Memorial Day is the "official" start of summer,and Labor Day the official end, despite the fact that both are technically off. But starting next week, we will pretty much return to "business as usual." Hoping you and your family had an enjoyable summer, and that this long (for some of us) weekend is an enjoyable and safe one.
I often hear from those who serve the retail market that they are rarely asked for their rates of return; this seems a bit odd, as it would make sense for investors to want to inquire into a prospective manager's track record.
An article in this past weekend's WSJ might hold the key to a possible reason: the dislike for mathematics.
Alexandra Wolfe's article, "Edward Frenkel and a Love of Math" explains how most folks avoid anything with numbers. Frenkel, a professor at UC Berkeley, suggests that "you say the word 'math' and people shut down."
When I was working on my second masters (an MBA), I also served as an adjunct professor, and once taught a class on business math. Perhaps because of my approach, I was able to get students, such as those Frenkel references, to find some enjoyment in math. But for most folks it would be difficult to break through the walls they've constructed.
I wonder if most adults could answer the following question: an investor begins with $10,000 and earns a 4% return; how much money did they make? Do most adults even understand what a percent is? If a financial planner or advisor tells an investor that his/her return was 6.12% versus the benchmark's 5.75%, would this mean much? Would they think it's a good or bad thing?
Further research would definitely be needed to try to uncover the basis for the avoidance of the subject, but I suspect that ignorance might be part of it.
As grandparents of two boys (ages four and soon-to-be two), my wife and I have become acquainted with the television show "Yo Gabba Gabba." A regular feature is called "cool tricks," where a guest displays something they think is, well, cool! For example:
I think there are some cool words. Some I discover while reading books or the WSJ, while many are introduced to me in other ways. One word I recently came across is autodidact, which means "a person who has learned a subject without the benefit of a teacher or formal education; a self-taught person."
Until roughly 15 years ago, anyone in the field of performance measurement was autodidactic, as there were no other ways to learn our craft. In fact, there were very few written resources available, either. I recall almost 30 years ago trying to design my first performance system, scrambling to find the right formulas to employ.
Times have changed. We've seen many books on the subject of performance measurement introduced; several that The Spaulding Group has published. And, to further meet the need, 15 years ago we introduced a training program, that began with our Introduction to Performance Measurement (now Fundamentals of Performance Measurement) and Performance Attribution. These classes have since been augmented with new ones, including a week long "boot camp," a course dedicated to risk measurement, a GIPS workshop, and two courses designed specifically for the CIPM(R) program.
While there is nothing wrong with the autodidact approach to learning, it can be difficult. We have too often come across folks who learned this way, but learned the wrong things. One thing we often find interesting and rewarding is when we teach folks who have been in performance measurement for 10 years or more, but who had never before had any formal training. Like "rookies," they end up learning a great deal.
It recently occurred to me how these two words, insights and perspectives, play a non insignificant (i.e., significant) role in performance measurement. I often reference both when I teach, but thought it appropriate to share some views here with you.
Insights
My favorite source for word meanings, Dictionary.com, provides the following for "insight":
- an instance of apprehending the true nature of a thing, especially through intuitive understanding
- penetrating mental vision or discernment; faculty of seeing into inner character or underlying truth.
I often gain insights when reading or listening to someone speak. Often, they're ideas that are transportable to our business.
To me, performance attribution is a huge source for insights, as it allows for the reader (to paraphrase the above definition) to apprehend the true nature of the source(s) of the return or excess return. By employing a flexible attribution model, one can twist and turn their portfolio about, seeing more than would otherwise be visible (for example, Ron Surz's "attribution with style" is just one way to look at the data from a different perspective (see below for this word) to gain additional insights into what's going on). We can penetrate the data and discern what is occurring, seeing into the inner character of the portfolio and the truth within.
In conducting performance attribution, we should strive to gain as many insights as possible, so that we are able to fully comprehend what has occurred.
