What happens when your classification is different than the index's?

I'm at the Spring meeting of the North American chapter of the Performance Measurement Forum in Boston. One of the issues that was raised deals with the case when a firm has a different classification structure than the index and the resulting impact this has on performance attribution. For example, if a firm assigns a stock that's in the index to a different industry than what the index has.

If we ignore this difference then the attribution results are questionable. If we change how the benchmark has the security assigned then we've manipulated the benchmark and arguably falsified the comparison. If we change our classification so that it aligns with the benchmark than we might feel that this doesn't truly represent how we manage. No good solutions.

Probably the best answer is not to have a different classification. But this may not always be practical. Perhaps in those cases where the firm feels that such differences are necessary we should have a new attribution effect: "classification effect." Just as we can have "pricing effect" to identify pricing differences between the benchmark and portfolio, we can have a "classification effect" to identify the impact of differences in how we classify our securities. To my knowledge no one has done this but it can't be that difficult to accomplish.

Thoughts?

When to rebalance benchmarks

We got a call recently from someone asking how often they should rebalance their benchmark. Apparently someone within their firm is pushing for daily, but this individual was concerned with the amount of effort that would be involved.

My response was that they should ideally rebalance the benchmark when they rebalance the portfolio; to rebalance more frequently would detract from the variations which are being caused within the benchmark which would most likely vary from what they're doing, and thus eliminate the allocation shifts which may or may not be in the manager's favor. But to confirm my beliefs I reached out to Neil Riddles, aka "the benchmark king" to get his thoughts. He responded:

One of the important considerations for benchmarks is that they should be a passive representation of what the manager is doing in the active portfolio.

If the portfolio has a set rebalance period, then mimicking that makes sense.  For example, if it is rebalanced quarterly, then rebalancing the benchmark quarterly is best.

If the portfolio is rebalanced when it gets a certain percentage out of line, that policy should be applied to the benchmark as well.  For example, if the portfolio is rebalanced when it gets out of line by 10% (55/45) then the same rule ought to be applied to the benchmark.

Ideally, the benchmark rebalancing should not be dependent on what goes on in the portfolio.  So, if the portfolio rebalances on a non-regular schedule (or does not follow other explicit criteria) then we would not want to rebalance at the same time.  The reason is that, absent an investment in the portfolio, the investor could not achieve the benchmark results.

At any rate, rebalancing daily is likely to maximize the error introduced because the benchmark is trading costlessly.

I think our views are almost identical. Formal guidance would always be helpful, and we'll look to develop that at some point.

p.s. I dubbed Neil "the benchmark king" quite some time ago, using the nicknames assigned to various prisoners in "The Great Escape." For example, Steve McQueen was "the cooler king." Oh, and if you've never seen the movie, you should!

Isn't it time to verify the verifiers?

A client recently asked what the qualifications were for a verifier; the answer: none. Granted, we would expect that they understood the Global Investment Performance Standards (GIPS(R)), performance measurement, portfolio accounting, the requirements and expectations for conducting a verification, etc., but there is no way to validate this. There is no certification either at the firm or individual level. But should there be? Well, consider this.

We recently conducted a verification for a new client who had previously been verified for several years by the another firm. Now, one might argue about "gray areas," but disclosures? Our client's presentations didn't have composite descriptions! Come on, didn't our competition even have a checklist? And when I mentioned this infraction they informed me that they used to have them but their prior (not to be named) verifier told them this was no longer a requirement! Really, and where exactly is this written?

This verifier did this firm the favor (or more correctly, disservice) of providing them with a formula to handle carve-outs: take their equity returns and add 5% for the T-bill rate to represent cash. Interesting. And where exactly did they dream this up? Isn't this what one might call "hypothetical returns"? When I told them this was invalid our client at first said "let's get XYZ on the phone," to which I responded, "great, lets!" But, our client quickly decided this was fruitless. Unfortunately, this isn't the first time I have found that this particular verifier uses creative but non-compliant methods for carve-outs.

