Patrick Henry as a model

I have always enjoyed history; so much so that when I went to college there were only two subjects I considered majoring in: math and history. I chose math because I thought there were greater prospects for jobs with this major, though I have continued to support my love of history through reading and occasional tours of various historical sites. And this past Christmas I asked for a few biographies (one of my favorite types of books to read) and one was Lion of Liberty: Patrick Henry and the Call to a New Nation by Harlow Giles Unger. Although I, as most Americans, knew him for his famous "give me liberty or give me death" speech, I hadn't realized what a powerful figure he was during the American Revolution.

You may recall that after we won our independence we created a government based on the Articles of Confederation. However, because of its lack of power at the central government level, there was a move to make a change, which resulted in our Constitution. However, Henry, an anti-Federalist (i.e., a strong supporter of "states rights") voiced exceptionally strong opposition to it. When the matter was discussed in his home state of Virginia, he spoke often and at great length against the problems that he foresaw. You can imagine that he wasn't too popular among a number of those who felt that a change was needed, including his fellow Virginian George Washington.

Change is often difficult. And when ideas are put forth for public review and comment, the document's framers are sometimes upset with the lack of support they fully expected. I know from comments I received that my not too subtle opposition to some of what was proposed in the GIPS(R) (Global Investment Performance Standards) 2010 exposure draft wasn't well received by some. I never doubted that those involved had the best interests of our industry at heart. We are fortunate to have an Executive Committee made up primarily of volunteers who devote many, many hours for the benefit of the industry at large. But anyone who enters the public eye is open to criticism, as well as support.

As a former elected official I know too well how my actions often engendered negative responses, sometimes biased as a result of being a member of a different party, but also often because of sheer disagreement. I recall for example how we had a plan to rezone one parcel of land in our town to develop a shopping center. We were confronted by many upset residents who found disagreement with our plans. As a result of their arguments we learned somethings which we were not previously aware of, and totally altered our plans (obviously to the dismay of the developers).

One of the "seven deadly sins" is pride, and no doubt "pride of authorship" is only one example of how this sin can be manifested. As one who does a great deal of writing, I learned a very long time ago that such an attitude about my writing would be a huge problem. This should extend to ideas, too. But we who criticize should also be sensitive to those we offer our comments  too, again recognizing that their motivations are well placed. While we may not always agree with the outcome, we should always be respectful of those who crafted what they deliver.

Investment advice from the movies

I thank Todd Brunskill from First Rate for bringing this paper to my attention via Linkedin: some interesting quotes with commentary by CFA Institute's Director, Investor Education, Thomas Collimore. It's clever, humorous, memorable and insightful. I think you'll like it.

No, no, no, no, no!!!!!

Is my title strong enough? Perhaps not, but it's all I have right now. It is in response to an online article I stumbled upon that strongly encourages investors to ask for, believe it or not, time-weighted returns! The article, by Doug May and titled "Five rules for measuring portfolio performance," offers such advice as:

• encouraging investors to "Ask if your advisor can provide a ‘time-weighted’ portfolio return calculation. By using a time-weighted return, fluctuations that have nothing to do with portfolio picks can be eliminated from the evaluation." Because advisors often don't manage the money, what possible benefit is there to eliminate the cash flows from the evaluation? And even when advisors do manage the client's money, there is still a good reason to show money-weighting, as clients also want to know how their portfolio or they are doing, which time-weighting is unable to provide.
• to justify this, he offers an example: "if an investor decides to add money to his or her account at the market bottom, this additional money invested at the optimal moment will skew portfolio returns upward. Portfolio investments could be lagging the market, but the timing of the additional money might result in above-average returns." "Skew portfolio returns?" No, we want the impact of the flows to be shown so that the investor can see exactly how they are doing.
• "By using a 'time-weighted' measurement, which is the industry standard for periods longer than three months, distortions from contributions and withdrawals will be reduced or eliminated." I confess that this is a new one: the industry standard for periods longer than three months? I am not familiar with that standard. In fact, there are no standards on what to report to clients; there are only standards on what to show a prospective client.

I am quite sure that Mr. May is a very nice and intelligent person; he is a CFA charterholder which reflects a great deal of investment knowledge. However, he is relying on an incorrect view regarding the purpose of time-weighting. Let us not forget that this form of measurement was introduced in the mid 1960s as a way to evaluate how the manager performed. I have, as my loyal readers know, opined on this topic many times. I think that my newsletter discussion  last June summarized my arguments quite well.

