Disclosure paradigm

I have become a big fan of Malcom Gladwell and have made it through Outliers: The Story Of Success, The Tipping Point: How Little Things Can Make a Big Difference, and Blink. I'm now working on his most recent book, What the Dog Saw: And Other Adventures and came across a discussion which has some relevance to our industry.

Unlike his earlier books, which have common themes running throughout them, this recent one is a hodgepodge of his earlier writings, including a discussion on the Enron case. Enron created SPEs (special-purpose entities) to overcome difficulties in obtaining financing and presumably for other purposes. And although they were documented in their financial records, there were questions as to whether or not enough information was provided. Gladwell writes that "you can't blame Enron for covering up the existence of its side deals. It didn't; it disclosed them. The argument against the company, then, is more accurately that it didn't tell its investors enough about its SPEs." (emphasis in original) He then asks, "But what is enough?" Each SPE (and Enron had 3,000) had paperwork in excess of 1,000 pages; edited versions averaged 40 pages.

This discussion on disclosures can extend to GIPS(R) (Global Investment Performance Standards) and what compliant firms share. Recall that the GIPS Executive Committee had proposed to require firms to disclose details about their risks in composite descriptions, and many in the industry were concerned about how much might be necessary; and, if enough wasn't shown, would that then put their firm at risk?

The point at hand can be easily summarized by Gladwell: "You can try to make financial transactions understandable by simplifying them, in which case you run the risk of smoothing over some of their potential risks, or you can disclose every potential pitfall, in which case you'll make the disclosure so unwieldy that no one will be able to understand it."  Furthermore, "in an age of increasing financial complexity, the 'disclosure paradigm' - the idea that the more a company tells us about its business, the better off we are - has become an anachronism."

I'd say it's a good thing that the proposed risk disclosure requirement was dropped, because many firms feared this disclosure challenge: when do you have enough! The problem still remains, however, because (as noted in a recent newsletter) Jonathan Boersma, Executive Director of GIPS at the CFA Institute Centre for Financial Market Integrity and member of the GIPS Executive Committee, mentioned at last month's PMAR VIII conference that the EC "feels strongly that risk should be addressed in the composite description." The sample descriptions in Appendix C are apparently being used to imply this need. But, to put it simply, is a risk disclosure required or not? In a recent post I mentioned how a requirement found its way into the 2005 edition through the glossary, hardly where one would expect to look; are samples now a means to convey requirements? Hopefully, not.

Model fees ... and what does this mean?

I gave a talk today at the CFA Society of Philadelphia on GIPS(R) 2010 (Global Investment Performance Standards) and mentioned that effective January 1, 2010, compliant firms must disclose, when reporting net-of-fee returns, if model or actual fees are used. Earlier this year I mentioned that there is no definition of "model fees" in the glossary but that I suspect it means highest actual fee. Well, someone asked if it's possible to use "average fee."

While I suspect not, given the lack of clarity here I'm reluctant to give a definitive "no!" With no explanation as to what "model fee" means, some might suspect they have some leeway.

I will e-mail the GIPS help desk to try to gain some clarity.

In the middle of the day...

I'm completing a report for a client who asked me to review their performance measurement system and processing. They offer their clients the option of treating flows as middle-of-day events. I strongly oppose this method.

First, there's a reduction in accuracy: we value portfolios at the start and end of day, but not at the middle. Thus, we're not having an exact method (which we'd have with start- or end-of-day treatment) but an approximate method.

Second, I believe the reason firms choose this is simply because they can't decide whether to use start- or end-of-day.

The answer, I truly believe, is:

• Inflows: treat as start-of-day events
• Outflows: treat as end-of-day events

and don't bother with midday.

Expanding the role of a glossary...but no more!

What is a glossary? Well, www.dictionary.com defines it as

glos·sa·ry

/ˈglɒsəri, ˈglɔsə-/ Show Spelled[glos-uh-ree, glaw-suh-]

–noun,plural-ries.

1.a list of terms in a special subject, field, or area of usage, with accompanying definitions.

2.such a list at the back of a book, explaining or defining difficult or unusual words and expressions used in the text

The GIPS(R) (Global Investment Performance Standards) 2005 edition had an expanded role for glossaries: as a source of requirements. Take the expression Composite Definition: it's defined as "Detailed criteria that determine the allocation of portfolios to composites. Composite definitions must be documented in the firm's policies and procedures." (emphasis added) Who would think to look to the glossary as a place for requirements? To me, a glossary is a place to go if I find a word or expression for which I need clarity, not to find requirements.

Well, the GIPS 2010 edition has changed this; we now find "Detailed criteria that determine the assignment of portfolios to composites. Criteria may include investment mandate, style or strategy, asset class, the use of derivatives, leverage and/or hedging, targeted risk metrics, investment constraints or restrictions, and/or portfolio type (e.g., segregated or pooled, taxable versus tax exempt)." Not only has the "requirement" been removed, the expression has been nicely expanded.

Since the standards require firms to make composite definitions available upon request (see paragraph 3.A.4), you have to have them somewhere. Should they be in your P&:P? I would think this would be a good practice, but it's not a requirement. But since they are part of the process used to assign accounts to composites, I'd say they either should be there or at least referenced in the P&P.

Like a Rolling Stone...

My West Coast amigo, Juan Simpson, has posted something regarding the Rolling Stones. Now, the trick is to figure out what the Rolling Stones have to do w/performance measurement ... well, check it out!

http://cipmexamtipsandtricks.blogspot.com/2010/05/performance-professional-like-rolling.html

P&P Swap

Recall that we extended an invitation for firms to participate in a GIPS(R) (Global Investment Performance Standards) Policies & Procedures swap. Well, we've gotten some very positive responses to this idea, and decided to extend the deadline by two weeks until June 15.

If you wish to join in, please send me (DSpaulding@SpauldingGrp.com) your P&P (redacted or otherwise; we won't do any editing) by June 15.

Residuals when you don't expect to see them

Most folks in our industry are aware that if you employ a holdings-based model for attribution, you're subject to residuals creeping in. Residuals are the unexplained differences between the excess return (portfolio return minus benchmark return) and the sum of the attribution effects. Because holdings-based models don't capture intraperiod cash flows, they're subject to residuals. And so, our research confirms that most asset managers prefer to use a transaction-based model to be more accurate.

However, if you're using a monthly return formula (e.g., Modified Dietz), then you may still end up with residuals, because the transaction-based approach is capturing an exact return, while the Modified Dietz arrives at an approximation to the true, TWRR. Ideally, you should be using a daily return method so that you will eliminate the residual.

Note: you can still have what might be called a longitudinal or intertemporal (occurring across time) residual, unless you employ an appropriate linking method.

p.s.,  I believe I'm the first to use the term "intertemporal" to describe this form of a residual. I believe it's a handy way to distinguish between single-period residuals which can arise from using a holdings-based model, and residuals across time, when using an arithmetic approach.