A great example of why BF is better than BHB

The late Damien Laker once opined that there was no difference between the two "Brinson models," Brinson-Fachler and Brinson-Hood-Beebower. I went out of my way to enlighten him on this subject, pointing out that the allocation effect for the latter uses only the benchmark sector return while the former uses the benchmark sector return minus the benchmark return:

As a result, there can be sizable differences in the results and, at times, even sign-switching!

The BHB model rewards investors who overweight positively performing sectors, while the BF only does so if the sector outperforms the benchmark. When discussing this in our training classes, I explain that if all the sectors are positive, BHB would want the investor to overweight them all!

The WSJ today reported that all 10 stock sectors of the S&P 500 will, in fact, have positive gains for this year ("All 10 Stock Sectors Post Gains in Big Year." Dan Strumpf Page C4).

 

Thus, we have such an occurrence when the investor is supposed to overweight everything; but how can they do this without borrowing money? They can't. BF, more correctly, I believe, wants the investor to only overweight those sectors that fall above the benchmark itself.

Thus, we have a perfect example to draw upon to demonstrate the superiority of the older (by only one year) model, which Gary Brinson crafted with Nimrod Fachler.

Be mindful of the costs before setting new rules

In yesterday's Wall Street Journal there was an article regarding the impact of the so-called "Volker Rules" on small banks ("Banks Play Small Ball Vs. Volker," by Andrew B. Johnson and Andrew Ackerman). In it we find the following: "In a legal filing with the U.S. Court of Appeals for the District of Columbia, the trade group said U.S. regulators showed 'utter disregard' for the costs the provision would impose on numerous small banks." [emphasis added]

I was immediately reminded of some of the provisions that have been proposed over the years for those who comply with the Global Investment Performance Standards (GIPS(R)). I mentioned before the response from one individual to the costs that would be realized by firms to provide compliant presentations to existing clients ("well, isn't that just too bad").

At the most recent GIPS conference in Boston we learned that consideration was being given to require compliant firms to provide copies of presentations to all mutual fund shareholder prospects. The costs have been estimated by some to exceed $1 million a year for some firms. Having sat in many meetings of groups involved with the Standards, I know that cost is rarely, if ever, a topic of discussion. But it needs to be. What are the benefits of such a requirement versus the costs that would be incurred? As I've  noted in the past, this idea about mutual fund shareholders brings up the bigger question: who is the prospect/client for a GIPS compliant firm? In my (and many others') view, the fund itself is the client/prospect, not the shareholders, as they are being marketed to by the fund itself.

While I would not characterize the attitude of those who oversee the Standards as showing "utter disregard" for the costs, I do hope they will be mindful to the impact of new ideas on the purse strings of those who have chosen to comply. The idea, long a hallmark of the Standards, of a "level playing field," may be a thing of the past if costs make it no longer feasible for firms to comply.

Taking costs into consideration should be a required step for those who set rules that others are required to follow!

Seasons' Greetings!!! Merry Christmas!!! Happy New Year!!!

I am taking this week and next week off, so won't be posting very much. My office closed early today, and will close early on New Year's Eve. And, of course we'll be closed tomorrow and New Year's Day.

2013 has been a grand year for our company in so many ways. I am grateful for the contributions from our entire team, but especially Patrick Fowler, our company President & COO; Chris Spaulding, EVP who is responsible for business development; and Steve Sobhi, VP and head of Western Region Sales.

Let me take this opportunity to extend a warm Merry Christmas to our Christian friends and colleagues, and a Happy New Year to all of you. May 2014 be a fruitful, blessed, healthy, and stupendous new year for you, your families, and your companies.

Why do we compound returns?

John Simpson, CIPM and I are each (individually) teaching our Fundamentals of Performance Measurement course this week to two different clients: CalPERS in California and Florida State Board of Admin in, well, Florida, where else? One topic we take up is "multi-period performance," which means geometric linking.

I typically ask "why don't we just add the individual period returns together?" For example, if our returns are 1%, 2%, and 3%, why not just show 6% (the sum of the three)? The math is pretty simple, right?