It is way too easy for individuals to recommend time-weighting; it's more challenging to step up and point out this measure's shortcomings and the value of money-weighting. But we must!

And the reason you're having quarterly verifications done is why exactly?

One of our GIPS(R) (Global Investment Performance Standards) verification clients recently mentioned that they may be under pressure to move to quarterly verifications. I found this of great interest, because we, and most other verification firms, recommend annual verifications. What possible benefit is there to have quarterly, other than:

• you get to see your verifier's smiling face more often (if they show up, that is, as opposed to doing "remote verifications")
• you get to keep your verifier's employees active throughout the year
• you get to pay more money for the service?

We have heard from a number of firms who undergo quarterly verifications that they are still waiting for their 2nd quarter 2010 (or earlier!) verification report!!! So, what's the point? We have already conducted 2010 annual verifications  for some of our clients. To recommend quarterly suggests that the client might suddenly somehow stop doing what they know they're supposed to be doing procedure-wise. Firms should not confuse quarterly verifications with the recommendation to update presentations quarterly; in fact, we believe that most firms don't (update their reports quarterly), adding even further justification to ask why not just do them annually? We will be happy to do quarterly if a client wants us to, but none of ours do; and this includes our clients who were previously undergoing quarterly verifications with their prior verifier.

Annual is sufficient. But what is also important is that the verifier keeps in touch throughout the year and is willing to respond to questions as they arise. We, of course, do this. We have been extremely proactive with the standards, by:

• sending letters to clients detailing upcoming changes
• hosting webinars on the standards (which are complimentary to our verification clients)
• commenting in detail in both this blog and our newsletter about the standards.

We consider our verification clients, make that all of our clients, to be friends, and we enjoy their company. However, we don't believe in wasting their time or money: visiting quarterly means that quarterly they need to prepare for our visits: heck, annual is tough enough! Why disrupt their operation?

If someone has a good reason for quarterly, please share it, 'cause I surely don't know of any.

How many risk measures are enough?

I was teaching our Fundamentals of Performance Measurement course yesterday and came upon a metaphor to use to justify the need for multiple views on risk: John Godfrey Saxe's poem about the blind men and the elephant. You are no doubt familiar with the story, how the blind men go to the elephant, each approaching it from a different part. One thinks that it's like a wall while another thinks it's like a snake. Since none are able to see the "big picture," their observations are very limited.

Well, to me, risk is like that elephant, and if we only use one or two measures, we only see a limited amount of what lies before us. The more measures, the better perspectives.

I love Yale Endowment Fund CIO David Swensen's statement, from his book Pioneering Portfolio Management, that “Quantitative measures of risk for individual portfolios leave much to be desired." Yes, I suspect that most people would agree that they are limited and have a much to be desired. Our only choice is to employ multiple, though limited, measures. A basket that includes Sharpe ratio, M-squared, tracking error, information ratio, value at risk, liquidity risk, extreme risk analysis, and, if you really want to, standard deviation, is a good start, I believe.

Performance Fees - Good or Bad?

Our second "guest blogger" for the year is Carl Bacon, CIPM. Carl is the chairman of Statpro, an internationally recognized authority on performance measurement and risk, an author, a consultant, and currently a member of the GIPS Executive Committee and chair of the GIPS Verifier/Practitioner subcommittee. 

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After a brief lull during the credit crisis performance (or incentive) fees are again becoming increasingly high profile.  An excellent time therefore to pose two questions:  Are they a good thing? And if used, how should they be structured?

Supporters of performance fees would suggest that they are desirable because they align the interests of the asset manager with the investor. If the manager performs well, the investor's assets rise in value.   For the most part investors appear happy to pay performance fees for good performance. If the manager performs poorly only a smaller base fee and no incentive fee is paid. For more see the following from the CFA Institute:
http://www.cfapubs.org/doi/abs/10.2469/faj.v61.n4.2736

Those not in favor claim that rather than aligning interests, performance fees create a conflict of interest, and for the most part are biased in favor of the asset manager. Certainly during my 25 year plus career in asset management performance fees have had a beneficial impact on revenues.  In the first 10 years the pressure on fees trended down.  For the last 15 years average fees have increased significantly across the entire industry. Hedge funds demonstrated to the entire industry that clients, including institutions (and the hedge fund industry has become more institutionalized during this period), are prepared to accept high management fees if they are dressed up in the form of a performance fee.  Hedge fund clients first accepted 2 % annual fees plus a 20% incentive fee, and just before the credit crisis 3% annual fees and 30% incentive fees(or even higher) were not uncommon.  Recently fees may have dropped back to 1.5% and 15% but are already showing signs of reverting back to 2% and 20%.

