When is income not income?

Simple answer: when you didn't create it. That is, when you're not responsible for it being here.

I conducted a GIPS(R) (Global Investment Performance Standards) verification for an asset manager whose clients get income from stock lending. The option to engage in stock lending is one that the client enters into with their custodian; the manager typically has no involvement at all, other than to purchase securities which someone wants to short, which therefore necessitates the borrowing of shares and the receipt of income.

Therefore, this income should not be recorded as interest income (which would benefit the manager for something they aren't responsible for) but rather should be treated as a cash flow. Sorry :-(

The special language of the GIPS standards

Within the GIPS(R) Standards (Global Investment Performance Standards), certain words have special meaning; and it's important that compliant firms understand this. In this animation we touch upon some of them

Mixing & changing returns

A GIPS(R) (Global Investment Performance Standards) verification client sent me a note recently, stating that they had historically used Modified Dietz for their returns, but will be switching to "true daily." He asked if this was permitted or if they would have to restate their history. This also raises the question about multiple methods being used simultaneously.

The answer to both is "yes, it's permitted." As long as the returns that are employed meet the GIPS requirements, you can switch. Of course we wouldn't expect that you would be switching in order to obtain a higher return, meaning that if we saw a lot of switching, back-and-forth, then we'd object, but this isn't what is happening here.

And, it's not uncommon for GIPS compliant firms to have accounts in the same composite whose returns are calculated differently. This can happen, for example, if you have a mutual fund (that has daily returns) along with a separate account (which might use Modified Dietz).

Your calculation policy document should explain the returns employed, historically and currently.

An animated approach to understanding ex post and ex ante risk

Attribution analysis ... when the numbers don't add up!

I was sent an attribution problem by a client to research for them. The details appear here:

I've highlighted the issues they were concerned with. First, in yellow we find that the technology sector's allocation effect is positive (0.222%), even though (a) it's overweighted (75% vs. 67%) and (b) the sector's index return (7.37%) is below the overall index return (7.51%).  How can this be? Note that the Brinson-Fachler model was used, meaning that this situation should result in a negative allocation effect. Why? Because the manager overweighted a sector that underperformed the overall index return (meaning there were other sectors that performed better).

Second, in blue we find that the finance sector's selection effect is positive (0.212%) although the portfolio underperformed the index (7.47% vs. 7.79%). The model expects the effect to be negative in this case. And why? Because the manager underperformed the index, so the selection effect should be negative to reflect poor selection decisions.

And so, what's the problem?

Well, if you duplicate these numbers you'll see that the sector effects were arrived at by adding the effects of the underlying sub-sectors. This isn't the way it's done. We need to apply the attribution effect formulas to the sector levels. And when we do that, we get:

  

By calculating the sector effects using the same formulas as we use at the subsector level, our numbers make sense. The technology sector's allocation effect (-0.011%), as well as the finance sector's selection effect (-0.105%), are now both negative, as we'd expect. 

Conclusion: sometimes the numbers don't add up ... because they're not supposed to!

I can't hear you because it's too noisy

Odd title for a blog post, right? Well, it's my silly way to introduce a term which is often bantered about but not often discussed: "noise." No, I'm not talking about the sounds that come through the hotel room while you're trying to sleep or the sounds that interrupt your concentration. I'm speaking of "statistical noise."

In a recent post I introduced an animation that provides an overview of standard deviation. This post could have gone on and on and on, as this is a topic that has many angles on which to comment. And perhaps I'll do that in future posts, but for today we'll discuss noise and standard deviation.

What is noise?  Well, the often-criticized-but-frequently-cited Wikipedia defines it as "the colloquialism  for recognized amounts of unexplained variation in a sample." We anticipate that there will be some variance, but some of it comes from unknown sources, which makes it difficult to draw conclusions about what is occurring in our sample size or population.

Interestingly, we tend to get more noise as we shorten our time periods. For example, if we measure standard deviation over the past 36 months using daily returns, we're dealing with a great deal of noise. If, however, we lengthen our periods, our noise reduces. Thus, using months is quite common, though one might argue that quarters are better still, and why not move to years? Well, there are probably two reasons. One, for standard deviation to have much value we need at least 30 observations, and 30 quarters would equal 7 1/2 years, which may be too long as an organization can experience a lot of change over such a period. And 30 years would be even more difficult.

Yes, there's noise even in 36 months. And when (as the video pointed out) the distribution is probably not even normal, the value of the statistic is even more questionable / challengeable. No wonder it's a popular statistic both to use and discuss.

Introducing "mini surveys" for the masses!

Well, perhaps not ALL of the masses, but rather the investment industry masses.

