Pension funds, GIPS, and legs...

It has occurred to me that the pension fund performance topic and compliance with GIPS(R) (Global Investment Performance Standards) "has legs." In other words, "staying power." It's not going to go away any time soon.

The most recent person to pick up this topic is Susan Mangiero, who blogged about it on Monday, citing my earlier post. I appreciate Susan's interest in this topic and believe that her post will only add more attention to this important topic. And so, expect more to be said.

Non-discretionary cash: what to do with it

I was contacted earlier this week by a client who was dealing with a situation where one of their clients had requested them to raise a sizable amount of cash, for the ultimate purpose of investing it into a new strategy, while keeping the balance of their portfolio in its existing strategy. Unfortunately, once the cash was raised the client was nowhere to be found to finalize the agreement for the new strategy, so the cash sat in its original GIPS(R) (Global Investment Performance Standards) composite for an extended period of time, putting a drag on that portfolio and composite's performance. What options did they have available to deal with this? Well, actually three:

1. Adopt the significant cash flow option. This allows the firm to temporarily remove accounts from composites when there are "significant" flows. The challenge for this firm is that many of their composites only have a few accounts, and to adopt this option might result in breaks or gaps in performance.
2. Use a "temporary portfolio" to move the securities into which are to be sold, or the cash that results from the sales. While I think this is a great tool, it does create some accounting challenges when it comes time to reconcile to the custodian, since the custodian only knows about one account.
3. Flag the cash that was raised as "non-discretionary." This would require a separate cash account to be established (e.g., "Non-discretionary Cash"), which is flagged on their accounting system as "unmanaged." There could be an issue with reconciliation here, too, but it's not nearly as daunting as with temporary portfolios.

To me, this scenario is a clear example of cash being non-discretionary: once it was raised, the manager could do nothing with it until they got instructions from their client. While the standards don't speak directly to this, within the Composite Definition Guidance Statement we find a reference to "client-restricted securities," so the Standards are clearly mindful of situations where the manager is unable to take action for securities. Cash is no exception when the manager cannot invest it.

In my view, all firms should be sensitive to situations like this. Think about it, once you raise cash for a client it immediately becomes non-discretionary and you could arguably move it out (into a temporary portfolio) or flag it (as non-discretionary). Perhaps you don't want to do this in all cases, especially when the impact is de minimis, but when the cash is sizable relative to the portfolio and/or remains in the portfolio for an extended period, waiting for the client to withdraw it (or, in a case like our client's, to instruct you as to what they want done with it), to take such action is quite reasonable and appropriate. You should have a policy on this matter, however, and you should employ your process in a consistent manner.

p.s., Recall that I will discuss the topic of policies & procedures in next month's webinar. To learn more or to sign up, please contact Patrick Fowler. (It will be held on May 27)
p.p.s., The GIPS website provides access to PDF versions of the standards and guidance statements. I frequently access these to quickly find information. Just do a "find" on the topic you're interested in, and you can quickly be sent to the section(s) of interest.

Error Correction Policy ... some ideas and clarifications

The revised GIPS(R) (Global Investment Performance Standards) Error Correction Guidance Statement provides clarity over the earlier version, though I suspect that many individuals whose firm claims compliance with the Standards haven't read it (but should!). This topic is one that is often confusing and sometimes results in policies which are lacking in substance and clarity.

Next Month (Friday, May 27, to be exact) I will host a webinar that will touch on many of the policies we expect to see a GIPS compliant firm to have. But given some recent questions that have arisen about error correction, I thought it would be a good idea to touch on this topic here, though in cursory fashion. I may take this up in greater detail in next month's newsletter.

Levels of errors

A firm can have as many as four levels of errors, and perhaps more, if they wish to be creative. Here's what is included in the guidance statement:

1. Do nothing! We would expect this to exist for errors deemed so immaterial that there is no need to take any action at all. While this is an option, most of our verification clients don't avail themselves of it.
2. Correct only These errors are still deemed "immaterial," though they are of a level that at least warrants correcting them. 
3. Correct, and disclose the error Here the firm will not only correct it, but also indicate in their materials that an error was corrected. By the GS (guidance statement), this is still considered an immaterial error, which to me adds some confusion, as I'll touch on below.
4. Correct, disclose, and redistribute This is the only level of "material" errors the GS references. It is deemed to be of a level that warrants giving corrected copies to individuals who (a) received the prior version (with the error) and have since become clients and (b) are still legitimate prospects. And, in some cases, requires you to disclose the error for 12 months!