Of course the answer really depends on how the performance fees are structured. There are many flavors, but essentially there are two main types; asymmetric and symmetric. Asymmetric fees shown in the diagram below are by far the most common and are very seductive to investors.

Typically asset managers will present these types of fees to clients at a base fee rate considerably lower than their normal management fee with an incentive fee only for performance greater than a hurdle rate.  Clearly there is considerable variation in the hurdle rate, angle of the participation rate, time period, excess or absolute return, caps and collars and perhaps a high water mark but the basic structure is the same.  This is attractive to investors; they are paying a lower fee and will only pay higher fees if the manager performs well.

A rare alternative would be a symmetric structure. In this type of structure the base fee would probably not be lower and may even be higher than the normal management fee. Incentive fees are paid for out-performance, but crucially fees are rebated for under-performance to the extent   that the asset manger may ultimately make a net payment to the client if performance is sufficiently bad. Though unpopular with asset managers, these types of fee genuinely align the interest of both parties.

Some critics of performance fees make the claim that asymmetric fees in particular encourage managers to take more risk if performance is poor because they have little further downside and considerable upside. This is not my personal experience.  Often when in a hole, I've observed that managers in effect stop digging and take less risk when performing badly.  On the flip side I have observed managers "lock in" out-performance when they have achieved the cap and take much less risk. This obviously reduces the business risk of the asset manager but presumably the client would like the manager to continue talking risk if they are obtaining good rewards. Risk-adjusted returns such as M2 would help alleviate this problem.

Sadly performance fee arrangements often end in acrimony. For long term agreements the original authors on both sides may have moved on, and if badly written at the point when both partners should be celebrating good performance, relationships can be damaged by a dispute about the size of fees to be paid. Performance fee agreements should be clear, concise and as simple as possible. I would always recommend including a few worked examples to ensure both parties fully understand the agreement. There is a tendency to complicate performance fees with high water marks and variable hurdle rates; frankly the more complex the agreement the more likely interests will be misaligned.  Keep it simple.  Investor interests are best protected by structuring performance fees over longer time periods, three or even five years. 

It always surprises me that endowment or pension funds that are selecting a portfolio of managers to diversify their manager selection risk require performance fees as a matter of principle. I can't prove it, but my observations over many years measuring the performance of managers with and without performance fees would suggest the implementation of a performance fee does not actually improve performance.

A portfolio manager is either skilled or unskilled. Those extra hours staying behind in the office will not necessarily add to performance.  Sufficient constraints and incentives already exist such that managers are always encouraged to deliver good performance with or without performance fees.  In order to attract new clients managers must demonstrate a superior, consistent track record, they often have their own money invested and if they have two clients with the same strategy, one with a performance fee and one not, legally they are simply not able to direct their favorable trades through the performance fee client.

Logically the investor is choosing the asset manager.  Why if they are skilled in their choice of manager, and choose good performing managers,  should they wish to penalize themselves with a higher performance fee? And, if they choose unwisely, reward themselves with a lower base fee for underperforming managers?  Worse still, if they are in the majority and merely average, the performance of the good performing managers will offset the underperformance of the poor performing managers leading to average performance overall.  But since performance fees are asymmetric in nature the performance fees will more than exceed the advantage gained from the lower base fees of poor performing managers and investors ultimately pay above average fees for average performance. Investors should treat performance fees as a necessarily evil, only accepting performance fees to access demonstrably superior managers where a simple base fee is not available.

There is a place for performance fees but if used they should be:

1. Unambiguous and fair to both parties
2. Symmetrical
3. Risk-adjusted
4. Simple

Unfortunately, many performance fee structures are unfair and ambiguous, asymmetrical not symmetrical, rarely risk-adjusted and frequently complex.

Guest blog posts #2 & #3 ...

Last week I mentioned that I had been asked to submit an item for Statpro's blog. Because of my "long windedness" it was broken into two parts and the second one is now up! It addresses the recent changes to GIPS(R) (Global Investment Performance Standards). Please visit...thanks!

p.s., I just learned my piece was broken into three parts, and the third has just been posted!

