Compounding problems with hurdles

Some folks in a Linkedin group I'm a member of have been discussing the challenge of dealing with hurdle rates when calculating returns. As I showed in a December 2010 newsletter, you cannot compound these rates, as their rate of compounding is proportional with the monthly returns they're added to. In the examples I provided, where the annual hurdle rate is 1.00%, compounding can result in the actual annual hurdle rate ranging from 0.53% to 1.36 percent. So much for the agreed to 100 basis point hurdle.

And so, what is one to do if you want your compounded returns with the hurdle rates to tie out to what you've contracted to, or to track your hurdles on a monthly basis? The "simple" solution:

1. Take your annual hurdle and divide by 12 to arrive at the monthly rate
2. For each month that's being linked, add a multiple of the monthly hurdle rate to the linked return value.

That is, we link the returns first, then add the hurdle. Let's take an example. We'll begin with the way most firms do it, which we can call the "geometric" approach, since we are compounding the fee, along with the return. As you'll see, with this approach we add the hurdle, then link.

Suppose that we have an annual hurdle rate of 3.00 percent. If we intend to include the hurdle with our returns as they're compounding (i.e., to add the monthly hurdle first, then compound) we would take the hurdle rate (3.00% or 0.03), add 1 to it, raise it to the 1/12th power, and then subtract one, which gives us 0.2466 percent. This is our monthly hurdle rate. We add this amount to each monthly return, and geometrically link these values. The following table provides our data:

 I've labeled the columns to make the explanation hopefully clearer:

• (A) is our monthly return (just numbers I made up for this exercise)
• (B) shows the inclusion of the hurdle rates, on a monthly basis. Since we're doing this geometrically, we add the hurdle to each monthly return, and then link them. I'm showing the cumulative effect of this linking, so that February is the two-month linked return, March the three-month, and so on.
• (C) is the cumulative hurdle rate (since it's for the geometric approach, I linked the monthly hurdles). You can see that by themselves they link to the agreed to 3.00 percent.
• (D) shows the cumulative returns, based on the values in (A) (i.e., without the hurdle rate)
• (E) is the difference between (B) (the linking of the returns with the inclusion of the hurdle rates) and (C) (the linked hurdle rates)
• (F) is the difference between (B) and (D) (the cumulative returns without the hurdles included).

First, we notice that our return for the year with the hurdle is 21.3556%; when we compare this to our annual return without the hurdle (17.87%), we see that our hurdle isn't the 3.00% we would have expected, but significantly higher (3.49%). The additional 49 basis points makes success more challenging for the manager than what they had agreed to, yes?

I included columns (E) and (F) to show that on a monthly basis the numbers don't tie out as we might expect. Column (E)'s values should equal the cumulative returns, but we see that they don't match what's in column (D). Column (F)'s values should equal the cumulative hurdles (C), but here, too, the numbers fail to agree.

The problem with this method is that the resulting annual return, with the hurdle compounded along with it, will not agree with what your contract or client calls for (i.e., what you've agreed to), and will either be lower (and therefore easier to obtain) or higher (therefore more of a challenge), but in neither case correct. Who would agree to a hurdle that will vary, depending on market conditions? If I'm expected to deliver a return 300 basis points above the LIBOR rate, for example, isn't it reasonable to expect that at the end of the year, the compounded benchmark would be exactly 300 basis points higher than the compounded LIBOR rate?

Now let's consider the arithmetic approach. With this method, we will compound or link the monthly returns first, and then add the hurdle. To derive our monthly hurdle rate we take 1/12th of the 3.00% annual rate, which gives us 0.2500 percent. The following table provides us with the data for the full application of the method:

The column's meanings are consistent with the geometric table version. First, notice that in this case our annual return with the hurdles (20.8682%) is 3.00% higher than our linked return (17.87%; the return without the hurdle), meaning we reconcile to the agreed upon annual hurdle rate. In addition, on a monthly basis, our column (E) matches the cumulative returns in column (D), and column (F)'s values match the cumulative hurdles shown in (C).

While most firms no doubt utilize the first method (the "geometric" approach), I would argue that it's flawed, since the annual hurdle will only equal what the agreed upon value is, if the return for the year is 0.00 percent; otherwise, it will be higher or lower than the hurdle, which to me justifies a switch in methods to the recommended approach (arithmetic), where we tie out exactly on both an annual as well as a monthly cumulative basis. Certain numbers aren't supposed to compound, and you can include in this group returns with hurdles; compound the returns, then add the hurdles to them.