Verifiers who perform poor verifications do nothing to enhance the image of this important review process. In addition, they put their clients at risk. CFA Institute and/or GIPS Executive Committee: are you listening? Let's offer a certification for verifiers! PLEASE! I've been asking for this since 1992 ... surely it's time!

Whatever they want

I just got a call from a verification client who said that a prospect has asked to see monthly returns; he asked if he can provide them a GIPS(R) presentation just with the monthly returns rather than annual?

You can have monthly returns in your presentation but must also have annual. You can give a prospect whatever they ask for, even if it's not in line with the Global Investment Performance Standards (e.g., a representative account or an equal-weighted composite presentation), as long as you also give them the appropriate compliant presentation.

CIPM help has arrived!

We've launched a new blog: CIPM Exam Tips & Tricks. It's based, to some degree, on our popular training programs and is managed by my colleague, John Simpson, CIPM.

The site goes into detail on a number of important aspects of the examination and will no doubt prove helpful to individuals taking either the Principals or Expert level. It will also be helpful, we're sure, to anyone who's interested in performance measurement. So please visit!

Terminating composites

A client who complies with the Global Investment Performance Standards (GIPS(R)) mentioned that they have two composites which are so close that they'd like to combine them and then terminate the old composites; can they?

A firm can always create new composites, provided they abide by all the rules. In this case, the combination would create a third composite, which is the aggregation of the two that are close, thus all accounts that are in these two composites will now also be in the new one. But now the firm has three composites when they once only had two; can they terminate the two old ones now that they've created a combination of them?

Unfortunately, there is nothing in GIPS that addresses this, but I have it on good authority that yes, a firm can terminate composites! Recall that firms must have all actual, fee-paying, discretionary accounts in at least one composite. And so, as long as this rule will remain, then a firm can terminate a composite that it no longer needs. This composite name and description must be included on the firm's list and description of composites (soon to be list of descriptions) for at least five years after it's terminated. I'd also advise the firm to include an explanation as to why the composite was terminated in the composite presentation as well as the firm's policies.

Modified Dietz doesn't always do the job

We have a new client who wanted us to do a "non-GIPS(R) verification" of a composite. We do this type of work for clients who aren't able (or choose not) to comply with the Global Investment Performance Standards. We typically begin by understanding their rules since they're under no obligation to adhere to GIPS. We then validate that they have, in fact, abided by their rules. We obviously also test to see if their rules are appropriate and not misleading.

In this case we asked how they calculate returns and were told that they use Modified Dietz, which, of course, is a perfectly acceptable method to derive a time-weighted return (under most circumstances). In our client's case, because of their inability to value all portfolios monthly, they calculate the composite's return across a full year: that is, they value the composite (which is an aggregation of the member accounts) at the start and end of the year, and weight the flows across the year. Interesting.

The AIMR-PPS(R) actually allowed this approach for periods prior to January 1, 1993; GIPS has never addressed such a long period and only permits, at most, quarterly for periods prior to January 2001. And, we would argue that it's a far from appropriate approach given (a) the long period, (b) the market volatility, and (c) the presence of cash flows throughout the year. As my friend Carl Bacon likes to remind me, Modified Dietz is a money-weighted formula that achieves the status of being time-weighted by linking; in this case there would be no linking and the return is, essentially, a money-weighted one; hardly a viable way to measure a manager's performance.

We reached out to the client earlier today, and spent about a half hour explaining that while we could do this work, our report would have to include enough qualifying language to make the results less than ideal. They're now working on another approach.

Yes, Modified Dietz can work ... but not always!

Timing is everything

Please allow me to vent a bit more regarding the SEC / Goldman Sachs news.

In an editorial in yesterday's Wall Street Journal we learned that last Friday, when the SEC announced its lawsuit alleging fraud by Goldman Sachs, they announced the publication of an Inspector General report that revealed yet another SEC bungling of a Ponzi scheme, this time involving R. Allen Stanford. The editorial's speculation was that this was hardly a coincidence and was probably done so that the Goldman story got front-page attention while the latter was hard to find.

