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.

Accuracy in reporting

We all by now know of Madoff's illicit activities, which resulted in many victims, the most recent being his older son who took his life last week. But even Bernie can't compete with the leader of North Korea in reporting HIS performance. Okay, maybe I accept the 300 perfect game the first time he bowled ... was probably just a lucky streak. But a 38 under par golf outing? Well, maybe that's a bit of a stretch.

I guess his claims are such that anyone familiar with these sports KNOWS they're bogus. And I think THAT'S the point ... that if you're knowledgeable, you can quickly see through someone's lies. But the problem is that sometimes even the brightest fall victim.

Everybody complains about the weather, but ...

You've no doubt heard the expression about the weather and no one doing anything about it. Well, we could apply the same idea to information, especially regarding risk, and how firms measure and manage it. There is great interest in understanding what firms are doing, but how many are willing to participate in the discovery?

Well, to learn you have to give; that is, you have to be willing to explain what you do in order to learn what others do; at least when it comes to the survey that The Spaulding Group has undertaken, along with Capital Market Risk Advisors. But time is running out!

We encourage you to take just a few minutes of your time to complete the online form; this will entitle you to receive a complimentary copy of the results.

Unintended consequences

Performance attribution seeks to identify how a manager's decisions contribute to their returns; and while there is sometimes controversy about using at a model that analyzes things separate from these decisions, there can often be benefits as a result of seeing how unintended actions impacted the results.

No doubt Bernie Madoff never expected that his greed would result in the suicide of his older son, Mark, as reported today.Apparently the pressure of the investigations and at least one lawsuit was such that he felt there was no alternative. I have known individuals personally or through connections who took such action, and know that what they leave behind is usually a family that is devastated and stricken beyond imagination; no doubt this is happening with Mark's family.

We all have heard that his sons were apparently unaware of Bernie's crimes, and there is no way to know for sure, but I can see how this could have occurred. Regardless, I am sure that Bernie never expected that his actions would cause one of his sons to take such a drastic step. Bernie's actions have been tragic for so many, and here's just another sad example. My heart goes out to Mark's wife and children.

The table is turned on me

Over the past 14 years I've conducted numerous interviews for The Journal of Performance Measurement(R); these have always been great moments and have allowed me to meet some very interesting folks.

I was honored when IPA asked to interview me. Please check it out!

Getting by without a PC

I was called for jury duty and served today. My wife told me that I wasn't permitted to bring my PC with me, so I left it home. I learned after arriving that she was wrong (this time; she's usually right); they even had free wireless!; and so was pc-less when I could have been connected. Well, it turned out that being without the PC for most of the day didn't result in any damage to my health; and my inability to immediately respond to e-mails didn't cause any challenges.

I brought a textbook with me to study for an exam (scheduled for this coming Monday), and so the distraction of periodically looking on the PC to check e-mail or the stock market wasn't present, which allowed me more concentrated time. And since no one ended up being called (even if I had been, I wouldn't have been picked, given my prior stint as mayor (which allowed me to select both cops and judges, and to be sued a number of times)), I had several hours to devote to studying. A very productive day, I must say. And so, being without the PC for several hours isn't a bad thing. It's funny that I didn't want to go...glad I did!

Compounding is great, but is it always the way to go?

I recently discussed why we multiply our returns (plus one) when we compound. And I've written about the challenge with dealing with fees. But today I want to discuss handling "hurdle rates" in our indexes.

Let's say that your mandate is to beat a particular index by 100 basis points; how do you calculate your index to handle this? Many (and perhaps most) firms will take the monthly equivalent (in this case, 0.083%) and add it to that month's index return, and compound as we do with returns. The problem with this approach is that by the end of the year, those 100 basis points are no longer visible; in reality, the annual benchmark will likely be either higher or lower than this hurdle, because we're compounding the monthly hurdle rate by the monthly returns of the benchmark. Here are a few examples:

As you can see, the higher the annual return of the index, the larger the difference between it and the benchmark (which includes the compounded monthly hurdles); and the lower the return, the lower the hurdle. Does this make any sense? I think not.