To disclose or not to disclose

Let's take up the subject of "disclosure" for a moment.  Recall that the idea of retaining a disclosure of errors in presentations for 12 months wasn't well received when it was included in the GIPS 2010 Exposure Draft, and was subsequently removed from the final edition. A Q&A was published to try to add clarity to the revised intent, following the decision to abandon the verbiage from the Standards. I, like many others I suspect, interpreted what was here to suggest that as long as the firm maintained a list of recipients of their presentations, the disclosure wasn't required. Well, the disclosure isn't required for new recipients, but is for those individuals who you gave the prior version to (this point was clarified in the revised GS).

Okay, so for material errors, as long as you track recipients, when you discover material errors you need only disclose the error in the corrected materials you give to prior recipients; new recipients don't need to know of your error(s). The wording from the GS:

"Firms are not required to disclose the material error in a compliant presentation that is provided to prospective clients that did not receive the erroneous presentation. However, for a minimum of 12 months following the correction of the presentation, if the firm is not able to determine if a particular prospective client has received the materially erroneous presentation, then the prospective client must receive the corrected presentation containing disclosure of the material error." (emphasis added)

Well, what about the 3rd case of errors: immaterial that warrant correction, not redistribution, but disclosure? First, there is no indication as to how long the disclosure must be included in the materials (and since for other required disclosures that have no sunset provision, "forever" is the implied rule) and second, there is no option (as with case #4) to not include the disclosure.

I can't think of a situation where one would want to go with option #3 (immaterial but worthy of letting future recipients know that you had made an error). I can see someone going with three (#1, #2, and #4) or two (#2 and #4) levels of errors. If you can think of why you'd want #3, please let me know.

Materiality ... what is it?

I think that like former U.S. Supreme Court Justice Potter Stewart's remarks about obscenity (not knowing how to define it, but knowing it when he saw it), the same applies with materiality. I heard someone once suggest that you should establish a level that wouldn't require you do make too many changes; sorry, but that isn't approaching the subject in the spirit that it should. Essentially, the level should be such that it would cause the recipient to think differently from how they previously did. Of course there is no way to know generally how this would be, so we should select a level that we feel is appropriate.

What to include? 

When developing your policy you should cover everything that is in your presentations: numbers and words. For numbers we mean returns (composite and benchmark), dispersion, assets, etc. For words, we mean disclosures, such as firm definition, composite definition, etc. Errors can mean forgetting something or stating something incorrectly.

This is a rather long post, but it only scratches the surface. Again, I'll touch on this at our upcoming webinar, and most likely in next month's newsletter. To learn about the webinar, please contact Patrick Fowler.

Why performance measurement, Part II: Relative vs. absolute performance

Although for many this topic will be quite basic, I'm hopeful that there are still some insights that might be of interest. In it I point to a situation where an investor had no interest in relative performance, although it was arguably the appropriate approach.

Account minimums and timing

The Global Investment Performance Standards (GIPS®) permit firms to establish a minimum account size. This minimum is intended to represent the threshold, below which accounts aren't able to represent the composite's strategy. While many compliant firms, no doubt, use it as the minimum that they will accept, that's not the intended meaning.

Minimums are an option, however, and not everyone uses them. But if you do, how do you decide when to remove an account (when they fall below the minimum), and when to put it in (when it rises to or above the minimum)?  Some firms use the beginning market value as the determinant for removing an account. But is this appropriate?

Let's say that your minimum is $1 million, and an account's value on June 30 falls to $940,000. This would mean, given this approach, that the account will be included in June but removed in July. While this is permitted, does it make sense? If your minimum truly means that below this level the account isn't representative of the strategy, does it belong in the composite in June? Would it not make more sense to remove it from the composite if the ending value is below? What if it had dropped all the way down to $50,000? And what if it dropped because on June 5 the client made a huge withdrawal? Clearly the account that month doesn't represent the strategy. And yet, based on this rule, it would be there and its return would influence the composite's.

My suggestion: include it based on the beginning of the month value and remove it based on the ending month value. Meaning, that if, for example, at the start of June the account has risen above the threshold, it's included in June; if at the end of August if it falls below, it's out for that month.

Does that make more sense? Thoughts?

Pension funds and GIPS

Of late there's been some discussion occurring regarding pension funds (and similar entities, such as endowments, foundations, and even central banks; i.e., "asset owners") becoming compliant with the Global Investment Performance Standards (GIPS®). I believe that I was the first person "on record" supporting such a step, as I commented on this topic in response to an article that harshly criticized the idea, in Pensions & Investments a few years ago (I have the letter somewhere if anyone is interested in seeing it).

I still believe that the idea has merit, though it's important to understand why such an organization would (or perhaps should) seek compliance and what their compliance would mean.

One cannot lose sight of the reason we have the standards in the first place: to provide an ethical framework for asset managers to provide their past performance to prospective clients. This clearly doesn't apply to pension funds. So why would anyone want to go through the time-consuming and costly exercise to achieve compliance if they don't market their services?

