Benchmarks & the GIPS standards

We have gotten a series of questions lately regarding the inclusion of benchmarks in a GIPS(R) (Global Investment Performance Standards) presentation. I'll summarize some of it here.

Secondary benchmarks: can a firm show additional benchmarks along with their primary? Yes! But you must make it clear which is the primary.

Absolute benchmarks: can these be included in a presentation? Absolutely! In some cases an absolute benchmark would be the ideal one. If it is actually a secondary one (which is the case with one of The Spaulding Group's verification clients), the primary has to be identified. In addition, details regarding the absolute need to be included, as appropriate, so the reader understands what it represents and how it's constructed.

Reference benchmarks: in some cases firms show benchmarks which don't align with the actual composite's strategy, but rather for reference purposes. Can these be shown and must they be flagged as being "supplemental"? First, yes, they can be shown. Second, no, they aren't supplemental.

The GIPS glossary defines a benchmark as:

And so, a reference benchmark clearly matches the definition, and neither warrants nor requires the "supplemental information" disclosure, since it's not supplemental. Again, clarity is needed to ensure the benchmark's role is clear.

Have additional thoughts, insights, ideas, or questions? Please chime in!

Misleading information is legal?

While a great deal of attention was paid to the U.S. Supreme Court's decision on Obamacare this past week, another ruling should garner some interest, too: their conclusion that the 2006 Stolen Valor Act infringes on speech protected by the First Amendment. This means that individuals can falsely claim they won military decorations. As you might imagine, lots of folks are quite upset by this.

We encounter misrepresentations often, do we not? I recall getting a resume from someone once who claimed he was a Harvard graduate. After hiring him we learned (through a background check) that while he did manage to spend one semester at Harvard, he neither graduated from Harvard nor had a degree whatsoever; he was terminated as this was merely one of the fabrications in his resume.

Some folks use job titles which they actually do not have; they apparently like them better than their real ones. I knew a salesman who had "vice president" on his business card, even though he wasn't a VP; his justification was that it helped him sell. On the other hand, my Uncle Joe (everyone has one, right?) was a safe deposit vault attendant for First Pennsylvania Bank, and he would sometimes say he was "vice president of mops and brooms." Granted, it was clear that he was kidding; some folks aren't in their use of incorrect titles.

The greatest example of misrepresentation is clearly Bernie Madoff; at least in recent memory. Sadly, he managed to fool a lot of people for a very long time.

Rules such as the UAPS (Universal Advisor Performance Standards and GIPS(R) (Global Investment Performance Standards) exist so that individuals can provide performance information in a way that doesn't misrepresent. As Mike Alfred of Brightscope (who is working with The Spaulding Group on the UAPS) stated in an interview with WSJ's Jason Zweig, "Any industry that achieves high credibility across society has consistent standards for reporting outcomes so that a third party can judge whether you're doing a good job or not." Misrepresentation, regardless of whether it is protected by the free speech amendment, has long been found to be unwanted.

Alternative Investments ... just scratching the surface

At this week's European Performance Measurement Forum meeting, we touched on the subject of alternative investments. We hear this term bandied about quite a bit; so much so, that it often causes one to grimace when they hear it, because of the fear it can invoke.

While this category can include credit default swaps, as well as other varieties of swaps and swaptions; futures, forwards, and options; along with commodities and fairly esoteric investments, such as guitars, watches, and artwork; it also is where we house [pardon the pun] real estate and private equity.

In the case of real estate and private equity, while we may not know all the answers, many of the rules are fairly well agreed upon. The GIPS(R) standards (Global Investment Performance Standards) after all includes rules specifically for these asset classes.

But there is a broad, make that very broad, collection of instruments for which the rules are less clear. And when we speak about rules, we must consider:

• Valuing the assets
• Deriving returns on the assets
• Measuring risk of the assets
• Determining how to handle them as part of our attribution
• and no doubt a lot more.