If your mandate is to beat the index by 100 bps, then the benchmark should reflect this. Of course, if your contract specifically calls for this approach, then you need to be aware that your target will be unknown until the end of the year.

In my opinion, you should compound the index returns but simply add the monthly hurdle. And since we're not compounding the hurdle, it may make sense to simply divide it by 12, rather than compute the amount that you would need to compound it.

I will be addressing this topic in greater detail in our monthly newsletter, and welcome your thoughts.

Oh the places you'll go...

My wife got me a huge wall map for my birthday to annotate where I've traveled. It's pretty cool and will adorn one of my walls in my office. It comes with magnetic pins just for this purpose. And so, what's the point?

Well, just to mention that one of those places was Dallas, Texas, for the spring meeting of the North American chapter of the Performance Measurement Forum. And the highlight for some was a visit to the Dallas Cowboy's new stadium, which was also "pretty cool." Our group photo:

A cool tool!

We held the Fall meeting of the Performance Measurement Forum this week in Dallas, Texas; as usual, there was great discussion and much to learn. The highlight may have been a tour of the new Dallas Cowboys stadium.

One of the things I learned was a technique in Excel, which I suspect most people aren't aware of. Let's say you want to calculate the quarterly return in Excel based on monthly returns of 1%, 2%, and 3 percent. If you're like me, you would add one to each of these numbers, multiply them together, and then subtract one; something like:

While this clearly works, it requires you to add an additional column, which at times might not be convenient. Here's where the neat trick comes in:

• key in "=product("
• select the cells you want to multiply together (in our case, the ones with the three monthly returns)
• key in "+1)-1"
• and then, instead hitting "enter," hold down the "shift" and "ctrl" keys and then hit "enter."

Try it...it works! Pretty cool, I think. This process creates an "array," which I had never heard of before. There are apparently other neat tricks you can do with this, too.

I credit my friend Neil Riddles for educating me on this.

"Risk Premium" makes the big time!

In yesterday's Wall Street Journal, Marcus Walker and Brian Blackstone's "Europe's Crisis Widens" article includes the following text: "Bond markets across Europe's vulnerable fringe sank, as the 'risk premium' investors demand for lending to Spain and Italy hit record highs." I was pleased to see the use of the term "risk premium," which the authors felt compelled to place in quotation marks but failed to explain. Perhaps they (understandably) felt that anyone who was unfamiliar with the expression could easily "Google" it and uncover a massive amount of information.

We include discussions on this topic in our Fundamentals of Investment Performance course, and so this article will be a reference in the future, as it points out how the market can demand higher interest rates when its concerned with an issuer's solvency. In this case, we're speaking of countries within Europe who are having difficult times.

Are these debt issuers obligated to increase their payments on already issued bonds? No, the bond prices will fall in order to provide purchasers with a higher effective yield on their investment; those who hold the debt will, of course, see the value of their portfolios drop as a result. And going forward, as these countries issue new debt, they will likely see a demand for higher rates, which will, of course, mean higher costs to their country. The article also points out that the rating agencies are beginning to consider downgrades; interesting that the downgrades aren't leading the way, but are in response to the market's demands for higher yields to compensate for the higher perceived risks.

While the issue of "risk premiums" has, at times, come under attack, the reality is that we find this concept in numerous places, including the Sharpe and Treynor ratios, and Jensen's alpha. And some fixed income attribution models employ the premium to calculate the "spread effect."

If we can obtain a certain return for virtually no risk, we should be entitled to a higher interest rate if we're going to invest in something that has a higher risk; thus the risk premium.

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.

Do the letters mean anything?

Does it really mean a lot if someone has a string of letters after their name, such as PhD, CFA, CIPM, CPA, CAIA, FRM,...?

Well, I strongly believe that the answer is "yes"!

First, each set of letters represents an achievement. They indicate that the individual had to do something in order to be awarded the letters.

