An animated explanation on the differences between time- and money-weighting

It's Animation Monday, and today we have a brief explanation as to the key differences between time- and money-weighting. It's funny that these differences aren't understood by even the most senior of PMPs (performance measurement professionals). I hope you find this of value. Our training classes, of course, go into much more depth on this, but this brief overview should help, too! Please let me know what you think.

An overview of the CIPM program

We thought it would be helpful to introduce this video, which provides an overview of the Certificate in Investment Performance Measurement (CIPM) program. We support the program and encourage all performance measurement professionals to pursue it. If you won't, who will?

When is a balanced account not a balanced account?

This matter came up recently with one of our GIPS(R) (Global Investment Performance Standards) verification clients, and is worthy of some discussion.

What is a balanced account? I would say the characteristics are basically three:

1. It's an account that invests in two or more different asset classes (e.g., stocks and bonds),
2. where the manager makes the investment decisions in all asset classes, and
3. where the manager makes the allocation decisions.

What if the client makes the allocation decisions which the manager follows? Then it's not a balanced account. In these cases you have two or more different accounts (e.g., an equity account and a bond account).  Ideally, you would have them segregated on your portfolio accounting system so that you can place each in its respective composite.

Well, what if they cannot be separated, can we carve out the different parts and insert them into the appropriate composites? Yes, you can, as long as since January 1, 2010 you have managed the cash separately.

But what if we don't manage the cash separately, what can we do? Well, in this case you could establish a rule in your GIPS discretion policy that states that in those cases where the client controls the allocation decisions, the accounts will be deemed non-discretionary. I don't believe you have any other choices. Sorry.

Because many clients provide their managers with ranges to work within, the managers often treat them as balanced, since they have some discretion over the allocation. But if there is no flexibility, then the above applies.

Predict with caution; heed with even more

One of the books I was assigned in my doctoral program is William H. Starbuck's The Production of Knowledge, which I thoroughly enjoyed and highly recommend. It can be viewed as a softer criticism of the idea of predicting the future than Nassim Taleb's The Black Swan. And while I also recommend Taleb's book, I would encourage you even more to read Starbuck's. I decided earlier this week that it is worthy of another read, and so I will shortly tackle it again.

Well, this is perhaps a rather long intro into an article that appeared in today's WSJ by James K. Glassman, perhaps best known for his fabulously popular, Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market, which I commented on earlier this month. As noted in that post, this book can be purchased today for a penny, though some probably would suggest that it's still overpriced.

Carlos Lozada in a March 8, 2009 interview in The Washington Post asked Glassman "[do you] feel the need to apologize to someone who read your book, went in and got creamed?," to which Glassman responded "Absolutely not." Although he doesn't apologize for his error, and perhaps shouldn't, he at least admits that he was wrong in today's article.

In the WSJ Glassman mentions "While history is usually the best guide to the future, it is far from perfect." I don't know what he bases this statement on, because I would argue that history isn't a very good guide in many respects. This is part of Starbuck's and Taleb's arguments against making any prediction. Glassman is correct that the idea of the United States having a black president at this point would probably have been considered a "pipe dream," or that the Saints would have won the Super Bowl, and on and on. But that didn't stop him from suggesting that the Dow would achieve such a lofty level in a rather short time.

But why did the WSJ, a paper that is highly selective in who they let write articles or position papers for, include this piece by Glassman? Yes, he has held (and still holds) some lofty positions, but his ability to predict or offer advice on investing is such that he's among the last who should be granted such privilege. Or am I mistaken? What do you think?

In spite of our poor job at predicting, people still want to hear what pundits have to say about the future. I see that Jim Rogers will speak at this year's CFA Institute annual conference. I have read a couple of Jim's books and find him to be highly intelligent and engaging. But I recall a prediction he made during Bill Clinton's first term in office when spoke at the NYSSA; he said that Clinton would be the last Democratic president. Well, that was a bold prediction and he, of course, was in error.

I recall that in the Old Testament the punishment for fortune tellers is death; and while I would never encourage such an extreme response, I do think that we should be careful what we believe when we hear pundits talk about the future, even when they're some of the brightest people around.

