What happens when your classification is different than the index's?

I'm at the Spring meeting of the North American chapter of the Performance Measurement Forum in Boston. One of the issues that was raised deals with the case when a firm has a different classification structure than the index and the resulting impact this has on performance attribution. For example, if a firm assigns a stock that's in the index to a different industry than what the index has.

If we ignore this difference then the attribution results are questionable. If we change how the benchmark has the security assigned then we've manipulated the benchmark and arguably falsified the comparison. If we change our classification so that it aligns with the benchmark than we might feel that this doesn't truly represent how we manage. No good solutions.

Probably the best answer is not to have a different classification. But this may not always be practical. Perhaps in those cases where the firm feels that such differences are necessary we should have a new attribution effect: "classification effect." Just as we can have "pricing effect" to identify pricing differences between the benchmark and portfolio, we can have a "classification effect" to identify the impact of differences in how we classify our securities. To my knowledge no one has done this but it can't be that difficult to accomplish.

Thoughts?

When to rebalance benchmarks

We got a call recently from someone asking how often they should rebalance their benchmark. Apparently someone within their firm is pushing for daily, but this individual was concerned with the amount of effort that would be involved.

My response was that they should ideally rebalance the benchmark when they rebalance the portfolio; to rebalance more frequently would detract from the variations which are being caused within the benchmark which would most likely vary from what they're doing, and thus eliminate the allocation shifts which may or may not be in the manager's favor. But to confirm my beliefs I reached out to Neil Riddles, aka "the benchmark king" to get his thoughts. He responded:

One of the important considerations for benchmarks is that they should be a passive representation of what the manager is doing in the active portfolio.

If the portfolio has a set rebalance period, then mimicking that makes sense.  For example, if it is rebalanced quarterly, then rebalancing the benchmark quarterly is best.

If the portfolio is rebalanced when it gets a certain percentage out of line, that policy should be applied to the benchmark as well.  For example, if the portfolio is rebalanced when it gets out of line by 10% (55/45) then the same rule ought to be applied to the benchmark.

Ideally, the benchmark rebalancing should not be dependent on what goes on in the portfolio.  So, if the portfolio rebalances on a non-regular schedule (or does not follow other explicit criteria) then we would not want to rebalance at the same time.  The reason is that, absent an investment in the portfolio, the investor could not achieve the benchmark results.

At any rate, rebalancing daily is likely to maximize the error introduced because the benchmark is trading costlessly.

I think our views are almost identical. Formal guidance would always be helpful, and we'll look to develop that at some point.

p.s. I dubbed Neil "the benchmark king" quite some time ago, using the nicknames assigned to various prisoners in "The Great Escape." For example, Steve McQueen was "the cooler king." Oh, and if you've never seen the movie, you should!

Isn't it time to verify the verifiers?

A client recently asked what the qualifications were for a verifier; the answer: none. Granted, we would expect that they understood the Global Investment Performance Standards (GIPS(R)), performance measurement, portfolio accounting, the requirements and expectations for conducting a verification, etc., but there is no way to validate this. There is no certification either at the firm or individual level. But should there be? Well, consider this.

We recently conducted a verification for a new client who had previously been verified for several years by the another firm. Now, one might argue about "gray areas," but disclosures? Our client's presentations didn't have composite descriptions! Come on, didn't our competition even have a checklist? And when I mentioned this infraction they informed me that they used to have them but their prior (not to be named) verifier told them this was no longer a requirement! Really, and where exactly is this written?

This verifier did this firm the favor (or more correctly, disservice) of providing them with a formula to handle carve-outs: take their equity returns and add 5% for the T-bill rate to represent cash. Interesting. And where exactly did they dream this up? Isn't this what one might call "hypothetical returns"? When I told them this was invalid our client at first said "let's get XYZ on the phone," to which I responded, "great, lets!" But, our client quickly decided this was fruitless. Unfortunately, this isn't the first time I have found that this particular verifier uses creative but non-compliant methods for carve-outs.

Verifiers who perform poor verifications do nothing to enhance the image of this important review process. In addition, they put their clients at risk. CFA Institute and/or GIPS Executive Committee: are you listening? Let's offer a certification for verifiers! PLEASE! I've been asking for this since 1992 ... surely it's time!

Whatever they want

I just got a call from a verification client who said that a prospect has asked to see monthly returns; he asked if he can provide them a GIPS(R) presentation just with the monthly returns rather than annual?

You can have monthly returns in your presentation but must also have annual. You can give a prospect whatever they ask for, even if it's not in line with the Global Investment Performance Standards (e.g., a representative account or an equal-weighted composite presentation), as long as you also give them the appropriate compliant presentation.

CIPM help has arrived!

We've launched a new blog: CIPM Exam Tips & Tricks. It's based, to some degree, on our popular training programs and is managed by my colleague, John Simpson, CIPM.

The site goes into detail on a number of important aspects of the examination and will no doubt prove helpful to individuals taking either the Principals or Expert level. It will also be helpful, we're sure, to anyone who's interested in performance measurement. So please visit!

Terminating composites

A client who complies with the Global Investment Performance Standards (GIPS(R)) mentioned that they have two composites which are so close that they'd like to combine them and then terminate the old composites; can they?

A firm can always create new composites, provided they abide by all the rules. In this case, the combination would create a third composite, which is the aggregation of the two that are close, thus all accounts that are in these two composites will now also be in the new one. But now the firm has three composites when they once only had two; can they terminate the two old ones now that they've created a combination of them?

Unfortunately, there is nothing in GIPS that addresses this, but I have it on good authority that yes, a firm can terminate composites! Recall that firms must have all actual, fee-paying, discretionary accounts in at least one composite. And so, as long as this rule will remain, then a firm can terminate a composite that it no longer needs. This composite name and description must be included on the firm's list and description of composites (soon to be list of descriptions) for at least five years after it's terminated. I'd also advise the firm to include an explanation as to why the composite was terminated in the composite presentation as well as the firm's policies.

Modified Dietz doesn't always do the job

We have a new client who wanted us to do a "non-GIPS(R) verification" of a composite. We do this type of work for clients who aren't able (or choose not) to comply with the Global Investment Performance Standards. We typically begin by understanding their rules since they're under no obligation to adhere to GIPS. We then validate that they have, in fact, abided by their rules. We obviously also test to see if their rules are appropriate and not misleading.

In this case we asked how they calculate returns and were told that they use Modified Dietz, which, of course, is a perfectly acceptable method to derive a time-weighted return (under most circumstances). In our client's case, because of their inability to value all portfolios monthly, they calculate the composite's return across a full year: that is, they value the composite (which is an aggregation of the member accounts) at the start and end of the year, and weight the flows across the year. Interesting.

The AIMR-PPS(R) actually allowed this approach for periods prior to January 1, 1993; GIPS has never addressed such a long period and only permits, at most, quarterly for periods prior to January 2001. And, we would argue that it's a far from appropriate approach given (a) the long period, (b) the market volatility, and (c) the presence of cash flows throughout the year. As my friend Carl Bacon likes to remind me, Modified Dietz is a money-weighted formula that achieves the status of being time-weighted by linking; in this case there would be no linking and the return is, essentially, a money-weighted one; hardly a viable way to measure a manager's performance.

We reached out to the client earlier today, and spent about a half hour explaining that while we could do this work, our report would have to include enough qualifying language to make the results less than ideal. They're now working on another approach.

Yes, Modified Dietz can work ... but not always!