What documentation is enough?

GIPS(R) (Global Investment Performance Standards) verification clients often ask what they need if one of their clients asks them to make changes to their account; for example, if their client asks them to increase the amount of cash they have.

Ideally, the manager should have a written communication from the client: this can be a letter or email, which provides them with the instructions. I can understand, however, that asking a client to put their request in writing might be difficult, so there are other options, too.

I recommend that asset managers follow up such conversations with a "negative response letter." This is simply a letter, to their client, that basically says something like "Pursuant to today's conversation, we will do XXX for you. If we are mistaken in your instructions, please notify us at your earliest convenience." [I'm not sure that I would actually use the word "pursuant," but that's a different matter.]

A log of the call is also appropriate, whereby the individual who took the call will document what was stated.

An internal email from the person who took the call, summarizing the details of the call and instructs the appropriate party(ies) to take certain action, also helps.

The more documentation, the better. And make sure documents are included in the client's file for easy reference.

"I believed that one day I would find time to read everything"

In this weekend's Wall Street Journal there's an article by Roger Kimball about John Gross, who recently passed away. Don't know John Gross? You're not alone: he was an anthologist, editor, reviewer, and apparently much more. And, he had an insatiable appetite for reading.

The article is brief and worth your review, as it may serve to spark your own interest in doing more reading; I know it has for me. One quote from the article is worth mentioning: "In his memoir, Gross casually cited 'curiosity' as the prod for his reading." I think this is one of the reasons I enjoy reading so much, and enjoy reading about diverse topics.

I often need a role model to get me going. January is traditionally the month for resolutions, and many of us set goals for reading. Well, John Gross could very well be that role model for me. Again, please take a moment to read the brief article; hope you enjoy it.

A risk measure to consider...

Bruce Feibel, author of Investment Performance Measurement, spoke at the Performance Measurement Forum's North America chapter's Fall meeting on the topic of risk. I was quite pleased when he expressed his support for the risk-adjusted measure, M-squared, also known as Modigliani-Modigliani, named for its designers, Franco and Leah. This grandfather/granddaughter duo developed what Bruce and I feel is a superior metric to evaluate risk.

Unlike the other risk-adjusted measures, its results are highly intuitive. To me there's a parallel to the way we show gross and net performance, as well as pre- and after-tax results. For example, from a gross/net perspective we might see:

• Gross return = 17.45%
• Net return = 16.68%.

The net result reflects the impact of the advisor's fee. From a tax perspective:

• Pre-tax return = 19.35%
• After-tax return = 16.45%.

Well, with M-squared we could see:

• Before adjusting for risk = 18.27%
• After adjusting for risk = 16.45%.

Granted, we might not label our  results this way, but I'm simply trying to convey how the results align with what we often see today. Our return has been adjusted for risk, unlike the other measures. And unlike the other measures, its reported in percentage terms, which are much clearer to comprehend.

If you're not including M-squared in your reporting, you should be!

And, if you'd like more information on this measure, send me a note.

Should you have a "valuation" policy?

The new edition of GIPS(R) (Global Investment Performance Standards) has a shift from "market" to "fair" value, and even comes with a recommended hierarchy for firms to utilize. But even without this move, or even if all of the securities you invest in have market prices (the first level of the hierarchy), should you have a valuation policy? And, in the event that you invest in securities that don't necessarily always have market prices, do you need a policy? Yes, to both questions!

At a minimum your policy should explain your source(s) and frequency of pricing. With assets that are more challenging to price, you need to explain how you price them. You should address how prices are corrected, when errors are discovered, and what might justify a price being overridden. If you invest globally, you should address currencies and how they're priced (sources, timing, frequency).

GIPS requires, as-of 1 January 2010, firms to revalue their portfolios in the event of large cash flows. Your policy should explain what "large" means and also what "revalue" means and how it's carried out.

There's a lot to think about, no doubt. Policies ensure consistency, completeness, and correctness. In the drafting of the policy you should engage the appropriate individuals, which arguably include someone from operations, technology, performance, portfolio management, and compliance. It also might help to pass your document by your verifier for their input. You may want to form a "valuation committee," too, to address issues that may arise from time to time.

