What is the "sell side"?

We have been engaged in a research project for a client, who wanted information on "sell side fixed income attribution systems." This cause me to reflect a bit on the term "sell side."

You've no doubt run into the terms "buy side" and "sell side"; but do you know what the they mean? I used to always think of the sell side as the market that provides securities to asset managers, who in turn would represent the "buy side."

We might think of the sell side as those who sell from their own inventory (dealers), but this wouldn't be sufficient, would it, as brokers, too, make securities available to buyers. So to limit this to dealers is, I think, inappropriate. And of course, asset managers also sell, right? But to include them would result in no differentiation whatsoever.

During one of my doctoral finance courses, a professor offered a definition which I think is perhaps more accurate: the sell side sells liquidity. But even here, wouldn't asset managers sell liquidity, too? But to include asset managers is, I think, inappropriate, because once you do, then there is no need to differentiate between the two sides of the market. Yes, there are times when asset managers may provide liquidity, but in general, we're speaking of broker/dealers, yes?

Trusty Wikipedia offers the following: "It is a general term that indicates a firm that sells investment services to asset management firms." Investment services? Does not an asset manager sell investment services, too? But to avoid confusion, they add "These services encompass a broad range of activities, including broking/dealing [sic], investment banking, advisory functions, and investment research." It's interesting to note that this page states "This article needs attention from an expert on the subject." And the absence of references makes its information less valid. But who has written on this matter to any extent?

As always, your thoughts on this are welcome.

A challenging question: what to do with the money?

A colleague recently passed me a question that was sent to him: what is the proper treatment of class action settlement proceeds from securities-related lawsuits or bankruptcies, which are then deposited into an investment portfolio.

You may have encountered this yourself. When a firm goes into default on their bonds, the bondholders are left wondering if they'll ever see any money flow their way again. And at times, lawsuits are filed. Sometimes it takes years before a payment arrives. But when it does, how do you treat it?

First, do you treat it as an accrual? No, since there was no anticipation of any payment. Accruals should only be applied when there is a high degree of confidence or probability that a payment will be made. Once a bond goes into default, "all bets are off."

Second, is it income or a cash flow? Here, I think the answer is an "it depends." Technically, it's income. However, what if the bond was purchased by a prior asset manager, and your firm had no involvement in it at all. Because it's the same custodian, the income comes in and gets passed to you. For you to treat it as income would, I believe, be improper; for you, it's a cash flow. But if you were the manager who made the decision to purchase the bonds, then it's your income.

I hope this makes sense. Please comment if you have further thoughts or ideas you wish to share.

Committers of fraud need not apply...

You have perhaps heard that Abercrombie & Fitch is actually paying members of the reality show, Jersey Shore, money to not use their products; the individual known as "the situation" is one who has been particularly focused on. In this weekend's WSJ, Joe Queenan addresses the topic of hoping for certain individuals to avoid their products in "Please Don't Endorse Our Product."

This made me think of the case where a few firms embraced the Global Investment Performance Standards (GIPS(R)) who shouldn't have. The on-line publication Fundfire ran a few pieces on this, where they identified managers who were charged with fraud, who had not only claimed compliance but had also managed to get verified.

As I recently pointed out, the act of "claiming" compliance doesn't take much effort; anyone can do it. The real test is whether or not the firm actually is compliant. And while we expect verification to help determine this, it has been stated that this voluntary exercise isn't intended to identify fraud, and so the fact that a few tricksters were able to achieve a successful verification isn't necessarily a rap against this exercise.

But clearly, those of us who support the standards would prefer that firms that are less than ethical simply avoid claiming compliance; adding a fraudulent claim to their existing misdeeds might result in discrediting this important standard, which clearly we don't want to see.

Attribution survey ... please join in!

The Spaulding Group has announced that it's conducting a survey on performance attribution.

The survey will address all aspects of attribution, including approaches, preferences, and systems. Five cosponsors: DST Global Solutions, First Rate Investment Systems,  StatPro, Morningstar, and VPD have joined in so far for this research project. The cosponsors won't receive details about the participants - this information will remain confidential.