Perspectives
The website dictionary.com offers a variety of meanings for this word, and the following are best for our purposes:
- the state of one's ideas, the facts known to one, etc., in having a meaningful interrelationship.
- a way of regarding situations, facts, etc, and judging their relative importance.
- the proper or accurate point of view or the ability to see it; objectivity.
I often point out that the decision as to whether to use money- or time-weighted return methods should be based on the perspective in which we want the information to be presented. Again, to paraphrase the above, the way regarding the situation and facts, to judge their relative importance. Based on one's perspective, it provides the proper or accurate point of view, which actually results in an improved ability to see what has occurred.
A GIPS(R) verification client of ours asked me to review supplemental information that they propose including with their composite presentation. What they've done is broken their portfolio up into various sectors. These are not "carve-outs," because they don't contain cash, and if they did, it wouldn't have resulted from the cash being managed separately. It is quite common to see managers show the returns of asset classes (e.g., equities, bonds, cash), but for GIPS purposes this would be considered "supplemental." In our client's case, they break the data up into several categories, not necessarily mutually exclusive (see below).
I am gaining my own insights into this information, and realizing it caused me to consider performance attribution a bit more. I don't recall if it's ever been stated before (perhaps because it seemed obvious), but when we conduct attribution, the portfolio's components (e.g., sectors) which we analyze must be mutually exclusive; i.e., we couldn't have the same security sitting in two sectors simultaneously.
I liken what our client does to a form of attribution, since it provides the reader some insights into where the returns are coming from; however, as already stated, it wouldn't qualify as traditional attribution, given that it fails the "mutual exclusivity" requirement.
A question also arises regarding what is being presented; what's the perspective? If, for example, we're looking at U.S. large cap stock performance, is the manager saying "this is how the large cap sector of the portfolio performed" or "if I were to manage a large cap strategy, this is how I would have done"? These are vastly different, are they not?
Consider just a few of the differences:
- Cash: with the former, the exclusion of cash is appropriate, since we are only concerned with showing how the large cap stocks within the portfolio performed; with the latter, we'd expect to see cash present, since there would bound to be cash in a large cap portfolio, the relative composition of which might vary from time to time.
- Gaps: I have written in the past that I can see one justifying crossing gaps in performance, if you want to show how the avoidance of a sector (e.g., banking) might have benefited the overall performance, vis-à-vis the benchmark. And so, for the former I'd permit gap-crossing. However, for the latter I wouldn't, since the likelihood of someone managing a portfolio solely devoted to banking or any strategy going completely empty, would be extremely unlikely (I'm open to how you think this might occur); perhaps this would take place if the client decided to temporarily shift all their funds away from that strategy, but the resulting gap wouldn't be crossed.
- Makeup: for the former, we wouldn't necessarily have any expectation for a "minimum number of securities." However, for the latter, since it is equivalent to a portfolio being managed to a strategy, we would expect to see several securities present. While one or two might be okay for the former, they most likely wouldn't for the latter.
- Return methods: in the former case we would push for money-weighting, since the manager is controlling the cash flows; in the latter, an argument could be made for time-weighting, for if this were a separate portfolio, even though the cash flows might be under the control of the manager, we typically see time-weighting employed here.
And so, understanding the perspective, once again, is critically important.
Insights and perspectives: two words that really do have a lot to do with performance measurement. I may have more to say on this in our September newsletter, as I think it's an interesting topic; hope you do, too!
Earlier this year, the Global Investment Performance Standards (GIPS(R)) Executive Committee published a draft guidance statement which expands the reach of GIPS into the asset owner world. I have commented briefly on it here before, and wrote an article for Pensions & Investments. In addition, I provided a comment letter, which is (along with the other feedback received) available on the GIPS website.
I was recently interviewed by P&I about one letter in particular: the one from Towers Watson Investment Services (TWIS). They raised the question about the Standards applicability for consulting firms, especially in cases where they "can be viewed as having discretion over assets under management and provide performance for [their] clients." Excellent issue to raise.
While written guidance would probably be helpful, I believe that one can cull from the Standards what is needed for such entities to comply.
