Friday, January 9, 2015

We've Moved...!






Happy New Year!

The CIPM Exam Tips and Tricks blog has been moved to our NEW website!*  Please visit my blog   here!

I know that a number of you have used the Google "subscribe" function to be notified of new posts.  I don't believe the new blog has a similar subscribe function - but, if you want to receive notification of new or updated posts, you can "like" my Facebook page, where I post a status update for each new blog entry.  I also mention new posts on my Twitter feed and on LinkedIn, so feel free to add/follow me there!



* Actually, the move occurred last Autumn, and some more recent posts have been made there.  Many of the historical posts have been transferred to the new location - I will gradually add the remaining posts.

Tuesday, February 11, 2014

A Good Article on Jack Bogle, a Key Figure in Index Manager History...


Manager selection is an important component in the CIPM Curriculum... in that vein, I suggest candidates read through a writeup/review of Jack Bogle (and really, a new book on him) from the ThinkAdvisor website.  The curriculum doesn't make reference to Bogle, but his ideas certainly helped shape the industry, so it's a good read from a historical standpoint.

Wednesday, December 4, 2013

On Ethics...

This quick video succinctly touches on our role as professionals...

Saturday, October 19, 2013

Losing Is Painful...

Last night, my hometown team, the Los Angeles Dodgers, was defeated by the St. Louis Cardinals in the National League Championship series.  The Cardinals will go on to the World Series for a chance at what could be their 20th world championship... while the Dodgers get to start their winter vacations.

After the game, legendary Dodgers broadcaster Vin Scully was quoted as saying something to the effect of, "Losing feels worse than winning feels good."

When I heard this quote, it struck me that this applies to portfolio returns as well.  Which is one of the points of one of the readings at the Expert Level of the CIPM curriculum:  Reading 18 - How Sharp is the Sharpe Ratio.

One of the ideas that modern portfolio theory emphasizes is that we expect returns to fall in a symmetrical, normal distribution.  In a way, the idea of efficient portfolios at least implies that this symmetry is desirable.  One of the ideas of post modern portfolio theory, however, is that investors do not want symmetry in returns... investors definitely have a preference for the return history to have asymmetry to it.

Certain return statistics are referred to as "moments" in a distribution (history) of returns.  These moments describe the shape of that history.  In a return distribution:

  • mean return is the first moment, describing the center of the distribution
  • variance (or, alternatively, standard deviation) is the second moment, describing the range of the distribution
  • skewness is the third moment, describing the tendency to have returns in the tails of the distribution
  • kurtosis is the fourth moment, describing the flatness or peakedness of the distribution
Investors do not prefer symmetry.  Rather, investors prefer:
  • high mean returns
  • low standard deviation (or variance)
  • positive skewness (i.e., more returns in the right tail than a normal distribution would typically have)
  • low kurtosis (a flatter distribution, which means more extreme returns (again, preferably on the right)

This reading makes the point that investors typically feel losses more painfully than they enjoy gains.  Some of the risk statistics in this reading are designed specifically to focus on the number of extreme returns (painful losses or extreme wins).

The Adjusted Sharpe Ratio adjusts for skewness and kurtosis by using a penalty factor for negative skewness and excess kurtosis.

Downside deviation and downside potential focus on losing returns, while upside risk and upside potential focus on winning returns.

Omega ratio is upside potential divided by downside potential.

Conditional Value at Risk considers the size and shape of the tails of a return distribution, while Modified Value at Risk adjusts standard VaR for kurtosis and skewness.  The Conditional Sharpe Ratio and Modified Sharpe Ratio are, then, modifications of the standard return to VaR formula that substitute either Conditional VaR or Modified VaR, respectively - in an attempt to focus on extreme losing returns.

This is just a sampling from your reading.  Your focus for this reading is not the mathematics of these calculations, per se; rather, you should know the concepts behind why we want to measure extreme returns.

To summarize some differences between modern portfolio theory (MPT) thinking and post modern portfolio theory (post MPT) thinking:

MPT:
  • assumes normal distribution of returns
  • tracking error (the standard deviation of excess returns) measures active risk
  • returns above the mean and below the mean observation (of either absolute or relative return) are treated the same
Post MPT:
  • recognizes that investors prefer upside risk rather than downside risk
  • hedge funds (and other post MPT portfolios) are designed to be asymmetric with (emphasis on) variability on the upside but not on the downside
Happy studying!