This is the fourth time the firm has surveyed asset managers on the use of attribution. The results are always well received, given the importance attribution has in the world of investing.

Please join in: all participants will receive a complimentary copy of the results. 

p.s., less than a week after we announced the survey we're at more than 100 participants! Please join in and make this a phenomenal research effort. Reminder: all participants will receive a complimentary copy of the results. Thanks!

Beta ... what is 1.0?

Beta is a risk statistic which tells us essentially how our portfolio behaves relative to the market. It is a derivative of Modern Portfolio Theory, and more specifically, the Capital Asset Pricing Model (CAPM). The purpose of this post isn't to address whether or not beta is dead; Fama & French can tackle that one. It's really a lot simpler than that.

The market gets 1.0; our portfolio's value is measured using the following formula:

We measure the covariance of the portfolio's return stream relative to the market's; that is, how they vary relative to one another. We then divide this value by the variance of the market.

One question that has held firm for CAPM is "what's the market?" Well, that's something that is taken up in the hallowed halls of academia; for our purposes, we have the same question, but not perhaps from such a purist perspective. We want to know what gets the "1.0."

Standard practice seems to be to assign the 1.0 to the portfolio's benchmark. In my opinion, to do anything but this can be of little value. For example, let's say that you use the S&P 500 to represent the broad market, and everything, including your portfolio's benchmark, relative to it. And let's say that as a U.S. small cap manager, your benchmark is the Russell 2000. And so, you first calculate the Russell 2000's beta, which you find to be (for exhibition purposes only; not in reality) 1.53. You next calculate your portfolio's beta relative to the S&P 500, and it turns out to be 1.61. This tells us that both the portfolio's index and the portfolio itself are more volatile than the S&P 500, meaning that they both exhibit more risk. So what? We're interested in the risk you've taken relative to the index your managing against, aren't we? And wouldn't it be more appropriate to set the Russell 2000 to 1.0, and measure the portfolio's beta in comparison to it? We should let the academics try to define "the market." But when we're measuring a portfolio's risk, its market is its benchmark, and risk should be compared against it. This holds for tracking error, information ratio, Jensen's alpha, Modigliani-Modigliani, and any other risk statistic that uses a benchmark in its formula.

p.s., There may be some value to measure a benchmark's beta relative to the S&P 500 (or some other "market"), to exhibit how each behaves relative to it, so I don't want to "pooh-pooh" the idea completely. But from a fundamental, foundational perspective, use the portfolio's benchmark when measuring risk. You're not managing against "the market," other than as represented by the associated benchmark.

Words matter

In yesterday's WSJ, William McGurn wrote about adhering to codes of conduct, and began by citing West Point's code: "A cadet will not lie, cheat, steal or tolerate those who do." As a former Army officer who served with many "ring knockers," I was already familiar with this code. As McGurn points out, it's the last few words that may be the most difficult to uphold. He cites the recent University of Miami football scandal as an example of folks who prefer not to say anything, when they are aware of improper behavior. Bernie Madoff's firm might be the greatest example of individuals who knowingly allowed illegal, unethical, and improper behavior to occur in their midst, and even to be knowledgeable and willing participants.

Earlier this week I participated in a panel discussion regarding the GIPS(R) standards (Global Investment Performance Standards). Someone asked "what does it take to claim compliance." In reality, it doesn't take anything but a willingness to make such a claim; the important thing is what it takes to achieve and maintain compliance. I have witnessed cases where firms who claimed compliance when they knew that they weren't. On one occasion, I told a firm's chief compliance officer that her firm was not compliant, and said that they have two choices: continue to claim and hope that the SEC doesn't find out, or stop claiming and get their house in order, fully expecting that she would dismiss the first. But to my surprise, that was her choice. We dropped them as a client.