One reason is that it helps the firm get their shop in order. It requires the establishment of policies and procedures, and along with that controls. It forces individuals to think about how they organize themselves, what policies make sense, etc.

Would the plan have only one composite or multiple?

The plan might only have one portfolio,  per se, that is broken up across dozens or even hundreds of smaller subportfolios, each geared towards a specific market segment. There can be justification to create a single composite (for the entire portfolio) or multiple composites. If you go with multiple, where each aligns with a subportfolio, what do the numbers represent? The performance of the manager. Therefore, if an external manager is being used, it will be their performance; if it's an internal manager, it will be his or her performance. But not the plan's. And if the plan is set up as a single composite, then the return represents the performance of all the managers in aggregate. But again, not the plan's, because the plan's performance can only be measured in one way: using money-weighting.

The only concern that I have with pension funds, etc. embracing the GIPS standards and becoming compliant is that they will interpret them as being the most appropriate way to represent how they're doing, but this is about as far from the truth as one can get; it represents how their managers are doing. If anyone wants to know how the plan itself is doing, GIPS won't tell them. The Standards don't speak to this.

I have already had discussions on this topic with one pension fund and a central bank, both of whom claim compliance. I cheer them on for wanting to comply, but that is not sufficient as it fails to tell them what is most important: how THEY are doing. Yes, it's important to monitor the managers, but this can be done without the GIPS standards, and has been for many decades. "How are we (the plan) doing?" is a different question, and requires a different way of thinking and calculating returns.

Is a new standard needed?

May I be so bold as to suggest that this part of the market (pension funds, endowments, etc.) would be better served with a standard that is geared specifically to them. That would be preferable. With but one standard, that is the only place one looks for answers. But, it shouldn't be. Perhaps moving to GIPS is a good "first step" in the process; and hopefully at some point in the future we will see a standard that speaks to this market, providing a framework that will result in returns that answer the right questions.

Challenges with predicting the future

You may have heard that at last week's Masters Golf Tournament in Augusta, Georgia, young (not quite 22 years of age) Rory McIlroy was leading by four strokes after the third round, with just Sunday to play. The golf pundits expressed great confidence that Rory would achieve victory given his stellar play the first three days, and that no one was likely to be able to catch him. Sadly, this wasn't to happen as he finished Sunday with a rather poor 80. And from out of nowhere, South African Charl Schwartzel won the tournament. My point? With just one day predictions were far from accurate, even when given by the most knowledgeable of sports people.

When a doctor tells a woman that her "due date" is October 31, how likely is it that he'll be correct? Well below 50% it seems: Wikipedia, in an x-rated post, reports that it's below five percent. Mike Brown in How I Killed Pluto and Why It Had It Coming explained how, when his wife was pregnant with their first child, he wondered what percentage of babies were born before versus after the date; how many were born within a day, a week, etc. of the date. He attempted to develop statistics on this. No doubt such stats would be helpful in providing some degree of confidence as to when a baby will, in fact, arrive.

I spoke last Tuesday at a DST Global event in Singapore, where I delivered a talk titled "Performance Measurement: One Size Doesn't Fit All." Later I sat on a panel with Nick Wade of Northfield and an old friend, Trevor Persuad of Russell. The topic of ex ante risk came up, and I commented how difficult it is to make any accurate predictions, thus the need to couch such statistics with a declaration that qualifies what the number(s) represents and the assumptions underlying it.

It's necessary in many cases to offer predictions; it just important to understand what their basis is and potential for being correct.

p.s., As an aside, Trevor mentioned that you can't manage risk with Value at Risk, and I thought this was an insightful comment. Recall that VaR is based on a portfolio's history: how does one adjust their history? This is perhaps another topic that is worthy of some discussion.

Why bother with rates of return? Explained in an animated fashion.

While in China last week the subject of the value of rates of return came up a couple times; this inspired me to put this explanation together, which will be the first of at least three parts on this topic.

Deadline extended for "mini survey"

Last month we announced our first "mini survey." I had planned to reference it in our March newsletter. Unfortunately, I forgot, and so we have extended the deadline to participate until May 15. Please join in as your responses will be of value, and the survey will take you less than five minutes to complete. Thanks!

Changes in firm definition

I was asked an interesting GIPS(R) (Global Investment Performance Standards) question: Firm A changes its firm definition to include additional markets; must they include the history or can they simply pick up the new accounts for the expanded market as of the redefinition date?

Answer: they must include the history (five years or since inception).

Why? Well, think about this: let's say, for example, that a manager of institutional and wrap fee accounts can't bring the wrap fee accounts into compliance today because they don't have the history, so they define the firm without them. Then, six months later they redefine themselves to include wrap; if they could just start from that point, this would be an easy way around the rules, yes? That would be a problem. And so, they need the history. Make sense?

