Happy LDW (Labor Day Weekend)

Memorial Day is the "official" start of summer,and Labor Day the official end, despite the fact that both are technically off. But starting next week, we will pretty much return to "business as usual." Hoping you and your family had an enjoyable summer, and that this long (for some of us) weekend is an enjoyable and safe one.

Why retail investors could care less about rates of return

I often hear from those who serve the retail market that they are rarely asked for their rates of return; this seems a bit odd, as it would make sense for investors to want to inquire into a prospective manager's track record.

An article in this past weekend's WSJ might hold the key to a possible reason: the dislike for mathematics.

Alexandra Wolfe's article, "Edward Frenkel and a Love of Math" explains how most folks avoid anything with numbers. Frenkel, a professor at UC Berkeley, suggests that "you say the word 'math' and people shut down."

When I was working on my second masters (an MBA), I also served as an adjunct professor, and once taught a class on business math. Perhaps because of my approach, I was able to get students, such as those Frenkel references, to find some enjoyment in math. But for most folks it would be difficult to break through the walls they've constructed.

I wonder if most adults could answer the following question: an investor begins with $10,000 and earns a 4% return; how much money did they make? Do most adults even understand what a percent is? If a financial planner or advisor tells an investor that his/her return was 6.12% versus the benchmark's 5.75%, would this mean much? Would they think it's a good or bad thing?

Further research would definitely be needed to try to uncover the basis for the avoidance of the subject, but I suspect that ignorance might be part of it.

"Cool Words"

As grandparents of two boys (ages four and soon-to-be two), my wife and I have become acquainted with the television show "Yo Gabba Gabba." A regular feature is called "cool tricks," where a guest displays something they think is, well, cool! For example:



I think there are some cool words. Some I discover while reading books or the WSJ, while many are introduced to me in other ways. One word I recently came across is autodidact, which means "a person who has learned a subject without the benefit of a teacher or formal education; a self-taught person."

Until roughly 15 years ago, anyone in the field of performance measurement was autodidactic, as there were no other ways to learn our craft. In fact, there were very few written resources available, either. I recall almost 30 years ago trying to design my first performance system, scrambling to find the right formulas to employ.

Times have changed. We've seen many books on the subject of performance measurement introduced; several that The Spaulding Group has published. And, to further meet the need, 15 years ago we introduced a training program, that began with our Introduction to Performance Measurement (now Fundamentals of Performance Measurement) and Performance Attribution. These classes have since been augmented with new ones, including a week long "boot camp," a course dedicated to risk measurement, a GIPS workshop, and two courses designed specifically for the CIPM(R) program.

While there is nothing wrong with the autodidact approach to learning, it can be difficult. We have too often come across folks who learned this way, but learned the wrong things. One thing we often find interesting and rewarding is when we teach folks who have been in performance measurement for 10 years or more, but who had never before had any formal training. Like "rookies," they end up learning a great deal.

Insights & Perspectives

It recently occurred to me how these two words, insights and perspectives, play a non insignificant (i.e., significant) role in performance measurement. I often reference both when I teach, but thought it appropriate to share some views here with you.

Insights

My favorite source for word meanings, Dictionary.com, provides the following for "insight":

1. an instance of apprehending the true nature of a thing, especially through intuitive understanding
2. penetrating mental vision or discernment; faculty of seeing into inner character or underlying truth.

I often gain insights when reading or listening to someone speak. Often, they're ideas that are transportable to our business.

To me, performance attribution is a huge source for insights, as it allows for the reader (to paraphrase the above definition) to apprehend the true nature of the source(s) of the return or excess return. By employing a flexible attribution model, one can twist and turn their portfolio about, seeing more than would otherwise be visible (for example, Ron Surz's "attribution with style" is just one way to look at the data from a different perspective (see below for this word) to gain additional insights into what's going on). We can penetrate the data and discern what is occurring, seeing into the inner character of the portfolio and the truth within.

In conducting performance attribution, we should strive to gain as many insights as possible, so that we are able to fully comprehend what has occurred.

Perspectives

The website dictionary.com offers a variety of meanings for this word, and the following are best for our purposes:

1. the state of one's ideas, the facts known to one, etc., in having a meaningful interrelationship.
2. a way of regarding situations, facts, etc, and judging their relative importance.
3. the proper or accurate point of view or the ability to see it; objectivity.

I often point out that the decision as to whether to use money- or time-weighted return methods should be based on the perspective in which we want the information to be presented. Again, to paraphrase the above, the way regarding the situation and facts, to judge their relative importance. Based on one's perspective, it provides the proper or accurate point of view, which actually results in an improved ability to see what has occurred.