The editorial also pointed out that the report, itself, is difficult to find on the SEC's website; I wish that the Journal had provided the link, but I found it.

It was also interesting to learn that the SEC commissioners voted 3-2 along party lines to launch the suit, making this case even more intriguing, especially since it's rare that a split vote would result in such action.

Are we making up rules as we go along?

Not surprisingly, the SEC attack on Goldman Sachs got the most coverage of all stories in today's Wall Street Journal. In "Vital Legal Concept Key to Case" we learn how materiality plays a vital role in the government's case [recall how I've blogged on this topic relative to GIPS]. In "Bank Wages Battle to Save Reputation" we read what I basically suggested on Saturday, when I first blogged on this topic: from a Goldman spokesman that "As normal business practice, Goldman does not disclose the identities of a buyer to a seller and vice versa."  And in  "Role of Little Bond Insurer" we hear from Leslie Rahl who stated "If ACA performed an independent analysis and concluded that the [Abacus] portfolio met ACA's criteria, I'm not sure what the issue is." AMEN!

And again, back to my Saturday post and echoed in the last article cited, "Goldman on Friday said it has no obligation to disclose the identities of buyers to sellers and vice versa." Yes, where is this rule written again?

I learned of the SEC's creativity in coming up with new rules following their "performance sweep" a few years ago, when some firms were criticized for not informing their existing and prospective clients that they didn't revalue portfolios for large cash flows. I asked an SEC examiner where this rule existed that they were supposed to do this; of course no such rule exists. And while the Global Investment Performance Standards (GIPS(R)) at the time recommended that firms revalue for large flows, there was no obligation to do so nor a requirement that the failure to do so needed to be disclosed. And so why did firms need to disclose when they didn't revalue?

I learned a lesson ten years ago: if you want to get sued, become an elected official. As then mayor of the Township of North Brunswick (NJ), I managed to get sued several times; and in each case, we did nothing wrong. But, in each case, we settled. And why exactly if we weren't in the wrong? Two reasons: #1 cost; #2, you never know what a jury will do (think about the woman who left the McDonald's window with a hot coffee cup positioned between her legs). Unfortunately, Goldman now has to spend thousands (and perhaps millions) of dollars in legal fees to fend off the SEC.

As I suggested on Friday and stated in a WSJ's front page article today, "The move [to not inform Goldman in advance of their intent to sue, which is fairly standard practice] showed a combative streak from the SEC, which has been under mounting pressure after letting slip through its fingers early probes into the Ponzi scheme of Bernard Madoff." A new SEC that is tough, even on folks who didn't do anything wrong!

Recall how [now disgraced; then NY Attorney General; eventually NY Governor] Eliot Spitzer went after AIG's chairman Hank Greenberg, forcing him to resign, and yet nothing has ever resulted from this other than a lot of publicity and expense; looks like the same may be happening here.

Markopolis on Madoff

I just finished listening to Harry Markopolis' No One Would Listen: A True Financial Thriller. And while I've enjoyed many books more, it's still intriguing to learn of the extent Markopolis went to alert the SEC of Madoff's Ponzi scheme. For roughly ten years he repeatedly alerted them of his findings, providing enough details to justify his beliefs, but he was ignored.

There are many "must read" (or often in my case, listen) books that those involved in investing should pursue and this is one of them, given the impact Madoff has had and Markopolis' long pursuit. You'll not only gain insights into Madoff but Markopolis, himself! In his own words he is a bit of an eccentric. I think you'll enjoy it.

By the way: The Spaulding Group's May webinar will be dedicated to the topic of Madoff, with a guest presenter! Details to follow.


In the spirit of full disclosure, I want to alert you that I've signed up to be an Amazon Associate, meaning that if you make a purchase from my blog I will be compensated. I don't expect to retire on any money raised, but feel you should at least know of this new relationship. Note also that I would be recommending the book even if I didn't participate in Amazon's program.

Isn't there always the other side?

