Whose risk is it anyway?

Last week I interviewed Northfield Information Services' founder and president, Dan diBartolomeo for The Journal of Performance Measurement(R). Dan shared many insights with me, and I'm sure our readers will find his thoughts and comments quite compelling.

One thing that struck me was the issue of risk from the standpoint of "whose risk are we measuring?" That is, are we looking at risk from the standpoint of the manager or the client? I've addressed this from the performance standpoint, but Dan was speaking of it from a risk point of view, which I found quite interesting.

There are loads of questions one might want to ask when it comes to risk, and they have different degrees of meaning depending on whether we're speaking of it from the manager's or client's perspective. For example:

• the risk of being fired
• the risk of losing our money
• the risk of uncertainty
• the risk of not being able to meet our objectives.

When it comes to risk management, the manager and client should be looking at risk from a variety of perspectives, yes? Just like performance measurement!

p.s., We are embarking on a research project this month to see how firms manage and measure risk. We've teamed up with Leslie Rahl and Capital Management Risk Advisors. In addition, we have several cosponsors supporting this effort. We will gain insights into how managers are measuring and  monitoring their risk.

p.p.s., Dan diBartolomeo recently conducted a webinar for our firm, where he shared details on the Bernie Madoff scandal. He is also featured in the August issue of Risk Professional Magazine.

p.p.p.s., Dan's interview will appear in the upcoming Summer issue of The Journal. 

Going back in time

An interesting question was posed to me recently; one that I hadn't previously thought about.

A client who wants to become compliant with the Global Investment Performance Standards (GIPS(R)) has three strategies, each of which has been in existence for 20 years, and each having its own composite. The firm wishes to have history for one going back the entire period, for 10 years for the second, and only the minimum five years for the third. Can they do this?

I thought this was a bit of a perplexing problem because a "firm" is compliant, not a "composite." And since the "firm" wouldn't have been "compliant" eight years ago, for example, if only two of the three composites had returns, would that therefore invalidate compliance for those dates? And yet, the standards only require five years (or to the date of the composite's creation, if shorter) of history. And although there's a recommendation that firms go back beyond the five year minimum, there is no stated requirement that firms must be consistent in doing this.

My conclusion was that "best practice" would be where the firm is consistent, but that they could do as they desired. But to be sure I contacted the GIPS help desk, and they confirmed that there was no prohibition on what the firm wanted to do and that they could, as they wished, establish history for different historical periods for the composites. Interesting, I thought; and glad that they concurred with me.

Getting rid of the cash

Let's say you have a client who asks you to raise a sum of money, which requires you to sell securities. At what point is this cash no longer yours? That is, at what point should the cash no longer be reflected in the portfolio as being under your discretion? Well, as we used to say in the military,

immediately, if not sooner.

A problem many asset managers face is that the client asks you to raise the money, but then takes days, weeks, or perhaps even months to wire the funds out, all the time the cash is sitting in the portfolio, but you can't touch it! And, its mere presence is impacting your return. This cash, once raised, is arguably non discretionary, and should be isolated.

GIPS(R) (Global Investment Performance Standards) permits firms to temporarily remove an account from its composite in the event of a large flow, but this only solves part of the problem: the portfolio's return will continue to reflect this cash. And, what if the cash is still present after the allotted removal time has expired?

A better solution is to use a temporary account. The problem is that this can be a challenge for many, especially when you have to reconcile with the custodian.Perhaps a better solution is to identify this cash as "unsupervised." This is an analogous approach. Some systems support this, and you should consider employing this technique, where applicable.

"Audited performance figures are what I want" ... but can I get them?

A hedge fund is considering us and a small CPA firm to do their GIPS(R) (Global Investment Performance Standards) verification and they also want an examination done. If they pass, they want to be able to say that their records "have been audited." We never use this expression, because I was concerned that the auditor community had an official "lock" on it. Perhaps by implication, the reader might interpret it to mean that an auditor did the work. If our client wants to say that their numbers "have been audited," can they?

Well, I passed this question along to a couple colleagues at very large CPA firms to get their thoughts. I mentioned that this may fall under the category of a "silly question," but I've been known to ask these and obviously have no shame. While both responded I'm only at liberty to share one at this time:

“Audit” does have a defined meaning for us in public accounting.  However, there is no ownership of the term of course.  IRS does “audits” – in the generic use of the word.  Anyone who does an “audit” is an “auditor” – nothing to do with a professional designation.