Wednesday, October 16, 2013

A Little Piece on GIPS... (repost)



 

(Note:  I wrote this post as a guest blogger for the STP Investment Services blog, but it appears that blog is offline and we received a request for the information, so I decided to post the information directly here.)
 

The What, Why and Who of the GIPS Standards


In this blog post, I give you some quick and simple answers to the “what,” “why” and “who” questions that many people ask with respect to the GIPS Standards.  

What are the GIPS Standards?


The GIPS Standards are voluntary global standards for the presentation of investment performance results to prospective clients.  That the standards are “voluntary” and deal with presentation to “prospective clients” are two of the most important aspects of the GIPS Standards.

By voluntary, we mean that investment firms may choose to comply with the GIPS Standards – or they may choose not to.  There is no governing body that forces firms to comply with GIPS.  Different countries may have various laws that govern the presentation of performance results, separate from the GIPS Standards.  In fact, the GIPS Standards require compliant firms to follow the law in situations where the law differs from the GIPS Standards (in such a situation firms must disclose in their presentations the manner in which the regulations differ from the GIPS Standards).  It should be noted that locally, regulators may cite firms that have a false claim of compliance with the GIPS Standards.  Otherwise, with compliance being voluntary, the GIPS Standards represent a form of self-regulation that the investment industry has adopted on a global basis.

It is also important to consider what the standards are not.  The standards are not calculation standards or reporting standards.  When we say that the standards are not calculation standards, we mean that they are not an “A-to-Z” reference manual as to how the calculation of performance must be done.  Yes, it is true that there are certain basic requirements for the calculation of performance that must be met (covered in other chapters in this guide).  At the same time, it is up to the firm claiming compliance with GIPS to determine (and document) its policies and procedures for establishing and maintaining compliance with GIPS – including the calculation of returns, dispersion and other performance data.  As long as the requirements of GIPS are met, firms have a lot of leeway in defining how they perform the calculations.  One of the most important aspects of the GIPS Standards is that firms define (and document) their policies as clearly and objectively as possible, and that they apply their policies consistently.  This supports two main objectives of the GIPS Standards – fair representation and full disclosure.

When we say that the GIPS Standards are not reporting standards, we mean that the standards do not dictate the format of the firm’s compliant presentation.  The standards do prescribe requirements and recommendations for the content (i.e., the presentation elements) that must go into the composite presentation, and the accompanying disclosures.  It is up to the firm to format this information.  So again, the firm has a lot of flexibility in creating compliant composite presentations.  Again, the ideals of fair representation and full disclosure should be met. 

What items must a firm show in a composite presentation?


This list is not exhaustive, but a quick summary of what compliant firms must show includes:

  • Generally, time-weighted returns (TWR) that separate client contribution from manager results.  For closed end real estate and private equity funds, since inception internal rate of return is shown.
  • Annual composite returns (a composite is the aggregation of accounts managed to the strategy).
  • A measure of the internal dispersion (i.e., range) of returns of portfolios within the composite.
  • As a measure of risk, the variability (standard deviation)of the composite’s historical returns.
  • The amount of assets in the composite each year and the number of portfolios in the composite
  • The amount of firm assets each year.
  • Disclosures about the firm and the given composite designed to help the reader of the presentation understand the firm, the composite, and the performance history being shown. 
 
The GIPS Standards promote the comparability of manager performance across firms and across borders.  By requiring firms to show the same information, the prospect is better equipped to compare managers and make an informed decision as to which manager it should hire.
Why are there standards for performance presentation to prospective clients?

The GIPS Standards are a direct “descendent” of other predecessor standards that were created in various local areas dealing with presentation of performance results to prospective clients.  The GIPS Standards, introduced in 1999, are global standards that incorporate the best practices from the participating local country sponsors.

In the late 1970s and early 1980s, there were several abuses that were becoming commonplace as far as how firms presented their performance to prospective clients.  Some of the typical problems were:

  • Presentations that only showed the firm’s best performing accounts
  • Returns calculated based on unsubstantiated pricing
  • Annualization of partial annual periods
  • Reporting/presentation of best performing periods, omitting poor performing periods
  • Comparisons of performance with either low-return, or inappropriate benchmarks
  • Calculations that did not segregate manager returns from the client contribution
  • Presentations created by marketing departments that underplayed unfavorable data and highlighted persuasive elements

Because of these problems, prospective clients had difficulty making informed, sound decisions regarding what investment manager they should hire. 

