This photo of one of the legends of sports, not just basketball, was recently posted on FaceBook. I thought it worthy to use as the basis for a blog post.
It made me think of two of my Spaulding Group colleagues who recently completed degrees part-time, which isn't an easy thing to do. It requires perseverance, drive, patience, a willingness to push forward, a commitment to spend time studying and attending classes rather than doing some fun things, the ability to keep motivated for a fairly long stretch of time, and the desire to succeed. Having earned two master's degrees (and now completing my doctorate) this way, I know first hand what it's about.
I congratulate my younger son, Douglas, who earned his MFA in Creative Writing from Farleigh Dickinson University and Jessica Laffey, who earned her Bachelor's in Criminal Justice from Caldwell College. Two great performances!
When I teach our firm's Fundamentals of Performance Measurement class, I begin by saying how performance measurement isn't limited to investing. We encounter the opportunity to observe or participate in performances all the time. My friend, Herb Chain, is the President of the Queens (no, not Elizabeth, the NYC Borough) Symphony Orchestra, that holds performances regularly. They may get judged in a subjective way, based on how the audience feels they did.
Our younger son, Douglas (pictured above), is the artist in the family, given that he avoided sports throughout school (save for the few years he was in little league, youth soccer, and youth basketball), and concentrated on theater, instead (while his older brother, Chris, the athlete in the family, won the wrestling award as a senior, Doug won the theater award). Doug majored in theater and has worked for our firm for more than 10 years.
Well, a few years ago Doug took up a new pastime: obstacle courses. He has participated in several "Tough Mudders," as well as other events, including the one described in this video:
I'm teaching a Fundamentals of Performance Measurement class in Sydney this week, and it struck me how much we can use from golf that applies to performance measurement. For example:
- Measuring performance: performance in golf is measured quantitatively (a player's score), just as we do with performance
- Benchmarks: Here we have at least two standard methods:
- An index: the course's par
- A peer group: the field that the player is part of. E.g., Phil Mickelson just won "The Open" (aka, the British Open); anyone else playing in the tournament arguably had a chance to win.
- Rules: performance measurement has the BAI standards, the ICAA standards, the GIPS(R) standards, while golf has the PGA standards
- Risks: we have various risks that come into play in investing, such as market and idiosyncratic, while golf has bunkers, water hazards, woods.
Anything else come to mind?
Metaphors, analogies, etc., are very helpful ways to communicate ideas. It helps folks better to relate to concepts, and tying golf in (something many are familiar with) is just one example.
I was recently asked to do some analysis on a firm's return calculation process; this request stemmed from the fact that they were getting different returns for the same period. I surprised them, I think, when I said that more than one return could be "right."
During a Fundamentals of Performance Measurement class I am teaching this week in Sydney (Australia), I mentioned this discussion. I also mentioned how once again, Bill Clinton's famous "it depends on what you mean by the word 'is,' is" came to mind. In this case, it's the word "right" that is interesting.
What is "right"? In performance measurement it's deriving a rate of return using an acceptable method. Historically, there have been more "acceptable" methods, but this number has dwindled in recent years, mainly because of the Global Investment Performance Standards (GIPS(R)), but also because of the industry's general interest in providing more accurate returns (in 1988 I attended an event sponsored by the ICAA (now the IAA), that addressed this very topic). Gone (so to speak) are the Original Dietz method (which treated flows as mid-period events), as well as Modified Dietz and Modified BAI (which day-weight cash flows), unless you revalue for "large cash flows."
And so, we have three or more "acceptable" methods to choose from:
- Modified Dietz (revalue for large cash flows)
- Modified BAI (revalue for large cash flows)
- Exact (revalue for all cash flows.
Does this mean that the most number of returns we might have is three? No, because we have to contend with the weighting method chosen; here we could have:
- Start-of-day (for all cash flows)
- End-of-day (for all cash flows)
- Start-of-day (for inflows) and end-of-day (for outflows)
- Start-of-day (for outflows) and end-of-day (for inflows)
- Middle-of-day (something I'm not a fan of, but know that some folks like).
This suggests that we might have 15 different returns. But, when you consider that one vendor allows the weights to go from 0 (end of day) to 1 (start), with increments of 0.1 (i.e., 0.1, 0.2, ... 0.9), the number jumps even higher!
And this is only the time-weighted variety. What about the Internal Rate of Return (IRR) as a money-weighted return? That is arguably "right," too! You could use the IRR (the exact money-weighted return) or Modified Dietz (as an approximation).
Perhaps the exact method is the most right return (nice choice of words!), but even here there might be at least four varieties, based on how we choose to handle the cash flows, and of course exact for TWRR and MWRR will be different returns showing different results (unless there are no cash flows).
You still have the opportunity to encounter "wrong" returns (e.g., returns based on settlement date accounting, that ignore large flows, that use erroneous data, based on faulty methods, that don't revalue at least monthly), but they are, in most case, clearly "wrong."
You obviously want to avoid reporting different returns to the same party (this only leads to confusion, concern, and credibility issues). In the case of our client, they were getting two different returns from their performance system, one which I determined to be wrong.
Most firms are familiar with the challenge of having to reconcile their return to the custodian's and/or client's consultant, all of which may be technically "right." This whole subject makes for interesting discussions, I think.
A common myth that I often run into is the one involving building up returns from the underlying assets. That is, the belief that if you calculate the returns at the security level and then "roll them up" to derive the portfolio return, that is somehow better.
WRONG!