Madoff on risk

I was intrigued by an interview that appeared in last weekend's Financial Times: "Madoff spins his story." This is the longest interview to date of the formerly well respected investor, until his record-setting Ponzi scheme was revealed.

It's definitely worth a read, as we discover who some of the banks are that Madoff hinted previously were knowledgeable of his misdeeds. He is no doubt in many ways paying for his crimes, with the breakup of his family and the recent suicide of his older son. I am not by any means suggesting that one feel any degree of pity for him, as it's undeserved.

It occurred to me that I might approach him to do an interview for The Journal of Performance Measurement(R). Wouldn't it be interesting to gain some insight into his views on risk: how to measure it, how to identify it? Perhaps, how to detect a Ponzi scheme or fraud? He is quick to blame others for failing to find him out, as if it's not entirely his fault for what occurred. I'd ask him about managing money but given that he stopped doing any actual trades decades ago, it would be fruitless. But insights into his views on risk might be interesting. Something to consider.

A Campisi Perspective on the Brinson Models

Steve Campisi returns as both a "guest blogger" and "guest animator," sharing some of his insights on the Brinson models. I'm sure you'll find his commentary of value.

Why performance measurement?

Please allow me to share something personal with you. I am often asked why I chose to work in investment performance measurement, and I must confess that it was anything but a grand plan. I am reading Michael Gerber's E Myth Mastery, and came across the following, which aligns very much with what happened to me:

"The only answer I can give you to your question about why the work I do with small business is so important to me is, I don't know. I do know it's important, though. More than anyone could imagine. And it's important because I have made the commitment to do it. Why I made the commitment to do it is beyond me. It was just there; it showed up. And it was more than just interesting. It was compelling. It was elegant. It took my breath away. And I didn't make the commitment all at once. It took time. All the rest is a fairy tale."

Substitute "performance measurement" for "small business" and I think this statement applies to me. Clearly my love of math helps. I have come to love the three Cs (change, controversy, and confusion); the folks I've had the pleasure of working with; and we can add a 4th C: challenges. It is an increasingly important part of the investing world, and I'm "jazzed" to be part of it. As our firm's tag line reads, "Performance Measurement is our Passion." It truly is. My story is a bit longer, of course, but I think this summary sufficiently explains why I do what I do. And so, why are you in this segment of the business?

Attribution: a matter of perspective

While I often speak of returns being a matter of perspective (that is, whether we're speaking about how the manager did or how the portfolio or client did) to determine whether time- or money-weighting should be used, the same holds true with attribution. I was recently approached by a portfolio manager who wants to report attribution from a selection, country, and sector perspective. Okay, so right there we have three different effects we may want to consider. But it gets even more interesting. Let's consider this first approach:

Here we see that we are able to reconcile to the excess return, using either the country or sector effects. And notice that the sector's weights are relative to the portfolio, meaning that we are evaluating how each sector (as well as country) contributes to the overall excess return. And so, we see how our allocation and selection decisions worked out at the country, sector, and overall levels.

Now, let's consider the following:

Here we have grouped the sector data together, so that we are only focusing on how each sector contributed to the overall return. You'll notice that the portfolio's effects are different than what we saw in the earlier example, but that's because our analysis is now from the perspective of the sectors and the way the manager invested relative to them.

In our third example you can see how the sector weights are now relative to their respective countries:

We are now answering the question, how did the manager's actions at the sector level contribute to each country's performance?

And so, there are lots of ways to "slice-and-dice" our numbers, to provide us with different perspectives as to what is going on. It's important to understand that this is possible and to decide which way(s) makes the most sense for you. You may want to look at attribution from multiple perspectives, which is great, but understand what the information is reporting to you.

By the way, I have ignored the currency effects to make this presentation easier; perhaps we'll add this factor at a later time.

Plan sponsor performance

I recently suggested to a plan sponsor that they consider using money-weighting as well as time-weighting, pointing out that since they control the cash flows, such an analysis would provide some value. Well, today I got an email which offered the following:

It appears that you believe a plan sponsor has 100% control of their cash flows, but this is not true. At the total fund level, the drivers of cash flows are contributions and retirements, and these are impacted by pension legislation and other factors. Within the asset classes, things like the asset allocation study and board policy (acceptable ranges within each asset class) are key drivers affecting allocation changes.

I won't argue that the external cash flows may be controlled by other parties, but the allocations across sectors, as well as the selection of the managers are controlled by the plan sponsor, even if the board is involved in these decisions. Thus, money-weighting has value here, too. I guess one question to ask: "what does a time-weighted return tell us at the fund level?" Your thoughts are invited.

An animated approach to software searches

We get to listen in on a discussion as to how one might pursue performance measurement software.