The Spaulding Group has conducted research, much through surveys, since 1992 when we first investigated the industry's response to the performance presentation standards (AIMR-PPS(R) back then). In addition, we conduct proprietary research for clients. Members of the Performance Measurement Forum are familiar with our "mini surveys" which we run periodically, typically in response to a member's interest in obtaining information about a particular topic.

We decided to initiate mini surveys for anyone to participate in. We expect to run these quarterly. By "mini" we mean "five questions or less." So they're short and should only take a brief moment to complete.

Our first mini survey deals with fees and how they're calculated for GIPS(R) (Global Investment Performance Standards) purposes. Please join in and complete the survey today! We will stop accepting responses on "tax day" (April 15), which gives you one month to participate! Please join in by going here. Your identity will remain confidential.

Oh, and if you have a topic you'd like us to explore, send me a note!

An animated view of standard deviation

Today's animated post provides an overview of standard deviation; a very important measure for us performance measurement types!

Dealing with significant cash flows

I had a conversation recently with a GIPS(R) (Global Investment Performance Standards) verification client who is trying to deal with occasions when clients make very large withdrawals. In preparation for the transfers, their managers sell securities to raise the necessary cash, which can include income that won't be reinvested but rather earmarked for the withdrawal. Unfortunately, the cash places an understandable drag on the performance. How might they deal with this?

I'd say there are three options:

1. They can take advantage of the "significant cash flow" option: that is, to temporarily remove the portfolio from its composite, so that the distortions that arise from this client-directed activity doesn't impact the composite's performance. There is a guidance statement that discusses this in detail. This is a great option, however it doesn't work well if you only have a few accounts in the composite. You can apply this policy on a composite-specific basis (i.e., you don't have to do it "firm wide"). You should only use it in cases where there are enough accounts in the composite such that its implementation won't risk a "break" or "gap" in performance.
2. You can create a "temporary account" to hold the cash as it's being raised. This is an administrative / accounting process and is often a challenge, depending on the firm's accounting system and reconciliation process. However, it can be viewed as an ideal approach to solve the problem.
3. You can "flag" the cash that is raised as "non-discretionary" or "non-managed." To do this effectively, it would probably make sense to create another cash account (perhaps something like "transition cash" or "unmanaged cash") to move the cash into. It would still show up on the client's statements but would be excluded from your returns. This will only work, of course, if your portfolio accounting system allows assets to be flagged as "non-managed," and your performance system set to exclude them from their return process.

To employ any of these approaches requires that you do it consistently. Therefore, a policy and process is necessary to ensure that you do.

What is a benchmark?

I recently conducted a GIPS(R) (Global Investment Performance Standards) verification for a client who uses the S&P 500 as the benchmark for a hedge fund. But given that the hedge fund isn't constrained to S&P 500-like securities but can invest in all kinds of assets, is this truly an appropriate “benchmark”? Even though the firm has a “goal” to beat the S&P 500, is it fair to compare the fund to it? I would say “no.” Hedge funds are usually thought of as “absolute investments” that don't have benchmarks, per se. But on what can I base this position?

If we turn to the GIPS 2010 standards’ glossary we find the following definition for the word “benchmark”: “A point of reference against which the composite’s performance and/or risk is compared.” Based on this definition, the client would have grounds to say that the S&P 500 is fine. But I think that the wording here is incomplete. One must venture to the section on Presentation and Reporting to really understand what is meant by “benchmark.” In ¶ I.5.A.1.e, we find “The benchmark must reflect the investment mandate, objective, or strategy of the composite.”

Benchmarks serve as a way to determine if the manager performed well. Too often we see the wrong ones employed. I recall an advertisement that appeared in January 2000 touting how 39 of a fund family's mutual funds had outperformed the S&P 500. Included were global and style funds that had no relevance to the S&P 500 and would not give any valid indication as to whether or not the funds had done well or not. Unless the manager actually manages against the benchmark such that the benchmark reflects the mandate, objective and strategy, it is inappropriate to use.

In this case the fund can invest in commodities, industries, currencies, and derivatives; the S&P 500, of course, cannot. I am tempted to say "pick on somebody your own size." To show the S&P 500 as a reference is fine, just as many hedge funds also show a bond index or even the consumer price index; these are merely for reference purposes only. And this should be clear. Most hedge funds are "absolute" investments for which sadly there really aren't relevant benchmarks.

"It depends on what the meaning of the word 'is' is."