It is better to calculate the portfolio return based on its beginning and ending market values, its cash flows, and ideally, its values when flows occur.
Building up from the securities can often create errors. Plus, as I've explained before, security level returns should be money-weighted, not time-weighted, thus their use for rolling up has to be wrong!
I just reviewed one client's system that calculated returns this way, and discovered that not only were the portfolio and asset class returns in error, so were the security returns themselves!
Let's put an end to this myth!
I had a discussion recently with a good friend and colleague, who suggested that when evaluating a manager's performance, returns should be net of inflation. I'm not so sure about this.
What are the "nets" we're familiar with:
- Net-of-fees: most managers charge an advisory fee for their skill in investing their clients' assets. To report to their clients without the impact of fees is not showing the full picture. Yes, perhaps before the fees are removed (i.e., a gross-of-fee return) the manager did well, but the client wants to know the impact of the costs they incurred, which means transaction costs and management fees. Therefore, when reporting to clients, net-of-fee returns are, in my view, better than gross-of-fee.
- Net-of-taxes: a few years back, reporting "after tax" returns was being encouraged quite a bit. This was perhaps stimulated by what appeared to be excessively high double- or triple-digit returns which managers were regularly producing. If a manager provided a +50% return (net-of-fees, of course), but taxes took a big chunk out of it, because of capital gains, how well did the client actually do? Thus, the encouragement to show after-tax returns. Even the AIMR-PPS(R) and GIPS(R) (Global Investment Performance Standards) had provisions for after-tax returns (since dropped from GIPS)). In my view, managers who claim to provide tax-efficient management are obligated to provide after-tax returns. Clients who want to see them should be given them, too. As for everyone else, I'm not sure, but it would be an interesting conversation to have. If the manager isn't making an attempt to avoid the impact of taxable events, should they be required or encouraged to report the impact their trading has? If a manager is extremely inefficient when it comes to managing vis-a-vis the impact of taxes, surely their clients (and the market) would want to know this. Again, could be fun to discuss.
- Net-of-withholding taxes: When investing overseas, portions of income are withheld to pay local taxes. These funds may be recoverable. But until they are, should the returns reflect their impact? Probably, since the manager made the decision to invest in those countries and securities.
- Net-of-risk: Risk-adjusted returns are, in reality, a return that has risk stripped away. Measures such as the Sharpe ratio, Treynor measure, Jensen's Alpha, and Information Ratio produce a form of risk-adjusted (i.e., net-of-risk) returns. My favorite risk-adjusted measure, as you may be aware, is Modigliani-Modigliani (aka, M-squared). Its use results in returns that are truly net-of-risk, which can be easily shown next to the portfolio's benchmark(s), to better judge how the manager performed.
To show returns to clients that are net of:
- fees,
- withholding taxes,
- and risk
is, I believe ideal. To include taxes is also beneficial.
Okay, so what about net-of-inflation?
First, the manager obviously cannot control inflation. Inflation figures are reported ex post. And so, I don't know today what the inflation rate is; it's based on price changes over time. Can or should managers invest in a way to avoid or exploit inflation? Perhaps if they recognize that certain industries will benefit from inflation, they may invest in them, and industries that suffer, to avoid; is that reasonable? Do managers tout themselves as "inflation avoidance/efficient managers," as we have "tax avoidance/efficient managers? Not that I'm aware of, but clearly if someone does hold themselves out this way or employs such a strategy, then reporting net-of-inflation would seem to make sense.
We encourage managers to report the internal rate of return (IRR), or money-weighted return, to their clients, in order to represent how the client did. Should the manager judged on the IRR? In general, no, since the manager can't control the client's cash flow decisions, which may have a negative impact on performance. Perhaps net-of-inflation should fall under this idea, too; to show the client yet another net-of- figure, especially since their wealth is impacted by the effects of inflation. But, for the manager not to be judged. Again, an interesting question, worthy of some discussion.
I'll admit that it's a bit unusual that a sermon would be the inspiration for a blog post, but that's the genesis (pardon the pun) for this one.
At Church today, the Gospel was the well known (i.e., familiar) story of The Good Samaritan. Our pastor explained how most of the congregation could recite the story quite accurately. But he suggested that one shouldn't confuse familiarity with understanding, as the story's deeper meaning requires some effort to discern.
This made me think of many of the formulae and methods we employ in performance measurement. No doubt most performance measurement professionals are familiar with the idea of time-weighting, the Modified Dietz formula, some of the attribution models, many of the risk measures, etc. But, how many understand them?
In the case of The Good Samaritan, with each listening / reading, one has the opportunity to reflect more, or, if they're lucky, to be instructed by a knowledgeable theologian on some of the story's details, as well as background insights that aren't necessarily discussed in the parable. The same holds with the methods we employ on a regular basis to evaluate all aspects portfolio performance.
The Spaulding Group's training classes provide the opportunity to not only gain greater familiarity with many of the things we encounter, but also to expand one's understanding. I'll confess that my understanding continues to expand, as I spend more and more time reflecting on these materials.
I am excited that I will return to Sydney, Australia next week, to conduct both our Fundamentals and Attribution classes. While I've been there several times, it's been quite some time since I've been down under, and am looking forward to the trip. Sydney is one of the most beautiful cities I've visited. I enjoy the people and much of what the city offers. Hopefully, I'll be able to spend some time at the famous Opera House, too! If you know of someone who might wish to attend the training, please let us know, as there is still time to sign up!
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