McGurn mentioned how Miami's code states that violations "should" be reported. As a former member of the GIPS Investment Performance Council and Interpretations Subcommittee, I know how word choices are important. There is a big difference between "should" and "must."  Weighing our choice of words is important. But beyond the words is the character of the individual. We admire those individuals who, in the face of what appears to be acceptable (though in their eyes, poor) behavior, say "no."

The Spaulding Group is formalizing our standards of practice, to make it clear to our team what we expect. It is based on the CFA Institute's standards, which are arguably "best practice" for our industry. Perhaps codes of conduct shouldn't have to be written down, but at a minimum they convey our beliefs and rules. And not only won't we lie, cheat, or steal, we also won't tolerate those who do.

Math mistakes matter

In this past weekend's Wall Street Journal, Carl Bialik's article, "Technology Can't Save Us From Math Mishaps, brought home the problems we face daily in trying to ensure a relatively high degree of accuracy in the information we report.

He cited S&P's $2 trillion error which didn't dissuade them from lowering the U.S.Government's coveted AAA rating. It is interesting how this "error" was characterized: "The Treasury Department claimed that S&P originally used the wrong number - projected gross domestic product growth instead of projected inflation - to calculate what U.S. government spending and total U.S. debt would be for the next 10 years. S&P spokesman John Piecuch says that the original number 'was not a mathematical error at all,' but instead based on a different assumption about spending...John Bellows, Treasury's acting assistant secretary for economic policy, called it a 'basic math error.'"

Bialik further pointed out that a common cause for many wrong numbers is "insufficient safeguards to catch errors before the numbers are released." Amen. But how does one come up with these "safeguards"? That's the challenge. Mathematician Thomas R. Nicely is quoted as saying "The best method of preventing [errors] is to have two or more independent procedures for determining [or checking] the same result." If we were to apply this in the world of returns, would it mean, for example, to use two formulas (Modified Dietz and daily, for example? That, to me, wouldn't work, since the underlying data would be the same, and that's usually the cause for the errors, is it not?

One of our consulting clients compared their client returns to the S&P 500, and if they were off by a certain amount they'd flag it for review. On the surface this might appear reasonable, but given that their clients are primarily retail, non-discretionary accounts, that (a) aren't investing relative to the S&P 500 and (b) may only have one or two securities in their portfolio, it isn't likely to be very helpful. If the manager (or investor) is managing relative to a particular index, such a check is probably quite reasonable.

It's relatively easy to establish wide ranges to use as tests (e.g., if the return is below -50% or above 50% for some given period). But what about the errors that aren't quite that large? Which aren't quite so obvious?

Getting the soundness of the formulas down shouldn't be a problem; it's the data, right? And this is where it gets difficult. Processing the corporate actions properly, accounting for trades, capturing the right prices, getting the exchange rates correct, etc.  Data isn't a particularly "sexy" topic, is it (as opposed to returns, attribution, risk, and GIPS(R), that is)? But it's critical. And sadly, it's one of those areas that when everything goes well, the folks in charge probably don't hear very much; but when errors arise, they do.

Best practices in data management is a topic worthy of further discussion. If you have ideas you want to share, please pass them along. Thanks!

Netting same day flows...expanded commentary

Earlier this month I commented briefly on the question of netting same day cash flows. And, as promised, I expanded this topic in this month's newsletter.

I must confess that the analysis helped me gain greater appreciation for the proper treatment of cash flow timing. Our training classes include examples which dramatically show how mistakes in timing can lead to huge errors. This month's newsletter provides a similar, though different perspective on this topic.

A lot of times it's these small details that can lead to huge errors; and even when the errors aren't "huge," they can be still cause problems. In fact, it's probably the not-so-huge errors that are more problematic, because they're more likely not to be discovered.

Have thoughts, comments, insights, or stories to share? Please chime in!

Performance measurement and alternative investments...

I have spoken at several NYSSA events, and am very much looking forward to this one. Alternative investments seem scary, but are they? We'll discuss it on September 27; hope you can join in!

Should we blend?