Second, they bring attention to the organization(s) that bestow the letters and the industry for which the letters are linked.

Take, for example, the CIPM: Certificate in Investment Performance Measurement. They let us know that the individual has achieved a certain breadth of knowledge in the field of investment performance measurement.  But in addition, they indicate that the field is one that is worthy of recognition itself. Performance measurement is a profession in which many very talented individuals have decided to invest their time and energy; why shouldn't they and the industry they serve get this recognition?

I'm a bit surprised by the number of investment performance measurement professionals who haven't yet pursued the CIPM certification. Granted some might say "well, I've been in the industry for 20 years so I don't need the certificate," which is definitely a truism. My friend Carl Bacon could have easily said this as Carl has achieved quite a degree of notoriety over the years, most of which is well deserved ... (sorry; just kidding! all is well deserved). But Carl decided to pursue the certificate in the very first "class." And why? I believe to honor the profession and the program. Others such as Neil Riddles and Douglas Lempereur did this, too, even though each of them is a CFA charter holder. The latter two, I believe, add credibility to the notion that simply because you have the CFA (as if obtaining it is "simple") doesn't mean you have achieved the breadth of knowledge about investment performance which the CIPM program tests you for.

If you're fairly new to the world of investment performance, you should pursue the CIPM certification in order to gain the knowledge and hopefully designation which will indicate to others what you've accomplished. And if you've "been at this game" for some time and believe your years speak for themselves, then I encourage you to still pursue the CIPM, if not for you then for the industry.

I occasionally hear folks say "well, the CIPM program hasn't yet caught on so why bother." Well, of course it won't "catch on" until folks like them DO bother. So make the investment: in yourself and in the industry!

"All actual, fee paying, discretionary accounts... what does it mean?

Often when meeting with clients or teaching a class on the Global Investment Performance Standards (GIPS(R)), I mention the basic requirement that all actual, fee paying, discretionary accounts must be included in at least one composite. But what do these words mean? They can be confusing, so let's briefly touch on them:

1. Actual: a REAL account; i.e., not a model account, the results of back-testing, or a hypothetical account. You ARE permitted  to show the results of model, back-tested, and hypothetical accounts as supplemental information, but their results cannot be linked to those of an actual account and they aren't to be included in composites.
2. Fee paying: the client pays an advisory fee for the investment services. Granted, you can include non-fee paying accounts in composites, too, but additional disclosures are needed if you do this.
3. Discretionary: this is the most challenging word. We're not talking legal discretion, but rather the ability for the manager to execute their strategy. That is, if a client has imposed restrictions will their results be representative of the composite's style? If yes, then it's fine to include them; if no, then the firm should have a policy that would exclude them.

Hopefully this makes sense.

Trends in performance measurement...

We were recently asked by a client to come up with a list of current trends in performance measurement. In collaboration with my colleague John Simpson we propose the following:

1.    GIPS 2010(R)
2.    We are seeing non-traditional sectors (alternative asset classes, such as real estate, private equity, and others, along with hedge funds) showing interest in GIPS.
3.    We also see increased interest in the retail market for GIPS compliance.
4.    GIPS verifications are definitely up; don’t know if this is a result of Bernie Madoff, the market downturn, or both or something else, but we get inquiries from lots of firms who want to get verified; in some cases these are firms who have been claiming compliance for some time, while in other cases they’re firms who are also wanting to become compliant with the standards
5.    Money-weighting (granted, WE do a lot of talking on this subject, but many of our clients, too, find it of value)
6.    We are seeing some interest in reviewing report packages, to ensure that what is provided is appropriate; either us do the review of they do a self-review; some of this translates into report design, as you would expect.
7.    There seems to be some interest in reporting standards, though I think reporting guidelines would be better and I think this is what most folks really mean
8.    Ex ante (forward looking) risk
9.    Data quality; is the data scrubbing sufficient? this also includes validation, to some extent, of the indices.
10.  We continue to see interest in fixed income attribution
11.  CIPM Program
12.  Balanced portfolio attribution.

