Announcing a webinar to address the GIPS changes occurring in 2010

For the past year much of the focus regarding the GIPS(R) standards has been on "GIPS 2010," the next edition of the Global Investment Performance Standards, to be published in early 2010 (thus the "2010" in the name) and to go into effect in January 2011. But, we must not lose site of what is about to occur this coming January, most of which is part of "Gold GIPS," published in 2005 (i.e., the current version of GIPS).

We've touch on these items in this Blog as well as our firm's monthly newsletter. Of late we've received various inquiries regarding some of the specifics and so decided to host a webinar dedicated to this topic. And while you'll notice the webinar details elsewhere on the Blog, I thought it fitting to spend a moment to explain what we'll cover.

John Simpson and I will go over all the changes. We will spend additional time on the carve-out change, which will prohibit the use of cash allocation going forward, and the new Error Correction Guidance, which requires firms to have a policy dealing with this topic. Time will be available for questions.

This program will be on Friday, November 20, from 12:00 (noon) to 2:00 PM, EST. As with all of our webinars, it will be free to our verification clients and members of the Performance Measurement Forum. For others, a nominal fee will be charged. This is not only an educational event, it's a way to ensure you're prepared for this next round of changes.

To learn more or to sign up, please contact Patrick Fowler (732-873-5700; PFowler@SpauldingGrp.com).

Celebrating 20 years

This won't be the only time you'll read about this, but it may be the first: The Spaulding Group has entered its 20th year in business! Why 20 years should be any more special than 19 or 21 is obviously because society tends to associate extra attention to dates ending with zero or five, so we'll do that, too! And, you can imagine that we're quite proud to have achieved this milestone.

Our firm has grown in several ways over the past two decades and we are grateful for the many folks who have permitted us to serve them during this time. Many of these individuals have allowed our relationship to go beyond a business one, such that we can look upon them as friends. We are also appreciative of the many firms and individuals that support us. I am particularly thankful for our staff and management team.

During the past 20 years we've weathered two market downturns, with the more recent one only now coming to a close. We, as well as just about everyone else, are hoping that 2010 is much better than 2009 has been. And, we look forward to continue to serve our clients and the investment industry for many years to come.

Should the IRR be net or gross of fee?

I was asked this question yesterday and thought it worthy of comment.

First, to clarify, "net" means after the fee is removed, while "gross" means before the fee is deducted.

There are generally two reasons we show IRR. First, in cases where the client controls the cash flows we show it to provide the client with THEIR return; that is, the return that takes into consideration not only the manager's performance but also the impact of the client's cash flow decisions. Why wouldn't we want to show "net"? This would truly reflect how they are doing, after (a) the impact of the manager's decisions, (b) the impact of their cash flow decisions, and (c) the impact of the advisory fee. So I'd say use "net."

The second occasion would be when the manager controls cash flows. As noted in yesterday's blog, I argue for IRR whenever this is the case, not just for private equity managers. Here we're showing the impact of the manager's entire range of decisions, from their management of the portfolio to their cash flow timing decisions. Net would reflect the entire impact and so this would generally be the better return, I would say. However, when the manager is providing their performance to prospects then both gross and net would be ideal. So in these cases, I'd say show both.

If it looks, walks, and sounds like a duck ...

Several years ago I pleaded with the then, "powers that be," to loosen the rules regarding the use of IRR for GIPS(R) compliant firms. At that time, the ONLY asset class for which the rules applied was private equity.

The soon-to-be-published GIPS 2010 edition (which goes into effect 1 January 2011) will most likely expand this to include real estate partnerships. Hurrah!!!!

But why stop there???

The rule should be quite simple: if the MANAGER controls the cash flows, then IRR applies. How hard is that?

The basis for my initial pursuit was because we had a client who invested in public equity, but established partnerships EXACTLY the same way as a private equity manager, and controlled the cash flows. I made (what I thought was) an excellent defense for the position to expand the rules, but I failed :-(

We have a new client that invests in illiquid assets that are not private equities. Again, they establish partnerships. Again, they control the flows. But, the rules, as written, say to use time-weighting. WHY???? If the GIPS Executive Committee were the SEC, I'd ask for a "no-action letter," to permit the client to use IRR. But, they're not. And so, what do we do?

I recently asked that the rules be expanded again. And, I believe the EC considered this. And, I am confident that at least one of the members agrees with me. But, so far no movement. Hopefully we will see this change in the future.

Note: you will no doubt hear from some folks who say that the IRR isn't used because the manager controls the flows but because the asset is illiquid. I can provide MANY references supporting my position. I hope that we will succeed in the near future as this makes perfect sense.

Getting a grip on risk

One of our clients asked us to calculate a variety of risk statistics for them this week and in the course of the assignment we were asked some intriguing questions, a couple of which I'll share with you today.