A client alerted me about a new Q&A that is on the GIPS(R) (Global Investment Performance Standards) website. I'll save you the trouble of looking it up, and provide the particulars here. First, the question: 

"For one of our composites, we use a portfolio-weighted custom benchmark that is created monthly using the benchmarks of the individual portfolios in the composite. The GIPS standards require that if a firm changes the benchmark, the firm must disclose the date of, description of, and reason for the change. Given the nature of the benchmark, the benchmark is subject to change each month. What must be disclosed to satisfy this requirement?"

The response is interesting: "The GIPS standards require that if a custom benchmark or combination of multiple benchmarks is used, the firm must disclose the benchmark components, weights, and rebalancing process. In this example, the benchmark may change every month as part of the normal procedure. It is required in this instance to disclose that the benchmark is rebalanced monthly using the weighted average returns of the benchmarks of all of the portfolios included in the composite. A firm is not required to disclose how the underlying portfolio benchmarks and weights have changed each month. If the benchmark for the composite were to change from a portfolio-weighted custom benchmark created monthly using the benchmarks of the individual portfolios in the composite to a market index, this would be a benchmark change that must be disclosed

"In the spirit of full disclosure and fair representation, firms must disclose the components that comprise the portfolio-weighted custom benchmark, including the weights that each component represents, as of the most recent annual period end. Firms should also offer to provide this information for prior periods upon request.

"Sample disclosure: The Long US Government/Credit Custom Benchmark is calculated using the benchmarks of portfolios in the Composite. The benchmark is rebalanced monthly based on the beginning values of portfolios included in the composite. As of December 31, 2009, the breakdown of the benchmark is 88.2% Barclays Capital US Long Government/Credit Index and 11.8% Barclays Capital US Long Government/Credit A+ Index. The breakdown of the custom benchmark for different time periods is available upon request."

Our client, and we as well, found this approach to benchmarking quite unusual. Usually when we think of a custom benchmark it is constructed to align with a strategy for which a single benchmark doesn't work (e.g., a balanced approach, whereby we'd find an equity and fixed income component). Here, the manager has a composite where the underlying portfolios all align with different benchmarks. I would respond to the question with a series of questions.

Does the manager actually manage differently for each of the client benchmarks, or does the manager manage against a common benchmark? If it's a common benchmark, then it should be the one that's used. If the manager manages differently for each client, in accordance with their respective benchmark, then why aren't they using different composites, since benchmark is an acceptable criteria for composite construction?

If the manager feels that the differences between the portfolios is not material, then I would advise them to pick one of the benchmarks and use that. What value is a benchmark that reflects a dynamic mix of underlying benchmarks, each representing the strategy for of a different client? And asset-weighting them means that the larger account's benchmark rules, yes? But why? And don't forget, the firm can provide additional benchmarks for reference purposes, too!

I think this question calls into the issue of the role of the composite benchmark: is it not to provide a basis to compare the manager's successful implementation of their strategy? If the manager is managing across multiple benchmarks, they may have success with one and failure with another: combining them means what, then?

This is an interesting topic, I think, and one worthy of some reflection, too. Your thoughts are welcome.

What goes around, comes around

The revelation that the U.S. Justice Department is now investigating S&P's ratings of pools of mortgage backed securities is perhaps totally unrelated to S&P' recent downgrading of the U.S. government's credit worthiness, but the timing does suggest otherwise. Assigning the coveted AAA ratings to pools with sub-prime mortgages (which individually would most likely have been below investment grade) provided many investors with confidence that was unfounded.

Sorry, but I liken S&P's recent actions to the SEC's, when their failure to catch Bernie resulted in them getting tough with the likes of Goldman Sachs.

Whether or not the government's investigations are in response to what S&P did, it's probably still justified and perhaps long overdue.

What is the difference between functions and features?

John Simpson and I are spending this week working on a new service which we will introduce later this year (stay tuned for details!). During the course of our conversation, a question arose: what's the difference between functions and features?

I must confess that I found it difficult to articulate a response, so I turned to the ever present and trusty Google to show us the way. One site told us that "features generally refer to physical attributes or specifications of any thing. Functions are what the thing does or is useful for." I'm not sure this is all that helpful, though I believe we were able to get a better grip on it.