Treatment of reinvestment of income in returns

A colleague sent us a note recently inquiring about the proper treatment of accounts that have dividends reinvested; that is, how the flows are to be handled from a return perspective. The essential question is "should the money flowing into the account, to purchase additional shares, be treated as a cash flow?" And the answer is a conditional one:

• If you treated the dividend that flowed out of the account as a cash flow, then yes
• If you didn't treat the divided that flowed out as a cash flow, then no.

We essentially want our flows to cancel each other out, as the dividend's impact should be kept within the account, and the manager should benefit from it. We cannot treat only the money coming in as a flow because then the manager wouldn't get credit for creating it.

Jane Austen's guidance on risk management

Perhaps it might seem odd that one can draw anything from Jane Austen's classic, Pride And Prejudice, in regards to our profession, but alas it is possible, and I believe I have.

The scene occurs at the start of Chapter 5 in Volume 3, shortly after the main character, Elizabeth, has learned that her younger sister, Lydia, has eloped with the once respected, more recently loathed, military officer Wickham. Elizabeth's uncle reflects upon what has occurred: "It appears to me so unlikely that any young man should form such a design against a girl who is by no means unprotected or friendless, and who was actually in his Colone's family, that I am strongly inclined to hope the best. Could he expect that her friends would not step forward? Could he expect to be noticed again by the regiment after such an affront to Colonel Forster? His temptation is not adequate to the risk." (emphasis added) In other words, Surely this man, Wickham, must weigh the risks of his actions and realize that they are such that to put Elizabeth's sister in any jeopardy isn't worth it.

Being aware of the risks is a critical part of investing, whether it's an investment of our money, time, or emotions. Too often investors don't consider the downside of their actions. As is often stated, risk isn't bad, what is bad is not taking the risks into consideration or knowing what those risks portend. One could argue that the gifted Jane Austen was offering some advice which is worth considering, did she not?

Some thoughts on money-weighted attribution

Welcome back to "animation Monday." Steve Campisi, CFA, who was our first "guest blogger," has become our first "guest animator"! Steve always has some insightful and interesting perspectives, and today he presents his views in an animated fashion.

Geometric vs. Arithmetic Attribution Animation, Part II

The response to Monday's animation has been terrific, and I've decided to make Mondays "animation day." That being said, because of some comments we received specifically about this topic, I decided to continue this one, with an elaboration on the issue of the "elimination of residuals." We thank Andre Mirabelli for sharing his views and allowing us to insert him into the scene. Hope you enjoy, both from a content as well as presentation perspective.

Some interesting GIPS misconceptions

One of the reasons we encourage firms that claim compliance with the Global Investment Performance Standards (GIPS(R)) to get annual verifications is because the standards are just too darn confusing. There is so much that is left to your interpretation, and it's just too easy to draw an incorrect conclusion.

I'll share with you just a few recent examples from verifications I've done:

• When a non-fee paying account isn't a non-fee paying account: Here's an easy solution to dealing with those accounts who don't pay their fees from the corpus of the account but instead pay them through some other means: make them non-fee paying. Simple. Much easier than having to deal with the accounting. But, sadly, incorrect. They do pay a fee and you have to account for it. However, an easy solution to avoid this is not to use the actual fees but rather the maximum fee, which I believe has more value, anyway. It's fairly straightforward and provides a simple and correct method to deal with this problem.
• A general approach to non-discretion: we often see clients who use rather broad definitions of non-discretion, such as "an account is deemed non-discretionary if its restrictions prevent the firm from managing the account according to the defined style." Actually, that is a good definition for non-discretion, but it isn't a good basis for a policy, as it is too ambiguous. You need to define the clear criteria or conditions under which you would draw this conclusion.
• Using a single sector index for a composite that crosses multiple sectors: You have to give it to Standard & Poors for the success they've had in promoting the S&P 500; it is viewed by many as "the market." And, we often want to use it as a comparative index, which is fine. However, the standards require that the benchmark match up with the composite's strategy. And so, if the composite allocates, for example, to small cap, mid cap, large cap U.S., as well as international stocks, then you need to have a blended benchmark which includes a representative from the broad world of indices for each of these sectors. 