A GIPS(R) verification client of ours asked me to review supplemental information that they propose including with their composite presentation. What they've done is broken their portfolio up into various sectors. These are not "carve-outs," because they don't contain cash, and if they did, it wouldn't have resulted from the cash being managed separately. It is quite common to see managers show the returns of asset classes (e.g., equities, bonds, cash), but for GIPS purposes this would be considered "supplemental." In our client's case, they break the data up into several categories, not necessarily mutually exclusive (see below).

I am gaining my own insights into this information, and realizing it caused me to consider performance attribution a bit more. I don't recall if it's ever been stated before (perhaps because it seemed obvious), but when we conduct attribution, the portfolio's components (e.g., sectors) which we analyze must be mutually exclusive; i.e., we couldn't have the same security sitting in two sectors simultaneously.

I liken what our client does to a form of attribution, since it provides the reader some insights into where the returns are coming from; however, as already stated, it wouldn't qualify as traditional attribution, given that it fails the "mutual exclusivity" requirement.

A question also arises regarding what is being presented; what's the perspective? If, for example, we're looking at U.S. large cap stock performance, is the manager saying "this is how the large cap sector of the portfolio performed" or "if I were to manage a large cap strategy, this is how I would have done"? These are vastly different, are they not?

Consider just a few of the differences:

1. Cash: with the former, the exclusion of cash is appropriate, since we are only concerned with showing how the large cap stocks within the portfolio performed; with the latter, we'd expect to see cash present, since there would bound to be cash in a large cap portfolio, the relative composition of which might vary from time to time.
2. Gaps: I have written in the past that I can see one justifying crossing gaps in performance, if you want to show how the avoidance of a sector (e.g., banking) might have benefited the overall performance, vis-à-vis the benchmark. And so, for the former I'd permit gap-crossing. However, for the latter I wouldn't, since the likelihood of someone managing a portfolio solely devoted to banking or any strategy going completely empty, would be extremely unlikely (I'm open to how you think this might occur); perhaps this would take place if the client decided to temporarily shift all their funds away from that strategy, but the resulting gap wouldn't be crossed.
3. Makeup: for the former, we wouldn't necessarily have any expectation for a "minimum number of securities." However, for the latter, since it is equivalent to a portfolio being managed to a strategy, we would expect to see several securities present. While one or two might be okay for the former, they most likely wouldn't for the latter.
4. Return methods: in the former case we would push for money-weighting, since the manager is controlling the cash flows; in the latter, an argument could be made for time-weighting, for if this were a separate portfolio, even though the cash flows might be under the control of the manager, we typically see time-weighting employed here.

And so, understanding the perspective, once again, is critically important.

Insights and perspectives: two words that really do have a lot to do with performance measurement. I may have more to say on this in our September newsletter, as I think it's an interesting topic; hope you do, too!

What about us?

Earlier this year, the Global Investment Performance Standards (GIPS(R)) Executive Committee published a draft guidance statement which expands the reach of GIPS into the asset owner world. I have commented briefly on it here before, and wrote an article for Pensions & Investments. In addition, I provided a comment letter, which is (along with the other feedback received) available on the GIPS website.

I was recently interviewed by P&I about one letter in particular: the one from Towers Watson Investment Services (TWIS). They raised the question about the Standards applicability for consulting firms, especially in cases where they "can be viewed as having discretion over assets under management and provide performance for [their] clients." Excellent issue to raise.

While written guidance would probably be helpful, I believe that one can cull from the Standards what is needed for such entities to comply.

Cases where the firm has discretion: There are times when a pension fund (or similar asset owner) has turned over responsibility for the management of the plan to a consulting firm. In these cases, the consulting firm has (a) the right and authority to determine the asset allocation (strategic and tactical) and (b) determine who will manage the various strategies (possibly with internal resources or through a subadvisor). Each underlying strategy (e.g., U.S. Large Cap Value) would result in a composite, that contains the appropriate subportfolio results for each of their clients. In addition, it would be appropriate to have a macro composite that consists of the entire portfolio, that will reflect the allocations as well as the management of the individual sectors. Because of the likelihood of materially different allocations, multiple composites would likely be created. The assets of the clients for which the firm has discretion would form the firm's AUM (Assets Under Management). These arrangements are similar to fund-of-fund managers.

Cases where the firm doesn't have discretion: Here, the firm provides advice to their clients, regarding allocations and managers. However, the consultant doesn't have the authority to make the ultimate decisions. In these cases, the firm could still create composites and provide returns, though these would be "supplemental" information, that would require clear and full disclosures regarding what is included. These assets would be AUA (Assets Under Advisement). Sufficient disclosures are necessary to make it clear that advice is given but not necessarily followed.

The Standards can, in many cases, be applied, without any additional guidance, but the same could have been said for asset owners. Therefore, some supporting guidance would no doubt be beneficial.

Should retail accounts be shown a benchmark?

Last week, during a talk I was giving to a group of operations folks, someone asked my thoughts on showing benchmarks to retail investors; specifically, those that are non-discretionary.