A function does something; features are characteristics or qualities of the function, or perhaps how it does what it does.

When assessing software, should buyers look at functions, features, or both? I would think that the focus would be on functions (what you're looking for the system to do for you), as these are fairly easy to identify. Features may vary from vendor to vendor, though functions may be almost universally available. And so, you might consider the features of one vendor versus another, as a way to decide which you prefer.

Care to share your views on this? Please do.

500! Can it be???

www

Google "500" and you'll find

• S&P 500
• Indy 500
• a card game called 500
• perhaps even a reference to a movie about the "500" days of summer.

Well, this post represents a "500" of a different kind: it's the 500th for this blog, which I think is pretty incredible. Granted, we've had a couple guest bloggers, but just like the 166,000+ miles on my BMW Z3, I'm responsible for most of them being there.

Close to 12,000 individuals around the globe have paid us a visit. We have a group of regulars (you know who you are), as well as folks who stop by once in awhile.

Blogging is something The Spaulding Group management team had talked about me doing for a few years before I actually began; I thought it would be much harder than it is to get set up, but it isn't. I've met several other bloggers along the way, and enjoy checking their work out, too.

You can't blog unless you have something to write about, and clearly I have. And, you have to have opinions, which I'm not short of, as well as an interest in writing. At times, my blog posts (like our newsletter) might be less sensitive in their construction than perhaps they should be. I never intend to offend; merely express my views, which at times run contrary to those of other folks. But if we all agree, how do we move forward? Different perspectives and ideas should be welcome, and they generally are.

I was chatting with a client last week who was questioning the idea of introducing the internal rate of return into their reporting for pension funds: he didn't realize that I would be excited by the prospect. His view was based on a methodology that has been around for close to five decades, so it's understandable why the idea of a totally different approach might not be welcome. But paradigm shifts are often good to experience.

Hopefully these posts have entertained and educated; given our readers something to think or reflect upon. I am appreciative of those who are comfortable commenting, even when they disagree with what I write. But I try to be open to other ideas. You may not change my opinion, but you'll at least cause me to reflect a bit more. I want to acknowledge my friend and colleague, Steve Campisi, who has frequently commented on posts, interjecting his views and broadening the topics to provide broader perspectives. He also contributed a couple "guest blogs," which we appreciate.

I haven't slowed down, and there always seems to be something to write about, so the blog moves forward.

Google occasionally updates the software that makes the blog possible, and this just occurred, with the replacement of "followers" with "members." I don't know what all of this means, but do know that if you're set to "follow," you may no longer be getting emails announcing posts. Our firm's COO, Patrick Fowler, figured out how to do this:

• Go to the bottom of the blog, and click on the Posts (Atom) link 
• In the drop-down menu, select Microsoft Outlook. Click "Subscribe now" and validate that it is a secure provider. The blog will now populate your Outlook RSS Feeds section. Note: the first time you do this be prepared to receive a LOT of posts (which can come in handy when you're up at night suffering from insomnia!

Have ideas to improve the blog? Want a topic addressed? Let me know! Thanks.

Is it okay to "net" same day cash flows?

I conducted a consulting assignment earlier this week, where I reviewed a client's operation, including their approach to calculating and reporting returns. A question came up as to whether or not cash flows can be netted if they occur on the same day. My initial reaction was that it would probably be okay; but after thinking about my general recommendation that inflows be treated as start-of-day events and outflows as if they occur at the end of the day, I decided to avoid committing to an answer without doing a bit of research.

This research proved to be fun and insightful for me, as it broadened my views a bit on cash flows, in general. While I still hold to my general position that inflows should, by default, be treated as start-of-day events and outflows as end-of-day, I also believe that there can be exceptions, which has always been my view. But in the course of my review, this point came home "loud and clear."

Space does not allow me to go into this topic in depth, other than to say that in general, "NO, it's not a good idea to net flows." I will opine on this at length in this month's newsletter. A little teaser, perhaps? If you have thoughts in the interim, please let me know!