Thoughts?

p.s., I decided to amend this slightly, so as to avoid confusion. GIPS, both explicitly and implicitly, requires firms to have "valuation" policies. For example, ¶ I.4.A.12 states "FIRMS MUST disclose that policies for valuing PORTFOLIOS, calculating performance, and preparing COMPLIANT PRESENTATIONS are available upon request.."  I guess the real point of this post was to touch a little bit more on "valuation." We can simply state that we "value our portfolios at month-end, and revalue for large flows, where 'large' is any external flow greater than 10%." I am speaking beyond this, however, and am addressing pricing of assets, in conformance with the requirement to use "fair value." I think the topic is much broader than perhaps one might think. Hope this helps!

Be our guest, be our guest...

Earlier this month I mentioned that we would begin to host "guest bloggers."

Well, I was asked to be a guest blogger for Statpro's blog, and the first part of my post appears today (the second will appear on Thursday)! The post deals with the GIPS(R) 2010 changes. I thank Karleen Fallon and Statpro for the opportunity to participate in their blog.

Please have a look!

Best practice when it comes to rates of return

A client asked about the "general landscape among financial companies in terms of usage of different performance engines/performance calculations." Specifically whether true daily or Modified Dietz is prevalent when it comes to portfolio and security level returns. I admire his due diligence in trying to obtain this information as they move forward with their own decisions.

When we use the term "best practice" what exactly do we mean? Unfortunately the GIPS(R) standards (Global Investment Performance Standards) uses this term for recommendations, suggesting that they are "best practice," but fails to define what "best practice" means? Is it:

• what is most commonly done (hardly, I would argue, the best basis for "best practice")
• what the leading firms do (again, not necessarily the best "best practice" source)
• what a few individuals on the GIPS Executive Committee think is what firms should be doing (arguably not "best practice," as the mix of members can change, would could cause a total redefinition as to what the term means).

Not knowing makes it a little mysterious and murky, does it not? I hesitate to offer my own definition, but may post this question on one or more of the Linkedin groups in the hopes that we might arrive at some consensus. But moving on to the questions at hand.

My thoughts:

• Portfolio level performance: it is evident that the industry is moving to daily time-weighted performance at the portfolio level. This should (assuming there aren't any data issues) result in the most accurate return. I would argue that the best approach would be to also have money-weighted returns at this level, so that the firm can provide multiple perspectives as to what is going on in the portfolio (i.e., how the manager did as well as the portfolio).
• Security, sector, asset class (i.e., sub-portfolio level) performance: here again we see a lot of firms employing time-weighting which I would say is the wrong approach (and I'm sure that some of my readers have heard this countless times from me and are thinking that I'm sounding like a "broken record," whatever that is!). If we go with what everyone else is doing, then do time-weighting and ideally daily; but this, to me, is incorrect: there is only one way to measure sub-portfolio performance: money-weighting. If you want to use Modified Dietz, that will be an improvement over true daily.

I thank our client for providing me with material for this blog and invite your thoughts.

p.s., I will most likely take the broad topic of "best practice" up in our newsletter

GIPS 2010 ... when do we have to comply? II (Further clarification)

In Friday's post I mentioned how there is confusion regarding when firms need to comply with the Global Investment Performance Standards (GIPS(R)) 2010 edition. I mentioned how you aren't obligated to comply until you begin to report on your 2011 numbers. It's important to be aware of the "bigger picture" and the context in which I was making this statement: I was referring to the compliant firm's presentations, not the "firm," per se. Granted, the FIRM is compliant with GIPS, not presentations. And what a firm does (as far as valuations, return calculations, etc.) are reflected in their composites, presentations, policies, etc., which are evaluated during verifications. We see a firm's compliance through their presentations and policies. I was speaking in the context of a client who is preparing for their 2010 verification: she wanted to know if their presentations needed to reflect the changes that went into effect this year and the answer is "no," since I will be reviewing their 2010 records. If I were to be looking at any 2011 numbers, then "yes," they WOULD have to comply with the new requirements.

Since the new rules went into effect on January 1, 2011, GIPS compliant firms must now comply with them, though the evidence of compliance may not be revealed until they begin to issue their composite presentations with the new wording and disclosures.

A colleague pointed out that the post might be "adding to the confusion. Firms that comply with the 2010 edition of the GIPS standards must comply as of 1 January 2011.  To indicate that firms look to the date which they report performance is extremely misleading.  If a firm compiles their compliant presentation annually and the firm waits until the beginning of 2012, they will be out of compliance.  The 2010 edition requires, among other things, that firms use a fair value methodology to value investments at month end and at the time of all large cash flows.  If firms are not adhering to this beginning 1 January 2011, they are going to be in a very uncomfortable position later."