The reason is compounding: returns compound. That is, returns from later periods benefit from gains/losses from prior periods. But what do we mean by that?

Well, I constructed an example to demonstrate how this works, and I think it's helpful.

Column A shows the three monthly returns (1.00%, 2.00%, 3.00%), which, if simply added together (what we might call "arithmetic linking") yields 6.00 percent (note that I don't show this in the table). The geometrically linked result appears in cell A5 (6.1106%).

To demonstrate how compounding works, we begin with an investment of $100 (B1). Column B shows the three periods' gains based solely on the returns applied to this amount ($1.00, $2.00, $3.00).

Compounding means that subsequent period returns are applied to all the prior period results. And so, let's step through this.

Cell C3 shows how the second period's return is applied to the prior period's result (2.00% of  the $1.00 earned in the first period equals $0.0200).  And so, the second period's 2% return not only gains from it being applied to the initial value ($100) but also the amount earned in the second period ($1.00).

Cell C4 is the third period's return (3.00%) applied against the prior period's gain that is earned from the initial value (i.e., it's 3.00% × 2.00% × $100).

Cell D4's gain comes from applying the third period's return to the second period's gain ($0.0200), which, in turn, came from the second period's return (2.00%) applied to the first period's gain (i.e., it's 3.00% × 2.00% × 1.00% × $100).

Cell E4's value comes from the application of the third period's return times the gain from the first period: 3.00% × 1.00% × $100: i.e., we don't just apply subsequent period returns to the immediate period before, but to all prior periods.

When we add these seven values together (1.00 + 2.00 + 3.00 + 0.0200 + 0.0600 + 0.0006 + 0.0300) we get 6.1106. Note that this ties in nicely with the compounded return. We earned $6.1106 for the period, which is 6.1106% of the initial value ($100).

Does this make sense? Each subsequent period's return is applied to each prior period's gain, as well as the starting value.

Here's an interesting point: you get the same results, regardless of the order of the returns.

This is because of the commutative property of multiplication (i.e., A × B = B × A); since compounding involves multiplication, the rule has to apply here.

Thoughts, reactions, insights, other ideas?

Acknowledging an anniversary and offering an opinion

We are putting the "final touches" on The Journal of Performance Measurement's (R) Supplement issue, that will include summaries of two of our surveys: attribution and presentation standards. While writing my letter (as publisher), I realized that it's been 20 years since the AIMR-PPS(R) was published. I'm not aware that this met with any fanfare, though it should have. It's clear that this publication took what the FAF (Financial Analysts Federation) dreamed of in 1986 and made it a reality; it also set the groundwork for a global standard, that became a reality in 1999 with the publication of GIPS(R).

I was sent a question yesterday regarding GIPS, dealing with the frequency of mutual funds being included in composites. I think there are two parts to this question.

First, should mutual funds be included in a firm's definition? In my view there is no reason why it shouldn't. It isn't difficult to get these accounts into composites (either as standalone, combined with other funds that are investing in the same strategy, or with separate accounts being managed to the fund's strategy) and it increases the firm's assets under management.

And so, if you agree, then the second question is, should the funds be in a composite? It makes no sense to ask this question if the funds are not part of the firm definition, right? And so, if they are, they must be in a composite. The only question is, do you combine them with separate accounts that are managed to the same strategy?

Reason for: it increases the composite's assets.

Reason against: given that funds typically experience daily cash flows, their performance may be materially different from that of the individual accounts, so separating them may make sense.

And so, it's up to you whether to combine.

Thoughts?  Further questions or comments?

Francis Xavier Desharnais

It is with deep sadness that I inform you of the death of Frank Desharnais. Frank was a bona fide performance measurement professional: with more than 25 years in our industry, Frank held leadership roles at Lazard Asset Management, Deutsche Asset Management, Neuberger Berman, and, most recently, Turner Investment Partners.

Ours is a rather small industry, and Frank was well known and liked by many. I learned of his passing from our mutual friend, Diana Merenda, who worked with him at Deutsche and Lazard.