This is a topic that we will not attempt to address quickly, as much time is needed for it. Hopefully, we will be able to provide guidance on much of what is faced in the industry today. And so, stay tuned! In the mean time, if you have ideas or questions, please pass them along!

GIPS and "non-assets under management" scenarios: what's the proper treatment?

Recently, The Spaulding Group created a website specifically designed to field questions on the Global Investment Performance Standards (GIPS(R)): http://www.gipshelp.com/. It has already had several questions posted, and more are coming in on a fairly regular basis.

It would be redundant to comment here, as well, on questions that we've addressed on the help site.

That being said, I will occasionally post here, too, if the question is one that has a lot of interest or one that I feel needs additional attention.

Case in point; the following was just posted:

If a firm has a composite consisting partially or wholly of "notional" accounts run on lines of credit, is it appropriate to fulfill the Composite Total Assets requirement outlined in the GIPS Standards using the total notional value? Given the fact that compliant performance can be (and is) calculated based on notional values, and that one could potentially have a composite consisting of accounts run solely on lines of credit (i.e. $0 "GIPS" AUM), this would be in the spirit of full disclosure, would it not? It appears that it would be misleading and of little use to a potential client to see only the amount of collateral (if any) in a composite. However, the GIPS do not specifically address this, and many other situations unique to notional accounts.

There exists a Q&A regarding Overlay Strategies that concludes that for purposes of FIRM assets, notional amounts must not be included. However, there appears to be no definitive guidance when it comes to composite assets.

I do not know what Q&A the person who submitted this is referring to; possibly:
http://gipsstandards.org/programs/faqs/gipsresults.asp?Id=49,
though it does not explicitly prohibit the use of notional values.

I think this is a great topic, and worthy of further discussion. I had hoped that the GIPS Executive Committee would have included more on the subject in GIPS 2010, but I guess we'll have to wait for the 2015 edition for anything formal.

My opinion has been that notional values, in certain situations, are the appropriate details to provide. One can show the AUM (be it zero or some other value) and separately, as supplemental information, the notional value. The returns should be derived, in most cases, based on the notional values.

I believe that this is "in the spirit of the Standards."

What do YOU think? Please chime in by commenting below.

Have a GIPS question? Please visit the GIPSHelp.com website!

Can you show two benchmarks in your GIPS presentation?

When you hear the same question multiple times in a short period, chances are it's a fairly common one, so I'll respond.

The question: Can a GIPS(R) (Global Investment Performance Standards) compliant firm show two (or more) benchmarks in a GIPS presentation?

The answer: Yes! However, if you're going to do this you need to identify which is the "primary" benchmark.

Some firms like to show the components of a blended benchmark, alongside the blend: that's fine! Others like to show something like the consumer price index; that's fine, too.

Just make sure you identify the primary; arguably the others appear for "reference" purposes.

What IS a model fee under GIPS?

The 2010 edition of GIPS(R) (Global Investment Performance Standards) introduced the term "model fee," but without any clarification as to what the term means. Consequently, we get questions like the following, which was sent by a verification client to me yesterday:

"Our composite net returns are based on the highest tier of our fee schedule. Does that then fall under 'Model Fees'? If there is some guidance on this subject can you please give me a reference."

The client was referencing the following provision:

Since the alternative to "model" is "actual," one might conclude that model referencing anything but actual. And so, I responded to the client that "yes, what they do falls within the realm of a 'model fee.'"

If you have any insights or thoughts, please offer your comment below.

Discretion ... a definition

Recall that GIPS(R) (Global Investment Performance Standards) has a fundamental rule that states "all actual, fee paying, discretionary portfolios must be included in at least one composite." Much of this is pretty simple:

• "actual": a real account; exclude back-tested results, model portfolios, and hypothetical portfolios (you can show non-actual as supplemental information)
• "fee paying": an advisory fee is paid to the manager (you can include non-fee paying, with additional disclosures)

"Discretionary" is a difficult and oft confusing term.

