Performance Reporting for Investment Managers: Applying the AIMR Performance Presentation Standards

Foreword Almost four years ago, the document that would become known as AIMR's Performance Presentation Standards was published in the Financial Analysts Journal (September I October 1987). This was the first milestone in the ongoing effort to establish consistency and public trust in the way investment managers measure and represent their professional results. The journey had begun in August 1986, led by Frederick L. Muller, CFA, then Chairman of the Financial Analysts Federation (FAF). The lack of standardization in performance reporting within the industry left the door wide open for misrepresentation on the part of practitioners and for mistrust-fed by bad press and bad experiences-among clients and potential clients. Something had to be done, either by outside regulation or by the financial management industry itself, to tighten up performance presentation practices. Muller strongly believed that industry professionals not only have the most experiential knowledge of what is needed but also have the most to lose by not having presentation standards. He asked Claude N. Rosenberg, Jr., to form a committee to recommend a standard method010gy for presenting performance records to the public. The members of FAF's Committee for Performance Presentation Standards (CPPS)-Claude N. Rosenberg, Jr., Robert A. Jeffrey, Robert G. Kirby, Dean LeBaron, CFA, and John J. F. Sherrerd, CFAconstructed the original set of guidelines for performance presentation, published the results of their work, and solicited comments from the managers who would actually be applying these Standards in the field. As a result of the comments it received, the committee fine-tuned its initial guidelines and presented a revised set at a two-stage 1989 seminar held in New York on January 24 and in San Francisco on February 28. The goal of the seminar was to promote widespread dissemination of the Standards and to discuss the issues inherent in measuring and presenting performance data. The key session was a panel discussion by the CPPS to present the Standards, discuss the response of the industry to their work as initially published, present their updated recommendations, and discuss the rationale underlying the Standards. Speakers at other sessions included members of the mutual fund, banking, and consulting communities, as well as a representative of the Securities and Exchange Commission (SEC). AIMR published the proceedings of this seminar under the title, Performance Measurement: Setting the Standards,

Interpreting the Numbers. On January 1, 1990, when the FAF joined with the Institute of Chartered Financial Analysts under the AIMR umbrella, AIMR assumed all further responsibility for the Performance Presentations Standards. In August 1990, AIMR amended the Standards to make them consistent with the SEC's position on presenting performance "advertisements" net of fees. At the same time, the AIMR Board of Governors endorsed the Standards, proposed a schedule for their implementation, and established the Performance Presentation Standards Implementation Committee (PPSIC) to guide the implementation effort. PPSIC members are Frederick L. Muller, CFA, Chairman; Dwight D. Churchill, CFA; Kathleen A. Condon, CFA; Thomas S. Drumm, CFA; Creighton E. Gatchell, Jr., CFA; David M. Kirr, CFA; Ronald D. Peyton; Lee N. Price, CFA; and R. Charles Tschampion, CFA. AIMR's implementation schedule calls for the Standards to be circulated for comment through 1991. The intention of the AIMR board is that the Standards will become effective on January 1, 1993. The PPSIC is now in the process of identifying implementation issues, clarifying the meaning of the Standards for various segments of the industry, and drafting specific guidelines for firms to use in adopting the Standards. The committee's aim is to clarify the meaning of the Standards, not to rewrite them. In addition to creating a committee to study implementation problems, AIMR sponsored two seminars on various aspects of applying the AIMR Performance Presentation Standards. The first was held on December 5, 1990, in Boston, and the second on March 19, 1991, in Los Angeles. These seminars addressed many aspects of implementing the Standards, including how to calculate the numbers according to the Standards, how to create acceptable composites, and where the SEC stands on performance advertising. The presentations also included case studies that convey the experiences of various constituents-managers, plan sponsors, consultants, and bank trust departments-in using or implementing the Standards. The speakers discussed many important aspects of the Standards, potential problems, costs, and, of course, the benefits of having industrywide standards. This publication, Performance Reporting for Investment Managers: Applying the AIMR Performance Presentation Standards, is the proceedings of those seminars. It provides an excellent resource for people in v

the process of adopting the Standards. The question and answer sessions provide valuable information as well; for example, in her question and answer session, Mary Podesta addresses concerns of many members regarding the definition of one-on-one presentations. Readers with additional questions should forward them to AIMR. The contents of this book are a tribute to the excellent panel of seminar speakers. AIMR extends its appreciation to these speakers for their contributions to the seminars and to this publication: Daniel W. Boone lll, CFA, Atlanta Capital Management; Dewitt F. Bowman, CFA, California Public Employees' Retirement System; Eileen Delasandro, Fluor Corp.; Barry W. Dennis, Callan Associates; Mary E. McFadden, CFA, Mellon Bank N.A.; Deborah H. Miller, CFA, Batterymarch Financial Management; G. Thomas Mortensen, RCM Capital Management; Frederick L. Muller, CFA, Atlanta

vi

Capital Management; Ronald D. Peyton, Callan Associates; Mary Podesta, Securities and Exchange Commission; Lee N. Price, CFA, RCM Capital Management; Paul W. Price, CFA, State Street Bank & Trust; Sam H. Smith, Trust Systems, Inc.; Robert G. Wade, Jr., Chancellor Capital Management, Inc.; and John H. Watts, Fischer Francis Trees & Watts, Inc. Thanks also go to Dean LeBaron, Trustee, Batterymarch Financial Management, who moderated the December 5th seminar; Darwin M. Bayston, CFA, President, AIMR, who moderated the March 19th seminar; and Susan D. Martin, CFA, Vice President, AIMR, who organized the program.

Katrina F. Sherrerd, CFA Vice President Research and Publications

Overview of the Seminar No single, common set of performance presentation standards will be ideal, conceptually and practically, for all users. Our industry is too various for that. Some practitioners will have difficulties applying the AIMR Standards to specific client situations or investment contexts. Anticipating this problem, the Committee on Performance Presentation Standards (CPPS) made a conscious effort to instill some flexibility into the Standards-many are guidelines, rather than rules. Flexibility can only be carried so far, however, before the result is no longer "standard." Inevitably, then, most users will need to make at least some adjustments in their present data collection or presentation practices in order to initiate compliance with the Standards. To comply, some firms will have to adopt new performance-accounting practices, some will need to collect or develop historical data that they do not have readily at hand, and all will incur some unpredictable amount of time and money costs to get the Standards up and running. Nevertheless, few doubt that the effort is a worthy one, for individual firms, for the industry, and for the public. The many questions and concerns about the real and potential pitfalls users will encounter in adopting the Standards motivated AIMR to set up another committee, the Performance Presentation Standards Implementation Committee (PPSIC), whose mission is to recommend to the AIMR Board of Governors a set of guidelines that will result in full and fair implementation of the AIMR Standards by the investment community by January 1, 1993. During 1991, the committee will be fielding questions and suggestions about implementation procedures, and following this one-year study, it will publish its report and recommendations. The seminar that is reported in these proceedings was designed to complement the work of the Implementation Committee. Most of the speakers are implementation veterans-representatives of firms and organizations that have at least begun the process of reshaping their data collection practices and reporting their performance results according to the AIMR Standards. Their experiences, recounted in this publication, should be instructive to all who face similar situations in their own firms. Their presentations reflect their own individual problems and solutions, however, which mayor may not have

wider application. They also do not necessarily reflect the position of AIMR and its Implementation Committee.

An Introduction to the AIMR Standards The AIMR Standards are not equally obligatory in nature. Although CPPS designed some Standards to preclude certain undesirable practices, others are more guidelines, or recommendations, than mandates. Lee Price, who has been involved with the Standards since their inception and is a member of the PPSIC, presents a useful summary of the major elements of the Standards, including a discussion of the practices that are considered "no-no's" and those that are less clear-cut. The latter are being addressed by the PPSIC this year. Price illustrates the type of issues being discussed by the committee using two examples. One question is whether a manager must send all composites to all potential clients. The answer is that sending only the composites that pertain to the client's interests is sufficient. A second issue is how to calculate dollar-weighted composites. Price suggests two methods, both of which produce approximately the same results as long as the calculations are consistent. Although the PPSIC is still addressing many complex details of how to apply the Standards, Price urges firms to take certain steps now to position themselves for full compliance: Avoid the "no-no's," disclose the methodology used to calculate returns, and start collecting and organizing historic data for use in appropriate composites.

Where the SEC Stands on Performance Advertising and Other Issues Since the enactment of the Investment Advisers Act in 1940, the Securities and Exchange Commission (SEC) has been responsible for regulation of investment advisor advertising. In 1960, it was given explicit authority to define fraudulent practices and to make rules designed to prevent fraud. Its first action under this mandate was to adopt the advertising rule, which prohibits misleading or false statements. With respect to performance claims, the SEC requires 1

disclosure of certain facts such as relevant information on market performance, the strategies used, and index comparisons. Mary Podesta reviews the evolution of the SEC staff position on the treatment of manager fees in performance calculations. In 1986, the staff issued a guidance rule stating that performance information should be presented net of advisory fees. This position is consistent with several SEC enforcement actions against advisors that did not show returns without deducting fees. In recent years, however, the staff position has been modified to permit presentation of gross performance data in one-on-one situations but not in public advertisements. In the question and answer session following her presentation, Podesta further clarifies what is meant by a one-on-one exemption from the requirement to present performance net of fees. Podesta notes that the SEC's regulatory emphasis has been on fraud prevention. The SEC has not been directly concerned with comparability of performance reporting and presentation. She commends AIMR for its leadership in developing standard presentation principles that will promote credibility of performance claims and permit direct comparisons of performance among investment managers.

How to Calculate the Numbers According to the Standards AIMR's Standards are performance presentation standards, not performance measurement standards. The measurement of performance-that is, the calculation of individual asset and portfolio returns for a period-is left to the discretion of the individual manager. The presentation of those returns across portfolios and time periods must comply with certain guidelines to meet the AIMR Standards. A variety of calculation methods are acceptable for presentation of returns. Certain aspects of such calculations do present complications, however. Deborah Miller provides some examples of these. For instance, the Standards require the use of timeweighted rates of return, which, in the exact calculation, require that the portfolio will be revalued when each cash flow occurs. This is not always practical, so the Standards provide guidelines. The preferred solution is to use an approximation method that provides daily accounting for contributions and withdrawals. One acceptable method IS to calculate the internal rate of return, weighted by the fraction of the time period (quarter or month) the cash is in the account. 2

Several problems interfere with the implementation of this methodology. One problem is pricing. For some fixed-income, international, or illiquid securities, market values may not be available. The treatment of fees poses another problem in calculating performance results. Although the AIMR Standards recommend presenting gross results, as long as the fee schedule is disclosed, the SEC requires public presentations of returns to be net of fees. In many cases, however, fees are not known in advance and must be estimated based on beginning-ofquarter values. Allocating fees among portions of an account is an additional complication, which Miller's firm has resolved by apportioning the fee according to the assets in each portion of the account. Miller also addresses difficulties firms may have in implementing the Standards governing balanced accounts and composites. Here, the problems are not so much in computational method as in the availability of data and the amount of detail that will be needed. In the second part of the two-part session, Paul Price reviews several specific calculation problems that arise in attempting to meet the Standards. One is dealing with cash flows in figuring time-weighted returns. He notes that failure to revalue the portfolio when large cash flows occur could distort return rates for the month and, consequently, forever in linked monthly returns, unless appropriate adjustments are made. The treatment of derivative securities also can cause problems. Their treatment depends on whether the transaction is intended as an equity investment (if combined with the cash balance required to exercise the future or option) or merely a change in the leverage of the equity asset class. The allocation of cash to separate segments of a portfolio is another area that may cause problems for people trying to implement the Standards. Price suggests that using separate portfolios for equity and fixed-income investments is the easiest way of segregating the cash components of these asset classes within a balanced portfolio. If this is not feasible, then the fixed-income and equity cash should carry separate identifiers. The same problem arises in the treatment of fixed-income and equity receivables and pay abIes. Unless both numerator and denominator are adjusted for receivables and payables, the result could be large distortions in returns figures. Price notes that the data sets required for meeting the Standards are minimal in terms of the detail needed for other management purposes. For example, analysis of security selection or evaluation of investment policies will require subsets of the data

needed for Standards purposes. The ideal is to collect data in a form that will satisfy the Standards but will have enough flexibility for analytical purposes.

Using the Standards Many firms have begun the process of implementing the AIMR Standards into their businesses. The speakers in this session present the experiences of nine firms, representing managers, plan sponsors, consultants, bank trust departments, and vendors. These presentations highlight the benefits associated with abiding by the Standards, as well as the difficulties firms are likely to encounter in implementing them. Implementing the Standards Atlanta Capital Management is a firm that already has in place some of the practices recommended or required to meet the AIMR Presentation Standards. It publishes three composites that include all accounts with similar objectives; its performance calculations are time-weighted; and it revalues its portfolios daily. It also meets most of the disclosure requirements of the Standards. Nevertheless, as Managing Director Daniel Boone points out, full compliance will be an expensive proposition for the firm-in both time and money. Boone uses the AIMR checklist (see Table 3 of the Standards) to analyze, item by item, precisely what the firm has done and will yet need to do to achieve compliance. The requirements of the Standards that Boone expects to cause the most change, and therefore cost the most time and money, are segregation of cash, creation of at least eight composites, collection of historical data, reweighting of results by account size, and generation of additional measures of risk and quality for each account. A Plan Sponsor's Perspective Dewitt Bowman reviews the experience of the California Public Employees' Retirement System (CaIPERS) in using the AIMR Standards to construct a search for an investment manager. Prospective managers were asked to submit annual performance figures in accordance with the Standards and to present the figures compared with the S&P 500 and an appropriate benchmark. CalPERS also required monthly returns for at least a three-year period and a sample portfolio as of a given date. Bowman found the Standards useful in imposing comparability on the performance presentation reports that manager applicants provided, but he believes that aggregate performance numbers have limitations in manager selection, and that deeper evaluation of individual performance will always be

necessary. The Standards were not always greeted with approval from the managers participating in the CalPERS search, however. Some of the complaints CalPERS received about the Standards addressed the use of capitalization-weighted, rather then equalweighted, performance figures and the allocation of cash to asset classes rather than reporting it separately. A Consultant's Perspective The AIMR Standards are an important adjunct to the manager search and review process Callan Associates uses to maintain and expand its extensive data base on available portfolio managers. Each prospective manager receives a copy of the Standards, although managers are only encouraged, not required, to report performance according to the Standards. Ronald Peyton believes that the AIMR Standards are an important first step in achieving uniformity of performance reporting and in preventing managers from presenting misleading information. He suggests, however, that additional work is needed in some specific aspects of reporting. Most of the problems are related to the treatment of cash. For example, in measuring real estate performance, cash that is reserved for tenant improvements and capital expenditures should be separated from cash that is actually returned to the investor. Allocation of cash is also a problem in reporting performance for balanced accounts. Measuring performance of cash managers also needs specialized attention. In a recent cash-manager search, Callan encountered six different methods of calculating returns; Peyton suggests that uniformity is needed in this area. Although performance problems are generally the same for international and domestic accounts, currency exchange and comparability make the allocation of cash to country portfolios particularly difficult. Peyton believes that the Standards are a useful foundation for protecting clients against misleading performance reporting. He recognizes, however, that not all managers will be able to establish a standardized performance reporting system immediately. Meanwhile, the key to success in manager selection is to validate the information applicants supply and to ask them to explain any noncompliance with the Standards. A Fixed-Income Manager's Perspective Clients set up bond portfolios for a wide variety of reasons other than return-to diversify, to hedge cyclical swings, or to reduce risk, for example. Because these objectives differ, so do the benchmarks and guidelines clients specify to govern the management of their fixed-income investments. The returns 3

of these various portfolios are bound to be just as disparate as their objectives. Returns alone, then, should not be considered a direct measure of performance for managers of fixed-income portfolios. John Watts suggests that four additional practices or standards would make the measurement of fixed-income portfolio performance more comparable. The first is to measure performance over a rate cyde-a period for which rates begin and end at the same point-rather than for an arbitrary period of fixed duration. The second recommendation is to measure and state the risk element of the portfolio. Because risk reduction is an important goal of most fixed-income investments, some means is needed to measure how well managers are achieving this goal. Watts also suggests measuring results in comparison with clients' own tailor-made benchmarks, because these benchmarks reflect the clients' expectations for the portfolio. Performance should be measured against those expectations. The fourth practice Watts recommends is to include in composites only results from similar portfolios-those that have comparable benchmarks and guidelines-because only those can be expected to have similar results. Watts recognizes that these four recommendations alone will not take account of all the special conditions that affect fixed-income investments, but he does believe that they would improve upon AIMR's efforts. A Multiasset Manager's Perspective Large organizations that manage several types of assets have both advantages and disadvantages in complying with the AIMR Standards. Their compliance problems can be quite complex because of the diversity of their portfolios, but most large firms already have data processing systems sophisticated enough to handle this complexity. Robert Wade lists some specific concerns his firm has about the Standards. One is the requirement to separate cash by type of asset in balanced accountsdetermining where the cash properly belongs is difficult. Another concern is with composites. Wade believes that composites containing too many accounts and going back too far in time are meaningless. Clients are usually interested only in composites representing the types of portfolios that reflect their objectives and only in performance for the past 5 or 10 years. Wade's firm also finds difficulty in presenting results net of fees, as the SEC requires in public presentations, because many of its fees are not standard but are negotiated on an individual basis. Lastly, Wade believes that a central depository for performance data, entered according to the Standards, would be a way to ensure compliance with the Standards and would also be a labor-saving con4