Cases where the firm has discretion: There are times when a pension fund (or similar asset owner) has turned over responsibility for the management of the plan to a consulting firm. In these cases, the consulting firm has (a) the right and authority to determine the asset allocation (strategic and tactical) and (b) determine who will manage the various strategies (possibly with internal resources or through a subadvisor). Each underlying strategy (e.g., U.S. Large Cap Value) would result in a composite, that contains the appropriate subportfolio results for each of their clients. In addition, it would be appropriate to have a macro composite that consists of the entire portfolio, that will reflect the allocations as well as the management of the individual sectors. Because of the likelihood of materially different allocations, multiple composites would likely be created. The assets of the clients for which the firm has discretion would form the firm's AUM (Assets Under Management). These arrangements are similar to fund-of-fund managers.
Cases where the firm doesn't have discretion: Here, the firm provides advice to their clients, regarding allocations and managers. However, the consultant doesn't have the authority to make the ultimate decisions. In these cases, the firm could still create composites and provide returns, though these would be "supplemental" information, that would require clear and full disclosures regarding what is included. These assets would be AUA (Assets Under Advisement). Sufficient disclosures are necessary to make it clear that advice is given but not necessarily followed.
The Standards can, in many cases, be applied, without any additional guidance, but the same could have been said for asset owners. Therefore, some supporting guidance would no doubt be beneficial.
Last week, during a talk I was giving to a group of operations folks, someone asked my thoughts on showing benchmarks to retail investors; specifically, those that are non-discretionary.
It's important to realize that benchmarks serve two purposes: first, as a way to demonstrate skill, where the benchmark is one that aligns with the investment approach, and second, for reference purposes. Since most retail investors won't be managing in a particular style for which a benchmark will align, we are left with the idea of showing benchmarks for reference purposes. In this case, it's more of a "by the way, here is how the DJIA, S&P 500, Barclay's Agg, US CPI did."
If the client has an objective, such as wanting to have a return of at least four percent, to meet his/her obligations without dipping into principal, then having an "absolute" benchmark (in this case, 4%) would make sense to show.
By including a variety of indexes the client can see how they're doing relative to various markets, and may decide to invest passively (or perhaps even actively) in one or more.
For some time it's been my view that time-weighting was oversold.
That is, when nearly 50 years ago (1966, to be exact) Peter Dietz published his dissertation, promoting a return method to eliminate or reduce the impact of cash flows, his idea was so powerful and intriguing that it caused the Bank Administration Institute (BAI) to publish the first set of performance standards (1968), which encouraged the use of (what they called) time-weighted methods, to eliminate or reduce the effect of cash flows. This was followed by the ICAA (now the IAA) in 1971, with a different set, but that also promoted time-weighting.
The industry's response was as you might expect: acceptance. Because there had been no rule regarding how to calculate returns and, as Peter discovered, the result was a mix of methods, most of which were simply wrong.
But Peter never intended to have pension funds, etc. to stop using the IRR (money-weighting). On the contrary, he, and many others (such as the UK's Dugald Eadie), identified the role of this method. But, either because of the inability to grasp what Peter, Dugald, and others were saying, or not even paying close enough attention, the use of the IRR as a method to evaluate a plan or account from the client's perspective disappeared.
I liken this overselling to the case involving a Catholic girl and a Baptist boy who were dating. The girl's mother recognized that marriage was a possibility, and suggested that it would be a good idea if she could persuade her boyfriend to convert to Catholicism. And so, the daughter began working on him, taking him to church regularly, explaining the rituals, etc. A few months later, in tears and sadness she phoned her mother to explain that the marriage wasn't going to happen. "Why, weren't you able to sell him on the Catholic religion and get him to convert?" The daughter replied, "yes, but I think I overdid it; he's decided to become a priest!"
Like the girl in this story, the industry was oversold. Fortunately, there are several of us who are encouraging firms to reconsider the use of money-weighting, and meeting with a fair degree of success.
.png)