I won't bother to identify the source for today's post's title, but it does serve a valuable purpose in trying to understand what words mean. I just finished How I Killed Pluto and Why It Had It Coming, and found it to be exceptional, not just because at one time I thought I wanted to be an astronomer. It's a book that I think everyone would enjoy. In it the author discusses the challenge in trying to determine a meaning for the word "planet," and seeks the help of a philosopher friend who says that words mean what we think they mean. Not very helpful.

In A History of Reading I encountered the following: "It would seem that, in order to read at even a skin-deep level, the reader requires information about the text's creation, historical background, specialized vocabulary and even that most most mysterious of things, what Saint Thomas Aquinas called quem auctor intendit, the author's intention."

Picking up from the "planet" example, there are some aspects of GIPS(R) (Global Investment Performance Standards) which could benefit from some eluci'dation (i.e., to be made clearer). I was recently engaged in a discussion about the meaning of "model fees." The term was introduced in the 2010 edition of the standards but without any explanation. Was it because the framers assumed that everyone would know what it means? Was it because they couldn't arrive at a definition themselves? Or, perhaps was it because it didn't occur to them that a definition was in order? I have no idea; but what I do know is that I don't know what the term means. Risking the possibility of being called pedantic, I will say that to me clarification is in order. I have opined on this in the past, and bring it up again, as my recent readings have once again caused me to reflect upon this matter.

The standards aren't designed to answer all questions and interpretation is often in order. But when the standards require a compliant firm to disclose if model or actual fees are used in their net-of-fee calculations (see ¶ 4.A.6), clarity is in order.Hopefully it will be forthcoming.

What to expect with a GIPS Verification

We decided to create an animation for our GIPS(R) (Global Investment Performance Standards) verification clients, to prepare them for the actual verification. We thought it would be helpful, and thought you might find it of interest, too.

It also demonstrates how these animations can serve many purposes.

PMARs 2011 Shaping up to be the best ever!

The Spaulding Group's Performance Measurement, Attribution & Risk (PMAR) North America conference returns to Philadelphia this May. We are on track for a record attendance. 

And after last year's very successful launch of PMAR Europe, is there any doubt that we will return to London in June? And like the Philadelphia event, this one looks like it will be a record attendance, too!

As you can see, we're going "all out" to promote these events!

We guarantee you'll learn a great deal and have a great time, too! So make sure you're at one (or both) of these unique events! You'll agree with past attendees that PMAR will be like no other conference you've ever attended.

Image source: PhotoFumia.com

Love Story's link to the world of investing...who would have thought?

If you're old enough you may remember the 1970 movie Love Story, that starred Ryan O'Neal and Ali MacGraw. While today's movie-going audiences would probably not find the movie very appealing, it did meet with a great deal of success four decades ago. One of the most unforgettable lines was uttered by both of these actors: "love means never having to say you're sorry."

And while we might debate the wisdom of this proclamation, one of our verification clients, Daruma Asset Management's founder and CIO, Mariko Gordon, uses "Love Means Always Having to Say You're Sorry" as her March newsletter's headline. She points out that we make mistakes (who doesn't) and it's okay to admit them. I think an investment firm's clients appreciate a manager who can not only acknowledge a mistake, but also identify its source, as it demonstrates that they have their finger on the pulse and know what's happening in their clients' portfolios. As Mariko points out, "our mistakes are calculated in real time and down to the penny, blinking red on [our] computer monitor for extra emphasis."

Mariko also wrote that "In the financial world, investors performing due diligence may ask about investment mistakes, but they often do so in an anecdotal way. They're more interested in specific examples of mistakes rather than assessing how mistakes are tracked, analyzed and dissected. Personally, I think it's more useful to ask the question broadly and see what sorts of mechanisms firms have to systematically track and learn from mistakes." (emphasis in original)

When it comes to mistakes, the GIPS(R) (Global Investment Performance Standards) of course have a (recently revised, thank you very much) guidance statement on error correction, which deals with some of the categories of mistakes firms encounter.

I encourage you to read Mariko's newsletter. Her practical and sound assessment and discussion of this topic is one that all should find interesting and insightful.

Let's stop celebrating GIPS as the only answer to our return questions

I recently wrote a letter to Pensions & Investments, which was published in their February 21 issue. Titled "Flaw in time-weighting return," it was a response to an earlier P&I article that discussed how plan sponsors need to ensure they're using the right benchmarks. And while I agreed that having the correct benchmark is critically important, it's even more important that plan sponsors employ the correct return methodology. I'm sure that you're not surprised that I was advocating the use of money-weighting for the plan to understand how they are doing, separate from the use of time weighting to see how the manager has done.