venience for the industry. A Bank Trust Department's Perspective Manager evaluation and comparison are major issues for bank trust departments, which service large funds and use multiple managers. To service this need, the Trust Universe Comparison Service (TUCS) creates various universes of manager and composite accounts based on rate of return data supplied quarterly by its members according to standards agreed upon by the member banks. These standards and some of the performance measurement practices of bank trust departments differ somewhat from the AIMR Standards. As examples of the similarities to and differences from the AIMR Standards, Mary McFadden describes Mellon Bank's methods of calculating returns and composites. For example, monthly dollarweighted rates of return are linked to estimated timeweighted returns for longer periods. Adjustments are made for large cash flows. The total returns and segmental returns are calculated for each account. Composites are calculated for groups of similar managers and for all master trust managers. The composites include all managers for the time they were active in a particular type of account. All accounts and composites have benchmarks, which can be tailor-made for individual clients. Mellon's Client Advisory Board, made up of plan sponsors, is enthusiastic about the AIMR Standards but concerned about the costs of performing true daily time-weighted returns. Also, such returns will probably continue to differ from those calculated by others because of discrepancies among pricing sources. Performance Measurement Systems Implementing the AIMR Standards will require large managers, such as bank trust departments, to adapt their computer systems to collect the appropriate information in a directly usable form. An initial difficulty in designing such a system is handling the volume of data that will result from daily valuation of thousands of portfolios. The solution devised by Trust Systems, Inc., which is in the business of developing computer systems for large trust departments, was to compute retrospective daily values at the end of the month. Sam Smith of Trust Systems cites another problem: How to retain the historically accurate data needed for composites and yet purge closed accounts from current data. This was accomplished by keeping separate, historical records for composites. Performance measurement in a large trust department serves many purposes. The measurements are needed for internal evaluations, as well as to report results to a wide variety of customers and

potential customers with diverse reporting requirements. The appropriate report may be by manager or department and/ or by account characteristics such as type, size, taxability, objective, and so forth. The only way to achieve the flexibility required to produce such a wide variety of reports is to carry a large number of composites. Smith suggests that for a large trust department, 80 might be a minimum number. Smith's experience in designing Standardsoriented computer systems indicates that modern technology should permit even the largest of trust institutions to apply the AIMR Standards. Portfolio Benchmark Design Manager performance usually is measured against an appropriate benchmark, as well as in absolute terms. The benchmark can also be used to provide risk profiles of a manager and to control a client's aggregate level of risk. To represent relative performance and risk accurately, the choice of benchmark is very important. Stephen Pelensky believes a benchmark portfolio should represent the manager's investment process, the types of securities the manager will consider for inclusion in the client's portfolio, the manager's weighting scheme, and the performance of the manager's portfolio. The benchmark should also help distinguish between real and apparent changes in a manager's style. Benchmarks may not be properly constructed for a variety of reasons: The

criteria for screening the portfolio's securities may arbitrarily include inappropriate securities or exclude appropriate ones; the risk exposures of the benchmark may not match those of the portfolio; the factor exposures of the benchmark and the portfolio may not be coordinated; the benchmark may be "overdefined," making distinction of the manager's value-added impossible; and the sources of return and risk in the portfolio may be misidentified. Creating Acceptable Composites Composites of a manager's performance are central to the Standards. They promote comparability among managers and with indexes. Thomas Mortensen describes the systems developed at RCM Capital Management to comply with the AIMR Standards, with particular emphasis on the systems required to create composites. Mortensen describes the three parts of a performance measurement system: the performance account reference data, the performance data base, and the performance composite data. Although this system was designed to meet the needs of a mid-sized investment management firm with approximately 200 accounts, Mortensen believes that the critical design elements of the system can be applied in any size organization. For example, they can be applied in smaller organizations using microcomputer-based portfolio accounting systems or service bureaus, providing that these accounting systems can supply data at the discrete level necessary.

5

An Introduction to the AIMR Standards Lee N. Price, CFA Principal RCM Capital Management

The business of being a portfolio manager is very creative. You have to be creative to be able to tell whether good news for the economy is good news for the stock market or whether it is bad news; and you have to be creative in the way you look at individual stocks and do your valuation work. Inevitably, some of that creativity flows over into the way investment performance is presented to potential new clients. The driving force behind the Committee for Performance Presentation Standards (CPPS) was to try to control some of that creativityto put a few brakes on the way things are done.

Performance Presentation liN 0- N 0' s" Although the Standards are worded in a positive fashion-that is, what to do rather than what not to do-the committee actually started out in a more negative vein. The committee felt strongly that there are some things that can be optional, and there are some things that definitely are not optional-the no-no's. To protect the professionalism of our investment management world, the no-no's had to be prevented. The first of these no-no's is presenting performance for selected time periods. The Standards state that managers should compile and present results for as long a period of time as accurate accounting can be accomplished, no less than 10 years if possible and up to 20 years if practical. Management organizations in business for less than 20 years should include results since inception. More importantly, results must be provided for each and every year, on both an individual and a cumulative basis, and must be compared to an appropriate index. Obviously, if managers avoid presenting their whole performance and just present those periods when they did a good job, they are going to be more effective in marketing presentations. It is important to remember that the Standards are minimum requirements; they do not say that a manager cannot provide more information, or information in a different format. For example, performance in up markets may still be com-

pared to performance in down markets. The second no-no is using selected accounts. Given the desire to attain new accounts, one cannot really blame a money manager for putting his best foot forward. If a manager is asked to provide data on a "representative account," he is hardly going to provide data on his worst account. Although he may try to pick one that is truly representative in terms of characteristics, the chances are that its performance will probably be a little better than representative. The Standards state that all client accounts should be included in at least one composite, and managers are encouraged to construct separate composites when valid reasons exist for doing so. This does not mean that a manager cannot also provide performance data on an individual selected account. In fact, consultants typically prefer data on a portfolio basis rather than a composite basis so that they can verify the manager's style, attribute performance, evaluate market timing and stock selection, and monitor cash positions. There is nothing in the Standards that says you cannot provide this level of detail to consultants, sponsors, or anyone else. This is just in addition to the composite data. A third no-no is the use of unweighted composites. This is probably one of the most controversial requirements. A lot of managers have been using composites for some time, but frequently the composites are calculated by adding up the performance for all of the accounts and dividing by the number of accounts. That is an easy way to do it. But we have heard over and over again from clients, particularly larger clients, that bias results from equal-weighting. There is no question that managing smaller accounts tends to be easier than managing large accounts, for example, accounts of $100 million to $500 million or more. The better performance on the small accounts is attributed to several factors, including better marketability on smaller transactions, and the ability to change performance with the use of initial public offerings on a small account. The fact remains that if a manager has 50 small accounts and 2 very large ones, the performance of the composite will be skewed toward the performance of the smaller ac-

15

counts even though most of the money may be in the two large ones, if the accounts are equal-weighted. So the Standards require that the performance composite be dollar-weighted. The fourth no-no is the use of paper portfolios. The concept here is not that paper portfolios are absolutely forbidden. For a new money manager starting out, particularly one with a new quantitative methodology, there is almost no way to show how he can perform without using a paper portfolio. What is forbidden is linking that performance with actual performance. This gives the impression of a longer record than you really have, and it also gives the impression that your paper-portfolio numbers represent real dollars under management. The Standards do not explicitly forbid the use of paper portfolios, but they are implicitly forbidden because they have no assets associated with them and the Standards require dollar-weighting of accounts. The last no-no is the concept of portable performance records. This is also controversial, but the CPPS members felt strongly that performance should be the responsibility of the firm, not the individual. That is not to say that an individual record cannot be calculated separately, but composite performance records cannot be changed just because someone has left the firm or because someone has joined the firm.

•

•

Review of the Major Elements in the Standards The list of no-no's highlights the types of concerns that the CPPS members had regarding performance. These concerns are reflected in the Standards. The key elements of the Standards are: • Time weighting is mandatory. • Total returns are mandatory. • Gross performance is preferred, but net-offees performance is mandatory when required by the Securities and Exchange Commission (SEC). • Calculations must be done at least quarterly. The Standards encourage monthly or even daily returns to promote more accurate return calculations and to avoid the problems with intraperiod cash flows. • Managers must disclose all accounts that are excluded from a specific composite. • Managers are encouraged to create multiple composites, delineated by similarity of objectives; for example, taxable versus nontaxable, unrestricted discretion versus South Africafree restrictions, and so forth. It should be noted that the Standards do not prevent an account moving from one composite to another 16

•

•

if the objectives of the account change over time. The goal is to provide meaningful composites. Balanced-account composites must comprise all assets, including cash, and all portfolios where the manager has discretion. The key distinction is whether the manager has discretion over the allocation. RCM has quite a number of balanced accounts where we manage both equity and fixed-income portions but the client dictates what the balance will be. According to the Standards, these are not balanced accounts. The equity and fixed-income components can still be separated and recombined, however, to create a constant60 /40 mix for comparison to a similar custom benchmark, for example a comparable mix of S&P 500 and Lehman Government/Corporate Bond Index. If a balanced account is separated and the components are used independently as an indication of performance-in other words, ifa manager is going to include the equity portions of his balanced accounts with the equities of his all-equity accounts to create a single equity composite-then he must allocate cash to the segments. This does not prohibit a manager from providing equity-only data to a consultant or to a potential client if they ask for it. Rather, it is an attempt to make comparisons more meaningful. If a manager is not breaking out a segment-for example, the equity portion of the European region-to show separately, then there is no need to worry about the cash allocation. Benchmarks should be agreed upon in advance. Obviously, benchmarks can change over time for existing clients, but for a new client the benchmark should be agreed upon at the time the account is taken, and then that benchmark should be used consistently in presenting historical performance. Lastly, and most importantly, I cannot overemphasize the idea that these are just the minimum level of standards.

Performance Presentation Standards Implementation Committee In 1990, AIMR appointed the Performance Presentation Standards Implementation Committee (PPSIC). The committee is now in the process of identifying implementation issues, clarifying the meaning of the Standards for the various segments of the industry, and drafting specific guidelines for

firms to use in implementing the Standards. The aim is to clarify the meaning of the Standards, not to rewrite them. As a member of the PPSIC, I will comment briefly on what the committee is doing. First, I would like to emphasize that these are performance presentation standards, not performance standards. There are a lot of differences in the way firms compute performance. Many of the methodologies attempt to simplify the return calculation when there are intraperiod cash flows; for example, the BAI and Deitz methods. 1 Valuation of less marketable or appraisal assets, such as venture capital, real estate, and international assets, also present problems. The Standards relate to the presentation of performance to clients, primarily potential clients, not the calculation of the performance for individual accounts. Presumably, clients and their consultants scrutinize the types of methodologies that managers are using to calculate their actual performance. The main focus of the PPSIC is to try to clarify aspects of the Standards that are proving difficult to implement or are ambiguous, particularly in response to comments we have received. About half of the questions addressed to the committee have been educational in nature. They are from people who just did not understand something or did not read the Standards very carefully; admittedly, it is not always entirely clear where to look to find the answer. Let me review two areas that the PPSIC has addressed. The first issue is whether a manager must send all of his composites to all of his potential clients. Obviously, this requirement is not reasonable in most situations. Take, for example, a firm that has 40 composites, half of which are for fixed-income accounts. It does not make sense to show the 20 fixed-income composites to an equity client, unless the client wants to see them. The committee feels that it is reasonable to show the client the composites that are most relevant to that client, to provide a list of composites, and to let the client know that all composites are available upon request. I should also mention that a representative composite for a specific account must be truly representative. If you are going after a $100 million account and you have decided to create different composites for differentsized accounts, which is quite reasonable, you might have one composite for accounts under $5 million and another one for accounts over $100 million. But if you are going after the $100 million account, then you really must show the composite for accounts greater than $100 million. lSee Ms. Miller's presentation, pp. 27-38.

The second issue is the recommended methodology for calculating a dollar-weighted composite. There are several ways to do this. One is to commingle all of the assets; that is, to treat all of the firm's cash flows-dividends, interest streams, cash-in, cash-out, lost accounts, and so forth-as one single account with a total cash flow stream. To do this, you need both the performance data and the cash flow data since inception, including all of the transaction data for all these accounts. This is really quite a job. The other alternative is to dollar-weight performance account by account-that is, for each period, calculate the weighted average of the performance of each portfolio. It turns out that these methods produce identical results. I have done it for RCM Capital Management for 1990 on a monthly basis. If you are using a consistent methodology for treating intraperiod cash flows to calculate the performance in each one of your individual accounts (month by month, quarter by quarter throughout history) and you are using that same methodology after you have created a compilation of the total, then you are going to end up with the same thing because, basically, you have made the same approximations. It is simply a matter of calculating the whole or the individual parts. Most people will find it a lot simpler to do it the second way. The areas that must be handled differently are new accounts and lost accounts. If you have a new account, you have to be careful that you do not show it going from a value of zero to some large amount, say $10 million, at the end of the period, because this will show an infinite return. Instead, you have to estimate a beginning value. For example, if the ending value is $10 million and you know you are up 10 percent, the effective starting value is $9.09 million, or $10 million divided by 1.1. The same is true if you lost an account during the period. You do not want to have that $10 million suddenly go to zero and show that you are down 100 percent.

Conclusion The PPSIC is still wrestling with myriad details, including the more complex issues of performance composites for derivatives, international equities, and assorted new fixed-income securities. Until the committee's report is complete, the major steps your firm should be taking now are: 1. Avoid the performance no-no's; 2. Fully disclose your methodology; and 3. Start collecting and organizing your historical performance data to create the appropriate composites by next year. 17

Question and Answer Session Question: Should firms use beginning-of-perIod, end-of-period, or average asset values to weight the composite? Price: The PPSIC favors using beginning-of-period assets. If you use end-of-period assets to create a composite for that period, you will in effect be overweighting your better-performing accounts. For example, an account that is up 100 percent will be overweighted relative to one that is up 50 percent. Obviously, the end of one period is the beginning of the next, so for firms that calculate end-of-period values, the information is available.

Question: How should after-fee performance be calculated? Price: There are several ways to calculate net-of-fee

performance. The important thing is that you cannot treat fees as a cash withdrawal. If you try to do the calculation net of fees by treating the payment of the fee the same way that you would treat the withdrawal of $100,000 from cash by the client, you are really not affecting performance at all. The reason for using time-weighting rather than dollar-weighting is to eliminate the effect of the timing of cash flows. Therefore, treating fees as a cash withdrawal is not an acceptable alternative. You have to treat it as a cost-an expense-and subtract it from the performance. The PPSIC also discussed whether fees should be deducted on a monthly or a quarterly basis and whether they should be subtracted on the date earned-in other words, when you bill them to your clients-or the date paid. Neither of these decisions will make a big difference; therefore, the committee favors leaving the exact calculation up to the firm. Also, when you are calculating net-of-fee performance, your theoretical fee schedule-the one pub-

18

lished in advertising material-does not matter. All you need to do is subtract the actual dollar fees from the composite return. Question: Regarding an account that has changed

objectives, should the prior-period returns remain in the original composite and future returns be reported in the new composite, and how should this be disclosed? Price: Yes, that is exactly what should happen. This

type of change would be disclosed where you list the number of accounts in each of your composites, in Table 2 of the Standards. This is the type of situation that an auditor would verify if you chose to have your performance audited. The main purpose of auditing performance is to verify that the composites are accurate, not to verify the prices, cash flows, and transactions. The auditor will look at all of the accounts and verify that every account is in its appropriate composite, that lost accounts remain in the composite, and, if you have moved one account from composite A to composite B, that there was justifiable reason for moving it. Question: How can a start-up firm comply with the AIMR Standards? The only record it has is the record of its managers before the firm was formed. Price: The managers of the start-up firm should be

honest. They cannot create a record that complies with the AIMR Standards. Therefore, they should disclose that they are a start-up firm with no clients and no performance record. But, they could also claim that the firm employs experienced portfolio managers and provide whatever record they can to substantiate their ability. That is just a practical way of meeting a difficult situation.