Frank was a member of the Performance Measurement Forum and a frequent attendee at our annual PMAR (Performance Measurement, Attribution & Risk) conferences, which I think speaks of his desire to continue to grow professionally, despite his experience and expertise.

He was a New Yorker by birth as well as choice, and only left the area to assume the role at Turner, a Philadelphia-area investment advisor. Despite the relocation, he remained a Yankee fan.

I knew Frank for around 20 years, though I regret not having spent more time with him. I had the chance to dine with him shortly after he joined Turner, and enjoyed learning more about him.

Frank left us too soon, and I know that he will be missed by many, especially by his parents, siblings, and other relatives. May he rest in peace.

Annualization and leap years ... there's the rub!

Nine years ago I was reviewing a client's performance system, and noticed on one of their reports they showed "annualized" and "cumulative" returns for the prior one, two, three, five, ... years.

It struck me as quite odd that the prior year's cumulative and annualized returns were different: how could this be? Recall that we annualize returns by taking the cumulative return, adding one, and either (a) taking the nth root, where "n" is the number of years or (b) raising the number to the transposition of n, and then subtracting one. Well, any number raised to the 1/1 (i.e., one) power, or having the 1st root, will yield that number, meaning the annualized return HAS TO equal the cumulative. But why not in this case?

Well, after some reflection I realized they weren't using the number of years (which in this case would have been "1") but rather the number of days in the period (366, since the prior year was 2004, a leap year) and dividing by 365. Oops!

This started me on a quest; sadly, one not unlike Don Quixote's, which has yet to get me to my desired goal of a definitive and clear answer to the question: what to do?

A client asked us this week about this very subject, and my colleagues (John Simpson and Jed Schneider) and I engaged in a back-and-forth discussion on it. Space does not allow me to do much here, other than to say that there is no "rule" on this subject, there are a variety of ways firms handle it (some not so good, some okay), and that the "right" way is rather complex. And finally, one must weigh the complexity with the error that results from using something other than the "right" method. I suspect that most folks would deem it "immaterial."

I will take this subject up in this month's newsletters, and expand upon it further in an upcoming article.

Dissertation Defense

For those of you who've been wondering...finally!

Handling cash when trading

Asset management firms have, for the past few decades, generally agreed that "trade date" (t/d) accounting is preferred. This practice has been so common that custodians regularly provide trade date reports (where they used to only do settlement date (s/d)) and even brokerage statements are often reported in a trade date manner. While managers (and their clients) are concerned about settlement, it's understood to be in the hands of the "back office" folks, and will only become an issue if there are problems.

If a security is sold, resulting in proceeds of $100,000, the portfolio managers want to know this so they can, that day or in a day or two, invest that money; however, if it's held in a "limbo state," awaiting settlement, then they may not be aware or recall.

Being consistent

A client sent us a note recently regarding an office that recognized the security part of trades on trade date, but the cash movement on settlement date. For example, if 10,000 shares of a security is sold on December 10 for €125,000, the security's position on their system is reduced by this amount; however, the cash that results won't appear until s/d. Or, if they decide to buy 25,000 shares of a security costing $250,000, the security will appear on t/d, but the cash won't be reduced until settlement date.

This is simply incorrect; it will result in return errors, especially if t/d and s/d span a month-end. I suggest this needs to be corrected on both a going-forward and historic basis.

Is GIPS(R) at fault?

You may recall that the Global Investment Performance Standards defines trade date as T (the day of the trade), T+1, T+2, or T+3. And so, T+3 can be considered trade date, so perhaps someone is suggesting that both the cash movement and trading are being done on trade date. While I can see the logic of this argument, the expectation is that they are the same day. If this isn't the case, errors will result.

Trading ahead

Many firms engage in trading ahead of cash arriving. For example, if a client tells them they are wiring €1 million on Friday, the portfolio manager may trade on Tuesday or Wednesday, knowing the cash will be available on Friday for settlement. While controls and formal agreements should be in place to allow this to happen, that is a separate issue from this discussion.