Since we typically think of it in light of legal discretion, this is often where firms stop. However, we're talking beyond the realm of legal; legal is assumed (that is, the firm has the ability to execute trades on behalf of the client). We're talking "GIPS" discretion. And so, WHAT DOES THIS MEAN?

I am preparing for The Spaulding Group's upcoming GIPS Fundamentals workshops and have come up with the following:

• Portfolios for which the firm is able to execute their strategy
• Portfolios whose composition and returns are representative of the composite’s strategy
• Portfolios for which the clients have not imposed restrictions or requirements that impede the manager from fully executing their strategy, such that the results will be representative of the strategy

I think nondiscretion is easier to define:

• Portfolios that have restrictions such that the manager isn't able to fully execute their strategy
• Portfolios whose composition and returns are not representative of the given strategy.

They're essentially mirror images of one another, though I tend to feel more comfortable defining nondiscretion, though I think what I have offered here works. What do you think? Please comment below.

Net-of-fee returns: what to do with the denominator

A colleague recently brought to my attention wording that appears in the 1993 edition of the Performance Presentation Standards, published by AIMR (Association for Investment Management and Research; the former name of the CFA Institute). On page 25, under a section titled "Net-of-Fee Calculation" we find: "In a net-of-fee calculation, when fees are paid from the corpus of the fund, the payments should be included as a withdrawal of capital in F (flows) and in FW (weighted flows). In addition, performance results are reduced by deducting fees as negative income [a positive number] in the numerator." The accompanying formula (that appears on 26) has the fees removed, separate from their treatment as a flow.

What this essentially means is that the fees cancel out in the numerator (which is the same as my recommendation to ignore them). The AIMR-PPS's denominator has them as a weighted flow; I recommend not doing this. Their result is a higher NOF return (since the denominator is reduced by the weighted flow). I believe ignoring the fees entirely is correct.

As I pointed out in an article for the CFA Institute, as well as in our firm's newsletter and this blog, we should completely ignore net-of-fee payments that come from the corpus of the account; we treat them as flows for gross-of-fee returns.

Note: this is MY (i.e., Dave Spaulding's) view on this matter, but I believe that logic and the results show that it makes sense. But chime in with your thoughts, by inserting a comment below! In reality, whether you treat them as a weighted flow or not, the difference is probably de minimis.

Cases of unintended consequences

We are witnessing a case, I believe, of unintended consequences in the world of American football (not to be confused with the rest of the world's view of football, which Americans call soccer). The fundamental question: do football helmets, which were intended to protect the head, actually cause more damage?

Hearken back to the pre-helmet days, when players had no protection at all. The first phase of protection was leather padding that merely sat against the head. This provided some degree of protection, no doubt. Over the years plastic helmets were introduced, with each version offering greater and greater protection.

But the consequence of these actions was that players were able to use their heads more aggressively, which has apparently caused too many cases of head trauma, in one form or another. [This relates to the theory that when more rules are introduced to enhance safety, individuals become more aggressive, thinking that given the added safety, they can take additional risks.]

The question: if players no longer had any helmets, or perhaps ones that were like the first variety, might they actually be better off? They wouldn't want to crash their bare (or barely protected) head into another player's midsection, for example.

Another example is boxing, where the likes of Mohammad Ali suffered from having their heads bashed against many times by opponents whose hands were protected by a well padded gloves.

I recall a movie that showed boxing around the turn of the last century, when bare-fisted boxing was forbidden, but occurred nevertheless. Gloves were being introduced and a boxer was asked something like "would you rather break your hand (without the use of gloves) or your jaw (as the result of an opponent using a glove)?" The boxer pointed out that he was quite fond of eating, so seemed to prefer the sans glove option.

If we were to make gloves illegal and require boxers to fight without them, their fists would no doubt be bloodied by the end of a match. But, would their heads be pummelled to the degree they are today? My guess is they would not.