Where the SEC Stands on Performance Advertising and Other Issues! Mary Podesta Associate Director, Office of Legal and Disclosure Division of Investment Management Securities and Exchange Commission

The Securities and Exchange Commission (SEC) regulates investor advisor advertising under the antifraud provisions of the Investment Advisers Act. Section 206 of the Act makes it illegal for an investment advisor to use any device or scheme to defraud a client or to engage in any practice or course of business that could operate as a deceit or fraud on any client or prospective client. The antifraud provision applies to all investment advisors as defined in the Act, whether or not they have to register with the SEC. Since the Supreme Court decision in the Lowe case,2 the antifraud rules have not applied to most newsletter publishers because these publications generally do not come under the definition of investment advisor.

Legal Framework for Performance Advertising In 1960, the SEC was given express authority to write antifraud rules. Specifically, it was authorized to define fraudulent practices and to make rules reasonably designed to prevent fraud. The first rule adopted was 206-4-1, the advertising rule. The approach in the advertising rule is very simple. It prohibits testimonials, claims that a formula or chart alone can be used to determine what to buy or sell, "free" offers that are not really free, and references to selective past recommendations unless the advisor provides a list of all the recommendations made during the previous year. The heart of the advertising rule is paragraph (a).5., which states that an advisor cannot use any advertisement that contains 1This speech reflects the views of Mary Podesta and does not necessarily reflect the views of the Securities and Exchange Commission (SEC) or Ms. Podesta's colleagues at the SEC. As a matter of policy, the SEC disclaims responsibility for any private statement by its employees.

2Lowe v. SEC., 1055.0.2557 (1985).

any untrue statement of a material fact or that is otherwise misleading or false. The SEC has interpreted the rule in light of statements made by the Supreme Court in the Capital Gains case. 3 In that case, the court said an advisor is a fiduciary that owes its clients the duty of full and fair disclosure of all material facts. The court also said that the Adviser's Act should be interpreted flexibly, not narrowly, in order to accomplish its remedial purposes.

Interpretations of the Advertising Rule The SEC administers the advertising rule in two principal ways: through staff "no-action" letters, and through the SEC's program of routine investor advisor inspections. In appropriate cases, the SEC will also bring enforcement actions against advisors for violations of the advertising rules. The interpretive, or no-action, letters of the Division of Investment Management provide informal general guidance about the advertising rule. Most of what an advisor needs to know about the advertising rule can be found in two letters: Anametrics, and O'Keefe. 4 In those letters, the staff started with the assumption that an advisor advertises performance to describe the advisor's competence or the experience of its clients, and thereby suggest that new clients could expect the same kind of competence or enjoy the same level of performance by hiring the advisor. The staff letters state the general rule that an advertisement is misleading if it raises inferences or implications about the advisor's performance or competence or the likelihood that new clients will have a similar ex3SECv .Capital Gains Research Bureau, Inc., 375 U.s. 180 (1963). 4Anametrics Investment Management (May 5, 1977) and Edward F. O'Keefe (March 14, 1978).

19

perience, if additional facts exist, which if disclosed would cause those inferences or implications not to arise. This position is consistent with the SEC's approach in other disclosure areas. For example, 1933 Act registrants must disclose the items on an SEC registration statement form, along with any other material information needed to prevent the statements presented from being misleading. In addition, whether an advertisement is misleading depends on the entire context surrounding its use. The Division of Investment Management staff looks at three things: the form and content of the advertisement; the implications and inferences that arise, given the entire context; and the sophistication of the audience to whom the advertisement is directed. In short, the Anametrics and O'Keefe letters require advisors to tell the whole story, not just selected pieces of it. For the most part, the guidance provided by the SEC is general. The Clover letter is a good example. 5 In this letter dealing with model performance results, the staff offered a number of general statements about investment advisor performance advertising. The letter states that an advertisement is misleading if it fails to mention relevant market information. For example, the advertisement might say that the advisor's performance is up 25 percent, but not tell you that the market was up 40 percent during that same period. Also misleading are advertisements that do not disclose relevant information about the strategies used to achieve performance or whether these strategies have been changed, and advertisements that compare performance to an index without disclosing all of the information that is material to that comparison. SEC staff monitors advertising primarily through its program of routine inspections. If violations of the advertising rules are found, they are generally handled informally through a deficiency letter. If the violations themselves, or together with other violations, are serious enough, the SEC will bring an enforcement action. As advisor advertising has focused more and more on performance, the inspection staff has had to verify advisor performance claims when it examines an advisor's books and records. In 1988, the SEC adopted an amendment to the recordkeeping rule to remove any doubt about the appropriate documentation that advisors need. It required advisors to keep all their advertisements and to create and retain information that can be used to substantiate their performance claims. A money manager can comply with this new requirement by keeping appropriately SClover Capital Management, Inc. (October 28,1986).

20

detailed client account statements together with the worksheets that were used to compute performance information. SEC examiners will look for these documents when they conduct inspections.

The Philosophical Approach The focus on money management performance is a relatively recent development. When the Advisers Act was adopted in 1940, money managers largely served wealthy clients who relied on them for assistance in managing private securities portfolios and other family financial affairs. These relationships tended to be long term. As the industry shifted to institutional rather than individual accounts, and as computers provided an efficient means to crunch the numbers, client demand, or advisor competition for clients-or both-brought performance advertising to the forefront of investment advisor promotional materials. The SEC's historical approach to regulating performance advertising and all other aspects of advisor advertising has been to prevent the presentation from being misleading or deceptive. It has not required comparability of presentations. This is in contrast to investment company advertising, where, with money market fund yields and recently with comprehensive rules for all equity and debt funds, the SEC has required investment companies in their advertising of performance to compute performance in accordance with specified formulas. The AIMR Performance Presentation Standards are directed not just at preventing fraud in advisor advertisements but also at promoting comparability. Although the SEC itself has not moved in the direction of mandating comparability, I believe it would not object to the industry establishing these Standards. In fact, AIMR should be commended for its efforts to develop standard investment performance presentation principles for advisors. The industry, clients, and regulators have known for some time that if all money managers can put their performance in the top quartile, something is wrong with the performance reporting system. The present system permits everybody to be good at something and allows the manager to pick what that something is. The AIMR Standards require performance presentations to cover a 10- to 20-year period, to be time-weighted, and to include all accounts, not just those that are still satisfied with the manager's services. They require advisors to use consistent, reasonable, and fully explained principles in constructing composites, and to present all their composites to clients. This will bring some needed

credibility to the performance reporting system. I hope members of the industry will recognize that supporting this kind of effort is in their best interest and will increase client confidence in the reporting system. Ultimately, client confidence in advisor performance figures may require some independent verification of that performance. Advisors could, for example, engage the services of independent accountants to audit their performance numbers. For accountants to play a meaningful role, however, audit standards will have to be developed for reviewing performance data. These standards should cover both the scope of the auditor's report and the methodology to be used in performing the audit. The accounting profession and the money management industry should consider defining the accountant's role and developing appropriate audit standards.

Deduction of Advisory Fees The Clover letter states, "Do not make claims about profits without disclosing the risk of loss. Do not focus only on the fact that performance is up, if the market is up even more." The controversial aspect of the letter, however, is the statement that advisor performance information should be presented net of advisory fees. Historically, advisors have not shown their presentations this way. The SEC staff's position on advisory fees is based on several arguments. First, advisor performance data show historical information on how clients fared, either individually or collectively, under the advisor's management. What they paid the advisor for that performance is material to understanding how they fared, in the same way that the brokerage commissions they had to pay are material to understanding how they did. Second, because advisor performance data are generally presented for a long period of time, merely stating what advisory fees are and not deducting them can result in a misleading presentation. This is because the performance numbers shown in the chart or graph get the benefit of the compounding effect that occurs from not deducting advisory fees during that long period of time. Third, the staff's position on deducting advisory fees is consistent with positions the SEC has taken in a number of enforcement actions. In 1984, in Bond Timing Service, the SEC censored an advisor for using ads that showed annualized returns without deducting fees. 6 6 Bond Timing Service, Inc., Investment Advisers Act Release No. 920 (July 23,1984).

In the past two years, the SEC has brought actions against three advisors for not deducting fees from their performance numbers? Since the Clover letter, however, the staff has modified its position in certain respects. First, the staff has made it clear that custodian fees do not have to be deducted. Second, the staff has permitted advisor performance data to be presented on a gross basis in connection with one-on-one presentations made by advisors or consultants to a prospective client, provided that certain specific disclosures are made. The effect of the Clover letter is to permit advisors that do not advertise in the traditional sense, but use performance charts or graphs in individual presentations, to continue to present their performance on a gross basis. In distinguishing between conventional public advertising and private one-on-one presentations, the staff was influenced by the fact that prospective clients in a one-on-one situation can easily ask questions, including follow-up questions, about the impact of fees on performance. Another factor is that individual presentations typically are made for institutional or wealthy individual clients. These clients would generally be in a position to ascertain the impact of fees on the advisor's net performance. In a letter to the Securities Industry Association (November 27, 1989), the SEC staff dealt with the issue of what to do about past historical periods for advisors who had not deducted advisory fees. Rather than requiring these advisors to go through the costly and time-consuming process of figuring out and deducting the fees clients had actually paid, the staff permitted them to deduct a model fee for periods before May 27,1990. The SEC staff is pleased that the AIMR Performance Presentation Standards contain a reference to the SEC position on fees and a supplemental note explaining this position in some detail. The dialogue between the staff and the industry since the Clover letter has been constructive and should continue. The staff hopes this exchange will result in greater industry support for the proposition that in public presentations advisor fees should be deducted from performance data. The Comptroller of the Currency proposes to liberalize the rules governing bank common trust funds. Among other things, the Comptroller proposes to allow banks to advertise common trust funds and to charge a separate fee for managing them. In effect, banks would be able to offer the 7Makrod Investment Associates, Inc., Investment Advisers Act Release No. 1176 (July 3, 1989); Harvest Financial Group, Investment Advisers Act Release No. 1155 (Feb. 21, 1989); and Managed Advisory Services, Inc., Investment Advisers Act Release No. 1148 (December 27, 1988).

21

equivalent of public investment companies. SEC Chairman Breeden has written to the Comptroller and has testified before a House of Representatives subcommittee that the long-standing position of the SEC is that if banks engage in these activities, they lose the exemptions for bank common trust funds under the 1933 Act and the Investment Company Act. This means that banks would have to register their common trust funds and the securities that they issue under the securities laws. The SEC has no objection to new entrants into the investment company business, but banks that offer public investment companies should do so under the same system of regulation that applies to nonbank affiliated funds. This means that these funds would have to comply with all of the SEC's requirements concerning performance advertising by investment companies. Although the SEC can and will enforce the 1933 Act and the Investment Company Act against publicly offered bank funds, it would need additional authority to regulate the sales practices banks use in selling these funds and to fix certain gaps in the Advisers Act and the Investment Company Act. The SEC is expected to continue to call for

22

financial services reform that will require bank securities activities to be conducted in a separate holding company affiliate subject to SEC regulations as a broker-dealer and to continue to call for closing the gaps in the other federal securities laws.

Conclusion The fiduciary duty an advisor owes to its clients extends to its performance advertising. Advisors are responsible for ensuring that their performance materials are not deceptive or misleading and that they comply with SEC requirements. This includes the requirement that advisory fees be deducted in any performance figures that are publicly disseminated. The AIMR Performance Presentation Standards, if they are accepted and followed by the industry, will help assure that advisors present honest and accurate performance information that clients and prospective clients can use to compare advisors. The SEC staff expects to continue to work with the investment advisory industry to bring some needed credibility to advisor performance advertising.

Question and Answer Session Question: Does the SEC's position on fees distinguish between mutual funds and the types of investors that use them and the very large institutional accounts such as pension funds? Podesta: The performance-fee rule that the SEC adopted some years ago took the philosophical approach that, in some respects, institutional or large clients of money managers can be expected to fend for themselves and that all of the requirements that apply to investment advisors in their dealings with clients perhaps need not apply to large accounts. About 16,000 investment advisors are registered with the SEC right now, however, and they do not all serve large, institutional accounts. Many serve the same kinds of clients who invest in mutual funds. Our real concern is with the advertising practices and the other standards that apply when advisors are dealing with the general public. Question: Has the SEC addressed performance fees, particularly when they are applied to accounts that otherwise might be put into a composite with fixedfee accounts? Podesta: No, we have not. Our understanding is that performance fees are used very infrequently by managers, which is probably why the issue has not come up. At a minimum, there would need to be disclosure about the mixing of accounts that pay conventional fees and those that pay performance fees. In a public presentation of advisor performance, you would still have to deduct the whole fee to show returns net of fees. It does not matter how the fee is determined. Question: How should performance fees be handled? Podesta: Our approach is that managers should deduct whatever people paid in the accounts that are in their composites. That is a clean way to do it. Also, advisor performance information is a historical number. It is what the accounts that the advisor was managing experienced, and the fees particular accounts in the composite paid are relevant to understanding that. If a client paid a performance fee, my

initial reaction would be that this number should be reflected in the calculation. Managers can explain about the types of fees that were paid and how that may reflect on their performance. Also, managers can present the gross numbers, but presenting just the gross numbers in a public presentation is not enough; the net number has to be presented too. Question: If fees are deducted when they are actually paid, when should they be deducted on an accrual basis-when billed or when paid? Podesta: Larry Friend, the Division of Investment Management's Chief Account, believes that the fee to be deducted should be the fee the advisor has earned, not the fee paid. This fee would have to be deducted no later than when it is billed. However, if the advisor computes its performance more frequently than it bills, it should deduct the fee earned for each performance period. Question: Does it make any difference whether the fee is paid by the fund itself or paid outside the fund by the plan sponsor? Podesta: No. The calculation should still reflect the fee. Somebody paid it, and in the end, the fee reduced what was in the client's pocket. Question: Please clarify what the SEC means by one-on-one presentations. Does it mean just one client and one manager? Podesta: No. The SEC interprets one-on-one as being broader than two people. It means one advisor group and one client or affiliated client group. A corporate sponsor that has several employee benefit plans seeking the services of managers is considered to be one client, even though there may be more than one type of portfolio. Similarly, an investment management firm is considered one manager even if several representatives of the firm may be present at the meeting. The important criterion is that there must be the opportunity for an individualized presentation and for the client or prospect to ask questions and have the information explained. Also, to use the one-on-one exception, the manager must

23

disclose his fee schedule, disclose that the returns are gross of fees, and illustrate what the performance would have been net of fees.

to distribute the information more broadly than that, then you need to provide both sets of numbers.

Question: Is a mass mailing of performance data to consultants considered one-on-one?

Question: Does the requirement to report performance net of fees apply to ongoing performance reporting to existing clients?

Podesta: You must focus on how the data are ultimately used. If each of those consultants is going to use that data only in one-on-one presentations with its clients, how you get that performance data to those consultants is not an issue. What matters is how the data are used with the person who is the prospective client. If that is one-on-one, then gross numbers alone can be presented.

Podesta: No. Reporting performance of an individual client's account to that client is not considered an advertisement and therefore is not covered by these requirements. According to the SEC, an advertisement is something that is distributed to more than one person; an individualized client statement is unique, not something that is going to be distributed to more than one person.

Question: How do you interpret the continuation of a one-on-one contact? For example, assume that a manager has a meeting with a prospective client. During the meeting, the client asks the manager to send the firm's performance every quarter. Does the fulfillment of this request constitute the continuation of a one-on-one meeting? To clarify further, can you send follow-up letters-with the same information in each one-to 100 prospects, assuming that you have already met with each of the 100 prospects on an individual basis prior to the follow-up mailing?

Question: Would you encourage AIMR to establish a Better Business Bureau to collect information on firms that play performance games?

Podesta: Certainly you can follow up with prospects if they have asked for the information and still comply with the one-on-one exception. You can follow up even if they have not asked for additional information, provided that the follow-up material complies with the SEC's disclosure requirements.

Podesta: Comparability is important, but it is a job the industry can best take on for itself, at least at this time. The first place to look for this kind of standard development is the industry. Presently and historically, the SEC's role has been to say, "This goes too far; this crosses into the realm of being misleading or being potentially misleading." As far as choosing one way to do something so the numbers will be comparable, those decisions are better left to an industry group such as AIMR.