I, like many others, was surprised by the revelation that Goldman Sachs has been charged with defrauding investors. While my research into this is somewhat limited at this time, I couldn't help but be struck by a statement in today's Wall Street Journal front page article on this topic:

 "Regulators say Goldman allowed Mr. Paulson's firm, Paulson & Co., to help design a financial investment known as a CDO, or collateralized debt obligation, built out of a specific set of risky mortgage assets - essentially setting up the CDO for failure. Paulson then bet against it, while investors in the CDO weren't told of Paulson's role or intentions."

Excuse me, "setting up the CDO for failure"? In retrospect we can see that it failed, but at the time many investors were willing to bet that these CDOs were going to pay them great returns. And why would Goldman tell the purchasers that Paulson was on the other side, betting against the CDOs? Isn't there always someone on the other side? Wouldn't that be improper for Goldman to identify the other side of the trade? Shouldn't the investors have realized that someone might hold the opposite position? Didn't the investors in the CDOs recognize that there were risks with their investments? There was a housing bubble and these investors expected there to be no problems with the markets (just as countless many others did). Okay, their investment failed; they took a bet and it didn't work out. Now Goldman is charged with fraud?

Many, many individuals felt that Paulson was tilting at windmills. That his investments surely wouldn't work out. Well, they did, and they resulted in billions of dollars for himself, his firm and his investors.

Investing is a zero sum game, is it not? For every winner there's a loser. Goldman appears to have constructed CDOs (that's what happens with these instruments, right?; someone has to take mortgages, bundle them together, and create an instrument) at Paulson's request and they were able to find someone to buy them; Paulson took the opposite view.

Can someone explain how fraud enters into this? It's not clear to me and perhaps there is a lot more to it, but this doesn't seem all that horrible. Is the SEC trying to show their power because of their horrendous failure in the Madoff case?

Why measure a pension fund's overall time-weighted return?

I've seen reports (for firm that have multiple managers) that show each manager's time-weighted return, along with the fund's overall time-weighted return. What is being conveyed by the comparison? And what does the overall return tell us?

It would be unfair to compare the managers to one another, since they're investing in different asset classes, market segments, etc. By virtue of their individual market they can have vastly different returns.  If small cap value stocks are in favor while large cap growth isn't, the mere fact that the SCV manager outperformed the LCG says nothing in particular. Wouldn't it be better to show how the fund benefited from each manager? This would be a money-weighted report.

And what does the overall return tell us: the one that says how the fund did, in general, from a TWRR perspective? Not much, I'm sorry to say. It basically says how the aggregation of managers performed from a time-weighted perspective. Whoopee! Wouldn't it be better to communicate how the fund did overall? For that, we would need money-weighted returns, yes?

More to follow.

Verifiers should be CPAs ... or maybe not!

I just had the opportunity to comment on a discussion that's taking place in the CIPM (Certificate in Investment Performance Measurement) group on Linkedin. The question that was posed: "What can be done to make the CIPM credential more recognized and respected in the financial industry?"

Someone suggested that GIPS(R) (Global Investment Performance Standards) verifiers should have the CIPM; this suggestion was trumped with the notion that verifiers should be CPAs. A few others agreed with this suggestion. And, you will probably guess that all who did support this idea happen to have CPAs ... a rather self-serving suggestion. A colleague of mine from Canada (aka, the 51st state) who happens to be a CA (Chartered Accountant) has made a similar suggestion; one that obviously I take exception to.

I know that we don't want to get into a debate on the practices of CPA firms and discuss some of the irregularities that have surfaced over the years. And I also don't want to discuss how a verification is quite different from a financial audit; granted, there are some similarities, but to suggest that one needs to have gone through audit training is a bit ludicrous.

Our firm has replaced several CPA firms for clients; in every case, the prior firm had made numerous errors in their reviews. One in particular, by a very well known accounting firm, had been verifying the client for ten years, and every year giving them a verification report, even though their client didn't even have GIPS presentations for their composites! Plus, they were missing several composites. So much for the CPA designation.