These, I believe, are examples of ideas that had a great deal of merit at the time, but the consequences that resulted seem to have shown them to have made the situations worse.

Two other examples: in the U.S. cars are required to have break lights at the center of the back window. As I recall, the basis for this was so that if the driver in front of the car immediately in front of you was stopping, you would be alerted by seeing the lights brighten, through the windows of the car in front of you. This sounds like a good idea, until you realize that you do not see those lights (or rarely do). The idea simply doesn't work. And yet, millions of dollars were no doubt spent to retrofit or reengineer cars to accommodate them.

Another: again in the U.S. public men's bathrooms must have urinals that are set lower than normal. Most people believe this is to accommodate young boys; it isn't. It's for handicapped patrons. But, this idea simply doesn't work, and yet the laws remain.

In many cases it is very difficult to project what is going to be the result of our actions, so to criticize those who came up with these ideas would be improper. They made sense at the time. In the case of the sports examples, the intent was to protect the head (football) and hands (boxing); but as a result of the added protection, in both cases the head has suffered.

I have pointed out how the notion of asset-weighted composite returns (for GIPS(R) (Global Investment Performance Standards)) was introduced because it just seemed to make sense to those who framed the rules (in spite of the objections from various parties). But in retrospect, I, as well as many others, believe it's the wrong approach. There are other examples, too, but I won't bother to rehash items that I've previously addressed here on in The Spaulding Group newsletter.

Benchmark Versus Portfolio Rebalancing: must or should they be the same?

A GIPS(R) (Global Investment Performance Standards) verification client was rebalancing their blended benchmark annually and their portfolio monthly. This sparked a whole long discussion with a few colleagues on the appropriate timing for rebalancing.

The basic question: must (or should) the portfolio and benchmark have identical balancing schedules?

The answer, I believe, has to be couched with a few key points:

• is the benchmark blended or a single market index?
• does the manager have control over the benchmark's rebalancing?
• does the manager's tactics require a balancing that is different than the benchmark's?

The first two points are related, though it's important that they be addressed separately.

If the benchmark is a blend of two or more market indices, then the manager clearly controls its timing. If the manager begins the year with the strategic balance established in the benchmark and portfolio, and the benchmark isn't rebalanced again for a year, but the portfolio is rebalanced monthly, then I think there's a problem. I would expect the timing to match.

If the benchmark is a market index, must the manager rebalance his/her portfolio to match that of the benchmark? I would say "no." We have a client that establishes its portfolio's allocations annually, and doesn't do much to the portfolio for the remainder of the year. The benchmark rebalances much more frequently. The portfolio manager's tactic is to let it ride. That is, not to make any adjustments once the allocations are established. I think this is perfectly fine. These details are disclosed as part of their marketing and GIPS materials.

There are no doubt other cases that could be considered, so there is probably not a "black-and-white" answer, though this may serve as at least the start of some guidance. Please let me know your thoughts by commenting below. Thanks!

GIPS Portability: what does "one year" mean?

The Global Investment Performance Standards (GIPS(R)) have provisions to accommodate firms and individuals that move their skills from one place to another. For example, the emerging markets team from Firm A decides to either set up shop themselves or move in with Firm B. Or, if Firm X acquires or merges with Firm Y.

We find the following in ¶ I.5.A.8.b: "If a FIRM acquires another firm or affiliation, the FIRM has one year to bring any non-compliant assets into compliance." What does this mean?

One sentence just isn't enough to explain what a firm is obligated to do. I have had many discussions on this topic, and have found very different views. In April's newsletter (which is admittedly late ("my bad"), but will appear very shortly), I provide my views on this matter. I welcome your comments, be they in support, in opposition, or simply if you have further questions on this important matter. Please email them to me. Or, post a comment below! Thanks!

Oh, and this topic will also be the subject of The Spaulding Group's monthly webinar (date & time TBA!)