It's important to realize that benchmarks serve two purposes: first, as a way to demonstrate skill, where the benchmark is one that aligns with the investment approach, and second, for reference purposes. Since most retail investors won't be managing in a particular style for which a benchmark will align, we are left with the idea of showing benchmarks for reference purposes. In this case, it's more of a "by the way, here is how the DJIA, S&P 500, Barclay's Agg, US CPI did."

If the client has an objective, such as wanting to have a return of at least four percent, to meet his/her obligations without dipping into principal, then having an "absolute" benchmark (in this case, 4%) would make sense to show.

By including a variety of indexes the client can see how they're doing relative to various markets, and may decide to invest passively (or perhaps even actively) in one or more.

Overselling time-weighting

For some time it's been my view that time-weighting was oversold.

That is, when nearly 50 years ago (1966, to be exact) Peter Dietz published his dissertation, promoting a return method to eliminate or reduce the impact of cash flows, his idea was so powerful and intriguing that it caused the Bank Administration Institute (BAI) to publish the first set of performance standards (1968), which encouraged the use of (what they called) time-weighted methods, to eliminate or reduce the effect of cash flows. This was followed by the ICAA (now the IAA) in 1971, with a different set, but that also promoted time-weighting.

The industry's response was as you might expect: acceptance. Because there had been no rule regarding how to calculate returns and, as Peter discovered, the result was a mix of methods, most of which were simply wrong.

But Peter never intended to have pension funds, etc. to stop using the IRR (money-weighting). On the contrary, he, and many others (such as the UK's Dugald Eadie), identified the role of this method. But, either because of the inability to grasp what Peter, Dugald, and others were saying, or not even paying close enough attention, the use of the IRR as a method to evaluate a plan or account from the client's perspective disappeared.

I liken this overselling to the case involving a Catholic girl and a Baptist boy who were dating. The girl's mother recognized that marriage was a possibility, and suggested that it would be a good idea if she could persuade her boyfriend to convert to Catholicism. And so, the daughter began working on him, taking him to church regularly, explaining the rituals, etc. A few months later, in tears and sadness she phoned her mother to explain that the marriage wasn't going to happen. "Why, weren't you able to sell him on the Catholic religion and get him to convert?" The daughter replied, "yes, but I think I overdid it; he's decided to become a priest!"

Like the girl in this story, the industry was oversold. Fortunately, there are several of us who are encouraging firms to reconsider the use of money-weighting, and meeting with a fair degree of success.

Combining time- and money-weighting

I am in Montana this week, conducting a session titled "Current Topics in Performance Measurement" for a conference of operations folks. One individual asked about combining time- and money-weighting into a single number. I think the idea lacks merit, as it takes away the best that both have to offer.

Time-weighting eliminates (or at least reduces) the effect of cash flows, so as to present the best representation as to how the manager performed.

Money-weighting takes cash flows into consideration, to present the return from the client's perspective, taking into consideration their decisions (as to when to add or remove money) as well as the manager's investment decisions.

There is absolutely nothing wrong having two different returns;  they serve two very different purposes. Perhaps someone can offer a justification for doing so which isn't clear to me, but until that happens, I vote for having two measures.

Revaluation vs. Repricing ... there IS a difference

It is quite common today to find firms revalue their portfolios for large cash flows. But what do we mean by "revalue"? Is "repricing" enough?

Think about this scenario:

• On January 31 the portfolio holds 20 different stocks, along with some cash.
• On February 15, a purchase is made for 500 shares of Dell (which remains, at least at the moment, a public company).
• On February 16 a large cash flow occurs and the portfolio is revalued. Since it's a trade date system, the Dell position is included.
• On February 18, the trade is cancelled, because it's determined that it was done for the wrong client. And so, the position is reversed.
• On February 28, the portfolio is revalued with closing prices.
• On March 5, the portfolio is reconciled with the custodian's month-end positions and found to tie out 100%.

UNLESS the firm went back to the February 15 revaluation and backed out the Dell stock, that revaluation is wrong.

When we get involved with designing performance systems for clients, the reliability of the daily valuations is often an issue we address. In most cases I am not a fan of storing daily valuations, but rather to back into them, when necessary. If you're using a method that revalues for large flows, you should ensure that this is more than just repricing; otherwise, some errors may be creeping in (here, you do all this additional work for a more accurate result, only to have an avoidable error appear). At a minimum it's worth asking, what happens when a cancel/correct occurs?

Tech Survey to be Expanded

The Spaulding Group has been surveying the industry for 20 years on a variety of topics. This year we focus once again on performance and risk measurement technology, with two surveys:

• One for the users
• One for the suppliers.

Until now the suppliers' survey has been sent only to software vendors; it serves as the basis for The Journal of Performance Measurement's "wall charts," which summarize, in a rather neat fashion, the responses we get. These charts have proven very helpful to firms that are looking for software.