I find it offensive that CPAs would make such a suggestion. The question that was posed dealt with the CIPM. While I fully support the CIPM program I wouldn't want to see possessing it be mandatory for a verifier. I would, however, encourage verifiers to obtain the CIPM as it provides them with an extensive knowledge of performance measurement; granted, not accounting, but accounting isn't part of performance measurement.

Composites, from the ground up

I received a question from a software vendor: "[can you build] a composite from the security-level holdings of member portfolios met GIPS(R) [Global Investment Performance Standards] rather than asset-weighting the ROR's? We have a client that wants to do this but I question whether it meets GIPS standard?"

The answer is "no," because the standards require composites to include cash and (as of 1 January 2010) cash must be managed separately.

However, if a firm wishes to do this for supplemental information purposes (e.g., to highlight their performance in particular asset classes, market segments, etc.) this would be fine. With supplemental information firms have a lot of options regarding how they can provide prospective clients their performance and risk information.

Why are you still here?

Fama & French's famous paper, "The Cross Section of Expected Stock Returns" (The Journal of Finance, June 1972), is credited with the "Beta is Dead" suggestion, as a result of the empirical evidence to discredit the Capital Asset Pricing Model  (CAPM), which was developed independently by Sharpe ('64) and Lintner '65). Beta has been found to be a poor predictor of a portfolio's return, with Fama and French's 3-factor model ('73), augmented with a fourth factor by Carhart ('97), generally seen as better models. In only two years we will reach the 40th anniversary of the '72 F&F paper and yet beta remains a solid part of many firm's risk measures.

Extending this further, Jensen, in '68 recognized that CAPM needed an additional factor (alpha), which some consider the manager's skill in finding performance beyond beta, generally known as Jensen's alpha and one of the many risk-adjusted return measures that are available and often used by asset managers. But if CAPM is truly dead, shouldn't Jensen's alpha be, too?

The Journal of Performance Measurement® is scheduled to include an article by Fama and French in its summer issue which does an exceptional job of describing the CAPM and addressing many of the tests which have been performed. It provides a very concise and fairly intuitive discussion of the many issues surrounding this area of investments finance. Perhaps if more in the industry understand the model's failings its constituents will be dropped from common use... but perhaps not.

We are planning a webinar in the coming months as well to discuss the model in what we hope will be an easy to comprehend manner. More details to follow.

Annualizing home runs and performance

The start of the baseball  season never disappoints in providing metaphorical examples to use relative to performance measurement. Watching ESPN this morning an announcer commented on St. Louis Cardinals' Albert Pujols' early season home run success, pointing out that if he continues at this pace he'll have 324 for the year, "shattering his career season record." That would be quite a feat. And this mathematical exercise conducted after only one game into a 162 game season. Usually I have to wait about a month to find examples; this has to be a record in prognostication.

I won't be betting on Albert continuing at this pace. But this is one of the reasons why we don't annualize returns for periods less than a year. If a manger has a fantastic January, to annualize it for a year would suggest that he is able to continue at this pace for the next 11 months (plus violate the rule about past performance not being a predictor of future outcomes).

Materiality is growing

Defining materiality can be a challenge: but if you thought doing it regarding returns was difficult, think about the other areas where it will be required for firms that claim compliance with the Global Investment Performance Standards (GIPS(R)), as a result of GIPS 2010.

Compliant firms will need to include details on their treatment of withholding taxes, if material (¶ 4.A.20). You must also disclose details regarding the use of leverage, derivatives, and shorts, if material (¶ 4.A.13).

Fair value is now being employed and it brings along a couple new requirements. If you use a fair value hierarchy which is materially different than the one recommended, you need to disclose this (¶ 4.A.28). The fifth level of the hierarchy deals with the use of "subjective unobservable inputs," and firms must now disclose if they're used to value portfolio investments, if material (¶ 4.A.27).

Compliant firms “must disclose and describe any known material differences in exchange rates used among the portfolios within a composite, and between the composite and the benchmark” (¶ 4.A.21).