Question: If I send a follow-up letter to a prospect that was previously being treated on a one-on-one basis, may I send gross performance data? Podesta: Yes. If you have established a one-on-one relationship and have talked to the person and then follow up on a one-on-one basis by sending something to that particular prospective client, that is still a one-on-one relationship. Question: Consultants want gross numbers, not net numbers. Does providing returns to a consultant meet the one-on-one exception criteria? Podesta: The consultant is a one-on-one prospect if the consultant will only use the information by sitting down one-on-one with people who may potentially be your clients and the consultant agrees to make the kinds of disclosures that are required for one-on-one presentations. If the consultant is going 24

Podesta: I certainly would not object to having AIMR collect that information, and if AIMR wants to send it to us, we would be glad to have it. Question: Isn't comparability of performance data more important than deduction of fees in avoiding misleading performance advertising?

Question: If custodian fees do not have to be deducted, how should a firm that has an all-encompassing fee go about showing returns net of fees? Podesta: Any all-inclusive fee paid to the advisor should be deducted. In saying that custody fees need not be deducted, the SEC was responding to the concern of money managers that custody fees paid to third parties often are not left to the manager's discretion. Some clients choose their own custodians and pay the custody fee directly. Question: Managers are permitted to deduct model fees from performance for periods prior to May 27, 1990. What method is recommended for modeling fees?

Podesta: The goal is to come up with a representative fee that accurately reflects what a representative client paid. If you have more than one fee schedule, you should use the one that was most commonly selected by clients. If the fee schedule varies based on account size, then the model fee should equal the highest fee paid by the accounts that are in the composite. Question: How should performance be shown in wrap-fee accounts? Podesta: In a wrap-fee arrangement there is only one fee paid to the advisor to cover all expenses associated with managing the client account; for example, both advisory fees and brokerage fees. The wrap fee is an expense and it should be deducted from performance. Question: Prior to the 1988 amendment, work papers supporting performance results did not have to be kept forever. What happens if they were properly discarded before the 1988 amendment and are no longer available? Can the performance results for those periods still be used? Podesta: Advisors have to meet the substantiation requirement beginning in 1988. For periods before 1988, any information that a manager has that can be used to substantiate performance for the past 10 years should be kept, if it has not already been discarded. Obviously, a manager cannot create documents that it never had, but it is a little surprising to us that managers do not have this information. After all, I would think that there are many occasions where an advisor would want to be able to verify numbers calculated during a different period by a different person. If advisors do not have the material necessary to substantiate their historical performance, they should not advertise that performance. Question: Who do you think should perform the audit of performance: consultants or accountants? Podesta: Any independent party with a measure of credibility can perform the performance audit. It must be done by someone who is truly independent, however. A consultant acting as an independent third party could serve this role. In some cases, however, because of his relationships with clients or advisors, a consultant may not be independent. Accountants have historically been given this job. They operate under standards that are set by the accounting profession and reviewed by the SEC.

Question: What is the SEC's position on portability of performance results? How does the SEC define "significant" in deciding whether it is appropriate for individuals to take their performance results with them when they leave an existing organization? Podesta: The SEC has issued only a couple of letters on portability. Let me explain our position using the example of managers starting a new firm. Obviously, these managers need to point to performance to advertise their new firm. We have said that you can take your performance results when you leave an organization if you alone were responsible for those results, and if the clients who follow you have not had an experience significantly different from the ones who do not follow you to your new firm. But this performance record is not the record of the new firm, and it cannot be used as the record of the new firm. The managers should state that they do not have any firm performance because they are a new firm, but they are experienced portfolio managers and here is how they did when they were in their previous jobs. Going forward, however, the new firm's performance must be based on the performance of real clients and actual assets under management. Question: There are significant differences in regulation and practices of managers around the world. Increasingly, with the globalization of investment activities, U.s. managers are competing with nonU.S. managers' market practices. To what extent does the SEC have any plans to deal with this in investment management regulation? Podesta: We are looking very seriously at this. A number of foreign investment advisors would like to do business in the United States if they could find a way to do so without having all the SEC investment advisor requirements applied to all of their activities. For example, they might argue that their Saudi Arabian and Italian clients do not necessarily want to receive the "brochure" that the SEC requires advisors to give to clients. We have not yet made a decision on this question. Right now the foreign managers that want to operate in the United States through an affiliate or subsidiary without registering the parent company must comply with the standards articulated in a 1981 letter to Richard Ellis. 8 Apparently those standards are a little bit restrictive. We have also been talking with our regulatory counterparts, particularly in the United Kingdom. 8Richard Ellis/R. E. Holdings Limited (pub. avail. Sept. 17, 1981).

25

Our regulatory systems are based on common principles and objectives. Through understandings with these other regulators, we may be able to work out some way of recognizing one another's systems of regulation. We also have a study underway of the Invest-

26

ment Company Act, which is now 50 years old, as is the Advisers Act. We are considering whether some fundamental changes should be made in the way we regulate funds and how we should regulate investment advisors who are doing business in international markets.

How to Calculate the Numbers According to the Standards Deborah H. Miller, CFA Trustee Batterymarch Financial Management

The AIMR Performance Presentation Standards address presentation of performance results, rather than performance measurement. Nevertheless, there are a lot of numbers to calculate to comply with the Standards. In this presentation, I will review some of the basic calculations.

Time-Weighted Rate of Return The AIMR Performance Presentation Standards require use of time-weighted total returns. Only this method will measure investment performance when a manager has no control over the timing of cash flows into or out of the portfolio. A time-weighted rate of return requires valuing the portfolio at each cash flow as well as at the end of the period. The subperiods are then linked together. It is not always possible to calculate exact timeweighted rates of return. There are approximation methods available for people who cannot calculate returns when cash flows occur during the month. The internal rate of return calculation using daily cash flows is used to estimate time-weighted rate of return when market values are not available at cash flow dates. This is a good approximation when cash flows are small-that is, less than 10 percent relative to portfolio value-and when returns are similar in subperiods. Other estimation methods are available, but they are less accurate because they do not account for daily flows. The following discussion illustrates some of the problems encountered in calculating performance according the AIMR Performance Presentation Standards. The basic rate of return calculation is as follows: ROR = MVE + period dividends and interest -1 MVB .

It is the ratio of the portfolio market value at the end of the period (MVE), plus income earned during the period, to the market value of the portfolio at the

beginning of the period (MVB); that ratio minus one is the rate of return earned during the period. This simple formula runs afoul of real life, however. One of the basic problems is that the simple rate of return calculation does not accommodate cash flows into and out of the portfolio. If there are cash flows during the period, the market value of the portfolio must be calculated on the date of the cash flow to be correct. Thus, the most accurate approach is to calculate the subperiod rate of return using the formula above, calculate an interim rate of return for the subsequent part of the one-month period, and then link those returns to get the return for the month. The Standards require a time-weighted return formula that minimizes the effect of contributions and withdrawals. Daily accounting for contributions and withdrawals is the preferred method. The Standards also state that portfolios should be valued at least quarterly, although monthly valuation (and linking) is the preferred frequency where practical. Although a quarterly measurement period will be acceptable for awhile, anyone devising a new performance system should implement a monthly standard reporting period. The second source of computational complication is pricing. Pricing requires accurate market values, which is fine for actively traded equity portfolios, but is difficult for some fixed-income portfolios, for some international portfolios, and for illiquid portfolios such as emerging market, venture capital, and real estate portfolios, among others. The issue of whether to use trade-date accounting and settlement-date accounting affects performance calculations. For performance purposes, trade-date accounting is the standard. The fourth source of computational complication is how to handle accrued interest. The Standards dearly state that an accrual basis, rather than a cash basis, should be used for calculating interest. The appropriate income figure to use in the numerator in the rate of return calculation is the interest 27

earned during that period, not the interest paid. For stocks, this is straightforward, but in fixed-income securities, income is accrued daily. Table 1 shows a comparison between accrualbasis accounting and cash-basis accounting for fixedincome securities. Finally, derivatives are a computational complication. Paul Price deals with this in his presentation (see pp. 32-38). An Example There are three steps to calculating the timeweighted rate of return: (1) value the portfolio at every cash flow, (2) calculate the rate of return for each subperiod, and (3) link the subperiod returns together. An example of a time-weighted rate of return calculation for a portfolio that has cash flows during the month is presented in Table 2. The portfolio begins the month with a market value of $1,000 and ends the month with a market value of $960. On day 11, which is a third of the way into the month, there is an inflow of $50, and on day 21, an outflow of $100 occurs. The time-weighted rate of return technically requires valuation of the portfolio any time a cash flow takes place. So, in this

case, two more numbers than already specified are needed before performance can be calculated. The lack of these two numbers-the interim market values-is why many people use approximation methods for the time-weighted rate of return rather than this technically correct methodology. In this example, the market values are known. Before the cash flow on day 11, the market value was $940, so the portfolio declined by 6 percent for that interim period. That is calculated by dividing the ending-period value of $940 by $1,000 minus 1, or-6 percent, for the first 10 days. Before the outflow on day 21, the market value was $1,025. The return for this interim period was 3.5 percent, calculated by dividing $1,025 by $990 and subtracting 1. The base for the second lO-day period is $990 because that is the beginning market value for this period, given the cash inflow of $50 on day 11. This is the key to why this methodology is immune to the distortion caused by cash flows. In the last 10 days of the month, the portfolio increased by 3.8 percent, which is $960 divided by $925 minus 1. The beginning market value for that last 10 days was $925, which took into account the outflow of $100.

Table 1. Comparison of Bond Returns on an Accrual Basis Versus Cash Basis Accrual Basis Portfolio at beginning of quarter 1: 12% short-term issue $1,000,000 Transactions at end of quarter 1: Short-term issue matures: Principal $1,000,000 Interest 30,000 Buy: $1 million 12% 10-year Treasury bond (980,000) Principal (50,000) +5 months accrued interest Portfolio at end of quarter 1: $1 million 12% 10-year Treasury bond $ 980,000 Accrued interest 50,000 Total market value $1,030,000 Quarterly return (first period): 1.030,000 - 1 x 100 = 3.0% 1,000,000 Transactions during quarter 2: Interest received $ 60,000 Portfolio at end of quarter 2: $1 million 12% 10-year Treasury bond $ 980,000 Cash 60,000 Accrued income 20,000 Total market value $1,060,000

Cash Basis $1,000,000 $1,000,000 30,000 (980,000) (50,000) $ 980,000

o $ 980,000 980,000 - 1 x 100 = -2,0% 1,000,000 $

60,000

$ 980,000 60,000

°

$1,040,000

Quarterly return (second period): 1.060,000 -1 x 100 = 2.9% 1,030,000

1.040,000 -1 x 100 =6,1 % 980,000

2 quarter's return:

1.040,000 -1 x 100 = 4.0% 1,000,000

1,060,000 -1 x 100 = 6.0% 1,000,000

Source: Maginn, J.L. and D.L. Tuttle, eds. (1990). Managing Investment Portfolios: A Dynamic Process. Boston: Warren, Gorham & Lamont, Inc.

28

Table 2. Time-Weighted Rate of Return Calculation: Date 08/31/90 09/11/90 09/21/90 09/30/90

Market Value

o

$

940 1,025 960

In(Out) Market Value Flow After Flow $1,000 50 (00)

o

$1,000 990 925 960

Return

N/A (940/1,000) -1 = --{j.0% 0,025/990) - 1 = 3.5% ( 960/925) - 1 = 3.8%

September Return: Time-weighted return: (0.94 x 1.035 x 1.038) - 1 = 1.0% Internal rate of return: 1,000 x O+r) + 50x 0+r)2/3 -100 x 0+r)I/3 r= 1.0%

=960

Source: Deborah H. Miller

To get the return for the month, link the three subperiod returns. Technically, linking involves multiplying 1 plus the subperiod return for each subperiod, and subtracting 1 from the product. The result is the end-of-month value of a dollar invested at these three subperiod rates of return. In this case, it is a rate of return of 1 percent for the month. The term "time-weighted rate of return" is a little confusing because the time it took to earn that -6 percent does not really matter. If the cash inflow had occurred on the 5th day of the month and the second flow on the 25th day of the month, assuming the market values and all the other numbers did not change, the rate of return would be the same-1 percent for the month. That will not be the case for the alternatives I will discuss. Internal Rate of Return The Standards require a time-weighted rate of return formula that minimizes the effect of contributions or withdrawals. Only the formula just discussed reduces that impact to zero. But the requirement of interim market values may prove onerous. The preferred alternative is an approximation method that provides a daily accounting for contributions or withdrawals. One of the commonly used approximation methods is the internal rate of return (lRR), or dollarweighted rate of return. It does not require knowledge of market values on the days of the flows. The IRR is a good approximation of the time-weighted rate of return when the cash flows are small relative to the portfolio value and also when the returns are similar in the subperiods within the month. It complies with the Standards, which specify use of a formula that minimizes the effect of contributions and withdrawals, preferably one that accounts daily for contributions and withdrawals. This methodology takes into account the timing and amounts of the

cash flows. To reduce distortion, however, the Standards require that when a cash flow is over 10 percent of the market value of the portfolio, the portfolio should be revalued on the date of the flow. The IRR is really a present-value formula that seeks the single rate of return at which the beginning market value plus the subperiod flows will grow to equal the ending market value. Table 2 shows how the IRR compares to the time-weighted rate of return. In the formula, the $50 cash inflow grows at rate R, but only for two-thirds of a month. The $100 outflow diminishes at R for the last one-third of the month. An iterative process is needed to solve this; R cannot be found directly. In this case, the IRR is 1.00, with rounding, the same as the time-weighted rate of return. This formula assumes the $1,000 grew at the rate of 1 percent throughout the month, but it actually grew -6 percent for part of the month, +3.5 percent for another part, and +3.8 for the last part. This is the source of some of the distortion these approximation methods can produce. Although finding the IRR is an iterative process, it is easily done on a computer or a calculator. When the Bank Administration Institute (BAD first published requirements for the calculation of performance in 1968, the IRR was much harder to calculate than it is today. The BAI recommended the IRR formula but simplified it by assuming cash flows occurred at the midpoint of the period. This ~implificationis not necessary with today's computmg power and would not meet the Standards' recommendation for daily accounting of cash flows. An even simpler methodology was put forth years ago by Peter Dietz of the Frank Russell Company. His formula avoided the iterative process needed by the BAI by assuming that half the net cash flow in period n (CFn ) occurred at the beginning of the period and half at the end:

ROR

=

MVE-.5CFn -1 MVB+ 5.CF n .

Half at the beginning increases your initial value (MVB) by 112 CFn . Half at the end decreases final value (MVE) by liz CFn. This method also does not meet the recommendations of the Standards because it does not do a daily accounting for the cash flows. It can, however, be modified to weight the flows by the fraction of the period the contribution is in the account:

ROR

=

MVE - (1- DW )CFa a_ 1 ' MVE+DWaxCFa

29

where OWa is the fraction of the period that the cash flow (CFa) is in the portfolio. Although not shown here, each day's net cash flows would be weighted by the appropriate fraction of the period. This day-weighted method, similar to the IRR method, recognizes the size and timing of cash flows and, therefore, would probably be acceptable according to the Standards.

Treatment of Fees The Standards permit results to be presented before fees are netted out, as long as the fee schedule is included and disclosures are made. The Securities and Exchange Commission (SEC) accepts this format in one-on-one presentations, but for materials distributed to more than one client, the SEC requires performance results after the deduction of management fees. For performance periods after May 27, 1990, the actual fees paid, not model fees, must be deducted from performance. Fees usually accrue during the quarter, but are paid only quarterly in a lump sum. Often they are not known exactly in advance. They may be based on beginning-of-quarter market value, on end-ofquarter market value, on a bank's appraisal, or on performance. The system our firm is designing to calculate net performance will estimate the fee based on the beginning-of-quarter value. That fee will then accrue daily and will be treated like negative accrued income. If we need to calculate performance for the first 10 days of the quarter, we will have accrued 10 days' worth of an estimated fee. After the quarter is over, and we know what the actual fees are, we will have to go back and restate performance based on actual fees. Most of our fees are based on end-ofquarter market value, but when we need to calculate performance before we know the actual fee, we will base it on the best guess we can make. We will still need to be able to allocate performance among portions of the fund. For example, for a global portfolio, we may need to be able to allocate the fee among the U.S., non-U.s., or European portion. We have decided to resolve this problem by allocating the fee on a pro rata basis based on the assets in each part of the portfolio. We recognize that this is not a perfect solution, because those proportions change during the period.

mance returns as distinct from average annual returns, which are always higher. Compound annual returns must be shown for all possible periods. They propose a format in Table 1 of the Standards. The annualization calculation depends on the time period involved. Periods shorter than a year should not be annualized. If performance data for only three quarters are available, show the linked three quarters' worth of performance. Do not compound it into a year's worth of performance. On the other hand, for periods exceeding a year, annualizing involves finding the rate of growth for a one-year period that would have produced the cumulative total for the whole period. Odd periods over one year are annualized to one-year periods. Table 3 summarizes the computations required to annualize returns.