When NOT to use "N/A"

In doing GIPS(R) (Global Investment Performance Standards) verifications under the new version, I've witnessed a few firms who insert "N/A" for years prior to 2011, when they chose not to report the 3-year annualized standard deviation. Not showing this figure is fine; "N/A" is, I believe, misleading.


N/A can mean:

• Not Applicable: but it CAN apply if there are at least 36 months of returns to run the statistic against
• Not Available: but it CAN be available; you just need to run the math.

You should just leave it blank! Just as with the example in the standards:

GIPS Guide Almost Here!

Several years ago, The Spaulding Group published the first guide on the presentation standards. At that time we still had the AIMR-PPS(R), and GIPS(R) was just getting started. Well, the book sold out pretty quickly, and we had plans to revise it, but hadn't made much progress, until last year, when we committed to get the job done!


I wrote the earlier version; this time I was joined by my colleagues, John Simpson and Jed Schneider. Douglas Spaulding, who is the editor of The Journal of Performance Measurement(R), was charged with getting the draft edited and laid out; something he (with help from our proof reader, Mary Meagher, and production assistant, Jessica Laffey) has done in record time! We plan to have the materials to the printer within the next week or so, with an expected book delivery back to us by mid May.


We are quite excited about the book, as it is a HUGE expansion on the prior version, and is part of our GIPS Orientation Kit™. The book lists for only $75, and we're having a "pre-release sale" at just $45 (i.e., a $30 savings!). If you're interested, please place your order by the April 30.


I also want to ackowledge and thank the sponsors for this book project:

• BNYMellon Asset Services
• CIPM Program
• DSTGlobal Solutions
• Eagle Investment Systems
• First Rate
• VPD

Single vs. Joint Evaluations

In Thinking Fast & Slow, Daniel Kahneman discusses the notion of evaluating items separately (single) versus in comparison with others (joint). You are no doubt familiar with the importance of having returns and risk measures of a portfolio, for example, shown along with similar statistics for a benchmark, in order to gain greater insight into what occurred. To learn that Manager A's performance in 2011 was 4.58% means nothing in isolation; it is only when we have something to compare it to are we able to judge whether this is a good or not so good result.

This section of Kahneman's book reminded me of the difficulty presented with GIPS(R) (Global Investment Performance Standards) composite returns, as they are currently derived. Today, only asset-weighting is required; and although equal-weighting is recommended, it is rare to see it shown. But if one really understands what the details are that comprise a manager's results, might they opt to see the other metric?

For example, if showing a prospect your composite, and its return for 2011 is 4.58% vs. the benchmark of 4.18%, you have demonstrated, at least for last year, superior skill. But if it turned out that the composite has five accounts, one huge mutual fund which had a return last year of 4.59%, and three smaller separate accounts, whose returns fell below 4.18%, but because of the fund's size, the composite return was skewed, might these facts prove helpful? If the equal-weighted average is below the benchmark, we draw a completely different conclusion, do we not?

As I have stated before, I have become a non-fan of asset-weighted returns, and don't see any value in them. Equal-weighting should reign; but, I am perfectly content with seeing both required. And why not? Might the mere insights provided by such information be worth the additional column?

A word about discretion

One of the problems with our industry is that we often use the same word to mean multiple things (e.g., "alpha" can mean excess return (portfolio return minus benchmark return) and Jensen's alpha, which takes beta into consideration), and multiple words (e.g., excess return, active return) to mean the same thing.

The word "discretion" serves two different roles in investing and performance measurement:

1. It describes a client relationship, whereby the client has granted the manager (or firm) the authority to trade on their behalf
2. For the GIPS(R) standards (Global Investment Performance Standards), it is used to indicate cases where the client has not imposed restrictions such that the account would not be representative of the manager's strategy (in this context, a nondiscretionary account is one where the client has restrictions that cause the portfolio to not be representative of the firm's strategy). In the expression "all actual, fee paying, discretionary accounts must be included in at least one composite," we're speaking of THIS form of the word.