Annualizing Beta: can we annualize beta? I contacted a colleague who advised me that "yes, we can." We simply multiply each monthly return by 12 (because an arithmetic approach applies to risk, vs. a geometric for returns; translation: returns compound, risks don't). But what happens when we do this? We get the exact same result? And why? Because since we are uniformly altering both the portfolio and benchmark returns, the covariance and variance (which are used in the formula) are adjusted uniformly, resulting in the same answer as the "non-annualized" value. Furthermore, as another colleague put it, "Beta is the slope of the regression equation – it makes absolutely no sense to annualize it." Consequently, beta is beta ... annualization does not apply.

Deriving beta from CAPM: I found this suggestion somewhat intriguing. Rather than use the standard covariance/variance formula, why not derive beta directly from CAPM? The formula, as our client provide us, was:

RP=RF+BP(RM-RF)

Translation: the portfolio's expected return equals the risk free rate, plus the portfolio's beta times the difference between the benchmark (or market) return and the risk free rate. Simple algebra suggests that if one knows the risk free rate, market return and portfolio return, one can easily derive beta, yes? Simple, yes? Unfortunately, this doesn't work, for at least a couple reasons.

First, Fama/French (as well as others) showed that the expected return isn't derived just from beta: they posited a 3-factor model which has been deemed superior to the single-factor CAPM approach. Second, the formula as provided is missing an "error term," which is needed because, as just mentioned, the formula is flawed ... beta doesn't cover everything. The "=" sign should be replaced by an "≠" (i.e., not equal) sign, thus negating the simple algebraic approach.

More was discussed and this month's newsletter will be replete with some of this material.

Verifier independence, revisited

Last Wednesday I offered some thoughts regarding verifier independence and perhaps wasn't clear. Simply because a firm does a client's audit shouldn't preclude them from taking on the verification. Independence needs to be reviewed regarding the full breadth of the services offered. As for the case I cited (about an accounting firm not taking on a client's verification), while I don't have any specifics it most likely was done because they were already doing a great deal of work for the client and felt that the additional task might be problematic.

No question that the subject of independence is a difficult one. What might be clearly a conflict in one person's eyes might not be in another: this is one reason that the determination of independence is to be done by the verifier and client.

Being fee conscious

In this weekend's Wall Street Journal, Jason Zweig discusses the importance of being conscious of fees. Our industry has worked towards encouraging managers to be more forthright regarding the impact of fees, but perhaps more is needed.

After-tax returns is an extension of this matter as it provides the investor with greater insight into what they're actually earning. Unfortunately, the after-tax standards first promulgated by the Association for Investment Management and Research (AIMR) and later included in the GIPS(r) standards, only to be scheduled for elimination in January 2011, didn't achieve the attention their developers expected: I think there was a "Field of Dreams" belief of "build it and they will come," but few did.

Investors, especially less sophisticated ones, need to get the full story about what they will end up earning, after fees and taxes are removed. More work is definitely needed here. Glad to see that Mr. Zweig is providing some much needed visibility to this topic.

Verifier independence ... what does it mean? (Should your auditor be your verifier?)

GIPS(R) has verifier independence guidance which is intended to ensure that a firm claiming compliance with the Standards is having a verification truly done by an independent third party. But what does this term really mean? We see two sides to it:

First, is there a risk that the verifier will verify their own work. For example, verifiers can't manage the process to achieve compliance, can't make decisions relative to becoming compliant, can't calculate returns, and can't make decisions about composites. Verifiers also can't prepare presentations, though we're aware of a couple who have been known to do this (a nice service, but it violates the rules).

Second, the verifier shouldn't be doing SO much other work for the client that they're biased in making their assessment as to the firm's status vis-a-vis the standards. For example, can a firm who conducts the accounting audit also do a GIPS verification? This is unclear, though we know of at least one of the "big four" firms who won't do this because they see it as a conflict. And while we're aware of smaller CPA firms who will gladly take on the GIPS work for their accounting client, we believe that this is wrong. Might the accounting firm's judgment be impaired when they realize that a negative report might cause their client to rethink who will do next year's audit?

Independence is to be decided jointly by the manager and the verifier, but both should be thinking about what the right thing is.

Hedge funds & GIPS

We are finding more and more hedge funds pursuing GIPS(r) compliance. We are pleased to see such interest as well as to count hedge fund managers among our verification clients.

While some believe that GIPS says everything that's necessary regarding hedge funds, we beg to differ. Dealing with side pockets, fees, and valuations are only a few of the matters which need further clarification.

Some time ago we launched, through the Performance Measurement Forum, a working group to develop guidance for this segment of the market, which would go beyond GIPS and encompass return measurement, risk, and attribution.

Because of schedule conflicts and other priorities, we have permitted the group to languish for a bit, but will soon resurrect it so we can complete our pursuit of this much needed material. Stay tuned for further updates.

Happy Columbus Day!

In spite of the pressure to do away with this holiday, there are many of us who fully support it, and so ...

Happy Columbus Day!

Do hedge fund managers misreport returns?

The current issue of The Journal of Finance (October, 2009) has an article by Bollen & Pool titled "Do Hedge Fund Managers Misreport Returns? Evidence from the Pooled Distribution."

It seems that there's "a sharp discontinuity in distribution [of returns] at zero." "The frequency of returns just below zero is significantly lower than expected, whereas the frequency of returns just above zero is significantly higher than expected." Further, "the entire distribution to the left of zero appears deflated relative to the corresponding mass to the right of zero."