Balanced Accounts The AIMR Performance Presentation Standards devote considerable time to balanced accounts, but this area continues to cause a lot of confusion. The goal is to accurately present the performance of the components of a portfolio as well as the portfolio as a whole. A component of a portfolio might be an asset class, such as equities in a balanced fund, or it might be a country, such as French stocks in an Table 3. Compound Annualized Return Computations Periods Less Than One Year Ql = 1O%,Q2 = 3,Q3 =-5 Return for three quarters = 1.1 x 1.03 x 0.95 -1 = 7.6%

Periods over One Year Year 1 = 17%, Year 2 = 15, Year 3 = 2, Year 4 = -5, Year 5 =-10 Cumulative return = 1.17 x 1.15 x 1.02 x 0.95 x 0.90 -1 = 17.3% Compound annual return (annualized or geometric return) (1.173)1/5 -1 = 3.2% Arithmetic return (always more than geometric average) (17 + 15 + 2-5-10)/5 = 3.8%

Odd Period over One Year Year 6 Ql = 13%

Compound Annualized Returns The AIMR Performance Presentation Standards require presentation of compound annualized perfor-

30

Cumulative return = 1.173 x 1.13 -1 = 32.6% Annualized = (1.326)1/5.25 -1 = 5.5% Source: Deborah H. Miller

international portfolio. To track portfolio components accurately, apply the same rules to the performance of the component as you would at the portfolio level. The information needed includes the income that component earned during the period and market values of the component, including the market values any time cash flows into or out of that component section. This point is particularly important for the presentation of performance of global portfolios. People want to know the performance for different countries or regions, as well as for the portfolio as a whole. Some system is needed that treats these regions or countries as a subportfolio within a larger portfolio and can track the cash flows into and out of those regional or national asset classes. The Standards go one step further for balanced funds. Managers must calculate performance not only of the equities subcomponent but also of equities plus cash held in lieu of equities, and of fixed-income assets plus cash held in lieu of fixed-income assets. This requires the segregation of cash into two pots.

count is lost will have to change. The composites also cannot be adjusted when personnel leave or come to the firm. Calculating composites requires a tremendous amount of detail to be kept on an ongoing basis. The Standards require inclusions of all composites for all time periods, plus additional data about what went into the composites: the number of client relationships, the total assets involved, the weighted average and median size account, the assets in the composite as a percent of total assets in that classification, and so forth. The Standards also require benchmarks, fee information, and risk data such as a regression calculation against your benchmark to provide an alpha and a beta. A cross-sectional standard deviation is also required. Once the one-year returns are added into the composite, the standard deviation of all those portfolio returns for that one year must be calculated. It is essentially a measure of dispersion that provides a way of judging how representative the composite is as an average. The greater the dispersion, the less representative is the composite of a firm's accounts as a whole.

Composites Conclusion The biggest impact of the AIMR Performance Presentation Standards is on the presentation of composites. The Standards are quite explicit with regard to computations. The composite must be weighted by the size of the portfolio, ideally monthly. Monthly market values are used to calculate a composite return for the month; then, the weighted performance for that month is linked to similar data for each month over time. The composite must include all accounts, even those no longer with the firm. Accounting systems that drop records when an ac-

The requirements for the composites are the major thrust of the Standards, and they reflect the philosophy of full disclosure. They are quite clearly described and will likely mean changes for most investment organizations. I have spent much of this discussion on the rate of return calculation, however, which is less specifically addressed in the Standards. Although there are acceptable estimation methods, I believe the trend will be toward daily market value calculations whenever feasible.

31

Question and Answer Session Question: Why are old standbys, such as the BAI and Deitz methods, not recommended today? Price: The BAI method was introduced in 1967, when the trustee business and the scope of the industry were not what they are today; the HP-12C and spreadsheet software packages were not available. In those days, internal rates of return (IRRs) were difficult to calculate without involved systems programming. It is easy to calculate IRRs today because most spreadsheet software packages and most financial calculators have built-in IRR calculations. The computational realities have changed so dramatically since 1967 that there is no longer a reason to play around with back-of-the-envelope schematics that push everything into a mid-month flow or to calculate some daily dollar average investment. Therefore, if you are not going to use daily valuations for a true time-weighted return, the next best alternative is to use IRRs, which now can easily be calculated accurately. Miller: Alternative methods, such as the Deitz method and one by the Investment Counsel Association of America that is similar to the Deitz approach, were developed to overcome the computational problems associated with calculation of the internal rate of return in the late 1960s. Today, calculators can be used to get IRRs, so there is no reason to accept a less-accurate calculation. Question: Why not put half of the income in the denominator of the rate of return formula you used in your presentation? Miller: The formula you refer to is the precise timeweighted rate of return. There are no cash flows into or out of the portfolio. This formula is used to calculate return between cash flows. It assumes you revalue the portfolio every day a cash flow occurs. You are probably thinking about one of the approximation methods that assumes half of the cash flows for the period occur at the beginning of the period and, therefore, they add half the cash flow, including reinvested income, to the denominator. Question: How is the market value adjustment to a book value account reported-as earnings, or as cash in?

Price: As earnings. Question: If you control cash flows so the dollars are always 100 percent invested in equities, do you still report time-weighted performance? Price: Definitely yes. That situation illustrates the reason why time-weighting came into being in the first place. Time-weighted returns measure a manager's ability to manage the money in his possession during the time he has it. Linking time-weighted returns, as opposed to dollar-weighted returns, is the only way to show that result. A manager's performance can be skewed considerably by the timing of cash flows over which he has no control. Therefore, dollar-weighting is not an appropriate measure of what the manager can do, particularly if the account is very volatile. Question: Should you use the same standard deviation formula to calculate both the dispersion of a composite and the standard deviation of returns across time? Miller: Calculation of the standard deviation for either purpose is the standard formula that can be found in any statistics book. It is a measure of the deviation of returns about the average return. For the dispersion of the composite, we use an equalweighted average, even though we are using a sizeweighted return for the composite. I do not know of anyone who is calculating a standard deviation with size-weighting in it. I don't believe the Standards require the standard deviation across time. Price: The standard distribution of composite returns should be calculated using the long-term rate for each portfolio as one observation in the normal distribution formula for return and standard distribution. Question: How is performance, particularly standard deviation, affected when accounts are not with the firm for an entire year? These accounts will not have a one-year return, so the return should not be included in the calculation of the standard deviation of yearly returns. Miller: Although our composite includes all ac-

35

counts for whatever portion of the year they were with the firm, the standard deviation only includes the portfolios that were in the firm for the entire year, because that is the only logical way we could devise to do it. We have thus far calculated standard deviation around the equal-weighted average of all portfolios. Of course, the composite is a size-weighted average, so one could argue that the standard deviation should be size-weighted as well, but I have not seen anyone actually doing that. On another point, someone stated that managers are supposed to show the average account size in each composite, but technically, the Standards require the size-weighted average account size! Question: Both my consultant and my investment manager provide me with investment returns, and they are always different. The consultant says it is because he uses day-weighting, but he works from my custodian's statements, which are valued at month-end. Does day-weighting require daily market values?

Therefore, we use our beginning-of-quarter market value as an estimate for the fees and accrue the dollar expense on a daily basis during the quarter, knowing that we will have to make some retroactive adjustments. For example, if the fee were 30 basis points a year on $100 million, we figure out how many dollars a day we are going to expense our portfolio. Then, we go back and restate it for the period based on later information. Price: As a trustee, we record the fees as they are

paid, and in our calculations, we only deal with the fees either as paid or accrued (they are normally accrued at the end of the period). The accrual methodology is worked out with the clients, so the timing is client-specific. Question: If you have already calculated monthly gross performance for all accounts, and you know the specific fee for each account by quarter, is there any easy way to net out the fee? Miller: If you know the fee for the quarter, you have

Price: No, day-weighting does not require daily

market values. Normally, you would take the starting market value and adjust for the day-weighted flows that actually took place. At the total-portfolio level, it is just money in or money out, contributions and withdrawals, on settlement date. For the asset class segments, it is purchases and sales on trade date. To reconcile differences in reported returns between your consultant and investment manager, go back to the basic return calculation. Determine the value used as the numerator of the calculation and the value-added for the portfolio; they should be the same. If people are working from custodian statements and other statements, differences can exist. If you can get down to that value-added number at the outset, you will eliminate the majority of the differences. Question: Do you allocate fees among segments based on beginning-quarter, ending-quarter, or average-quarter asset allocation? Miller: We are going to do it based on beginningquarter asset allocation.

Question: Please explain how to calculate performance net of fees. Miller: In many cases, our fee is calculated as a

percent of end-of-quarter market value, so knowing in advance what the fee is going to be is impossible. 36

to make some assumptions about what the monthly fee for each account was. The easy way is to subtract one-third of the quarterly fee from each month's performance. If the fee is 15 basis points for the quarter, take out 5 basis points a month. On a dollar basis, a certain number of dollars are going to accrue on a daily basis, so the result could actually be different-but is probably close enough to meet the SEC requirements. Question: For international accounts, should localcurrency returns be converted into U.s. returns, or may they be reported in local-currency terms? For total fund performance, is it accurate to calculate a capitalization-weighted return for respective local returns? Price: I don't know what the AIMR Performance

Presentation Standards Implementation Committee will decide, but I believe you should report to the u.s. clients in U.s.-based currency. This requires that returns be reported at least in base currency. I recommend they be reported both in local currency and in base currency to filter out the results of currency risk management. Many managers use hedging operations to minimize currency risk. That is part of the value added by the manager; it should probably be reported separately. Clearly, that cannot be done without monitoring both the local and base-currency returns. To monitor a multicurrency portfolio's performance, you have to segregate the currency futures

and currency activity by country, rather than allow the gains or losses on those futures contracts to accrue in total to the base-currency sleeve of the portfolio. Question: Will reporting standards for international accounts be monthly or quarterly? Price: I strongly support AIMR's recommendation for monthly valuations, although a quarterly frequency is currently stipulated. Question: What discretion is allowed under the Standards for the timing of inclusion of a new account in the composite? May the manager set conditions for inclusion-for example, when the portfolio reaches 90 percent invested? Miller: The Standards state that managers and new clients should agree in advance on the starting date for performance calculation. I would assume by implication that is also the date those numbers should enter into the composite. Question: Accrued interest cannot be invested. Should accrued income be used instead of cash in the rate of return calculation? Miller: The change in accrued interest should be used in the numerator of the rate of return calculation, because what you are reaHy interested in is what income is earned for that month, whether it is paid or not. The controversy is whether accrued interest should be included in the denominator. For example, for a fixed-income portfolio, should the denominator be the market value at the beginning of the month with or without accrued income? Our firm uses the liquidating value-the market value plus accrued interest-in the denominator, but I do not believe that is the universal approach. Price: We also include accrued interest in the denominator. That is the appropriate way because the fixed-income securities can be sold and the accrued income realized. It is part of the market value. Accrued income is in the beginning and ending values, and therefore it is in the denominator. It is not, however, added incrementally each day as a cash flow. The internal rate of return formula only requires the opening market value for the period, the closing market value for the period, and the actual cash flows that take place during the period. The accrual is not a cash flow in the computational program.

Question: Please elaborate on the mechanics of accruing dividend income. Price: For performance purposes, the dividend becomes part of the portfolio as a receivable on the ex-date. On the day it is paid, the receivable expires, and cash increases. Consequently, the value of the portfolio does not change on pay date. Question: What is the acceptable method for computing cash returns when recordkeeping is on a trade-date basis and cash is invested on a settlementdate basis? Price: There is no conflict. When a stock is purchased, it is recorded as an asset on the trade date, although the cash is not available for investment until the settlement date. Nevertheless, the equity segment should get credit for changes in the stock price subsequent to trade date. The difference in timing between trade and settlement dates is offset at the total portfolio level by the accounts payable and receivable. As previously mentioned, in balanced portfolios the payables and receivables need to be combined with their respective asset balances for performance purposes. Question: Please comment on the need to allocate cash between equity and fixed-income assets. Why not eliminate cash when reporting equity and fixedincome component returns and include it only in total account performance? Price: The allocation of cash is an issue only for balanced accounts. In an equity-only account, the movement from equity to cash that hurts the overall return will be very evident at the total fund level. The manager of a balanced account who moved from equity to cash could report the equity segment return if the market had gone up considerably during that period. His equity decisions would appear to be valid because they would not be degraded by the drag of cash. In a balanced portfolio, the reason for allocating cash by type of asset is to evaluate results when the manager has either correctly or incorrectly made an asset allocation decision to shift from the asset class segment to cash and equivalents for some period of time. The essence of the exercise is to make certain that the results of the management action are not lost in the reporting. In the case of a balanced portfolio, the impact of asset class decisions would not be measurable unless the asset class cash, as well as asset class payables and receivables balances, are not segregated and combined with those of their

37

appropriate asset class.

lieve maintenance of separate portfolios will be more manageable.

Question: How is cash to be allocated between equity and fixed-income portfolios on an account with an automated sweep at the custodian bank?

Question: How do you allocate cash in international portfolios? Do you allocate cash to each country?

Price: It is technically feasible to determine the cash allocation by referring to the asset class reference associated with each security CUSIP's respective purchases, sales, and income. Specific decision rules could be implemented for cash contributions, withdrawals, and expense payments. In practice, I be-

Miller: Currently, we do not allocate cash among segments of an international portfolio, but we are developing a new accounting system that will allow us to track subportfolios. The only way to present accurate performance of components is to treat them like portfolios, capturing all cash flows in or out.

38

How to Calculate the Numbers According to the Standards Paul W. Price, CFA Vice President State Street Bank & Trust Co.

The AIMR Performance Presentation Standards are representative of current presentation practices in the industry. The committee has done an excellent job in formulating standards that should lead to uniformity and contribute to comparability in the reporting of investment performance. These Standards also establish principles that in the future could logically be extended to other asset classes, such as real estate, venture capital, and international fixed-income and equity investments, once these classes become important enough to be segregated within balanced portfolios. The Performance Presentation Standards are designed to provide a uniform set of data for the purpose of peer group comparisons. Thus, they are a minimum requirement and are probably not sufficiently detailed for other management purposes. For example, the analysis of security selection effectiveness, as opposed to asset allocation effectiveness, also requires that performance be calculated for all the asset class segments without adjusting for their proportion of the cash holdings. Therefore, in the case of balanced funds, performance must be calculated for a number of subsets in addition to those recommended by AIMR. A performance measurement system should be able to show what a particular investment policy has accomplished. That type of analysis provides some insight for modification of the overall policy or of a particular direction of that policy. Looking at equity and fixed-income returns in balanced portfolios will suffice for the peer group comparison, but a much more extensive set of data is needed to evaluate investment policies. These data elements should help users meet the specifications of the Standards and yet have enough flexibility to be able to respond to any analytic task.

Performance Basics A true time-weighted return is not a linked internal 32

rate of return (IRR) but a linkage of the absolute performance returns during the periods between cash flows. Linking monthly IRRs is considered an acceptable approach if the cash flows between periods will not significantly distort the results. True time weighting requires portfolio revaluation each time a cash flow occurs. This is not administratively feasible for the vast majority of portfolios, and a practical alternative is required. The Standards require this be done when a cash flow exceeds 10 percent of the investment base. This is not a frequent occurrence, but it is crucial if the Standards are to be observed. The timing of a large flow can result in highly skewed rates of return; for example, the monthly rate of return will appear to be 25 percent or 30 percent when the absolute gain was only 2 to 3 percent. This distortion would remain in the performance record forever if the appropriate adjustments were not made. Two procedural notes: First, the IRR formula does not produce an exact rate of return. The rate is determined on a trial-and-error basis by calculating the present value of all of the cash flows and adjusting the interest rate until the difference in present value is within some tolerance, for example, $1.00. Second, flows should take place at the beginning of the day because interest is earned on the day invested. Sometimes the IRR computation formula gets in the way of understanding how certain transaction cash flows should be treated for performance evaluation purposes. The technical IRR process is merely a fine-tuning to account for the timing of cash flows. A rate of return is still investment gain divided by investment, or what I refer to as a numerator-denominator game. My experience has been that when trying to rationalize performance treatment for derivatives or when resolving performance return differences, expressing problems in terms of the fundamental numerator and denominator is the key to the solution. This is crucial! For instance, because monthly returns are

generally on the order of 1 percent or less, a 1 percent error in the numerator will have 100 times the impact of the same error in the denominator 0/100% = 1%, 1/99 = 1%, but 2/100 = 2%). Obviously, with these dynamics, an error in treating principal as an income flow can have a dramatic effect. When differences in calculated rates of return occur, often the first reaction is to believe that either the timing of cash flows or differences in the IRR computation mathematics is the cause. In fact, requiring both parties to determine the numeratorthat is, the net "value-added" calculated by summing the cash flows used in their computations-usually reveals the cause of the difference. When evaluating a transaction, it is useful to get back to basics and answer the following questions. • How does it affect the numerator? (Use real numbers.) • How does it affect the denominator? (Again, use real numbers.) • Does it affect both for the same time period?