The real estate and private equity rules now require firms to disclose material changes to valuation policies and/or methodologies (¶ 6.A.10.c and ¶ 7.A.14). And the real estate rules also require firms to disclose material differences between external valuation and the valuation used in performance reporting and the reason for the differences (¶ 6.A.10.d).

We find a variant to materiality in the changes to the portability rules, where we find that decision makers must remain substantially intact (¶ 5.A.8.a.i).

Much of this is highly subjective and will require some thought. We hope to provide some guidance on this in the coming months, most likely in our newsletter. And we welcome your thoughts on these issues, as well.

Getting the pricing right

I just finished listening to Gregory Zuckerman's The Greatest Trade Ever and highly recommend it if you'd like some insights into how John Paulson managed to make several billion dollars in a difficult market.

Much of the profit came from the rather esoteric credit default swaps he invested in. And because these are often private, over-the-counter deals, pricing can be quite difficult: unless there's a market, how does one price them? Other players who stumbled upon the same opportunity as Paulson found it nonsensical that their holdings were holding steady in price while the housing market was tumbling. We saw this same problem with other derivatives because of their infrequent trading. And because many of the mortgage backed issues had undeserved high ratings, their pricing was even more "out of whack."

The author discusses how Bear Stearns and Lehman's real estate holdings were overpriced: but what prices should they have used? Granted, they could have used "fair value pricing," but was this an option? Truly, a more conservative approach would have revealed much sooner how bad things were.

At a meeting of the European Performance Measurement Forum a few years back we learned of difficulties throughout Europe where managers knew their holdings were overpriced but from a regulatory perspective had no options available to adjust the pricing.

Bad prices mean bad performance. I've been hearing "GIGO" since the 1960s but it still rings true, five decades later.

What does "daily attribution" mean?

We're working with a client who needs to be able to respond to RFPs that ask "do you have daily attribution?" But what exactly does this mean? Does it mean "do you calculate attribution daily" or "can you report attribution from any day to any day"?

As I mentioned in March's newsletter, when it comes to transaction-based attribution there is no reason to calculate the effects daily: monthly works fine. But what if someone wants to report attribution ending (and/or beginning) for a day other than month-end? Not a problem: you just value the portfolio as of that date and calculate the effects between that point and the prior (or ending, if it's the starting point) month end, taking  into consideration the trading that occurs in the interim.

Why should a prospect care whether or not you actually calculate the effects daily? They should be concerned with the ability to report from any date to any date accurately, and this can be achieved without calculating daily effects.

And, as I mentioned previously, this doesn't apply to holdings-based, where more frequent processing is required to ensure a better degree of accuracy.

...they're in whack

This past week I spoke at First Rate's annual user conference in Arlington, Texas. My topic was GIPS(R) 2010, the new edition of the Global Investment Performance Standards, though we touched on other topics, such as the CIPM exam. When queried about the CIPM, I launched into a rather passionate call for support for the program, suggesting that if you consider yourself a "performance measurement professional" how can you not be pursuing and supporting certification? Performance measurement plays such an important role in our industry, we should champion it however we can.

Jason Zweig's WSJ column this weekend discusses the first quarter's gains and quotes Ted Aronson (of Aronson Johnson Ortiz) who remarked that "valuations aren't out of whack; they're in whack." Valuations, of course, are a fundamental ingredient in the measurement of performance. Part of the problem with the sub-prime mortgage driven crisis which we are making our way out of was the inability to properly value many issues.

I'm about halfway through listening to Gregory Zuckerman's The Greatest Trade Ever, which tells the story of how John Paulson was able to make billions of dollars by shorting the mortgage market. It's a fascinating book which delves into both the personalities of the various players as well as the investments which were made. That market experience has, of course, brought to the surface questions about models and the various risk measures, such as Value at Risk, which were being used.

How can these activities not further strengthen the value that our industry provides? Performance measurement remains a critical component of the market. And while we can debate how risk should be measured and managed, there's no doubt that it's not going to go away. We're in an exciting segment that will continue to be a fascinating and exciting one for many years to come.