When I teach classes on the GIPS standards or meet with verification clients, this is often an area that they find confusing, since they are used to using the word solely in the context of the first definition; the second one is a new one to them. In reviewing firm's policies and procedures, it is quite common to find their wording relative to composite inclusion addressing the legal aspects of the relationship, only. So, what's the solution?

For a while I've advocated qualifying the term when it's used in terms of the GIPS standards, since WHENEVER the standards use it, it means the second definition noted above. And so we'd see "GIPS discretion." However, I've come upon an even better solution!

Use the word "unencumbered."

To "encumber means to "impede or hinder." Isn't that what we mean when we say "nondiscretionary" in "GIPS speak"? And so, "unencumbered" would indicate cases where there is no impeding or hindering the firm's management. GIPS would then replace the wording to be "all actual, fee paying, unencumbered accounts must be included in at least one composite."

By adopting this change, we'd eliminate one of those huge confusing aspects of the Standards. Just a thought.

Code of Conduct for GIPS Service Providers

At the recent GIPS(R) (Global Investment Performance Standards) Executive Committee meeting in Brussels, Belgium, the EC discussed the possibility of creating a "Code of Conduct" for GIPS service providers. I think this is an excellent idea, though at this point have zero knowledge of what is actually being considered.

In Tuesday's post, I mentioned how The Spaulding Group will not take on a verification client who we believe has come by their historical performance records through some improper means, and recommended that other verifiers adopt this policy, too. I would think that this is an example of the code of conduct one would expect from service providers.

When the Performance Measurement Forum set off to develop a certification program for performance measurement professionals several years ago (which contributed to the creation of the CIPM program), ethics wasn't a section we considered. The CIPM program wisely has included it, and more and more we can see how ethics is an important topic for our industry. It seems that almost daily we learn of infractions. Granted, the political world may be outpacing our industry in this regard, but it seems as if some would like to overtake them.

Performance measurement professionals can serve as a key gatekeeper to the delivery of fraudulent information. And while we haven't yet heard of any PMPs who have allowed the presentation of information they knew was wrong, these individuals can still find themselves being pressured to do something they know would be wrong.

Verifiers can serve as yet another group to try to halt the spread of fictitious information, by holding firm when we learn of something unethical and to simply refuse to be a part of it. My feeling is that if a firm is willing to act improperly to obtain historical records, won't they do the same when it comes to other situations that arise? It's better to avoid even going down the path with someone who may not behave as we think they should.

Learning from USMA

I served in the U.S. Army (Field Artillery branch) for nearly five years, and spent 39 months with the 25th Infantry Division in Hawaii (tough duty, but someone had to do it). During that time I worked with several West Point graduates (I obtained my commission through ROTC), and recall learning the "cadet honor code":

A cadet will not lie, cheat, steal,

or tolerate those who do

There's a great lesson here, is there not, and a great example for us all to follow?

An article in yesterday's WSJ ("Weitz Firm Got Rival's Database, Suit Says," by Dionne Dearcey) spoke of a lawsuit filed by a former employer for Weitz & Luxemberg, Joseph C. Maher, who claimed Weitz had "a cache of files from a competitor [Waters & Kraus] that allegedly could be used to earn millions of dollars." These records were supposedly brought to the firm by a former W&L employee of the competitor, who had joined Weitz. We have no way to know at this time where the truth lies, but if Maher's allegations are found to be true, why would a law firm hire someone who stole records from their prior firm? (Please, no lawyer jokes)

We had a conversation recently with someone about the GIPS® (Global Investment Performance Standards) portability rules, which require:

1. Substantially all of the investment decision makers to be employed by the new or acquiring firm (e.g., research department staff, portfolio managers, and other relevant staff);
2. The decision-making process to remain substantially intact and independent within the new or acquiring firm; and
3. The new or acquiring firm to have records that document and support the past performance.