I agree. If you don't bother to familiarize yourself with the new requirements until late 2011 or in early 2012, you may have a rude awakening to learn that you were supposed to be doing certain things throughout the year that you perhaps failed to do. Compliant firms should be adhering to the rules today, though they don't have to make adjustments to their presentations until they begin to reflect 2011 returns. And so, even though a your firm's presentations don't need to reflect the changes until you begin to report on your 2011 numbers, you want to make sure you're comply with the rules, such as valuation. You also want to make sure your policies are adjusted to reflect the new rules.

I'm sorry if what I previously wrote was misleading, as my purpose was to reduce the confusion, not add to it, and I hope this clarifies the requirements. If you have any questions, please send me a note.

GIPS 2010 ... when do we have to comply?

It is becoming increasingly obvious that there is still confusion regarding GIPS(R) 2010, which went into effect on January 1, 2011; just yesterday I got a call from a verification client who wanted to make sure she was fully prepared for my upcoming visit. Any firm that claims compliance with the Global Investment Performance Standards must comply with these changes; but as of when?

It occurred to me that this might help:

• published date: 2010; thus, the name "GIPS 2010," because the revision was published in the year 2010.
• effective date: 2011; this is the date the standards went into effect. The problem is understanding what this means. I think perhaps a better term, never previously revealed is:
• compliance date: the date a firm must comply with the new provisions. And what is this date? It depends!

It depends? Yep! It's not a fixed date, per se, but rather a date which is tied into what you're actually reporting. The moment you begin to reflect any 2011 returns in your composite presentation, you must comply with the new rules. And so,

• if you report monthly returns in your presentations, then in February when you report the returns for January you need to comply,
• if you don't report monthly returns on your statements but do report quarterly, then in April when you report on your first quarter 2011 results, you need to be compliant,
• and, if you don't report monthly or quarterly, but only annual figures, then in January 2012 when you report on the year 2011 returns, you will need to comply.

 Hope this helps!

Private equtity attribution

I'll be teaching a class for a client later this month who asked for some specific topics to be included, one of which is private equity attribution. The challenges with private equity are:

1. They typically don't have indexes, so we can't use relative attribution
2. They use IRR, not TWRR, since the manager controls the cash flows.

And so, what is a private equity manager to do if they want attribution? The answer is simple: absolute attribution (aka contribution)! We can utilize IRR at all levels and reconcile to the overall return. We calculate our sector returns, for example, using IRR; calculate their weights, taking cash flows into consideration; and simply multiply the weights by the individual returns. Their sum should tie out to the overall return. For example:

We can see how each sector contributed to the overall return. And just like hedge fund attribution, we can slice up our private equity portfolio in countless ways (e.g., by industry, subsector, country). Does this not make sense? Thoughts?

Attribution question...answered!

A colleague sent me an interesting question, which I will summarize here:

An account has a single cash flow during the month, so there are two sub periods for performance to generate a TWRR. Although we can link the returns to get the full month return, it isn't as easy to derive a single weight that would maintain the integrity of a weighted average calculation. So, the preference is to calculate attribution for each sub period and link. However, we still face a scenario where many indices aren't available daily, so how do we get index return periodicity to match the account returns? This poses a number of questions:

• Can we assume linear performance for the benchmark?
• Do the cons of making assumptions around indexes outweigh the benefits? Should we be driven by the least common denominator? In other words if index data is only available monthly then attribution should only be produced monthly. This then means you need to explain the difference between the published return and attribution analysis.
• Can we manipulate portfolio weights so that we can use monthly analysis and linked returns?

In my view this essentially speaks to the holdings- versus transaction-based issue with attribution. There is a misperception many hold that daily transaction-based attribution is a superior methodology; the reality is that monthly is sufficient for transaction-based attribution; holdings-based, on the other hand, warrants a consideration for daily in order to improve accuracy. And there's the rub: once we move to daily we need to be able to capture the index details for the corresponding periods. And as noted in the question, even breaking a month into two pieces would require this. And, as correctly noted, not all indices provide daily information.