Derivative Securities Reporting the performance of derivative securities requires special consideration. The Standards state that "Performance results for anyone asset class (such as equities) should include cash equivalents and any other securities (e.g., convertible securities in an equity portfolio) held by the manager in place of that asset." This applies to derivative securities. Note that a futures contract does not involve a conventional"purchase" or "sale" but rather an agreement to settle daily for any change in the index market value. This is referred to as margin variation. For instance, an S&P contract represents 500 times the contracted index price. Consequently, if an S&P contract taken at 360 closed at 361, $500 would be paid to the owner of the contract the following morning; the margin variation is $500. Derivatives must be carefully defined. Intent is critical! For instance, an S&P future by itself is not a derivative. The intent must be to combine the futures contract with the available cash balances to produce the same effect as an equity investment. Otherwise, the transaction merely changes the leverage, or beta, of the equity asset class. As a consequence, the investment would be treated differently within the asset class for performance purposes depending on the intent of the transaction. The performance measurement system must have the flexibility to permit computation either way for different portfolios, or within a portfolio. Similarly, an option on a security could be con-

sidered as a beta-adjustment device or, if combined with the cash balance required to exercise the option, as the equivalent of a security transaction with a premium to obtain short-term downside protection. Again, the decision as to the appropriate treatment for performance measurement purposes depends on the intent. Using a simplistic numerator-denominator model can help in understanding the computational treatment for these transactions. Consider, as an example, the purchase of an S&P futures contract. In practice, without further adjustment, the cash movement for margin variation from a futures contract will only affect the numerator for the equity asset class, thereby altering the leverage, or beta, of the asset. No increment accrues to the denominator because there is no "investment" cost, only the gain or loss resulting from margin variation. Consider the case in which the intent is to use the futures contract as a derivative, or as a substitute for the asset class investments. In the absence of other equity assets, the denominator in the model will be zero. A positive numerator divided by a zero denominator would produce an infinite equity segment return. Obviously, an extremely large or infinite return is not valid for performance purposes. To provide the correct denominator (investment base) and represent the real intent, the purchase of a futures contract should be accompanied by a simultaneous transfer from the cash and equivalents account to the equity asset class in an amount equal to the face value of the futures contract. When the denominator is adjusted, the appropriate interest on the cash investment also must be transferred to correct the numerator. This adjustment will provide the correct returns for both the cash and equivalents and the equity asset classes. Obviously, these transfers would offset each other for the performance calculation at the total-portfolio level. To satisfy the requirements of the Standards, the performance measurement system must either hold separate asset class cash accounts or provide a programming methodology to give the effect of transferring the cash balance and interest between asset classes. Further, a method will be needed to determine at what level the adjustments will be made, either portfolio by portfolio or transaction by transaction.

Balanced Accounts The essence of the AIMR Standards on balanced accounts is that, for performance measurement purposes, both the equity and fixed-income portions of an account should be accounted for as if they were 33

separate portfolios, with their own cash and equivalent holdings, as well as on a consolidated basis. 1 Using two separate portfolios for equity and fixed-income investments is the most straightforward method of segregating the equity and fixed-income cash components. This allows an analysis of the performance of each asset class for security selection effectiveness, in addition to providing the overall portfolio return for purposes of asset allocation effectiveness. This technique also meets the proposed Standards for peer group comparison at the asset class level, adjusted for asset class cash. Consolidating the results of both types of portfolios will provide the total balanced-fund return, as required by the Standards. Because maintaining two portfolios may not be cost-effective in all situations, a satisfactory means of segregating the equity cash from the fixed-income cash within a single portfolio must be established. If the cash and equivalents are in commingled funds, establishing separate fixed-income and equity cash units, with a unique identifier (CUSIP) for each, is a simple matter. A further complication may cause a problem for some trade date systems, however. In addition to separating the equity and fixed-income

lEditor's note: This statement does not apply to balanced accounts that are presented only on a consolidated basis, that is, the separate asset class performance is not shown. See Lee Price, pp.15-18.

34

cash, the equity and fixed-income payables and receivables, which must be accounted for when completing the performance calculation, also must be separated. For example, suppose a portfolio purchases a $10,000 equity security. The equity market value will increase by $10,000, but equity cash will not be reduced until settlement date. Unless an adjustment is made for the payable, the denominator for the equity asset class will be overstated by $10,000. This will degrade the apparent performance of this portfolio segment. That is why running separate portfolios is a lot cleaner. If operating two portfolios is not possible, the performance calculation system should be adjusted to incorporate both the asset class cash and cash payables and receivables. Again, referring to the simplistic model, for each of the two asset classes, the interest from the cash investment should be included in the numerator and the cash balance in the denominator shQuld be offset by any net payable for that asset class. This will ensure that the positive impact from float will accrue to the asset class without degrading apparent performance by artificially inflating the asset class market value (the denominator).

Question and Answer Session Question: Why are old standbys, such as the BAI and Deitz methods, not recommended today? Price: The BAI method was introduced in 1967, when the trustee business and the scope of the industry were not what they are today; the HP-12C and spreadsheet software packages were not available. In those days, internal rates of return (IRRs) were difficult to calculate without involved systems programming. It is easy to calculate IRRs today because most spreadsheet software packages and most financial calculators have built-in IRR calculations. The computational realities have changed so dramatically since 1967 that there is no longer a reason to play around with back-of-the-envelope schematics that push everything into a mid-month flow or to calculate some daily dollar average investment. Therefore, if you are not going to use daily valuations for a true time-weighted return, the next best alternative is to use IRRs, which now can easily be calculated accurately. Miller: Alternative methods, such as the Deitz method and one by the Investment Counsel Association of America that is similar to the Deitz approach, were developed to overcome the computational problems associated with calculation of the internal rate of return in the late 1960s. Today, calculators can be used to get IRRs, so there is no reason to accept a less-accurate calculation. Question: Why not put half of the income in the denominator of the rate of return formula you used in your presentation? Miller: The formula you refer to is the precise timeweighted rate of return. There are no cash flows into or out of the portfolio. This formula is used to calculate return between cash flows. It assumes you revalue the portfolio every day a cash flow occurs. You are probably thinking about one of the approximation methods that assumes half of the cash flows for the period occur at the beginning of the period and, therefore, they add half the cash flow, including reinvested income, to the denominator. Question: How is the market value adjustment to a book value account reported-as earnings, or as cash in?

Price: As earnings. Question: If you control cash flows so the dollars are always 100 percent invested in equities, do you still report time-weighted performance? Price: Definitely yes. That situation illustrates the reason why time-weighting came into being in the first place. Time-weighted returns measure a manager's ability to manage the money in his possession during the time he has it. Linking time-weighted returns, as opposed to dollar-weighted returns, is the only way to show that result. A manager's performance can be skewed considerably by the timing of cash flows over which he has no control. Therefore, dollar-weighting is not an appropriate measure of what the manager can do, particularly if the account is very volatile. Question: Should you use the same standard deviation formula to calculate both the dispersion of a composite and the standard deviation of returns across time? Miller: Calculation of the standard deviation for either purpose is the standard formula that can be found in any statistics book. It is a measure of the deviation of returns about the average return. For the dispersion of the composite, we use an equalweighted average, even though we are using a sizeweighted return for the composite. I do not know of anyone who is calculating a standard deviation with size-weighting in it. I don't believe the Standards require the standard deviation across time. Price: The standard distribution of composite returns should be calculated using the long-term rate for each portfolio as one observation in the normal distribution formula for return and standard distribution. Question: How is performance, particularly standard deviation, affected when accounts are not with the firm for an entire year? These accounts will not have a one-year return, so the return should not be included in the calculation of the standard deviation of yearly returns. Miller: Although our composite includes all ac-

35

counts for whatever portion of the year they were with the firm, the standard deviation only includes the portfolios that were in the firm for the entire year, because that is the only logical way we could devise to do it. We have thus far calculated standard deviation around the equal-weighted average of all portfolios. Of course, the composite is a size-weighted average, so one could argue that the standard deviation should be size-weighted as well, but I have not seen anyone actually doing that. On another point, someone stated that managers are supposed to show the average account size in each composite, but technically, the Standards require the size-weighted average account size! Question: Both my consultant and my investment manager provide me with investment returns, and they are always different. The consultant says it is because he uses day-weighting, but he works from my custodian's statements, which are valued at month-end. Does day-weighting require daily market values?

Therefore, we use our beginning-of-quarter market value as an estimate for the fees and accrue the dollar expense on a daily basis during the quarter, knowing that we will have to make some retroactive adjustments. For example, if the fee were 30 basis points a year on $100 million, we figure out how many dollars a day we are going to expense our portfolio. Then, we go back and restate it for the period based on later information. Price: As a trustee, we record the fees as they are

paid, and in our calculations, we only deal with the fees either as paid or accrued (they are normally accrued at the end of the period). The accrual methodology is worked out with the clients, so the timing is client-specific. Question: If you have already calculated monthly gross performance for all accounts, and you know the specific fee for each account by quarter, is there any easy way to net out the fee? Miller: If you know the fee for the quarter, you have

Price: No, day-weighting does not require daily

market values. Normally, you would take the starting market value and adjust for the day-weighted flows that actually took place. At the total-portfolio level, it is just money in or money out, contributions and withdrawals, on settlement date. For the asset class segments, it is purchases and sales on trade date. To reconcile differences in reported returns between your consultant and investment manager, go back to the basic return calculation. Determine the value used as the numerator of the calculation and the value-added for the portfolio; they should be the same. If people are working from custodian statements and other statements, differences can exist. If you can get down to that value-added number at the outset, you will eliminate the majority of the differences. Question: Do you allocate fees among segments based on beginning-quarter, ending-quarter, or average-quarter asset allocation? Miller: We are going to do it based on beginningquarter asset allocation.

Question: Please explain how to calculate performance net of fees. Miller: In many cases, our fee is calculated as a

percent of end-of-quarter market value, so knowing in advance what the fee is going to be is impossible. 36

to make some assumptions about what the monthly fee for each account was. The easy way is to subtract one-third of the quarterly fee from each month's performance. If the fee is 15 basis points for the quarter, take out 5 basis points a month. On a dollar basis, a certain number of dollars are going to accrue on a daily basis, so the result could actually be different-but is probably close enough to meet the SEC requirements. Question: For international accounts, should localcurrency returns be converted into U.s. returns, or may they be reported in local-currency terms? For total fund performance, is it accurate to calculate a capitalization-weighted return for respective local returns? Price: I don't know what the AIMR Performance

Presentation Standards Implementation Committee will decide, but I believe you should report to the u.s. clients in U.s.-based currency. This requires that returns be reported at least in base currency. I recommend they be reported both in local currency and in base currency to filter out the results of currency risk management. Many managers use hedging operations to minimize currency risk. That is part of the value added by the manager; it should probably be reported separately. Clearly, that cannot be done without monitoring both the local and base-currency returns. To monitor a multicurrency portfolio's performance, you have to segregate the currency futures

and currency activity by country, rather than allow the gains or losses on those futures contracts to accrue in total to the base-currency sleeve of the portfolio. Question: Will reporting standards for international accounts be monthly or quarterly? Price: I strongly support AIMR's recommendation for monthly valuations, although a quarterly frequency is currently stipulated. Question: What discretion is allowed under the Standards for the timing of inclusion of a new account in the composite? May the manager set conditions for inclusion-for example, when the portfolio reaches 90 percent invested? Miller: The Standards state that managers and new clients should agree in advance on the starting date for performance calculation. I would assume by implication that is also the date those numbers should enter into the composite. Question: Accrued interest cannot be invested. Should accrued income be used instead of cash in the rate of return calculation? Miller: The change in accrued interest should be used in the numerator of the rate of return calculation, because what you are reaHy interested in is what income is earned for that month, whether it is paid or not. The controversy is whether accrued interest should be included in the denominator. For example, for a fixed-income portfolio, should the denominator be the market value at the beginning of the month with or without accrued income? Our firm uses the liquidating value-the market value plus accrued interest-in the denominator, but I do not believe that is the universal approach. Price: We also include accrued interest in the denominator. That is the appropriate way because the fixed-income securities can be sold and the accrued income realized. It is part of the market value. Accrued income is in the beginning and ending values, and therefore it is in the denominator. It is not, however, added incrementally each day as a cash flow. The internal rate of return formula only requires the opening market value for the period, the closing market value for the period, and the actual cash flows that take place during the period. The accrual is not a cash flow in the computational program.

Question: Please elaborate on the mechanics of accruing dividend income. Price: For performance purposes, the dividend becomes part of the portfolio as a receivable on the ex-date. On the day it is paid, the receivable expires, and cash increases. Consequently, the value of the portfolio does not change on pay date. Question: What is the acceptable method for computing cash returns when recordkeeping is on a trade-date basis and cash is invested on a settlementdate basis? Price: There is no conflict. When a stock is purchased, it is recorded as an asset on the trade date, although the cash is not available for investment until the settlement date. Nevertheless, the equity segment should get credit for changes in the stock price subsequent to trade date. The difference in timing between trade and settlement dates is offset at the total portfolio level by the accounts payable and receivable. As previously mentioned, in balanced portfolios the payables and receivables need to be combined with their respective asset balances for performance purposes. Question: Please comment on the need to allocate cash between equity and fixed-income assets. Why not eliminate cash when reporting equity and fixedincome component returns and include it only in total account performance? Price: The allocation of cash is an issue only for balanced accounts. In an equity-only account, the movement from equity to cash that hurts the overall return will be very evident at the total fund level. The manager of a balanced account who moved from equity to cash could report the equity segment return if the market had gone up considerably during that period. His equity decisions would appear to be valid because they would not be degraded by the drag of cash. In a balanced portfolio, the reason for allocating cash by type of asset is to evaluate results when the manager has either correctly or incorrectly made an asset allocation decision to shift from the asset class segment to cash and equivalents for some period of time. The essence of the exercise is to make certain that the results of the management action are not lost in the reporting. In the case of a balanced portfolio, the impact of asset class decisions would not be measurable unless the asset class cash, as well as asset class payables and receivables balances, are not segregated and combined with those of their

37

appropriate asset class.

lieve maintenance of separate portfolios will be more manageable.

Question: How is cash to be allocated between equity and fixed-income portfolios on an account with an automated sweep at the custodian bank?

Question: How do you allocate cash in international portfolios? Do you allocate cash to each country?

Price: It is technically feasible to determine the cash allocation by referring to the asset class reference associated with each security CUSIP's respective purchases, sales, and income. Specific decision rules could be implemented for cash contributions, withdrawals, and expense payments. In practice, I be-

Miller: Currently, we do not allocate cash among segments of an international portfolio, but we are developing a new accounting system that will allow us to track subportfolios. The only way to present accurate performance of components is to treat them like portfolios, capturing all cash flows in or out.

38

Implementing the AIMR Standards Daniel W. Boone III, CFA Managing Director Atlanta Capital Management

Implementing the AIMR Performance Presentation Standards will be more work than most people envision. Atlanta Capital Management has what we consider to be a high degree of integrity in our performance numbers. We have always included all comparable accounts in our composites, we use daily time-weighted returns, and we have a full-accrual system. Nevertheless, we have found that the process of implementing the Standards is a lot of work. I believe that it is worth doing, but that people should start now and plan for the effort. Atlanta Capital Management is in the process of implementing the AIMR Standards. In this presentation, I will highlight the steps we are going through, noting estimates of time and money involved for our firm. Implementation of the AIMR Standards is going to depend on the individual firm, so my time and cost estimates are firm-specific. The process, however, is universal.

Atlanta Capital Management Because implementation of the Standards is firmspecific, I will describe Atlanta Capital Management before launching into implementation issues. Atlanta Capital Management is 21 years old and has 60 accounts, representing about $1.7 billion of assets under management. Most of the accounts are taxfree, discretionary institutional accounts, although some are personal accounts. Historically, we have offered equity, fixed-income, and balanced portfolios, and more recently we have introduced a quantitative semipassive equity account. We have a few large accounts with significant restrictions, which have to be looked at separately because their performance differs from the rest of the portfolios. Currently, we publish three composites: equity, balanced, and fixed-income account composites. The composites include all accounts that share similar objectives. Our performance calculations are time-weighted. We have daily valuations of portfolios, a practice that exceeds the Standards, which call for monthly valuation.