I posted the piece on Linkedin, and it has engendered a fairly lengthy discussion in one of the groups. Not surprisingly, there still seems to be interest in relying on what GIPS(R) (Global Investment Performance Standards) has to say, when the standards do not speak to client or in-house reporting. And I am not advocating that the standards should. But it's important that we recognize where the standards begin and end, and it all has to do with what a manager gives to their prospects.

In a recent animation, which I posted here earlier this week, I touched on the frequent use of time-weighting and suggested that one of the reasons is that this is just the way we've always done it. Obviously, this is a topic I have a lot of passion about. If this was an idea that had little chance of succeeding, I would have given up some time ago; however, we are making progress in educating folks, as evidenced by some of the Linkedin comments. But that being said, I will try to be "mum" on it for a while, as there are lot of other things to address.

The last 10% & Mulligans

I am confident that anyone who has been involved with the development of software will agree that the first 90% of a project is much easier to accomplish than the last 10%; the balance sometimes takes "forever!" Even husbands who take on home projects often get 90% of it done, with a plan to finish the rest, but simply never get around to it. Well, the same issue seems to apply to writing books, as getting most of the work done is much easier, at least to me, then the balance.

Case in point: the second edition of my third book, The Handbook of Investment Performance. I got the transcript wrapped up in relatively quick time, but the editing, layout, etc. seemed to take much longer than we had planned. And as we neared the "finish line," I got an email from someone from CalPERS who had some corrections to errors he discovered: talk about perfect timing! For this I was quite grateful, as I had overlooked some of them in my review. Well, the wait is almost over and the book is at the printers, with a delivery date fast approaching.

The book has served as a "Mulligan" for me. If you're not a golfer you may not be familiar with this term, easily translatable as a "do over." In a casual, friendly game of golf, if a player hits an errant drive it isn't uncommon for him or her to say "I'll take a Mulligan," meaning I will hit that shot again, without any penalty. This book is a Mulligan for me as it is allowing me to make some significant changes to the first edition, which was arguably a Mulligan for my very first book, published by McGraw-Hill.

Shortly after the earlier edition went to print I had an "epiphany" which I would liken almost to being "born again," as it has caused me to develop passion for what has become one of my favorite topics: money- versus time-weighting. I was so pleased to be able to write it that this chapter will be available on the CFA website.

You'll also notice that I have clearly admitted that "Modified Dietz returns are money-weighted." There, I said it again! I have caved into my colleague and friend, Carl Bacon, who long ago chastised me for failing to acknowledge this. And although I had known for some time that he was correct, I hesitated in stating it because it only, I thought, makes this topic even more confusing. I hope that my presentation in the book is lucid. And as for Carl, I do hate it when he is right, but fortunately this does not occur too often.

Our firm is actually running a "pre-order" or "pre-release" special on the book, so if you're inclined to purchase a copy, this is the perfect time. For details please contact Patrick Fowler

The Handbook of Investment Performance arrives this week!

We are so excited: my fourth book, The Handbook of Investment Performance, 2nd edition, arrives this week! And, we've already had around 100 orders.

It's great to be able to have a "do over," and that is what this is. I was able to incorporate a great deal of new material into the earlier edition.

We are running a special right now, so if you'd like to get a copy, contact Patrick Fowler or call my office (732-873-5700): they'll give you the details. But hurry, as the special ends March 15!

When having a minimum isn't an option

Many firms that claim compliance with the Global Investment Performance Standards (GIPS(R)) no doubt believe that the use of a "minimum" for their composites is an option, and in lots of cases this is probably true. For example, firms that strictly and consistently limit the size of new clients probably won't have a problem when it comes to assigning accounts to composites. But at other times there needs to be a minimum.

Recall that a minimum is supposed to be a threshold below which the firm is not able to fully execute the composite's strategy; it isn't meant to be a convenient way to reduce the effort to assemble accounts into composites (i.e., to reduce their workload). If the firm holds strictly to their minimum for new accounts, then it is likely that this value will serve the purpose for the composite's minimum.

One of our verification clients doesn't have a minimum, which in theory would be fine. However, they have some accounts that are so small that they cannot hold all the assets necessary for them to truly represent the strategy. In these cases, a minimum is needed. And the accounts that fall below are simply excluded. Of course this means that the firm needs to maintain the minimum. That is, they have to ensure that as accounts rise above the minimum they are included, and as accounts fall below they are removed. Yes, this is some added work, but it's required to ensure that the accounts in the composite truly represent the strategy.

Animation nation gets some publicity

Susan Weiner is a fellow blogger and a friend, who I enjoy chatting with, both through emails and our respective blogs. After seeing my recent move into the world of animation, she asked me to be a "guest blogger," which I was of course very pleased to do. That post was launched today; hope you find it of interest.