However, if we employ a transaction-based approach, then we don't have to segment the month nor do we have to worry about index details for the sub periods. By using the beginning sector weights, plus weighted flows (just as we do with Modified Dietz) we can accomplish our objective. The returns, too, have to take into consideration the intra-month activity to ensure accuracy.

Is net-of-fee performance supplemental information?

One of the most confusing areas of GIPS(R) (Global Investment Performance Standards) is "supplemental information." Since firms are required to label this information, it's important to know what it is. In essence, it's any performance-related information that accompanies a GIPS presentation that is neither required nor recommended. For example, attribution results aren't required nor are they recommended, and so if a compliant firm decides to include an attribution report with their presentation, it would be considered "supplemental."

A colleague asked whether net-of-fee returns are supplemental. I must admit that I found the question to be a bit odd, but there actually is some logic to how this is arrived at. Paragraph 5.B.1 of the 2010 edition recommends that firms show gross-of-fee; it doesn't recommend net. Does this mean that net must be supplemental, since it's neither required nor recommended? In reality, the standards permit either and often refer to both (see, for example, ¶ 4.A.5 and ¶ 4.A.6).

While I can see the logic behind the question, there seems to be evidence that net-of-fee returns are not supplemental. I often suggest to clients that they use the sample presentations in the standards as templates for their use; and if we look at Appendix A (page 46) of the 2010 edition we find a sample that shows both gross- and net-of-fee returns. If net-of-fee were supplemental, it would be so indicated here.

The requirement is that firms must show either net- or gross-of-fee returns; they can show both or either. Neither is supplemental.

Gaining access to the data

We decided to introduce "guest bloggers," and our first "guest blogger submission" is from Stephen Campisi, CFA. Steve has offered his comments on many of my posts, and for a variety of reasons I thought it fitting to have him provide us with some of his original thinking. As a portfolio manager with a very strong background in performance measurement, attribution, and risk, he provides unique perspectives on a number of topics. Hope you find this post of interest and value.

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I’m working with the due diligence department of a major investment firm that wants to use my fixed income attribution model to screen bond managers for consideration into their product platform, as well as for performing ongoing due diligence and monitoring of their existing managers. They like the model’s robust analytics and drill down capabilities along with its minimum data requirements.  They expect to implement the model at the sector level, since it’s unnecessary to get issue level data to perform the analysis. So, they began contacting their existing managers, asking only for the characteristics of each sector: coupon, price, duration, weighting and return.  To their surprise (and to mine) they were denied this data from one of the largest bond managers around, citing difficulties in getting the data at first, and then switching their story to the potential legal problems with disclosing this data, since this information is not provided to every investor in their fund. They went back to the bond manager, clarifying that they would not be violating any rules in distributing this data, since the SEC rules only apply to individual bonds and not to the total portfolio or to the major bond sectors.  For example, which investor would be harmed because the manager had noted in a report that the average coupon of the corporate sector was 3.5%?  Seems rather silly, no?  This appears to be more of an unwillingness to provide the data, rather than an inability to do so.

So, let’s consider this in the broader context of the legal concept of “informed consent” which requires providing potential investors with all the information they need to make the best decision that is in their own best interests.  And how can an investor do this when managers are unwilling to provide general information about the major factors and parameters of their funds?  I’m told that one would be hard pressed to get returns by sector from equity managers, so that it’s not simply the bond managers who are so seemingly recalcitrant.  In a post-Madoff age of increased disclosure and due diligence, it seems that fund managers should be required to disclose the major characteristics of their fund so that investors can perform their own analysis and see whether the managers’ claims of the sources of risk and return are justified. It’s not enough to accept a manager’s simple attribution analysis as adequate due diligence into the investment process.  Hopefully we have learned this from the Madoff scandal, and hopefully the fund managers will recognize their responsibility to provide greater transparency into their investment process – starting with providing simple data summaries needed for due diligence staff to corroborate the managers’ claims. This could be a “win-win” for everyone, but right now it’s just a dead end.

Make 2011 a year of epiphanies!

My last post of 2010 dealt with some epiphanies I had relative to performance measurement, and how they altered my thinking regarding money-weighting, the aggregate method for composite returns, and asset-weighting composite returns.

Well, today is the Feast of the Epiphany, and it occurred to me that a wish for me and you for 2011 is that we all experience many epiphanies this year: there is nothing wrong with having our eyes opened up, to see things from different perspectives, and to continue to learn. Hope you agree.

Happy New Year!