A record setting event!

I've already mentioned that The Spaulding Group's next webinar will be held this coming Monday, August 15 at 11:00 AM EST. I learned today that registration has been phenomenal, and that it will likely set an attendance record for us. And while loads of our verification clients and Performance Measurement Forum members have taken advantage of their opportunity to participate at no cost, there are many others who have signed up, too.

The topic, Excel Tips and Tricks for Performance Professionals, will be hosted by Jed Schneider, CIPM, FRM and Neil Riddles, CFA, CIPM. They will provide some of the tips and tricks they have learned in their 50 plus years (combined) in investment performance measurement, attribution and risk. Tips will include custom formatting, date manipulation, pivot tables, using arrays to link returns, using IRR and XIRR to calculate internal rates of return, offset function, conditional formatting and other tricks for use in performance calculations.

There are only a few more days before this event, so if you're interested, sign up soon! If you can't  make it, you can still obtain a copy of the event.

Again, the webinar is free for Spaulding Group verification clients and members of the Performance Measurement Forum. A modest per site fee of $150 is charged for others. By "per site" we mean that you can have a room filled with people, but will only be charged $150, which is quite reasonable. Please contact Patrick Fowler (732-873-5700) for more details or to register.

p.s., I should mention that there is no truth to the rumor that Jed and Neil will be doing their "cool tricks" on Yo Gabba Gabba.  And if you don't know what I'm talking about, you probably don't have young children or grandchildren (I didn't know what this was, either, until recently).

Benchmark changes ... when to make them

 Let's say that you have a balanced portfolio, and you've selected the S&P 500 to represent the equity portion, and the Barclays Agg for the bond side. Your strategy for the portfolio is 80% stocks, 20% bonds, thus your index is blended in the same fashion (i.e., 80% S&P, 20% Barclays).

Because of the challenges in the stock market you've decided to move more money into bonds, reducing your exposure to stocks to just 40%. And so, your portfolio now looks like 40% equities / 60% bonds. Do you alter your benchmark accordingly? That is, should you alter the balance of the two indexes which represent the benchmark?

No!

And why not? Because this change is a tactical move, brought about by your belief that such an adjustment will be good for your client, given what's going on in the market. If you adjust the benchmark, you won't know if this was good or not. By keeping the benchmark aligned with your long-term strategy (80/20), this temporary shift allows you to see if it was good or bad.

Make sense?

Financial advisers and the reporting of past performance

Today's Wall Street Journal had a very interesting article by Jaime Levy Pessin titled “Advisers’ Little Secret: Their Past Results.” It touches on the subject of financial advisers’ general lack of past performance for prospective clients.

Many advisers primarily provide advice, and don’t have discretion over their clients’ portfolios. Thus, the performance of these portfolios wouldn’t necessarily be representative of the adviser’s skills, as individuals may choose some of what the adviser recommends, but include some of their own decisions, too.

Where the adviser has discretion, there are opportunities for them to showcase their performance. The GIPS® standards (Global Investment Performance Standards) are clearly the best way to present past performance. It requires firms to construct composites, which are collections of accounts that are managed in a similar fashion. A challenge for many advisers when it comes to GIPS is the need to have a “firm,” as only firms can comply with the standards. Unless the adviser has this ability, or unless their entire organization is prepared to comply, the Standards probably won’t apply.

Advisers can still construct composites even though they aren’t able to comply. And, they can have these returns verified by and independent third party, just as GIPS compliant firms do (in addition to performing GIPS verifications, we have done these reviews for several advisers, and provide “non-GIPS” verifications for several firms, too).

Of course, many firms are reluctant to allow their advisers to showcase their performance, because monitoring such presentations can be extremely challenging, especially when a firm has thousands of advisers.

Interestingly, many of the advisers’ clients or prospective clients never ask to see performance results, thus appearing to obviate the need for this effort. Hopefully more retail investors are realizing that adviser past performance, just like anyone’s, is worth investigating.