I could cite more, but three is enough for today. Suffice it to say, the standards are complex.

An animated debate on geometric vs. arithmetic attribution

Here's a new way to communicate ideas, issues, and controversial topics. Hope you like it!

Riskless stocks

In this weekend's WSJ, Jason Zweig reminds his readers of James K Glassman's 1999 best seller, Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market (which, by the way can apparently be had at Amazon for a mere one penny!). Jason mentions that in his new book (which I won't bother to reference), he admits that he "was wrong."

Recall that Glassman picked up on the hot bull market of that time and made this bold, and apparently rather unrealistic, prediction for the future of the DJIA. Glassman and his coauthor, Kevin A. Hassett felt that "stocks and bonds are equally risky over long horizons," because "stocks had never  lost money over the long term." Zweig further points out that investors back then had apparently learned that "socks weren't risky."

Zweig cites LA-based Oaktree Capital Management's chairman, Howard Marks, who said that this logic is false. Zweig also alerted us of a new "superb forthcoming book" by Marks that "helps explain risk clearly": The Most Important Thing. The book is due out May 1, and I preordered my copy today.

Rather than repeat here any further commentary from Jason, I will leave it to the reader to link across. Some insightful points are raised which are worth having a look at.

A bit of history on the NYSE

When I was an undergrad there were only two subjects I considering majoring in: history and mathematics; I chose the latter, but have continued to enjoy the former. In today's Wall Street Journal, Jason Zweig begins with a reference to the possible NYSE Euronext and Deutsche Börse AG merger, but quickly moves on to provide us with a bit of history on the NYSE and the role of exchanges.

Jason is an excellent writer, and I very much enjoy his columns, and today's is no exception. In a fairly crisp manner he discusses some background on the exchange and how the they have evolved. It's definitely worth your while to have a look.

More support for changing the way we do things ...

I love the weekend edition of The Wall Street Journal. Invariably I find one or more articles to reference in one place or another. And this past weekend it was Matt Ridley's "A Key Lesson of Adulthood: The Need to Unlearn." As Matt so correctly put it, "We all think that we know certain things to be true beyond doubt, but these things often turn out to be false and, until we unlearn them, they get in the way of new understanding." It's ironic that this article appeared as President George W. Bush's former Defense Secretary, Donald Rumsfeld's Known and Unknown: A Memoir was being released. Rumsfeld spoke of the "unknown unknowns," as things we don't know that we don't know. While he was ridiculed for what some thought was a silly statement, it has a great deal of value.

In our slice of the investment universe, many performance measurement professionals should strive to be open to unlearning concepts they've embraced for years or, in some cases, decades. I have commented at length in this blog, our newsletter, and articles about the undeserved adulation awarded to time-weighting, and how money-weighting should be the most commonly used method to derive returns.

Matt Ridley cites the word "disenthrall" from Mark Stevenson's An Optimist's Tour of the Future," who borrowed it from an 1862 message from Abraham Lincoln to Congress, suggesting that they disenthrall themselves from "the dogmas of the quiet past," meaning to "think anew." Well, performance measurers should disenthrall themselves from the belief that there is one way and one way alone to measure performance and think anew! And, for that matter, that GIPS(R) (Global Investment  Performance Standards) hold the key to everything we do in performance measurement. We very much need to "think anew" about much of what we do.

In defense of quarterly verifications

A recent blog post questioned the value of having quarterly verifications done. Interestingly, we received the following response: "Running the verification on a quarterly schedule can help catch any possible errors sooner, rather than later, potentially minimizing the impact of that error and preventing it from compounding as the firm awaits for the annual verification review." I found this interesting for a few reasons.

I cannot deny that this could be a benefit; however, I question why errors would be appearing that require the verifier to uncover. The firm should have controls, policies, and procedures in place to ensure the accuracy of their returns. In addition, the annual verification provides confidence that they are following the rules of the Global Investment Performance Standards (GIPS(R)). But other thoughts occurred to me, as well, which I wish to share.

First, given that we have heard that one verifier who promotes quarterly is several quarters behind for many of their clients, if a client is hoping to learn of errors in a timely manner, it appears this might not be possible.