Summary of the Standards The Performance Presentation Standards comprise a set of rules, supplemented by guidelines in areas in which alternate methods are permitted. Disclosure is a central tenet of the Standards. In preparing for implementation of the Standards, I relied on Performance Measurement: Setting the Standards, Interpreting the Numbers. 1 This publication provided valuable insights into the issues the Standards address. The "Overview of the Seminar" and the "CPPS Panel Discussion" proved particularly valuable. In addition to enumerating the rules, the Standards provide examples of how to present performance data. Tables 1 and 2 of the Standards illustrate one approach to complying with the Standards, using as an example a tax-exempt equity composite for XYZ Capital Management.2 The firm has been in business for 17 years. Table 1 illustrates the actual and annualized equity performance versus the benchmark (S&P 500) for each year of the 17-year period. The Standards also require cumulative returns for each successive year and a comparable index for use as a benchmark. These numbers are also presented in the table. The tightness of the distribution of portfolios around the composite is measured by its standard deviation. Supplemental information required by the Standards is disclosed in footnotes, in this case 10 of them. Table 2 provides additional information required by the Standards. It presents details on the assets under management in this style of investing since inception. For this composite, the table provides annual data on the dollars of assets under management, the proportion of accounts with comparable investment guidelines included in the composite, the percentage of XYZ's total equities lChariottesville, Va. Association for Investment Management and Research (1989). The Standards printed in this publication were revised and are printed in Performance Reporting for

Investment Managers: Applying the AIMR Performance Presentation Standards (1991), pp. 6-14. 2

Seepp.11-12.

39

managed that are represented in the composite, the number of clients in the composite, the average account size, and the median account size. Table 2 includes an additional nine footnotes disclosing information relevant to the performance. The Standards also provide a checklist for investment managers and their clients and prospects, and for consultants, to assure proper conformance to the AIMR Performance Presentation Standards (see Table 3 of the Standards).

Implementation of the Standards We adopted a simple approach to implementation of the Standards. The approach involves following the checklist provided in Table 3 of the Standards. Two people were assigned to the task-an investment person and an administrative person. An investment person is necessary because implementation requires some investment decisions and has some investment implications. Exhibit 1 presents our estimates of the time and money it will take to conform with the AIMR Standards, organized according to the AIMR checklist. The requirements marked with a to! on the list will be no problem for our firm to meet; those marked with an )( will require new practices on our part. Performance Calculations Time-weighting. The Standards require calculation of returns on a time-weighted basis, which our system already does, so no change is required here. Furthermore, because we do daily valuation, we do not have to worry about revaluing an account when large cash inflows or outflows occur. Total returns. The Standards require total returns, which is what we do already, so no change is required here. Fee disclosure. The Standards are explicit with regard to the disclosure of fees. Although we usually disclose our fees, I suspect that an occasional performance record has gone out without stating a fee. This will now be a requirement. I have written a memo to the marketing department, as well as to all the investment managers, to inform them of this require~ent.

Assignment of cash to sectors. The Standards require that the performance results of broad security classes, such as equity or fixed-income, include the performance of cash or substitute securities held in that portfolio. In our balanced accounts, we report only one cash number; it is not allocated between fixed-income and equity segments. Because we are not currently in compliance, we will need to take several actions, including reprogramming our ac40

counting software, reprogramming client and internal cash reports, and determining a methodology for changing cash allocations. These changes are not straightforward. New problems emerge, such as how to handle an overdraft when you are overdrawn only in the equity portion of a balanced account. We estimate that the changes necessary to revise our client reporting system will take about four days and cost about $7,500. Devising a new methodology for the asset allocation in balanced accounts is where the investment person becomes important. As of January 1991, our performance statistics will be generated with cash assigned to each of the two asset classifications, equities and fixed-income. Suppose a balanced account is 60 percent (assume that is equal to $60) invested in equities. The stock market goes up 20 percent, but the bond market does not move. The $60 becomes $72, and the total value of the account is now $112. The actual asset allocation has now moved from 60 percent to 64.3 percent. As the cash comes in, does the equity manager give the bond manager $4.80 to bring the equity allocation back to 60 percent? Under the AIMR Performance Presentation Standards, a formal decision by the portfolio manager has to be made to move cash back and forth between sectors of the account. It does not just flow back to 60 percent on its own; the manager must make some discreet decision to sell equities or transfer cash to the other side of the account. Previously at Atlanta Capital Management, we rarely changed asset allocation, and let cash flow to the underweighted sector. Some kind of warning device is needed to alert the system to transfer cash back and forth on a discretionary basis. I expect that developing the methodology to reallocate assets between equity and fixed-income portfolios will require an additional two days of time. Disclosed exclusions. The Standards require that managers disclose all exclusions from performance calculations and presentations. This will be incorporated into compliance with other areas of the Standards. Performance methodology. The Standards require that the method of linking interim performance results be explained. We handle this in the footnotes to the tables. Balanced accounts. As I mentioned, the cash-allocation requirement is being implemented in our firm for balanced accounts on January I, 1991. Another requirement is for additional risk information. Our accounting system does not generate risk or volatility numbers. Part of the accounting system or some all-inclusive system must be programmed to supply this information for every account. I estimate

Exhibit 1. Atlanta Capital Management's Performance Presentation Standards Checklist*

Subject I.

Performance Calculations A. Time-weighting B. Total returns C. Fee disclosure D. Assignment of cash to sectors

L L A A

L L A

Disclosed exclusions Performance methodology Balanced accounts 1. assign cash A 2. no equity only # L 3. other information A H. Convertibles I. Comparable indexes J. Leveraged assets

A

K.

A L A

II.

E. F. G.

Performance start date

Actions

Estimated Time and Money

Memo to firm Reprogram accounting software Reprogram client and internal cash reports Methodology for changing allocation See H.B. below Explain in tables 1 and 2 notes

112 day 4 days

Begins January 1991

incl.

Project for 1991

7 days

?

Deleverage results of futures product

2 days

?

Add to management agreement

liz day

$ 300

Investment Manager Composites of Performance Results Prior-3 composites A. Composites for A Now-8 composites all accounts Find data on noncomposite accounts Create tables 1 and 2 (8x) Write footnotes Create new summary of all B. Submission of all A composites with assets by year. composites Exclude small and inappropriate composites explicitly. Offer on request. Possible excluded accounts summary. Footnote disclosure c. Inclusion of lost accounts L Covered by I.D. effective 1/91 D. Cash included L 10 years initial objective E. Historical data L Longer if practical Footnote disclosure F. Compound annual numbers L Footnote disclosure G. No partial periods L Footnote disclosure H. No bought records L or changes to compo Recalculate approximately 200 Account size weighted I. A quarterly composites Relink and annualize J. Data requirements Table 2 data 1. # of relationships L Table 2 data 2. assets under L management Table 2 data 3. average and medium L account Data missing on accounts 4. 0/0 total assets A excluded from composites 0/0 asset type Estimate composite asset value as 0/0 of comparable, of equity assets, of total assets K. Fee information L

$7,500

inc!.

7 days 8 days 1 day 1 day

incl. incl. incl. 5 days incl. incl. incl. 3-4 days

3-4 days

inc!.

41

L

L.

L

M. Statistical measures

Typical indexes

Ill. Verification of Performance Data L A. Audited L B. Not audited

Balanced composite of S&P and Shearson indexes Table 1 Calculate standard deviation and characteristic line (8x) Develop other risk measures on accounting system

1 day

1 day ?

$ 2,000$5,000

Not auditing Write statements

incl.

4 days

IV. Education of staff and professionals V.

Estimated Time and Money

Actions

Subject

SEC fee adjustment All presentations one-on-one Cannot send quarterly mailing Reprogram accounting Adjust composite results in spreadsheet to subtract actual fees in 1990 TOTAL

4 days

54 days

$10,000$20,000

v = No problem to implement. X = Will require new practices to implement. * Adapted from the AIMR Performance Presentation Standards checklist. Source: Atlanta Capital Management

that this will take seven days, but I do not know what it will cost. It could cost thousands of dollars to cover every account. This is a project for 1991. Convertible securities. The Standards require that convertible securities be consistently assigned to either equities or fixed-income and not shifted between asset classes without notice being given to clients. This is not a problem for our firm because they have always been treated and coded as equities. Comparable indexes. The Standards require that managers provide the indexes against which their submitted performance records have normally been compared. This is something that our firm does. Leveraged assets. The Standards prohibit reporting results based only on leveraged numbers. Returns must also be reported on an unleveraged basis, with the interest on the margined portion added back. We will have to try to deleverage the results of our futures product to comply with the Standards. In some cases, it is not apparent that this is possible. We estimate that it will take us at least two days to refigure historical results. I am not sure how much it will cost, in part because I do not know what problems we might encounter. 42

Performance start date. The Standards suggest that managers and new clients agree in advance on the starting date for performance calculation. Although this item is not listed separately in the checklist, I have added it because we plan to revise our investment management agreement to add this clause. This is estimated to take one-half day and cost about $300. Investment Manager Composites of Performance Results Composites for all accounts. The Standards require that managers submit a composite of all accounts managed for each period submitted and that these composites include results from any and all accounts no longer clients of the firm. We have been presenting three composites with performance shown for each year and also compounded for 5 and 10 years. These results are compared to an equity index (S&P 500), a fixed-income index (Lehman Intermediate Index), and a balanced index comprising a 60/40 weight of the equity and fixed-income indexes. We include numerous footnotes explaining how we calculated all those numbers. Because our composites now will have to cover

all accounts, separated by investment objective, we will have to present at least eight composites. In addition to our standard equity composite, we will have to have a composite for some of our large accounts that have restrictions-the less than fully discretionary accounts. A third equity composite will encompass personal accounts. We generally report a fixed-income composite. A number of our fixed-income accounts, however, are very risk averse and have shorter-term objectives. Returns on those are substantially different from returns on our more aggressive fixed-income total return accounts, so we will have to have a separate composite for each of them. Accounts that emphasize tax-free income will also need a separate composite. Finally, our balanced accounts and accounts invested in our quantitative low-risk product will have their own composites. Retrieving the amount of assets back in history and assigning these amounts to the appropriate composites over time will take several days. We estimate that 16 days will be needed to find the data and calculate the performance of each of these composites. I do not know what it will cost to do this, although I know we will encounter obstacles to overcome. If an account was restricted, for example, the records going back 10 years on asset sizes or performance are probably incomplete. We have always excluded accounts of less than $1 million, and with disclosure we still may exclude them. Submission of all composites. The Standards require that all composites be available to new prospects. Presentation of these composites according to the Standards will be a major project. To report on eight composites, with two pages for each, and three fee schedules-one each for personal, institutional, and semipassive accounts-will require considerable space in the performance section of our marketing booklet. I am considering developing a single page that summarizes all eight composites. One category could be excluded accounts, so we can provide the ones that are most appropriate and yet account for all of the assets over time. This will take one day and an unknown amount of money. Inclusion of lost accounts. The Standards require the inclusion of results of all accounts ever managed, including those of clients no longer with the firm. Atlanta Capital Management has always included all accounts managed in every period in the composites we publish. For some managers, the older historical records may be difficult to find, especially if they were restricted accounts and therefore omitted from the standard composites. Cash included. The Standards require that all performance results in the composite include cash and cash-substitute securities. If cash is included in the

performance calculation, it will be included in the composite automatically. Historical data. The composites are supposed to cover each of the past 10 years, or more if the manager has been in business longer. Retrieving our 21year history will take a lot more time and cause more difficulty than for the lO-year results. We may try initially to get just 10 years' worth of data for compound annual results, with no partial periods, no bought records, and no change in the records because of a change in personnel. I estimate that this will take five days. Compound annual numbers. The Standards require compound annualized returns for all periods. We comply and note this in the footnote. No partial periods. The Standards require a clear statement indicating that no selectivity of account performance for partial periods exists. We so note in a footnote. No bought records. The Standards require a statement that composite or other data have not been altered for reasons of personnel changes or other reasons. We so note in a footnote. Account size weighted. The Standards require that composite results be weighted for the dollars under management. Composite results presented on an unweighted basis may be presented as additional information. We have always used equal-weighted, rather than size-weighted, results for our composites. We have a few large accounts that could affect the index, but in compliance with the Standards, we will reweight our calculations. Any distortion will be disclosed. This will require relinking and annualizing about 200 quarterly composites, which we think will take about three to four days. Data requirements. The Standards require disclosure of specific data, shown in Table 2 of the Standards. This will require some effort on our part to comply with each requirement. Some data on accounts that were not part of our composite are missing and are going to be hard to find. The checklist and the Standards themselves appear to be somewhat inconsistent on the reporting of percentages. One says give the percentage of all accounts that share comparable investment guidelines, but the checklist says give the percentage of total assets under management. This is an area that the AIMR Performance Presentation Standards Implementation Committee should address. We estimate that it will take three to four days to comply with this requirement. Fee information. The Standards clearly state that fee information must be provided. We already provide our fee schedules, so this does not entail a change in policy. 43

Typical indexes. The Standards require that composites be accompanied by typical indexes against which the manager has been judged. We have been doing this for the three composites that we present; now we will have to do it for eight composites. This may be a little complicated for our balanced accounts. In fact, I am not sure that combining the results of our balanced accounts and trying to come up with a composite makes sense. In the past, we have taken a portion of equity and a portion of our fixed-income results and combined them 50/50 or 60/40 to show a representative balance. Complying with this requirement is estimated to take one day. Statistical measures. The Standards encourage the presentation of risk measures and other pertinent information for use in performance analysis. Although we currently calculate the standard deviation of our composite, we have not yet addressed other measures such as duration of bonds. That is a project for next year, and it could cost a significant amount of money. I estimate one day of work to incorporate the standard deviation into the reports, but I have no idea how much time and money will be involved to add other measures. We have budgeted $2,000 to $5,000 for this project. Verification of Performance Data Auditing. The Standards encourage audited composite and other performance figures. We do not plan to have our accounts audited. We reconcile our accounts each,month to the banks. We are very careful, and we provide a statement that the numbers are independently calculated. Additional Costs of Compliance In addition to the steps outlined in the AIMR checklist, we estimate that there will be more time and costs invested in implementation of the AIMR Standards. Education of staff and professionals. First, we will

44

incur costs associated with the education of our staff and professionals. This is estimated to require about four days. SEC fee adjustment. Second, we will incur time and costs associated with complying with the Securities and Exchange Commission (SEC) requirement for presenting performance results net of fees. Since May 27, 1990, performance results sent out in a general letter must have actual fees deducted and have a representative fee before that time deducted. Gross results can be provided in a one-on-one situation, but a letter addressed to multiple potential clients is considered advertising and must include net-of-fees performance results, unless it is a followup to a prior one-on-one meeting. We will probably develop a spreadsheet program and subtract out a representative fee before 1990 and the actual fee in 1990 and after. This approach will require constructing another 8 composites, so we will now have 16 composites in all. We estimate these adjustments will take four days and cost between $10,000 and $20,000.

Conclusion We estimate that complying with the AIMR Performance Presentation Standards and SEC requirements to the extent outlined in the AIMR checklist will take 54 days and cost $10,000 to $20,000 cash outlay to outside firms. I did not assign a cost number to employees' time, but it would be substantial. The elements that will cause the most change are (1) segregating cash, (2) creating at least eight composites, (3) gathering 10 years of history and searching out old data for all the accounts that have not been included in our composites, (4) reweighting our results by account size, and (5) generating additional measures of risk and quality for each account.

A Plan Sponsor's Perspective Dewitt F. Bowman, CFA Chief Investment Officer California Public Employees' Retirement Fund

In 1990, the California Public Employees' Retirement System (CalPERS) applied the AIMR Performance Presentation Standards in constructing a search for an investment manager. 1 AIMR had recently published these Standards and was trying to increase their use within the management community. Our situation was ideal because we could impress upon the management community that we expected them to comply with certain standards in submitting information about their performance. Doing this, however, meant revising some of the requirements contained within our request for proposal (RFP) procedure, which is not subject to easy modification. Although we did say that performance results should be submitted in conformance with the AIMR Standards, in actual practice we had to accept records that were not presented in that format because of inconsistencies in our RFP procedure and the inability of some managers to comply with the Standards.