If you'd like a copy of the spreadsheets, send me a note.

Even the Bible encourages IRR ...

"Men have had recourse to many calculations"

Ecclesiastes 7: 29

What's the interpretation of this line? Sadly, my bible doesn't reference which return formulas the writer was referring to, but one with an open mind can conjecture that it's a verse that recognizes that many return calculations are available and that one would be remiss not to consider them all.

To rely solely on time-weighting, for example, would provide us with limited knowledge. And since Ecclesiastes falls within the "wisdom" books of the bible (along with Job, Psalms, Proverbs, Song of Songs, Wisdom, and Sirach), clearly we're looking for ways to enhance ones wisdom; ones knowledge. A multi-dimensional view can only be obtained by considering alternatives, with each serving a purpose; fulfilling a role.

And so, what further evidence is needed that IRR (internal rate of return; money-weighting) should be part of ones arsenal?

p.s., While I knew that the bible was a source of comfort, insight, and guidance, I didn't realize it could also be a source of support for money-weighting!

A brain teaser?

For today's post I'm taking a different tact, and  presenting a situation we're facing this week, to see what ideas you can provide. I'm visiting two clients in Boston over a three-day period, and then a third in Chicago. Here's my itinerary:

• Monday morning: Departed Newark for Boston
• Monday: Visited Client A to conduct a pre-GIPS(R) verification
• Tuesday & Wednesday: Visiting Client B to conduct a non-GIPS verification
• Wednesday night: Flying from Boston to Chicago
• Thursday: Visiting Client C to review their operation
• Thursday night: Return to Newark from Chicago

And so, there are three legs to the flying: from Newark to Boston, from Boston to Chicago, and from Chicago to Newark. Some salient points:

• Living in New Jersey, I typically fly out of Newark
• Each client has agreed to reimburse us for travel
• The total cost for the airfare is $710.10.

And so, how do we allocate the travel equitably across all three clients? I believe I have identified the best answer, and will share it on Friday. In the mean time, if you'd like to, reflect on it yourself and feel free to post it as a comment, or send your answer directly to me. Thanks!

Benchmarks: the good, the bad, and the ugly

A Wall Street Journal article spoke about high school graduating students who are "saddled" with being declared "most likely to succeed." One such individual who earned this title stated that she has "been constantly evaluating [her] success and using that silly award as a benchmark." And quite a benchmark it must be, no doubt.

At a recent Performance Measurement Forum meeting, we touched on hedge funds and their use of benchmarks. The key here is that the managers are not managing against these benchmarks, but rather use them only for reference purposes.

Benchmarks are critically important, in all aspects of life. And while being known as the graduate who is "most likely to succeed" might be a challenge, we no doubt compare ourselves to others.

Our younger son, Douglas, has become quite an athlete and participates in various events, like the Tough Mudder (and I thought the Army's obstacle courses were tough!). He told my wife what his time was for his first such event, and she thought it was a good one (any time would have sounded good to this proud mother); I, on the other hand, wondered what it meant relative to others, because without a benchmark, such as mean, median, high, low, it's difficult to judge (oh, and his time WAS very good). But a number by itself means little.

A lot can be said about benchmarks, and more will be ...

Is it "material"?

GIPS(R) (Global Investment Performance Standards) compliant firms are now required to have an error correction policy. This calls for firms to establish rules for materiality, something many struggle with from a definitional perspective.

The CFA Institute's Standards of Practice Handbook provides a definition of this term in relation to "material nonpublic information": "Information is 'material' if its disclosure would likely have an impact on the price of a security or if reasonable investors would want to know the information before making an investment decision. In other words, information is material if it would significantly alter the total mix of information currently available regarding a security such that the price of the security would be affected."

Might this not serve as the basis for a definition of materiality relative to errors? Perhaps "Errors are 'material' if their disclosure would likely have an impact on the assessment of the composite or strategy, or if reasonable investors would want to know the information before making an investment decision. In other words, errors are material if they would significantly alter the total mix of information currently available regarding a composite, such that the assessment of the composite would be affected."

Thoughts?