The CFA Institute did not use that term for the PPS and now GIPS, basically because our profession convinced them that it was the incorrect term for us when WE do the work, and we wouldn’t use it.  Nor do we, as our work is performed under the ATTESTATION standards, not AUDITING standards.

Wouldn’t their use of the term conflict with GIPS?

This raises at least two issues, does it not? First, if our competitor has suggested that they are doing an "audit" and that the client could state that their numbers "were audited" would conflict with the profession's governing body as well as GIPS, itself. Second, it appears that the common use of the term ("our numbers have been audited") is improper. Interesting, is it not? And perhaps not such a silly question, after all!

Karnosky-Singer attributes

Perhaps the best known model to reflect the attribution effects due to currency is the one developed by Denis Karnosky and Brian Singer, both formally of Brinson Partners. The fact that they worked with Gary Brinson is probably part of the reason for its tie in with the Brinson equity models. The K/S model is actually quite flexible and can be adapted to any attribution model, including fixed income models, though little has been written about this. This is "on my plate" to do in the near future.

Two important features of the K/S model should be emphasized. First, on the market side (where we look at the traditional effects one might find from a Brinson (e.g., Brinson-Fachler) model, for example) we use local return premiums rather than merely local returns. That is, we back out the risk-free rate from the returns, as this rate ends up on the currency side.

Second, we show two attribution effects for the currency side: the contribution from the underlying assets (that is, the impact simply due to changes in the FX rates on the assets in the portfolio over the period) and from currency forwards (that arise from our employment of various forward strategies). While one might want to lump these effects together, separating them provides the reader with a much better insight into what has occurred in the portfolio.

If, for example, we don't employ any hedging, then all of the effects would presumably come from the underlying assets. If, however, some hedging is taking place, then we would see how each is contributing to our excess return.

Attribution standards

Someone e-mailed me this week asking about the status of attribution standards. He cited my article, "A Case for Attribution Standards" (Journal of Performance Measurement, Winter 2002/2003) and wondered if any progress has been made. Sadly, no.

When the Performance Measurement Forum developed our draft standards close to a decade ago we hoped they would spur some interest and an endorsement, but this hasn't occurred.

Since the release of the article and the draft, a French group (GRAP) released guidelines for fixed income attribution and the European Investment Performance Council also provided guidelines.

There was much confusion when the subject of standards was first broached, with some interpreting the idea as defining what type of model, for example, one must use. But rather the idea is about disclosure: that is, for firms that employ attribution to disclose how they do it (e.g., arithmetic or geometric; holdings- or transaction-based; which model).

Perhaps this inquiry and some additional discussion might inject some renewed interest in this concept.

Confused?

We occasionally ask folks what they think is the most confusing aspect of the GIPS(R) (Global Investment Performance Standards), which typically results in a variety of responses. To me, the most confusing term is "discretionary account." Recall that compliant firms must place all actual, fee-paying, discretionary accounts into at least one composite. But most firms read "discretionary" and immediately take this to mean legal discretion; that is, does the firm have the authority to trade on behalf of the client.

But this isn't what the term means...it's dealing with discretion from a GIPS perspective. That is, has the client placed any restriction or requirement on the manager such that the result will not represent the manager's style? If "yes," then it's non-discretionary.

I was at a new client last week and they were putting every account into composites, even though they clearly had some flexibility at hand. For example, they had a new client which imposed a restriction which would have caused roughly 10% of their model's typical holdings to be excluded from this client account, which would have resulted in returns which wouldn't represent the composite. They were planning to create a whole new composite just for this account. And while they aren't prohibited from doing this, why do it if you can simply flag the account "non-discretionary"?

Discretion is a great tool that's available to all GIPS-compliant firms, but it must be used in a proper manner. Their rules for discretion must be documented in writing. And general rules such as "an account is deemed non-discretionary if the CIO (chief investment officer) feels the account has restrictions that impedes his ability to invest" don't work: we need clear cut rules; rules that can be tested by an independent party.

If you'd like to share what you think is confusing about the standards, feel free!