 (See ¶ I.5.A.8, Global Investment Performance Standards. 2010)

In most cases, managing to meet the first two requirements is a lot easier than meeting the third. And so, what is a person to do to get the records, especially if they are leaving in less than an ideal way?

Well, if they are a CFA charterholder, stealing the records would be considered an ethics violation; but what if they aren't a charterholder, can they steal them? Of course they can; who's to stop them (unless they get caught or sued, of course)? But would that not still constitute an ethics problem?

Last year The Spaulding Group adopted a Standards of Practice, based on the CFA Institutes's, and appointed both a Chief Ethics Officer (John Simpson, CIPM) and Assistant (Jed Schneider, CIPM, FRM). And we made the decision that we will not accept a verification client if we suspect they obtained their historical records through some improper means. Yes, it is tempting to copy records in order to achieve compliance; but such action says something about the character of the individual(s), and we would prefer not to include them among our clients. We encourage all GIPS verifiers to adopt a similar rule. As USMA (United States Military Academy) proclaims, "...or tolerate those who do." And we won't.

Performance examinations: when should you have them done (and when absolutely not)?

By now, if you're a regular (or even infrequent) reader of this blog and/or The Spaulding Group's newsletter, you know of my dislike for GIPS(R) (Global Investment Performance Standards) performance examinations. I have commented at length as to how compliance with the Standards and having annual verifications done are investments, but that in most cases, examinations are an expense or cost that should be avoided. But are there times when they should be done?

Yes, of course!

• If the firm believes they have value! To put it simply, if the firm disagrees with me and feels that this exercise provides them with benefits, then by all means, have them conducted.
• If a prospect virtually mandates that the composite(s) that align with their strategy have them done, and you feel that by having them conducted, you'll stand a better chance of winning the business
• If you find that for your primary composites the market fairly often inquires into whether or not examinations are done.

We've told our verification clients that we'll come in immediately, even over a weekend, if they require an examination to be performed (no one has yet taken us up on this offer). Until that time, most of our clients avoid the expense.

Are there times when they should absolutely NOT be done? Well, one particular case comes to mind:

• For non-marketed composites.

Note that the GIPS standards do not speak of "marketed" and "non-marketed" composites, but the industry surely understands the concept. We see absolutely no need to have examinations performed for non-marketed composites. By sheer virtue of their status, any possible benefits are nonexistent, are they not?

We know that some firms do have them done, but don't understand why. If you do, please let me know the reason(s) why. If you're a verifier and conduct them, chime in, too! And, if you have them done but don't know why, ask your verifier and tell me what they report, as I am curious as to the benefits they provide you for the costs involved. Thanks!

Simplifying a data problem

We have a GIPS(R) (Global Investment Performance Standards) verification client who uses Advent's Axys portfolio accounting system. Most of their clients are at Schwab, and they have a direct feed from Schwab to Advent. However, they had a couple accounts elsewhere, and hadn't included them in their composites, because they hadn't added them to Advent. This was a problem that had to be addressed.

They reached out to Advent, and were apparently told that they would have to add everything for each account for each time period, meaning market values and transactions. This would be a monumental task for our client. But, life doesn't have to be so challenging. Before you continue to read, reflect on how you would handle this. [pause]

For GIPS, we don't care about subportfolio activity; just market values and external cash flows: that's it! But how can we get this onto Advent?

SIMPLE!!!

For each account, assign a unique dummy (fictitious) security, with them owning just one share. The security's starting value is ...

[drum roll]

...the starting value of the portfolio! For example, if the portfolio begins with $513,078.22, then the security is worth $513,078.22, and they have one share, meaning their market value is $513,078.22.

What happens when a cash flow occurs? Enter the flow on the date it occurs.

Subsequent months, whatever the broker/custodian tells you is the market value becomes ...