Anniversaries & milestones to celebrate

In the current issue of The Journal of Performance Measurement(R), we have an interview with Dean LeBaron, founder and former chair of Batterymarch. The reason for his selection is that he was a member of the FAF's (Federation of Financial Advisor's) Blue Ribbon Committee that worked on the first performance presentation standards (which turned into the AIMR-PPS(R) and arguably GIPS(R)). This year marks the 25th anniversary of the group's formation, and we thought it fitting to honor the occasion with one of the surviving members. If you would like to receive a complimentary copy of the interview, please contact our editor, Douglas Spaulding.

Speaking of the Journal, it's in its 15th year, which is quite a feat. We have published so many great articles over the years, and have had the pleasure of interviewing so many notable individuals. Many thanks to our editorial staff, advisory board, authors, advertisers, and subscribers, for their support and contributions. I will shortly interview Howard Marks of Oaktree Capital Management, who joins the list of several portfolio managers who have shared their views. Our interview will focus on much of what he presented in his most recent book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. In his book, Howard devotes considerable space to the topic of risk, so I look forward to exploring this subject further with him.

Last week we held the 50th meeting of the Performance Measurement Forum. This milestone coincided with the Spring meeting of the European chapter, which was held in London. The group has grown considerably over the years, with representatives from some of the leading investment firms, custodians, and software vendors as members. Once again, our meeting was filled with a great deal of sharing and dialogue.

A lot to celebrate!

43% of CIPM Expert Exam Candidates Pass!

We just learned that the scoring for the most recent test session for the CIPM (Certificate in Investment Performance Measurement) has been completed, and the results are that 43% of the 185 individuals who sat for the Expert Level passed. At the Principles level, 51% of 276 candidates passed. Candidates came from 31 countries.

As a long-time supporter of the program, I am pleased with these numbers for a few reasons: first, to see the breadth of countries represented is impressive. Second, the fact that less than 50% passed the expert says that it's becoming more challenging, which is arguably a good thing. The CIPM reflects a high degree of expertise in our profession, and  it should be both comprehensive and rigorous, which it is.

We congratulate those who have achieved the CIPM designation and those who passed the Principles level, and can now move on in the Fall to take the Expert. And, we encourage those who weren't successful to try again. You may want to avail yourselves of our firm's preparation courses. John Simpson, CIPM teaches them, and his students always comment very positively about how good they are. In addition, we offer Flash Cards which can also be quite helpful in the preparation process.

Client reporting standards: are they necessary?

At last month's PMAR (Performance Measurement, Attribution & Risk) IX Conference in Philadelphia, PA (USA), Beth Kaiser, CFA, CIPM of the CFA Institute informed our attendees of the initiative that is underway to develop client reporting standards. And this week in London, at PMAR Europe II, Stefan Illmer, PhD did the same. I have great respect for both Beth and Stefan, and appreciate their sharing of many of the details of this project.

Last night at dinner, I was reminded by my friend Steve Campisi, CFA that at one time I supported seeing such guidance being developed (perhaps I was suffering from a senior moment in not recalling this). In reality, I do support guidance, though not standards, and not promulgated by an institution of the CFA Institute's stature.

My concerns can be boiled down to: what will the added costs, in manpower and money, be for firms to become "compliant" with these standards and to have their compliance reviewed independently by an independent verifier?

I have a great deal more to say on this topic, but will save it for this month's newsletter, when I will also share some of the key details about this initiative, something all asset managers, especially those compliant with GIPS(R) (Global Investment Performance Standards) should be aware of.

Total Strategy Assets

I conducted a pre-verification for our newest London client yesterday, and they asked a very interesting question: can they disclose their "Total Strategy Assets," along with the composite and firm assets, in their GIPS(R) (Global Investment Performance Standards) composite presentations?

The answer (drum roll please): of course! Why not?

Let's say they have an emerging markets equity strategy, but for various reasons have more than one composite for it. Thus, they would show a prospect the composite that best aligns with their needs, but in reality they manage more in the strategy then shown in the composite assets field. Wouldn't it be beneficial for both the prospect and the firm to disclose this? I would say "absolutely!"

Great idea!

Alphabet soup ... does it really matter?

I stumbled upon an article I had saved from The Wall Street Journal, April 24, 2006 issue titled "Alphabet Soup," by Karen Hube. The subtitle reads "Financial advisors are adding more titles to their business cards. Do any of these labels really matter?