Why would this be? There are more than a few reasons. For example, investors don't like to see negative returns, no matter how small they might be. Also, investors typically respond to positive returns by investing more money into their portfolios.

The presence of less liquid assets appears to possibly be the source of the return discontinuity: that is, the question of how these assets are priced. "Managers have more discretion when valuing illiquid securities." Their "results suggest that some managers distort returns when possible," suggesting "the purposeful avoidance of reporting losses."

Oddly (coincidentally?), the disparity disappears around the time of audits, suggesting that some oversight may be needed.

We should find the empirical evidence and the authors analysis troubling. GIPS(r) will require the use of "fair value" pricing effective 1 January 2011, which might help with this. Further suggestions on pricing of less liquid assets might also be needed, if additional evidence surfaces which calls into question the appropriateness of what's taking place. At a minimum, this article raises loads of questions.

Performance measured and rewarded?

I will rarely make any political comments here, but this time I simply can't help it.

Yesterday's announcement that U.S. President Barack Obama is this year's Nobel Peace Prize recipient is just too amazing to pass up. The beauty of investment performance measurement is that it's non-subjective ... we measure results mathematically. Granted, we might disagree on the methodology, but we still use numbers. Subjective measures are much more difficult and are often subject to bias. I think we're witnessing such action right now.

But, I won't say any more than that. I will let Peggy Noonan do the talking: http://online.wsj.com/article/SB10001424052748703746604574464083239280914.html.

p.s., out of fairness, here's a different view on this topic: http://www.youtube.com/watch?v=GMJuEOaF84o

Consolidated reporting

Many firms like to group a client's accounts together, to provide a consolidated report that presents the client with the "overall picture" of what they hold. This is commonly done in the brokerage arena, as well as by others. So, how does one calculate performance for such an arrangement?

Well, what question are you trying to answer? I believe it's "how am I (the client) doing, overall?

And if so, then the answer is quite simple: a money-weighted return. Ideally, we'd use the internal rate of return to do this, though Modified Dietz would work as an approximation to the IRR.

Mea culpa

"As with all generalizations
it may be both exaggerated and unfair"
Pablo Triana

Anytime one hints at a generalization, they're bound to offend one or more individuals. In my "Letter from the Publisher" in the current issue of The Journal of Performance Measurement(R), as well as once or twice in my blog, I've touched on how accounting firms have occasionally let us down in their oversight of client financials. By no means was this intended as a generalization...if anything, most of the time accounting firms do what is expected of them; just as we'd expect that most of the time the rating agencies perform in a proper manner. It's those "tail events" that get most of the attention. Recognizing this, I should avoid any hint that these problems are any bigger than they are. Granted, when they hit they get a lot of attention.

Just as with the scandals involving the Catholic Church a few years ago, most priests are far from being pedophiles; unfortunately, that didn't stop some folks from offending quite innocent priests with their insensitive remarks. My remarks, too, may at times be insensitive, and for this I offer an apology.

Measuring

Methodology, like sex, is better demonstrated than discussed
- E.E. Leamer

I'm reading Measurement, Design and Analysis by Pedhazur & Schmelkin for a course I'm taking and am finding it quite interesting. While we often address topics such as how to measure returns or risk, there is an entire discipline that addresses the broader subject of "measurement."

One thing the authors address is the average, something many of us calculate regularly. When it comes to performance, the reality is that in many cases, NO ONE gets the average return! Think about your GIPS composites: you show an asset-weighted return (which is an average), but do any of the accounts in the composite achieve it? In my experience as a verifier, it's not uncommon to find that no one does. This is one reason we require a measure of dispersion, to show the breadth of returns around this average.

There is such an allure, an almost magical quality,

in specialized terminologies, in formulas and fancy analyses
- Pedhazur & Schmelken

The authors suggest "that the choice of an analytic approach is by no means a routine matter," and I suggest that many of us wrestle with this on a regular basis. We are frequently told by firms that they have to report time-weighted returns, and sometimes I ask "why?" The typical response: "because GIPS requires it." BUT, in many of these cases GIPS doesn't apply, and yet they believe they're bound to the tradition of using time-weighting, even when it doesn't make sense! To paraphrase these authors, "returns and risk measures are generally presented with little or no attention to substantive context, the characteristics of the manner in which they are applied, or the properties of the measures used." To extend my paraphrasing a bit further, "knowledge of the methods and analytic approaches employed is essential for critical evaluation of a performance or risk report." But how extensive IS this knowledge?

The authors cite D.A. Freedman's exhortation to "start a new trend." Well, Steve Campisi, Stefan Illmer, and a few others have joined me in an effort to do just that, regarding at least the way we measure returns, and more likely much more. As I continue to make my way through this 800 page book, don't be surprised if you see further references to it in the future.

p.s., if you're wondering how the lead quote fits in, I can't recall ... I'm sure I had a good reason for using it, other than it sounded neat. Plus, it gave me the opportunity to show off one of my favorite clip art pieces!