Key events in the history of performance standards development:


  • 1966:  Peter Dietz’s seminal work, “Pension Funds:  Measuring Investment Performance,” was published, introducing what came to be known as the time-weighted return.
  • Late 1960s:  the Bank Administration Institute published return calculation guidelines based on Dietz’s work.
  • 1987:  Financial Analysts Federation created the Committee for Performance Presentation Standards (CPPS).  Key recommendations from their report:
  1. The use of time-weighted return was recommended.
  2. Presentation of performance gross-of-fees was recommended.
  3. The report recommended the inclusion of cash in portfolio returns.
  4. Construction and presentation of asset-weighted composites was recommended.
  • 1990:  The Association for Investment Management and Research (AIMR) board of governors endorse the AIMR-PPS.
  • 1993:  The AIMR-PPS is published.
  • 1997:  2nd edition of AIMR-PPS published
  • 1999:  The first edition of the GIPS Standards was published.
  • 2005:  The second edition of the GIPS Standards was published.
  • 2010:  The third and current edition of the GIPS Standards was published, going into effect on January 1, 2011. 
  • 2012:  Guidance Statement on Alternative Investment Strategies and Structures issued
  • 2013:  Exposure draft for the Guidance Statement on the Application of the GIPS Standards to Pension Funds, Endowments, Foundations and Other Similar Entities reeased

To whom do the GIPS Standards apply?


The GIPS Standards are voluntary standards that may be adopted and complied with by any investment firm with discretion over assets.  This includes all of the traditional asset classes (cash, equities, fixed income) and alternative asset classes (commodities, private equity, real estate, hedge funds).  The GIPS Executive Committee has recently introduced a document clarifying that pension funds, and other managers of managers, can claim compliance with the GIPS Standards.  While the GIPS Standards are commonly followed by managers seeking institutional clients, there are also a large number of retail investment managers that claim compliance with GIPS. 

How does compliance with GIPS benefit managers, beyond being hired?


Compliance with GIPS can benefit investment firms in many ways, including:

  • providing track record transparency and the ability to have a full/fair review of performance results for internal purposes
  • creating a framework within which the manager’s firm can document the decisions made and the justification behind them when a new scenario occurs in the performance processing and/or investment operations of the firm
  • allowing a better process for ensuring the marketing literature reflects the underlying information
  • promoting an improved reputation due to the recognition of GIPS compliance

How does the existence of GIPS benefit investors?


Some of the benefits of GIPS for investors include:

·         An enhanced ability to compare the performance of strategies among managers

·         The improved likelihood that investors can understand the information in managers’ presentations and the data behind it; thus, they are able to ask relevant questions to enhance their understanding of the strategy

What is Verification and How Does It Add Value for Investment Firms?


Verification is the use of an independent third party to test an investment firm’s claim of compliance with the GIPS Standards.  Verification tests two things, specifically.  First, it tests whether the firm has complied with all of the composite construction requirements of GIPS on a firm-wide basis.  Secondly, it tests whether the firm’s policies and procedures are designed to calculate and present performance in compliance with the GIPS Standards.  Firms that claim compliance with GIPS are not required to be verified, but for investment managers seeking institutional business, it has become a de facto requirement.  Most institutional investors will inquire as to whether managers they are considering a) claim compliance with GIPS, and, b) have been verified by an independent third party.  Managers are often eliminated from consideration if they have to answer no to these questions.  Thus, establishing and maintaining compliance with GIPS, accompanied by verification by an independent third party are essential to investment managers seeking to grow their business.

I hope this post helps give you an introduction to the GIPS Standards and the concepts of compliance and verification.  If you have any questions on these topics, please feel free to contact me at jsimpson@spauldinggrp.com. 

Tuesday, October 15, 2013

Battle of the Nobel Prize Winners: Fama vs. Sharpe!





OK, I'm just kidding... there is no grand battle here between economists (and Nobel prize winners) Eugene Fama and William Sharpe. 

That being said, CIPM candidates at the Principles level *are* expected to deal with the following Learning Outcome Statement regarding the work of these economists:


  • Compare Sharpe's return-based style analysis and Fama and French's three-factor model
so what are the key differences between the Sharpe's return-based style analysis and Fama/French return-based style analysis?