Great question. Do they? Well, I won't comment on the ones for financial advisors, but will for performance measurement professionals. Yes, the CIPM (Certificate in Investment Performance Measurement) really does matter.

It further strengthens our profession; and, it enhances your own stature, identifying you as someone who has achieved a high level of valuable knowledge.

And so, I have but one question for you: if you haven't gotten yours, yet, what's holding you up?

Is the sun setting on your disclosures?

The GIPS 2010 Exposure Draft sought to obtain a consensus to build a case to establish sunset provisions for certain required disclosures (e.g., name or strategy changes to composites) for GIPS(R) (Global Investment Performance Standards). And we are aware that some firms have implemented them in their policies. However, just to make it very clear, they do not exist!

While the GIPS Executive Committee hoped to establish them, because of the limited feedback they received, none resulted, none exist. Therefore, any disclosure shown as being required in the Standards is required forever, or until it no longer applies (e.g., if a change occurred for a year that is no longer reported, because it happened more than ten years ago, then one can arguably remove it, but not if that period is still shown on the presentation).

Any verifier who allows their clients to establish sunset rules is, in my view, doing their client a disservice, not a favor, since there is no basis for this. That's my interpretation, but I'm open to others'.

Goldman Sachs & Currency Attribution

In yesterday's Wall Street Journal, the editorial writer Holman W. Jenkins, Jr. wrote a piece about Goldman Sachs, explaining how they, and their chairman, Lloyd Blankfein, are being vindicated, as the SEC's attempt to shift attention from their (the SEC's) failure to catch Bernie Madoff, to a highly successful firm and individual, is faltering. This is sadly reminiscent of the government in Ayn Rand's Atlas Shrugged, where this populist strategy, to assign blame and negative attention to the successful firms and individuals, is an easy one to employ, as the public often seems willing to damn these targets, which can be akin to killing the proverbial goose that is laying our golden eggs.

And so, what does this have to do with currency attribution? The proper assignment of blame (and credit).

I was speaking with a client recently who explained that because they don't manage currency, they do not do currency attribution; rather, they use the basic Brinson Fachler (BF) model that only shows allocation and selection (they avoid interaction) effects, based on the base (US$) returns in their global and international portfolios. I suspect that many other firms hold to this same approach. And so, is there anything wrong with it?

Well, consider what would happen if, for example, we have a stock in Euroland, that had a zero percent annual return (i.e., its price was unchanged for the year) as measured in local (Euro) terms,during a year where the Euro's return relative to the US dollar was up 15 percent. By using the security's base return (15%, which arises solely from the currency change), we are unable to identify the true source for the security's return, and attribute it entirely to its selection.

To properly evaluate a portfolio's performance, when multiple factors are at work (the local dynamics of the security, coupled with the exogenous impact of currency movements over time), we must separate their contributions in our attribution analysis, by using the local (i.e., Euro in this case; not base, i.e., US$) returns in the BF evaluation of market effects, and a currency attribution approach to complete the job, in order to fully reconcile to our excess return, by addressing the impact of currency movements (and the contributions from any hedging we may have employed).

The decision to use a multi-currency attribution model has nothing to do with the management of currencies, but simply the exposure to two or more currencies, and thus the associated foreign exchange movements which occur, independent of what happens to the securities we invest in.

Light bulbs & GIPS Verification

There was an editorial (The Light Bulb Police) in yesterday's Wall Street Journal that spoke of the upcoming ban in the U.S. on conventional 100 watt incandescent light bulbs. One sentence in particular grabbed my attention: "The question an (allegedly) free society should ask is if CFL [compact fluorescent light] bulbs are so clearly superior, why does the government have to force people to buy them?"

It occurred to me that this question could have been offered against the once planned requirement within GIPS(R) (Global Investment Performance Standards) to mandate verifications; in a sense, this was an argument I made, as I believed with confidence that the market would apply a de facto requirement upon firms to undergo annual verifications.

Of course, the GIPS Executive Committee saw the wisdom of not requiring GIPS compliant firms to undergo verifications, because the market has done this for them. I think that this same attitude should be used as a test for future changes to the standards, as many items can no doubt be left to the firms themselves to discover the benefits of.

p.s., I am one of those U.S. citizens who oppose this new law. I have the right today to purchase CFLs, but have decided not to, in spite of the expectation that it might save me a whopping $50 per year. There are disadvantages to CFLs, including the fact that they aren't as bright as incandescent lights; perhaps the same can be said about the members of Congress who voted for the law's passage.