I recommend that the firm create a "pseudo cash" account (or "anticipated cash," or "cash due," etc.) for the amount coming in; the trades that occur should go against this amount. Thus, a simulated external cash flow occurs on the date trading commences. When the cash actually comes in, it can be treated as a cash flow, netting against the outflow from this secondary cash account.
 
Policies & procedures

Firms should probably have policies regarding cash flow treatment if it is anything but "standard" trade/date movement (and, of course, be correct!).

Something rather simple can, at times, be complex. Hopefully this is helpful. If you have any thoughts, please share them; thanks!

How often should a GIPS compliant firm be verified?

The Spaulding Group surveys on the Global Investment Performance Standards have consistently shown that most compliant firms get their verifications done annually. But is this the optimal frequency? Well, let's consider this topic for a moment.

How about more often than annual?

A couple verifiers we know encourage quarterly verifications. We believe strongly that this most benefits the verifiers themselves, as it allows them to keep their staff busy throughout the year. The disadvantaged are, in my view, the clients themselves. Why? Because we believe that quarterly is:

• Too frequent. There is nothing to be gained from having your verifier show up four times a year.
• Disruptive. Having your verifier come to your offices four times a year can create stress and create frustration. But even if your verifier is one who rarely shows up to your offices (but insists on doing their work remotely), you still are disrupted: you've got to gather materials together four times a year and answer any questions that arise, which takes time away from your normal and no doubt more productive activities.
• Potentially more expensive, since there is no economy of scale that you're taking advantage of.

And so, we strongly oppose such a level of frequency. Mind you, we like to be kept busy throughout the year, too, but we offer many other services (e.g., consulting, operations reviews, systems  reviews, training), and so spend time doing these activities rather than revisiting our clients' offices three more times (recall that we only do "on site" verifications).

How about less frequently than annual?

By having verifications done less than annually, the firm should save some money, since by bringing the verifier in every two or three years, for example, they can "bundle" the years together, and obtain a degree of economy of scale.

However, we don't recommend this, because:

1. Falling out of compliance. It is very easy for firms to overlook something or make mistakes if they extend the period between verifications for too long. Asset management firms are dynamic, adding new strategies, changing old ones, adding new clients, experiencing staff and organizational changes, which can often impact the firm's GIPS compliance. In addition, the Standards are complex, and changes do occur, and so less frequent verifications increases the risk of becoming non-compliant.
2. Marketing disadvantage. Recall that GIPS-compliant firms must now not only state whether they've been verified, but also, the period of their verification. Once you've gone beyond a year, your verification is seen by many as being "stale." Thus, you may have a bit of a credibility challenge with some prospects. Unfortunately, you may not even be aware that you're being overlooked because of a stale verification.
3. What prospects expect. We have reason to believe that most prospective clients expect annual verifications. Since most firms get annual verifications, to do them less often isn't seen as a wise decision. Do the potential savings justify the risks? Recall that verification, like compliance itself, is an investment.

And so, what is the optimal frequency for verifications.

Well, just like Goldilocks, who found one bed to be too hard, one too soft, and one that was "just right,"

• Quarterly is too often
• Every two, three, or more years is too seldom
• Annual is "just right."

Most of our verification clients get their verifications done annually. We believe this is the optimal frequency. The benefits of

• Increased confidence the firm is remaining in compliance
• Less disruption to the organization
• The ability to avoid "stale" verifications
• Which makes the firm more competitive

make this frequency ideal. We believe that prospective clients, too, expect to see annual.

If you have any questions, thoughts, or insights on this,  please share!

We're winning ... finally! Money-weighting is catching on!

Having preached the benefits of money-weighted returns for the past several years, along with a group of comrades, including Steve Campisi, CFA, I'm quite pleased to see that the idea is catching on.

GASB, the U.S. Government Accounting Standards Board, now requires public pension funds to report the internal rate of return (IRR). I was asked to provide some guidance during the directive's development. One could fully understand why time-weighting was considered, but they wisely saw the wisdom of money-weighting.

