, we decided to number them."

Hearing this, the man called out "44." Silence. Again, "44!" And again, silence; no reaction at all.

And so, he turned to the bartender and asked, "is there a joke numbered 44?" and was told "yes, there is."

"Well, how come when I yelled it out, no one laughed?" The bartender's response: "some people don't know how to tell a joke."

Understanding the why

While driving to Boston to moderate a panel on fixed income investing, my wife and I were listening to David Baldacci's latest book, Zero Day. Early in the book he explains why folks in the UK drive on the left-hand side of the road. It apparently dates  back to the "jousting days," when knights typically approached their opponent on the left hand side, since most were right handed, and this would be a better way to attack.

The reason Americans drive on the right-hand side is, as I understand it, is attributable to an American Indian custom of approaching oncoming riders on the right, as a way to show that they came in peace. Funny how both are apparently due to horse riding, but for completely opposite reasons.

Understanding "the why" behind why we do things can be quite helpful.

I was engaged in a conversation with another verifier last week at our European Performance Measurement Forum meeting in Budapest, Hungary. The question we addressed: "why do firms in Europe not have GIPS(R) (Global Investment Performance Standards) performance examinations done, while they are quite common in the States? The "why" here is pretty clear: it dates back to the days of the AIMR-PPS(R), when large accounting firms wouldn't do a "Level I" ("verification" in today's terms) verification, but would do a "Level II" (equivalent to today's examinations). And so, for many years lots of U.S. firms were only having Level II (examinations) done. When GIPS was introduced, these same verifiers dropped the prior restriction. As a result, the firms that perhaps would have avoided Level IIs had their verifiers offered Level Is continued as they had been.

Understanding "the why" might cause us to reconsider some of the things we do, though I wouldn't hold my breadth on anyone shifting the side of the road they drive on any time soon.

Real Estate - is it leverage or not?

The Global Investment Performance Standards (GIPS(R)) require compliant firms to make certain disclosures regarding the use and extent of leverage in their portfolios (See ¶ I.4.A.13).
Does this include real estate?

Answer: No!

Yes, real estate investing is a leveraged asset, but this isn't what the standards are referring to. Here we speak about things like options and margin accounts.

It therefore naturally follows that mortgage backed securities and asset backed securities are not leveraged assets, either! A verification client of ours was wrestling with this and fortunately called for clarity.
MBS and ABS in your portfolio? Fine; no need to disclose.