And so, what do you think?

Getting the returns right...

Earlier this week I posted on calculating returns for employee stock purchases and promised that this would be addressed at length in this month's newsletter. Well, our friend (and frequent commenter to this blog) sent me a note, which I want to share with you:

Dave:

I really don’t get your case study on linking and annualizing returns. Take a look at my attached spreadsheet which illustrates my understanding of your scenario.  Here are my issues:

1.       You are compounding returns that are instantaneously granted through the discount stock purchase program. But, this is a one-time granted return and it only affects the initial purchase amount. It does not compound against the purchases previously made.

2.       You assume there is no price appreciation over the purchase period, so what is there to compound? There are no market returns that affect the prior invested amounts.

a.       I added a column that randomly generates returns within +/- 10% per quarter. However, you can overlay this with zero returns if you wish.

3.       I treat the initial purchase as something that grows instantaneously at the beginning of the period, and then at the end of the period the additional amount is added.  This allows the initial purchase to get the discount adjustment gain, and then be subject to market price change. Again, the market change can be switched off.

4.       I calculate a simple gain against the average invested amount (it’s like a Dietz return) and it equals the 60% you state in your question. It’s a reasonable and intuitive measure of value gained from the discount program.

5.       I also calculate an IRR that is “annualized” although I don’t think that either compounding or simply multiplying are perfect. You’ll note that neither of these are close to your compounded value of near 75%. Again, I think your error is because you are continuing to compound the original 15% gained at purchase against the entire accumulating amount. This is wrong, as the discount only applies to a single purchase. That said, there really is no compounding here. The mechanics have gotten ahead of the question and the investment scenario.

I don't know how to attach a spreadsheet to a post (or even if this is possible), so if you want to see Steve's spreadsheet, send me a note and I'll pass it to you.

I greatly appreciate Steve taking the time to chime in, and have no disagreements with his arguments.

Hedge funds & the GIPS standards

We were on the phone today with a small hedge fund manager who wishes to comply with the Global Investment Performance Standards (GIPS(R)). First, we think this is GREAT, since there is clearly a trend in this segment of the market to achieve compliance. BUT, there is a lot of confusion here, beginning with how hard can it be? Well, it aint that hard...for a hedge fund manager, that is.

Recall that the standards require that all actual, fee-paying, discretionary accounts to be in at least one composite. Okay, great. And what does that mean in the world of hedge funds?

Well, since most hedge funds managers manage a limited number of funds, where each is distinct from the others, we're usually talking a one-to-one relationship; that is, one fund = one composite. And so,

• the return of the fund equals the return of the composite. 
• the fund assets are the composite's assets
• there is no measure of dispersion
• and since most hedge funds limit cash flows to once a quarter or once a month, the returns are fairly easy to calculate.

So, the work shouldn't be too complex.

This doesn't mean there aren't issues (such as how do you deal with side pockets and how to value certain assets), but it's definitely not as challenging as it is with most long-only managers.

If you know of a hedge fund manager that wants to comply but can use help, please point them our way! They can call (732-873-5700) or e-mail (CSpaulding@SpauldingGrp.com) Chris Spaulding for more details.

VaR pitfalls

I am very pleased to announce that the NYSSA has published a brief article of mine on the Pitfalls of Value at Risk. I had written an earlier background piece on VaR for their journal, so this can be viewed as a follow-up piece. Hope you have the chance to review it, and please let me know your thoughts.

Annualizing and linking returns: a case study

I got an e-mail question on Friday with the following request: We have a discount stock plan at our firm. You can buy discounted stock at the end of each quarter and can sell it immediately for a 15% profit.  The question arises about what your annual return would be.

"Many of my colleagues argue that 15% a quarter sums to  60% annually (ignoring geometric linking which cannot apply since there is no compounding).  I have a problem with this because the money invested is four distinct unrelated transactions and if you divide the total gain by the sum invested you would get 15%"

When I first considered this problem I focused only on a single execution, to determine the annual equivalent (recognizing that it's generally inappropriate to annualize for periods less than a year). If we treat this as an event for a quarter, then the process is pretty simple:

• Add 1 to the return (1.15)
• Raise it to the inverse of the period expressed in years (1/0.25)
• Subtract 1.