Second, verification tests whether the firm's processes and procedures are designed to calculate and present performance results in compliance with the standards. It would seem that the annual review should affirm that this is the case; what would cause the firm one or two quarters later to suddenly diverge from their processes and procedures, resulting in errors that require the verifier to discover?

Third, many of our clients previously had quarterly verifications done; they no longer do, suggesting that they prefer annual (because we will do quarterly verifications if they want).

No doubt events can occur during the year which require the firm to have to make decisions which might result in problems, such as the discovery of errors, the creation of new products, acquisitions, or simply questions that arise from within the firm. I would expect that the firm's verifier would be available to respond to questions and offer guidance; we do. We often get calls and emails throughout the year from our clients, and are happy to offer our opinions and recommendations.

Clearly, if the firm desires to have quarterly done, then the verifier should be happy to accommodate them; we would. We just happen to feel that such frequent visits are disruptive, more costly, and accomplish little, if anything. Yes, it keeps the verification firm's staff busy throughout the year, but beyond that, where's the value? We firmly believe that annual is sufficient and the ideal timing for verification.

Is GIPS at the center of the investment performance measurement universe?

At times it appears that many individuals in performance measurement, as well as those on the periphery (e.g., portfolio managers), see GIPS(R) (Global Investment Performance Standards) as being at the center of everything we do. It's quite common to hear, for example:

• is our client reporting compliant with GIPS?
• is our custodian compliant with GIPS?
• are our returns compliant with GIPS?

"GIPS, GIPS, GIPS." That's the chant or mantra.We've experienced brokerage reps asking whether their firm complies with GIPS, even when the question doesn't fit. Custodians and GIPS? Hardly "perfect together."

And while like Copernicus and Galileo I am risking a charge of heresy or blasphemy to suggest otherwise, I feel compelled to do so: no, the world of performance measurement doesn't revolve around GIPS; there, I've said it! But at times it definitely appears to be that way. But just as the geocentric or Ptolemaic views were based on what appeared to seem quite intuitive and logical, the same kind of erroneous view is wrong regarding GIPS, in spite of similar apparently obvious appearances or what your intuition suggests.

GIPS has become the sole performance measurement standard that is referenced these days, in spite of the fact that others (e.g., the Bank Administration Institute's from 1968 and Investment Counsel Association of America's (now the Investment Adviser Association) from 1971) have existed and not been repealed. Clearly there is room for more guidance, but GIPS isn't the "end all" for all things performance. And while it serves as a useful tool to gauge how firms are doing, it's not always the ideal. For example, in the world of brokerage, where most of the firm's clients are non-discretionary, to provide time-weighted returns is ill advised, contrary to the GIPS standards (which speaks not to this part of our universe).

GIPS is an extremely valuable standard which we obviously support and often comment on. We have loads of clients who comply and encourage others to do so as well. However, to think that GIPS is a panacea that answers all questions related to performance is simply incorrect. Unfortunately, like the old saying that if the only tool you have is a hammer, all problems look like nails, it appears that GIPS is the sole standard and therefore the answer to everyone's performance question; but it isn't.

Two (or more) sets of books

I conducted a GIPS(R) (Global Investment Performance Standards) verification for a client on Monday and was asked if it made sense to calculate returns in multiple ways. That is, if they know that the client's custodian or consultant calculates returns using a different method than prescribed by GIPS, would it be prudent to maintain a separate return stream which they could turn to in the event they need to reconcile?

I was intrigued by this question as it hadn't previously been posed, and I am unaware of anyone who does this.

There is absolutely nothing wrong with maintaining multiple sets of returns. But, I recommended that they don't do this as a matter of standard practice, but rather only when approached to justify their return or reconcile to one (or both) the other parties. Why do all this work when you don't know if it will be needed? Wait and then do the appropriate calculations and analysis.

There are many reasons for potential differences in returns, and the return formula is just one. Many asset managers are often charged with doing this sort of thing and perhaps if they know that a particular client religiously asks them to prove out their numbers, then in that case perhaps doing it on an ongoing basis makes sense, but otherwise, I'd do it ad hoc.