First, it might be helpful to review what style analysis is.  Style analysis is a process that is used to try to classify either a portfolio or an individual stock, based on traits (or characteristics) of the given portfolio or stock.  It is a process that evolved over some time, and major advances in this area came from separate contributions by William Sharpe and Eugene Fama (along with Kenneth French).

Equity style itself is based on the idea that stocks that share certain traits tend to have similar returns.  Style attempts, then, to aggegate stocks at an intermediate level between the broad market (on the macro end of the spectrum) and by industry or other small groupings (at the micro end of the spectrum).  If we think of the linear market equation as being a predecessor to style analysis, that equation attempted to describe stock or portfolio performance in terms of a single factor, the market factor (or beta):


 where R(A) is the account or stock return, R(f) is the risk-free rate, beta is the volatility of the portfolio compared to the market, R(mkt) is the return of the market (or benchmark), alpha is the manager's risk-adjusted value added and epsilon is unexplained performance.

Work by researchers in the 1970s found that two factors explained a large portion of stock returns:  capitalization (i.e., size) and valuation.  The capitalization factor is based on the idea that large cap stocks perform differently than small cap stocks, generally speaking.  The valuation factor is based on the idea that stocks that sell for low multiples of earnings or book value based variables tend to perform differently than stocks selling for high multiples of earnings or book value based variables.

In the American stock markets, we typically categorize styles based on size on one dimension (large cap, mid cap, small cap) and value on the other dimension (value, core/neutral, and growth).  Combinations of these are also considered styles or sub-styles (e.g., large-cap growth, small cap value, etc).  This is a system that was popularized by Morningstar in the 1990s, when they began to classify mutual funds in this fashion.  

William Sharpe, in 1988, published work based on his methodology for using regression analysis to explain the performance of any portfolio or stock by doing linear regression to find the appropriate mix (or, equivalently, the allocation) of style indexes.  The major contributions of Sharpe with respect to style analysis, as cited in your reading, are:  

  • All portfolios except style index funds are a mix of styles, and that style is a continuum
  • His research allowed plan sponsors to separate manager style bets from the manager’s pure alpha  
  • His work focused on price/book variables while that of his predecessors' focused on price/earnings variables; this influenced future construction of style benchmarks
 Fama and French (as documented in 1992 and 1993) found further evidence supporting the idea that size and value were factors that explain portfolio (or stock) performance, in addition to the market factor (beta).   They expressed this in their three-factor model:

 where SMB is the size effect (small minus big) and HML is the value effect (high multiples minus low multiples).

So, to summarize, Sharpe and Fama/French have the following similarities:
  • both are methods of returns-based style analysis; and , thus, use style as a means of understanding performance
  • both used book value based variables rather than earnings values to explain the fundamental value of companies

A couple of points of contrast:

  • Sharpe and Fama/French used different factors in their returns-based style analysis approaches.  Sharpe explained performance as a weighted scheme of style indexes.  Fama/French explained performance in terms of the three factors (beta, size, value) and coefficients assigned to those factors.
  • Your reading tells you that Fama/French used book value based variables, whereas it points out specifically that Sharpe used price/book (aka P/B), which was a major change from predecessors and shaped the development of style indexes into the future

Happy studying!

P.S.:  Yesterday I mentioned that Eugene Fama's work that recently won the Nobel prize in economics can be found here.  If you want to read William Shape's Nobel prize winning work, you can find that here


Monday, October 14, 2013

Congratulations to Eugene Fama (Nobel Prize)!


Congratulations to Professor Eugene Fama of the University of Chicago!  The Royal Swedish Academy of Sciences just announced that Mr. Fama (along with Robert Schiller and Lars Peter Hansen) has won this year's Nobel prize in Economics, for their work on developing methods to study trends in stock, bond and housing markets.  For more information on the announcement, see here.

Of course, Professor Fama should be familiar to CIPM candidates and certificants for his work developing the Fama-French three factor model.  In honor of Mr. Fama's accomplishment, I will spend some time discussing the Fama-French model in a post later today.  But first, I wanted to separately acknowledge this accomplishment by an individual that has contributed to the world of performance measurement.  Congratulations!

P.S.:  Their paper can be found here.