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.