And our answer: 74.90 percent. This is the annual equivalent of that single quarterly event.

If the ability to generate a return quarterly is 15%, then we could geometrically link four quarterly returns of 15% each:

• Add 1 to each return (1.15)
• Multiply them together
• Subtract 1.

And we get ... 74.90 percent return!

p.s., The same day I got this e-mail and did the analysis, a technician came to my home to winterize the sprinkler system. The cost for the service? $74.90. Kind of weird, right?

p.p.s., If you think this is the last word on this subject, you'll be pleased to learn that we will address this at much greater length in the November newsletter. As you'll see, depending on one's perspective, we can get different answers!

There are no original questions, only original answers

This thought occurred to me when a few of us were wondering about a particular issue, and thought of posting it on Google. Through experience we have come to realize that whatever question we come up with, someone has asked it in the past. And while there may not be consistency in answers, there should at least be some help available from some source.

Sometimes, when asked a question, a person will speak "with authority," as if surely their answer is the only correct one, when in reality it's merely their opinion. I am no doubt guilty of this, myself, and should qualify some responses with "in my opinion."

I am finding that in academic writing, when making a case, the author/researcher must draw upon the existing body of knowledge to support their position. It is not unusual to find well in excess of one hundred sources referenced in these articles. As I pursue my doctorate, I am faced with this challenge, and will be drawing upon much of what exists in the performance literature (as my topic, no surprise I'm sure, is performance-related).

If a person only quotes materials that he/she has written as authoritative proof of their position, one might be understandably skeptical. This doesn't necessarily mean the person is wrong; just consider that there's minimal evidence to support their claim. On the other hand, having loads of documents to back one up may not necessarily mean that they're correct, either. This, of course, can make this analysis quite frustrating.

When we take over from another GIPS(R) (Global Investment Performance Standards) verification firm we often find situations where mistakes were made. Occasionally, when we offer a different opinion, the client may think that it's merely a "matter of opinion." This, of course, might be true. Fortunately with GIPS we have the standards themselves, guidance statements, and Q&As to turn to for support. But these may still not be sufficient, in which case it's necessary to be able to build a case for a position which is close to being irrefutable.

We receive questions on almost a daily basis. Oh, and contrary to this post's subject, some of the questions are original! Our industry is still, in a sense, in its infancy with much still to be discovered. Consequently, the answers aren't always obvious. And, our answers might change as new information is presented or discovered. This, I believe, adds to the enjoyment of performance measurement.

Consistency in performance

I recently came across the attached clip from USA Today, which was actually published several years ago (I had saved it). While it may be a bit hard to read, what we are seeing is that one of the judges asked a contestant to "tone it down," which he did. The following week he was criticized for not "exuding more." What's the point? Inconsistency.

Years ago, while attending an ROTC officer training summer camp, I experienced similar swings in directives from the officer who was in charge of my group. There was a huge swing in his approach the second time I was evaluated compared with the first. This was frustrating and impossible to deal with.

With performance measurement, consistency is often thought of as an important criteria to employ.  Changing the rules in a conflicting manner can be a huge problem.

That doesn't mean we can't make changes, but they should be understood, rationalized, justified, and communicated. For example, going from Brinson-Hood-Beebower to Brinson-Fachler for your equity attribution will result in some pretty big changes in the allocation effect. Knowing this, understanding it, and communicating what may occur is very important.

Introducing money-weighted returns isn't a contradiction with consistency because we wouldn't introduce it to measure the manager's performance; rather, it would be to supplement what is done and to provide the client with the return on their portfolio (i.e., how they performed).

Consistency is something to be mindful of when employing performance measurement systems and approaches.