...the price for the security! And so, if the next month the portfolio is worth $538,135.78, then this is the price of the security. And since the portfolio owns only one share, that's what they're worth. The only caveat here! Since they may have brought cash in, then the price of the security has to be the market value, minus the cash amount. Likewise, if there is a cash outflow, they will have to adjust the security's price, so that cash is handled properly.

[i.e., the market value from the statement must equal the price of the ficitious stock, minus the value of cash, meaning (algebraically derived) the share price equals the market value of the statement minus the cash value!]

Two issues remain!

(1) As of January 1, 2010, GIPS compliant firms must revalue their portfolios for large external cash flows, even those firms who use the aggregate method to derive composite returns (which Advent uses), even though this method doesn't use the underlying portfolio returns. So what must they do? IF they discover that large flows occurred, then they would have to revalue the portfolio on those days, and consequently set the fictitious security to this value (plus or minus the cash flow amount).

(2) ALSO, the "large cash flow rule" applies to the composite, too, meaning that if the composite has a large flow, the entire composite is revalued. HOWEVER, given the size of their composite, the likelihood of it (the composite) experiencing a large flow is infinitesimal.

Make sense?
Can you think of a better way or a flaw in my method? Let me know!

What were they thinking?

Those who were around "at the creation" recall the debates regarding whether composite returns should be equal- or asset-weighted. Two groups in particular, the ICAA (Investment Council Association of America; now the IAA) and IMCA (Investment Management  Consultants' Association), lobbied AIMR (Association for Investment Management and Research; what is now the CFA Institute) for equal-weighting. I'll confess that at the time, I didn't pay this a whole lot of attention, and didn't formulate an opinion.

AIMR wanted the composite return to represent the experience of a "single account." That is, what the return would be if the composite was an account itself. IMCA and the ICAA felt that asset-weighting might influence some managers to favor larger accounts, knowing  that their returns would skew the results. And, I suspect that they also thought that equal-weighting made more sense as it shows the average return of actual accounts. But AIMR was steadfast ("resolute," in "W" speak) in their position, and refused to budge. IMCA was so determined that they created their own standard, which went into effect the same time the AIMR-PPS(R) did: it never caught on, however.

The AIMR-PPS did, of course, catch on, and motivated other countries to develop standards, which led to the creation of the Global Investment Performance Standards (GIPS(R)). And as with the AIMR-PPS, asset-weighting because the required way to derive composite returns.

But why? What is the benefit of the composite looking like an account, when it isn't one? The composite is comprised of one or more real accounts, that were managed individually; no one "managed" the composite. Would it not be better to see the average experience of real accounts?

When I conduct GIPS verifications I occassionally run across cases that SHOUT OUT to me that this is all wrong. Here's one recent example:

Because of the huge size difference, account A's return IS the composite's: account B doesn't even have to show up. What's the point of worrying about B? It has zero influence on the return. And yet, the manager's ACTUAL performance in this discipline lies between these two accounts: actually RIGHT IN THE MIDDLE of them (what mathematicians and statisticians call, the average)!

Okay, so the Standards recommend that firms show the equal-weighted composite return. Great! How many firms do? The number is approximately zero. And why not? Perhaps it's because they would prefer not to hand out their presentations on legal size (i.e., 8 1/2" x 14") paper, or resort to a 9 or 10 point font size to fit everything that's required on the page.

I know that this commentary is about as welcome to some as ants at a picnic. But seriously, what were they thinking when they advocated asset-weighting? NO ONE MANAGES COMPOSITES! Firms don't get paid TO MANAGE A COMPOSITE! Would it really be so bad to say, "okay, maybe equal-weighting makes more sense, so effective 1 January 2015, equal-weighting will be mandatory, asset-weighting is optional, and the change goes into effect on this date, but firms are encouraged to restate history"? And what's the likelihood of this occurring? Again, approximately zero. Oh, well.

p.s., Yes, the figures in the table come from a client, though they've been altered slightly, out of respect for our client's confidentiality.