Interesting way to increase your odds of beating the market

In his weekend column for The Wall Street Journal, Jason Zweig points out a method that some advisors have apparently used to outperform (or at least increase their chances of outperforming) their benchmark: simply calculate the return of the index without taking income into consideration. He mentions a few advisors who, for example, compare their performance to the S&P 500 sans dividends. One individual claimed that he was "CRUSHING the S&P 500." Well, I guess it can be a lot easier to do this if you include income in your portfolio, but ignore it in the index.

Fortunately this isn't standard practice. If one choose to do this, we would expect they would include a footnote explaining this practice, but we also shouldn't be surprised if this added detail is overlooked.

The Spaulding Group Hires Jed Schneider

In case you hadn't heard, The Spaulding Group, Inc., has hired Jed Schneider, CIPM, FRM, formerly of Morgan Stanley Smith Barney. Jed is being brought on to head the firm's verification business (GIPS(R)) and non-GIPS), and is titled a Senior Vice President.

Because of the significant growth in this segment of our business, we felt that we needed to take these moves: not only to bring on a highly qualified and seasoned performance measurement professional, but also to have him be responsible for the practice. He will work closely with Christopher Spaulding, SVP of Sales and Client Relations, to build the practice even further.

Our verification model calls for us to only use senior level people, and we believe that this, along with a host of other reasons, has contributed to our recent growth. Our clients range from less than $1 million to over $500 billion under management, and includes US, Canadian, and European-based firms.

We have known Jed for many years, and know that he will work well with our clients. We are pleased that the press release we issued earlier this week has been picked up by at least three industry publications. For further information, please contact Patrick Fowler, Chris Spaulding, or Jed Schneider.

Pension funds and rates of return

A letter I wrote appears in the most recent issue (May 30) of Pensions & Investments, that's in response to a letter Jonathan Boersma wrote (April 18), which was in response to one I had written (February 21), in response to an earlier article (December 27, 2010), regarding pension funds and risk. I should mention that Steve Campisi also wrote a letter (May 16) in response to Jonathan's. Much of this dialogue deals with two primary topics or issues:

1. Pension Funds (and other similar bodies) and their compliance with the Global Investment Performance Standards (GIPS(R))
2. The use of money-, versus (or perhaps more accurately, in addition to) time-weighted returns.

Steve and I (along with a third colleague) are working on an article where we address the former in great detail.  There are benefits to these institutions complying, though there are potential risks as well, given that the standards are intended for asset managers who sell their services to others, including these very plan sponsors (I use this term in a broader way then many, as I think it can apply to not only pension funds, but also endowments and foundations, as well as other similar organizations).

As for the second point, the argument is, perhaps to some, tiresome, while to others one that needs continuous, or at least frequent, attention (see, for example, the Linkedin group dedicated to this topic). I won't repeat myself on this subject here, though this doesn't mean that I am one who has grown tiresome of the topic and its salient arguments.

Please take the time to review Jonathan's, Steve's, and my letters on this topic, as it's an important one, which perhaps needs greater attention and consideration.

NJ Beaches & Performance Software: they have more in common than you might think

The current issue of New Jersey Monthly Magazine has a "shore guide," which ranks New Jersey's beaches. And so, it's not unreasonable to expect someone to ask, "what's the best beach?" But the magazine doesn't say, nor should they, for the "best beach" will depend upon what you're looking for in a beach. The magazine does offer the best:

• Family Fun Beach (Point Pleasant)
• Family Quiet Beaches (Stone Harbor, Bay Head & Sea Girt)
• Secluded Beach (Strathmere)
• Boardwalk (Ocean City)
• Nude Beach (Gunnison Beach, Sandy Hook)
• Gay-Friendly (Asbury Park)

and more, but not a single "best beach." 

And so, what does this have to do with performance software?

We are often asked "what's the best performance system" or "what's the best attribution software," but it always comes down to what your needs are; what you're interested in; what you require. There is no single "best system."

Just as vacationers are interested in certain attributes for the beach they're going to spend time at, software users, too, have certain requirements which need to be taken into consideration.