The art of writing is rewriting

As someone who loves to write, I learned a long time ago that there really is no such thing as "writing," per se; rather it's rewriting. One must be prepared to write, revise, and revise again. Often with letters and reports I do this many, many times. Today of course such acts are pretty simple, but before word processors they were much more challenging.

My last job in the Army was in the Field Artillery's Directorate of Evaluation, where as an operations research analyst I engaged in studies, which resulted in rather lengthy reports. Fortunately, I didn't type the reports: we had civilian employees who did this. But, because the best we had were IBM typewriters, when we made revisions the entire document (or at least the pages affected) had to be retyped. And revise and revise again we did.

Allegra Goodman discusses this topic in a WSJ article this weekend; I encourage you to read it. It's quite brief, and the investment will be a good one. She points out the even the best writers revise.

Often even with the Blog posts I revise and revise and still miss things. Take yesterday's post, for example. I read through it about four times, making slight changes each time, but still managed to miss an error in a calculation (a calculation I've written hundreds of times, mind you). Thanks to my friend Steve Campisi the error was caught and corrected.

We revise for a number of reasons:

• to find errors, such as in formulas, grammar, word choices, and spelling
• to eliminate text that we don't need
• to make our writing better
• to replace passive verbs with active ones
• and on and on. We can always find some way to make improvements.

I rarely let something go without at least one review; and when I fail to take the time to read through at least once, I often later find out I had made an error. Even e-mails should have a read through or two; but unfortunately, in my haste to get something out it often includes a boo boo or two, which is regrettable and inexcusable.

I also love it when someone else reviews my work.  Many of my more important letters and reports get reviewed by one or two folks in the office. Granted, neither are English majors, but they both are pretty good at finding things, which is good. I also often ask my wife, Betty, to review my work, as she's great at catching things, but since she doesn't work for us I can't take advantage of her copy editing as often as I'd like.

And so, what does all of this have to do with performance measurement? Not much, but let's simply call it a weekend diversion, sparked by Ms. Goodman.

Which version of Modified Dietz is better?

This week I'm reviewing a software vendor client's system and saw that they used a version of Modified Dietz which we typically don't see. Here's the normal form:

and here's what they use:

In reality they will provide the same result so it really shouldn't matter which we use, right? In fact, I was first introduced to the second formula way back in the 1980s. I prefer the first version because I think it's more intuitive. What are we doing in the second? Does it make sense? Can you explain it?

I have reflected on the first form quite a bit and think its meaning is clear:

To me you can rationalize what is being done; not so easy with the first version. I think the first is a bit more challenging to implement, too, so I vote for #1! How about you?

"We calculate IAW the GIPS standards..."

The first thing you may be wondering is what "IAW" stands for; and no, it's not an abbreviation that is being used by twitters or text messagers (at least not that I'm aware of). The military loves abbreviations and acronyms (oh, and they're not always the same thing), and long ago when I was in the army I frequently used IAW to mean "in accordance with." I'm not trying to encourage its use ... just decided to slap it in here for a change.

Okay, now to the topic. The GIPS(R) standards (Global Investment Performance Standards) prohibit firms from stating that their returns are calculated according to GIPS, except when reporting to clients. But what if you're asked "are your returns calculated in accordance with the GIPS standards?" Must you say "sorry, but under penalty of law (or the nearest thing) I refuse to answer! Nah. Of course you can answer. But you shouldn't be stating this in your own materials.

What about software vendors? Nothing has been issued regarding this group, but I think they should be considered a "special case." They're selling software to help firms comply with the standards. And consequently, it's imperative that they be able to state what aspects of their software conform to the standards. And so if a vendor has a statement such as "our returns comply with GIPS," in my opinion, it's okay. What isn't okay is for the vendor to state that their software is "GIPS compliant." Only asset managers can comply; software is a tool to help them comply!

p.s., What did I mean that acronyms and abbreviations aren't always the same? Acronyms are abbreviations that can be spoken as a word, for example GIPS, RADAR, and NASCAR. Since not all abbreviations can (e.g., IAW, COB, NLT), not all are acronyms!


p.p.s., I just used two other abbreviations we, in the military, used: COB and NLT. It wasn't unusual to end a memo, for example, by saying "Your response is due NLT COB Friday.": meaning "no later than" "close of business."  Just a bit of useless trivia as we end the week!