We consult to several brokerage firms, and most find their advisers asking whether their numbers are “GIPS compliant.” While this recognizes the value of the standards, it also demonstrates a misunderstanding of what the standards are. Ms. Pessin identified efforts that are underway to define rules for this segment of the market, something we've discussed doing with some of our clients.

To summarize: if GIPS doesn’t apply, an adviser can still create composites to showcase those strategies they wish to market. And, they can have these returns verified, to add further credibility to what they provide.

Does the comma belong?

Okay, I've seen this more than a few times, but it just struck me: there's a comma missing!

And what, pray tell, am I speaking about? Paragraph 4.a.1 of the GIPS(R) (Global Investment Performance Standards) 2010 edition. We find the following being the required wording:

"[Insert name of FIRM] claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards."

But isn't there supposed to be a comma, right after "Standards"? I..e., shouldn't it be:

"[Insert name of FIRM] claims compliance with the Global Investment Performance Standards (GIPS®), and has prepared and presented this report in compliance with the GIPS standards."

The wording before the comma ("[Insert name of FIRM] claims compliance with the Global Investment Performance Standards (GIPS®))") could stand alone as a sentence, right? And the second part ("has prepared and presented this report in compliance with the GIPS standards") assumes the same subject being present (i.e., "[Insert name of FIRM]"), which would make that an independent clause, which could stand alone as a sentence, yes? Therefore, a comma is in order.

But, it's not there. Can you add it? I would say "no," since your presentations are to match what's in the standards, exactly (except, of course, that instead of [Insert name of FIRM] you'd have your firm's name. Might you insert a [sic], to indicate that you know that it's wrong, but you're not going to correct it? I wouldn't object.

Thoughts? Any English majors (or minors) out there want to chime in? I know we have at least one writer reader who surely knows more about these details than I, and I'm all ears (or more correct, eyes!).

Oh, and please don't interpret this as a criticism of the standards compilation: as someone who does a lot of writing and publishing, I've definitely had more than my share of typos, and grammatical, notational, and spelling errors.

Takers vs. givers and GIPS discretion

Jed Schneider and I are doing a GIPS(R) (Global Investment Performance Standards) verification for a client, and a question came up regarding the need to create a composite.

A U.S. Equity manager is asked by a client to purchase some Canadian stock; would this (a) cause the account to become "non-discretionary" and/or (b) must the firm create a separate composite? Before I answer, let's consider the opposite situation:

Let's say you're a North America Equity manager (e.g., you invest in U.S. and Canadian stocks) and you have a client who says "No!" to the Canadian stocks; what would the answers be here? Well, first, it's up to the firm to determine if the exclusion of these stocks would cause such an impact that the account would not be representative of the strategy; if they feel that it would, they can declare it "non-discretionary" (for GIPS purposes). And, there would be no need to create a separate composite for the "U.S. only securities. However, they could (if they wanted) create a separate composite.

Why would the earlier example be any different? If the addition of Canadian stocks would cause the account to no longer be representative, why not declare it "non-discretionary"? And again, they would be under no obligation to create a separate composite. However, they could, if they wanted.

And what if they created a separate sub-portfolio for the Canadian stocks, so that they could have the U.S. stocks included, is this permitted? Yes, as long as the cash is being managed separately. And the Canadian-only portfolio, again, need not be included in a separate composite, because this was an accommodation for the client (just as the removal of Canadian stocks would be). Make sense?

In an email confirming his agreement with our position on this, our colleague John Simpson wrote:

If a client asked a US equity manager to buy some Canadian stock, then as far as composites there would be three options:

1. If the strategy is not inhibited/prohibited by the request, the portfolio should remain in the composite
2. If the strategy is inhibited/prohibited, the portfolio should be marked as nondiscretionary and excluded from composites
3. Alternatively, the portfolio could be added to a separate composite.

I do think that such a request might be more likely to make a portfolio nondiscretionary than a restriction in general, but I guess it depends on the Canadian stock purchased (or the restriction).