This year we are expanding the suppliers' survey's reach to include custodians. The reality is that this segment of the market is also a supplier of this functionality, and it will be helpful to gain insights into what they offer.

Both surveys are being finalized, and will be available for public input shortly. As with all of our surveys, participants will receive complimentary copies of the results. If you have any questions about this topic, please contact Patrick Fowler.

Cash can be your friend or enemy

I was interviewed by Julie Steinberg of the WSJ for an article that appeared this week ("These Two Funds Picked a Really Bad Day to Debut," August 5, page R1) regarding the impact contributions can have on a mutual fund's performance. While time-weighted returns eliminate the impact of the flows (by bifurcating the period before and after the flow), it does nothing for the cash's potential drag or boost of a fund's perfor-

mance, if it ends up not being invested immediately.

The delay in investing new cash can be (a) because the market is not that liquid, (b) because the manager wants to hold off on putting the money to work (which can be for a variety of reasons), (c) to be available for market timers, who, when they sell, demand payment quickly (before trades would settle), (d) probably other reasons unknown or not recalled by me at this time.

If there's more cash than the manager would typically have sitting around for any length of time in an up market, returns can suffer; if, however, the cash is hanging around in a down market, then there can be a benefit to having it not yet invested. Since mutual fund investors will likely not be able to see what goes on day-to-day, the impact of cash won't typically be known.

I also mentioned that an investor's returns will usually be quite different from the fund's, because of contributions and/or withdrawals the investor makes during the period. He/she/they should ideally see a "personal rate of return" (read: money-weighted) to know how they are doing (in addition to the fund's (time-weighted) return). More and more fund families offer this.

The WSJ relentlessly tries to educate retail investors, and I think this was a great article in that it provides investors some insights into this important topic.

The tentacular reach of the GIPS standards

I was recently interviewed by Pensions & Investments ("Fiduciary delegation," July 22, 2013) regarding the appropriateness of expanding the Global Investment Performance Standards (GIPS(R)) to outsourcing firms: firms that provide investment services to pension funds (i.e., that make investment decisions on behalf of the fund). I explained that while the Standards perhaps should include some verbiage directed to this segment of the market, for the most part, what is required to comply is within the corpus of the Standards.

The interest in expanding into this sphere falls on the heels of the Standards' introduction of draft guidance for plan sponsors. Thus, we see the Standards expanding into more markets, which is a very good thing.

I've also been asked about the appropriateness of investment consultants claiming compliance. While doing so would only be valid when the consultant has total responsibility for the investment decisions, there are still opportunities for the sharing of some of the consultant's skills. In reality, the Universal Advisor Performance Standards (UAPS) may be more appropriate, since they don't require full discretion over client assets as GIPS does.

In our view, GIPS remains "best practice," regardless how you define that term. And where appropriate, it should be adopted.

I was recently in Sydney, Australia, where I taught our firm's Fundamentals of Investment Performance and Performance Attribution courses. I was disappointed to learn that GIPS has very little value in that market. This surprised me given the role the former Australian Investment Performance Standards (AIPS) had, prior to the convergence of all CVGs (Country Version of GIPS). It would be an interesting case study to discern why this market has decided to suspend the adoption of presentation standards: a future project, perhaps.

Being willing to be different and the need to challenge / confirm conventional wisdom

In this month's Spaulding Group newsletter, I wrote a bit about the high jumper Dick Fosbury, who introduced an entirely different way to scale the bar. I vividly recall watching the meet on television in which this was first publicized. Many laughed (including the announcers) at what he was doing, as it was so different. But today, if you watch this event at any major tournament, you'll see that Fosbury's Flop is pretty much the standard approach.

This, to me, raises questions about our acceptance of methods that have been around for a long time. I won't go into any detail here, as I've opined several times in the past on it.

We also must confirm ideas that have been generally accepted. I am nearing the completion of my doctoral dissertation, and hope to defend it shortly. It addresses aspects of transaction and holdings-based attribution, and some of my hypotheses may appear trivial, given that everyone knows this. But, to "know" and to have "proven" are two different things. We often accept things as being factual, even though there has never been any proof behind them. Just about everyone knows that if you drop a penny off the top of the Empire State Building in New York City and it hits someone on the head, they'll die ... but, it's not true! In my role as a "researcher," I cannot accept things that are generally believed; I must demonstrate empirically that they're valid. But, these are only a couple of the several hypotheses that are included, and only provide some fundamental grounding from which the others can be developed.

I don't know yet whether we'll publish the dissertation; perhaps a limited number of copies, for those who think they'd find it of interest. For me, it's been a long struggle, but an educational and enjoyable one. It's the journey, right, that's supposed to be enjoyable, not necessarily the destination?