But there's no difference in the numbers!!!

In addition to doing GIPS(R) (Global Investment Performance Standards) verifications, we also conduct "non-GIPS" verifications, for firms or individuals who can't comply with the Standards, but still want their numbers reviewed. And occasionally we discover return methods which seem a tad irregular. For example:

• a calculation that treats all cash flows as if they occur on the first day of the month (even when they don't)
• a Modified Dietz implementation that only values the portfolio once a year (i.e., that weights the flows across the full year).

You're probably not surprised to learn that we reject these methods, and insist that the client use a more standard method. They are understandably frustrated, however, when they find that the results aren't very different from what they had previously calculated. This can be because their composite has a lot of accounts, because there aren't that many flows that occur, or for some other reason. One client, before fully implementing the change, did a sample test and found the results to be relatively close to what they previously had. This, of course, makes us a bit uncomfortable: do we say "okay, you've proven that your method works, so don't worry about it" or "sorry, your method is still faulty regardless of the comparability of the results, so you have to extend the exercise to the full set of portfolios"?

One could no doubt construct an argument for either approach. We have taken the more conservative one and require the client to fully implement a more appropriate method. To "sign off on" a verification report that used an irregular method would lend credence to the method and serve as an endorsement for it, which would totally conflict with the industry's clear aim to provide the most accurate information possible. We don't insist that clients who don't comply with GIPS adhere to the GIPS rules, but we do expect them to use methods that have been deemed acceptable.

GIPS & UMAs ... perfect together?

We have had a few clients raise questions of late regarding how UMAs fit within GIPS® (Global Investment Performance Standards). The two major questions: (1) Are these accounts to be included in composites? (2) Are they included in firm assets?

"UMA" stands for Unified Managed Account, and can be viewed as an extension, if you will, of a wrap fee account, in that it’s a separately managed account (as opposed to a pooled account or mutual fund), where the investor is typically participating in a sponsored program that’s offered by broker/dealers and other financial institutions. They typically allow the client access to multiple managers who are providing management of various investment strategies.

UMAs differ from wrap fee accounts in that the managers usually provide the sponsor with their model, and it’s up to the sponsor to execute the trades associated with the model. And unlike wrap fee programs, the investor isn’t a client of the manager; rather, they’re a client of the sponsor and don’t have a direct relationship with the manager.

When these types of accounts (that is, where a manager provided their model to a third party to execute for their clients) first surfaced, the answers to how GIPS fit in were pretty clear: they didn’t! That is, if a manager merely provides their model to another manager or a sponsor who is then responsible for executing it, the manager has no way of knowing (a) whether it was, (b) whether it was done properly, or (c) when it was done. The manager receives a fee (which is often tied to the amount of assets) for their model, but they have no direct oversight for the assets. Therefore, the accounts aren’t to be included in composites and the assets aren’t part of the firm’s asset’s under management: these are “advisory assets,” and are therefore excluded from the firm assets.

Of late we’ve seen a graying of the lines occur, where it appears that some programs place the managers into a role where they “may have discretion” over the assets. They again pass their model onto the sponsor, but it’s understood that the sponsor will execute it in a timely manner. In these cases, the UMAs are looking a lot like wrap fee relationships, and one could argue that the accounts are to be in composites and the assets are part of the firm’s AUM.

These programs afford us an opportunity to step back and perhaps simply consider when an account would or would not be required to be in a composite, and whether or not the assets are firm assets. Here are some tests which might help:

1. Has the client signed an agreement with the manager directly, whereby the manager assumes (full or partial) discretion over the client’s assets, or is the manager formally defined as a “sub-advisor” to the sponsor?
2. Is the sponsor obligated to carry out the manager’s model directions, including trading and rebalancing?