Whether the client is taking something away from your strategy ("no technology stocks for me!") or giving ("please add some health care to the mix"), the same rules for GIPS discretion can apply.

And so, we have agreement at our firm; what do you think?

August webinar: some tips & tricks

The Spaulding Group's next webinar will be held Monday, August 15 @ 11:00 AM EST. The topic will be Excel Tips & Tricks for Performance Professionals. Jed Schneider, CIPM, FRM and Neil Riddles, CFA, CIPM, will provide some of the tips and tricks they have learned in their 50 plus years (combined) in investment performance measurement, attribution and risk. These will include custom formatting, date manipulation, pivot tables, using arrays to link returns, using IRR and XIRR to calculate internal rates of return, offset function, conditional formatting and other tricks for use in performance calculations.

The webinar is free for Spaulding Group verification clients and members of the Performance Measurement Forum. A modest per site fee of $150 is charged for others. By "per site" we mean that you can have a room filled with people but will only be charged $150, which we think is quite reasonable. Please contact Patrick Fowler (732-873-5700) for more details or to register.

Shall we interact?

I had a conversation with a client last week, where we addressed a variety of aspects regarding performance attribution. They asked how common it is for firms to report their interaction effect. While I don't believe we've addressed this question in any of our surveys, my gut tells me that most firms avoid doing so, in order to avoid having to explain it.

What is interaction? All one need to is to look at the formula to answer this: it's the difference in weights (portfolio minus benchmark) times the difference in returns (again, portfolio minus benchmark); and these components represent allocation and selection, respectively. And so, it's the interaction of these two decisions.

Why is it needed or why does it appear? Because the individual effects (allocation and selection) are isolated from one another, so as to not allow the influence of the other to impact its results (e.g., the selection effect is the difference in returns times the BENCHMARK weight, not the portfolio, since portfolio weight would reflect allocation). But this answer fails to mean much to most folks, thus the desire to avoid it.

The topic of whether it should be included or not is often hotly debated, as there are passionate voices on both sides of this issue. I've written an article on the topic, as have others, including my friend, Steve Campisi. In the end it's up to the firm to decide how they wish to handle it.

We will include a question on this topic in our upcoming attribution survey; more details to follow. We hope you'll join in, as we want as many participants as possible, all of whom will receive a complimentary copy of the results.

Asking the right questions

One website I frequently visit is Fox News' site. Since I've given up watching news on TV, my primary sources for news today are the WSJ, Bloomberg's website, and this one. The Fox News site often has what might be called "human interest" stories. I found a report that individuals who use Internet Explorer aren't as bright as those (of us!) who use Firefox. It seems that AptiQuant, a self-proclaimed "world leader in the field of online psychometric testing," published the results of a study. Now who would have thought to inquire into the IQs of individuals who use one search engine versus another? I guess the question posed was "how smart are the people who use Firefox, as opposed to Internet Explorer?"

Anthony Robbins, the well known motivational speaker, published a tape series (probably now on CD) a few years ago that addressed specifically the "power of questions." He was speaking more about the questions we might ask ourselves (e.g., "why am I so fat?"), and how they should be rephrased (e.g., perhaps to "how can I lose weight and feel good doing it?"). The notion of asking the right question has been one that resonates with me.

When it comes to much of what we do, we need to be mindful of what the question is! We give answers, often without being asked the question, perhaps presuming what the question would be. The reality is that when it comes to risk, return, and attribution reporting, the question should drive what the answer is. This is not to say that asset managers should not report performance and risk without seeking questions from their clients; but it should be understood the perspective of the information being shared.

We have been commissioned to conduct research for a client, and thus are phrasing the survey questions according to the interviewee, and in some cases recognizing that multiple perspectives are in order. Take plan sponsors, for example: when we speak of attribution with this group, do we mean "Brinson-Fachler," for example? I would generally say "no." But it, again, depends on what the question is.

We have all encountered dumb questions (reporters are known for asking some pretty dumb ones, yes?). The above study, to me, is just another example (though I did ask my management team what browser they're using!).