Our neighbor to the north, Canada, has a new set of security industry standards that also mandate the IRR.

GIPS(R)'s new initiative to encourage asset owners to comply includes the recommendation for the IRR. Regretfully, I didn't recommend in my comment letter that this be a requirement: I should have. But, a recommendation, for now, is very good.

What next? Well, there's plenty of room for more. For example, the GIPS Executive Committee should see the wisdom of mandating the use of the IRR whenever the manager controls cash flows. This is something a few of us have been asking about for some time; actually, dating back to the mid-1990s under the AIMR-PPS(R).

Stay tuned; I'm sure more will follow!

Let's disaggregate aggregation

I recently learned of a firm that has enhanced their system to provide the ability to aggregate multiple portfolios for performance reporting. They reference GIPS(R), so clearly the fact that it's permitted within the Standards for composite returns is seen as justification for their work.

When embarking on any performance or risk development / design work, it is extremely important to understand WHAT is being done; the PURPOSE of it; what it is intended TO DO.

I have many times criticized the use of the aggregate method; to me, it's seriously flawed. I've shown examples of the flaws, which apparently prompted the GIPS Executive Committee to declare the ability to add accounts intra-month invalid (which I'm fine with, but would have preferred a public comment period, since this was a change to the Standards, and as such, warranted input from those affected).

Are we looking for (a) the average return of (b) the return of the portfolios, as if they constituted a single account? Chances are the former, which would have dismissed this approach.

There are many ways to calculate returns; it's important to spend the time understanding what is intended in order to properly select the ideal approach.

Gilbert Beebower

I just learned (via P&I, November 25, page 4) of the passing of Gilbert Beebower.

You may recall that he, along with Gary Brinson and L. Randolph Hood, wrote a piece for the Financial Analysts Journal (1986: "Determinants of Portfolio Performance") that helped in the development of the nascent ideas of performance attribution. What many of us refer to as the "BHB" model was adopted by numerous asset managers and software vendors.

Although the article's chief aim was to recognize the importance of asset allocation, a peripheral benefit was the encouragement to employ attribution to better identify the sources of return. And even though the earlier Brinson-Fachler model appears to be the dominant approach, we cannot overlook the contributions of Beebower, et al.

He no doubt made many contributions to our industry, and is deserving of our recognition.

A Half-Dozen Sharpe Ratio Facts

Just when you thought it was safe to ...

I'm doing a bit of research on the Sharpe and Information ratios, and am finding loads of confusion. This may end up becoming an article, but for now I'll share with you some "facts," at least as I understand them, regarding the Sharpe ratio.

1. The Sharpe ratio was developed by William F. Sharpe (Sharpe, William F. (1966). "Mutual Fund Performance." Journal of Business), who was awarded the Nobel Prize in Economics.

1a. Sharpe's Nobel was not awarded for this risk measure, but rather for his work on CAPM.

2. Sharpe referred to his measure as "reward to variability," and to Treynor's (which was published in 1965) as the "reward to volatility."

2a. Neither terms seem to have made it into the common lexicon.

3. Sharpe introduced a revised version of his formula in 1994 (Sharpe, William. (1994). "The Sharpe Ratio." Journal of Portfolio Management). It appears, though not yet confirmed, that the earlier version dominates in our industry.

4. Although it appears that many firms use annualized values in their formula, Sharpe (1994) states that "To maximize information content, it is usually desirable to measure risks and returns using fairly short (e.g., monthly) periods. For purposes of standardization it is then desirable to annualize the results."

5. In Sharpe (1994), the author acknowledges how "The literature surrounding the Sharpe Ratio has, unfortunately, led to a certain amount of confusion." For example, he cites an article by Treynor-Black that define the ratio as "the square of the measure we describe," which, as Sharpe points out, would mean that it is always positive.

6. Although the Sharpe ratio is often criticized, from our research it remains the dominant risk-adjusted measure.

Stay tuned: more to follow!