I originally thought there would be more issues, but believe these two should suffice. If you can answer “yes” to both, then you’d be obligated to include the account in a composite (unless they fail to meet the firm’s discretionary policy, of course) and the assets in the firm’s AUM. Granted, I think it would be difficult to see a situation where you’d answer “yes” to the first and “no” to the second, but that’s not really an issue. The manager must have confidence that their trades are being executed and that they have clear responsibility for the assets.

Can discretion be shared? Yes, it can, without obviating the manager’s responsibilities under GIPS.

Recall that in the world of wrap fee, the compliant firm can view the sponsor as the “client,” and the same would hold here, too. This simply means that the additional workload of shadowing client account assets may not be necessary. If the manager relies on returns and other data (e.g., market values) that come from the sponsor, they must have confidence that they meet the GIPS requirements; otherwise, they will have to maintain the necessary records themselves.

Since I’m unaware of anything being written on this topic before, what I present here is simply my interpretation of the standards and how they would apply to UMA accounts. By all means I welcome your thoughts on this topic. Perhaps this will result in a dialogue, which I would welcome.

If your UMA relationships fail these tests, can you refer to these relationships in your marketing? Yes, you can! Just don't include the accounts in composites and the assets in your AUM. You can include a separate asset number  (e.g., "assets under advisement") and include a narrative that describes the extent of this business, in order to showcase how your models are used by others.

Some GIPS compliant managers want to include these accounts, because it increases  their assets under management while others would prefer not to, because it means more work. It really shouldn't be a matter of choice; there should be clear tests that would determine the appropriate treatment of UMAs. And of course, a manager may have some UMA relationships which would be included and others which wouldn't. The manager should document these relationships so that the rationale behind their decisions is clear.

The Poseidon Effect

During our Fundamentals of Investment Performance class, when we get to the discussion of time- versus money-weighting, a question arises as to why firms continue to exclusively employ time-weighting, when it's quite clear that there's a major role for money-weighting. I typically use a scene from the 1972 move, The Poseidon Adventure, as a metaphor for one possible reason.

The scene occurs shortly after the boat has done a "180," and the major characters (Gene Hackman, Ernest Borgnine, Red Buttons, Shellly Winters, etc.) are gathered together along a corridor. Hackman (Rev. Frank Scott) tells them they need to go in the direction that is the complete opposite of where everyone else is running. Borgnine's character (Mike Rogo) challenges him, asking what makes him so sure since everyone else is rushing the other way. Hackman insists that the others are heading to their deaths because that direction won't provide a way out.

Now, if you use the wrong return formula surely death won't follow. However, our natural tendency to want to "go with the crowd" can cause us to miss out on doing things a better way. Avoid the "Poseidon Effect" and take advantage of what money-weighting has to offer.

Dispersion relative to what, exactly?

A client recently asked us a question regarding GIPS(R) (Global Investment Performance Standards) which we have heard in the past, and so I decided to post it here and offer a response.

Should the dispersion which is shown on a GIPS presentation be based on net or gross of fee returns?

Excellent question, I believe. The Standards, to my knowledge, don't address this nor have I been able to find any Q&As on it. And so I would say that it's "open to interpretation." In reality, it really shouldn't matter that much, assuming that the fee percentage is relatively consistent across the period, we wouldn't expect to see much in the way of a difference between the dispersion for gross or net-of-fee returns. The differences would be de minimis.

Must you disclose across which return it's measured? There is no requirement to do this, though it would probably be advisable. Since you probably have a statement in your disclosures which reads something like "Dispersion is calculated using standard deviation," to amend it with "Dispersion of gross-of-fee returns is calculated ..." wouldn't be difficult.

What would I recommend the dispersion be relative to? Gross-of-fee returns. I place little benefit in net-of-fee returns as they don't provide the same value to the reader as the gross returns (because most firms have a mix of fees in place, so the net return is difficult to decipher; one can always take the gross return and adjust it by the fee they expect to pay to arrive at the approximate net return they would have had). But again, it's up to you to decide.