The Search Process In this search, CalPERS was looking for domestic equity managers. Being a very large fund, we expected each of the candidate managers to have the qualifications and ability to manage amounts of $500 million or more. To assure that, we imposed some minimum qualifications on the candidates. First, the firm must be registered with the Securities and Exchange Commission (SEC) as an investment advisor and, as of July 1, 1989, must have at least $500 million under management in the category submitted for consideration. Also as of that date, the firm, or the key professionals working together, must have a three-year history of performance to be reported in accordance with the AIMR Standards. We also lThese Standards were initially set forth by the Financial Analysts Federation (FAF) in 1987 and revised in 1989. Upon the combination of the FAF and the Institute of Chartered Financial Analysts (ICFA) on January 1, 1990, AIMR assumed all further responsibility for the Standards. Throughout this presentation, they will be referred to as the AIMR Standards.

specified that the key investment professionals must have a minimum of five years' direct investment experience and that the firm must have a positive net worth. We believed that the firm should have at least one major public-fund client with assets of $1 billion or more and an account of at least $100 million in the discipline submitted for consideration. This requirement is entirely justified in hiring a manager expected to deal with at least $500 million; nevertheless, we may drop it in the future. CalPERS' minimum requirements are set forth in the Appendix. All proposers were required to submit annual performance figures on a total-return basis, in accordance with the AIMR Standards, from inception of the subject equity product compared to an appropriate benchmark. We also required monthly returns for at least a three-year period. In addition, the firms were to provide a sample portfolio as of June 30, 1989-both in hard copy and disk format. Details on the performance records required are presented in the Appendix. Most large-fund managers have to go beyond what the Standards require. Annual returns are important, but not sufficient. The way those returns are developed, the types of portfolios used in achieving them, and whether the returns are truly indicative of the style you want the manager to use are equally important considerations. Exploring those attributes is not really possible without going beyond the annual aggregate numbers. We also asked for the returns compared to the S&P 500 and then to a suitable benchmark that is indicative of the manager's particular investment style.

Results of the Search CalPERS sent out approximately 75 requests for RFPs and received responses from 40 managers. These responses were subjected to substantial analysis. Table 1 provides a summary of the performance information for large-company active-value managers. The PERS figures refer to the returns CalPERS actually experienced from managers we 45

Table 1. Domestic Equity Manager Candidates: Summary Performance Information (Large-Company Active Managers) Large-Company ActiveValue Managers

6 Months 1989

1988

1987

13.4 10.6 16.5 15.9

24.2 22.0 16.8 25.5

3.0 2.9 5.2 1.2

15.8 N.A. 18.6 N.A.

13.4 N.A. 12.0 13.7

15.1 10.6

23.7 23.1

1.0 30.3

19.7 17.7

12.5 20.0

16.4 17.0 16.5 16.4 19.8 19.1

20.5 18.7 16.8 23.1 27.7 23.2

-D.l 5.5 5.2 4.9 2.3 4.0

23.8 N.A. 18.6 24.8 15.9 34.8

10.8 N.A. 12.0 14.8 14.2 16.7

Benchmark

15.2 6.1 4.9 12.9

17.8 12.8 11.9 12.2

2.6 26.6 41.2 3.8

19.5 23.2 N.A. N.A.

11.2 14.9 N.A. N.A.

22.4 b 11.5b

SAF S&P500 S&P 500 Index

16.8 16.5

16.3 16.8

2.6 5.2

18.2 18.6

10.8 12.0

10.8 16.1

18.8 16.3 12.5 15.2

26.0 23.0 15.0 14.4

6.2 19.2 13.2 0.9

18.5 16.0 N.A. N.A.

15.6 19.2 N.A. N.A.

16.5b 11.6b

18.6 18.6 16.8 19.3 15.6 15.2 10.8 12.9

11.5 12.4 16.3 22.2 7.5 11.7 -3.6 19.7

5.0 6.9 2.6 3.6 14.4 6.9 -D.8 4.8

16.5 N.A. 18.2 21.1 14.7 22.3 33.3 22.6

9.3 10.7 10.8 13.4 11.5 10.2 -D.l 12.6

16.6 16.5 16.5

11.7 10.1 16.8

10.8 12.2 5.2

17.9 N.A. 18.6

11.8 N.A. 12.0

ManagerR ManagerS

18.0 18.0 15.9 20.4 20.0

18.3 18.3 16.8 9.2 17.6

6.5 -5.7 -11.5 8.0 5.7

25.2 N.A. N.A. 20.1 13.4

16.6 N.A. N.A. 9.5 12.4

Internal Portfolio SAF S&P500 S&P 500 Index

15.5 16.8 16.5

16.6 16.3 16.8

N.A. 18.2 18.6

N.A. 10.8 12.0

Manager A RFP PERS

S&P 500 Index ManagerB ManagerC Equity Only Total Return Manager 0 RFP PERS

S&P 500 Index ManagerE ManagerF ManagerG ManagerH Equity Only Total Return PERS c

1986

3 Years From PERS Ended Inception 6/30/90 thru 6/30/89

15.23 16.1 a

16.5b 15.4b

Large-Company ActiveGrowth Managers Manager I Equity Only Total Return PERS

Benchmarkd

ManagerJ RFP PERS

SAF S&P500 ManagerK ManagerL ManagerM ManagerN Manager 0 ManagerP RFP PERS

S&P 500 Index ManagerQ RFP PERS

Benchmarkl'

N.A. 2.6 5.2

Notes: 'First full quarter of performance, fourth quarter 1986. b First full quarter of performance, first quarter 1987. c 50% Standard & Poor's 500 + 50% Shearson Lehman Govt./Corp. d 65% Wilshire 5000 South Africa Free + 35% Salomon Broad Treasury / Agency. e First full quarter of performance, third quarter 1986. f Inception date 2/1 /87. g NYSE & AMEX South Africa Free stock universe. h First full quarter, third quarter 1987. Source:

46

California Public Employees' Retirement System

1O.6e 1O.8e

17.3a 16.1 3 12.1 f 7.8 f

h

9.4 10.8 16.1

currently employed but who were also asked to submit RFPs for contract renewals. Managers' PERS numbers tend to differ somewhat from the returns they report in their proposals. For example, Manager A reported a return of 13.4 percent for the six months ended June 30, 1989; in the account it manages for us, the actual return was 10.6 percent. The figures we actually experienced from that manager were less than the figures it reported, and that is a fairly consistent result. In this case, the discrepancy has a very logical explanation. CalPERS has South African restrictions, which made a big difference in performance in 1988. South Africanfree (SAF) funds significantly underperformed funds that were not similarly restricted. This demonstrates that these Standards must be applied with some discretion. You cannot assume that what is reported is the type of performance that will be achieved or that the situation on which the report is based is comparable to your situation. Performance is only one factor, and it accounts for no more than 20 to 25 percent of a proposer's total score. By state law, we have to weight fees at about 25 percent. After fees, style is a significant factor. CalPERS does not want all of its managers to use the same style. We want a proper spread, and to some extent, we try to work the search so that the style representations will be in accord with what we are seeking. We also want a consistent investment philosophy, a clearly defined strategy, and some indication that this strategy and philosophy are being followed in the actual management of the accounts. The only way to determine these elements is to look at the actual accounts. We commissioned Wilshire Associates to do an analysis of the characteristics of those portfolios to assure that the actual investment transactions the manager was making were consistent with the style it espoused. As part of the selection process, the board interviewed 15 of the 40 respondents. The decision about which firms to interview was based on the criteria outlined above, not just on performance. All 15 of the firms interviewed conformed with those more stringent requests. For several reasons, however, not all of them had prepared their responses strictly in accordance with the AIMR Standards. All of the firms that did not use the Standards explained why. Most believed that the Standards were not applicable to them. CalPERS always demands full disclosure. If something has been presented that does not make sense or is not consistent with what we have asked for, we will go back and ask about it. If we do not get candid answers, that counts very heavily in our

evaluation of a manager's response. I would think that a manager submitting a proposal to manage $500 million would exercise a great deal of care in the preparation of the RFP. In general, that is what happens, but I am always surprised at the lapses I find. For example, we checked the annualized figures one manager submitted and found no way to come up with the composite reported. When we asked about this, the manager said, "That was a mistake made by one of our clerks in the back office." In an RFP submitted for serious consideration, a lot of care needs to be taken.

The Standards in Practice In the process of selecting a manager, we received a lot of feedback on the AIMR Standards. The most frequent observation was that the requirement for performance figures to be capitalization-weighted is not realistic. These managers believe that weighting accounts equally provides a truer indication of what they have accomplished. Some of these firms had a few accounts substantially larger than the bulk of their accounts, and capitalization-weighting skewed the results toward those larger accounts. The other major complaint, particularly from firms that are essentially asset allocators, was that the treatment of cash is not consistent. They contended that cash should be an individual component. From my perspective, the cash component should be removed from the total to determine how well the candidates manage securities. To do this, we had to go beyond the actual figures submitted. Many of the managers chose to submit figures only for large accounts, so they arbitrarily cut off accounts of less than $500 million. I do not know whether inclusion of those smaller accounts would have reduced the performance figures. Asking about their management of large funds perhaps implied that we were only interested in the performance of those funds to the exclusion of smaller accounts. There was a fair amount of pruning or concentration on results in those areas the managers believed would be most appropriate, so the managers' performances were not presented on a totally consistent basis. In my opinion, as long as performance is fully disclosed, that type of "highlighting" is helpful. A composite of all the accounts provides a good overall measure of comparison. Making a good evaluation of managers, however, requires getting deeper into the composition of those accounts, the various restrictions they might have been under, when cash flows came in, and various other factors that can affect performance. The issue of whether returns should be pre47

sented net of fees, as the SEC is contemplating, concerns me. I do not want fees to be deducted, because we specifically negotiate fees. The fees we negotiate may be substantially different from those reflected in the manager's schedule. If the performance is reported net of fees, and the fee schedule is not reported, it is not possible to determine actual investment performance.

Conclusion Despite the limitations of reporting aggregate num-

48

bers, I believe that the AIMR Standards are very important. The industry needs standards. Managers' reported performance is almost always better than specific account performance, whether it is your own account or other accounts the same manager may be managing. The Standards do have value, and they need to be applied. At present, there is far too much variation in the way performance is reported. In future searches, we will be more consistent in requiring at least one performance figure that is in conformance with the AIMR Standards.

Appendix. CalPERS Request for Proposal: Selected Criteria A. Minimum Qualifications Respondents to the Request for Proposal must meet all of the following minimum qualifications and requirements to be given further consideration. FAILURE TO SATISFY THE FOLLOWING WILL RESULT IN THE REJECTION OF THE PROPOSAL. The firm must certify in writing that it meets all of the following minimum qualifications. Such certification must include evidence of how each qualification is met and must be signed by an authorized member of your firm. 1.

2.

3.

4.

5. 6. 7. 8.

The firm just be an SEC-registered investment advisor or provide an explanation for the nature of an exempt from registration (Form ADV is required to be submitted). As of July 1, 1989, the firm must have at least $500 million under management in the category submitted for consideration. Qualifying management experience is defined as actual portfolio management of equity securities for institutional clients. As of July 1, 1989, the firm or the key professionals working together, must have a three-year history of performance (to be reported in accordance with the AIMR Performance Presentation Standards of August 2,1990) on an actually managed, live portfolio managed in accordance with the proposed product. (Simulated results are not acceptable.) As of July 1, 1989, the key investment professionals of the firm must have a minimum of five years' direct investment experience. The professionals who meet this requirement must be identified and permission granted to check backgrounds. Provide references for verification. As of July 1, 1989, the firm must have a positive net worth. The firm must have at least one major public fund client (state, major city, or major county with assets larger than $1 billion) with an account of at least $100 million in the discipline submitted for consideration. The contracting firm must be directly responsible for managing the assets of the account. The firm's discipline and portfolio development must be able to accommodate a restriction against investment in securities of companies with investment in South Africa as reported by the Investors Responsibility Research Center (IRRC).

B. Performance All proposers are required to fill out the performance section. 1.

Provide annual performance on a total return basis in accordance with AIMR Standards from inception of the subject equity product compared to an appropriate benchmark (for US. tax-exempt accounts). Please provide (1) three years of monthly returns on a composite account and (2) a sample portfolio as of 6/30/89, both in hard copy and on an IBM PC compatible diskette. The format is month, year returns for the returns data and the format requirements are CUSIP number, stock name, number of shares, market value for the sample portfolio.

6 months 1989 1988 Return S&P 500 Index Passive Benchrnark*

1987

1985

1986

1983

1984

1982

1981

1979

1980

1978

1977

1976

% %

% %

% %

% %

% %

% %

% %

% %

% %

% %

% %

% %

% %

% %

%

%

%

%

%

%

%

%

%

%

%

%

%

%

*Please Specify:

3 Years Ended 6/30/89 Return S&PSOO Benchmark*

5 Years Ended 12/31/88

3 Years Ended 12/31/88 % % %

% % %

10 Years

Ended 12/31/88 % % %

% % %

49

Appendix. CalPERS Request for Proposal: Selected Criteria (Continued) 2. 3.

4.

Describe causes for investment return deviation (both positive and negative) from benchmark by year. Be detailed and specific. Describe how investment returns in question B(l) were calculated (be detailed and specific). Indicate which accounts were included (i.e., one representative account, equal weighting of public fund accounts, etc.). What was the pricing source for securities used? Indicate whether a trade-date or settlement-date basis was used. For actively managed product only, please provide the highest and lowest return contained in the composite in question B(l) for each year. Comment year by year as to the cause of the return dispersion. 6 months

1989 Highest Return Lowest Return Difference 5.

1987

1988 % % %

% % %

% % %

% % %

% % %

1983 % % %

1981

1982 % % %

% % %

1979

1980

% % %

% % %

1977

1978 % % %

% % %

Are performance returns independently audited or verified? If so, how? By whom? Be specific.

Source: California Public Employees' Retirement System

50

1984

1985

1986

1976 % % %

% % %

A Consultant's Perspective

l

Ronald D. Peyton President & Chief Executive Officer Callan Associates

The AIMR Performance Presentation Standards represent the culmination of a great deal of thought and analysis that attempts to combine ethical ideals with practical implementation. The need for this selfregulation has risen from the unfortunate actions of a few investment practitioners. To quote the AIMR Committee for Performance Presentation Standards, "If the investing public is to be treated fairly, and if the investment management industry is to represent the highest ethical and moral standards, a fair and understandable policy should be followed." Callan Associates, as a consultant and advisor, seeks to protect clients from misrepresentation and therefore endorses the AIMR Standards. Consultants are a prime beneficiary of the AIMR Standards because we must explain these numbers to our clients. Setting these Standards is very much like setting a target for performance. We can measure the variations from the Standards, and in the process of defining them we can evaluate whether they are appropriate variations. This provides a real advantage in understanding composites. Callan Associates realizes that implementation of the AIMR principles can be difficult, time consuming, and sometimes impossible if the historical information required is not available. We are sensitive to the concerns of money managers and therefore we in no way discriminate against any organization that provides us with performance information based on alternative standards. Because we employ an honor system, full disclosure is key. Qualified firms are included in Callan searches without bias as to whether they use the Standards. Noncompliance with the Standards will be disclosed, however, and judgments on appropriateness will be made.

Collecting and Validating Information For decision makers, the process of collecting and l Mr. Peyton extends his appreciation to his colleagues, Ava C. Williams, CFA, and Barry W. Dennis, for their contributions to this presentation. Mr. Dennis spoke at the March 19th seminar and his question and answer session is included herein.

validating information is very important. Our manager search and review process begins with an annual questionnaire to managers asking for their performance history. New manager applicants for our database get a much broader questionnaire intended to gather historical information. Included in our request is a copy of the AIMR Performance Presentation Standards. These standards are also described to each manager when Callan first contacts them to request information for inclusion in our data base. As part of our questionnaire, we have created a system called a "performance summary," which focuses specifically on the performance composite and is used to validate the numbers. The summary requests information pertaining to (1) the sector allocation of the composite, (2) the performance calculation methodology, (3) the existence of simulated data, (4) the people behind the track record, (5) survivor bias, and (6) the nature of the returns. To confirm that the composite is reasonable, we ask managers to disclose information on the sector allocations of the composites. With equities, for example, we inquire as to the percentage holdings in common stock, preferred stock, convertible bonds, bonds and mortgage-backed securities, cash and cash equivalents, and "other." This gives us an indication as to whether the composite truly represents equity management (versus balanced) and if the composite includes cash. We also ask managers to define their performance calculation methodology so we know how they treat fees, transaction costs, cash equivalents, and whether the composite is dollar-weighted or average-weighted. We specify that the composite should be quarterly, time-weighted rates of returns that include cash, and the composite should be gross of fees. To check for this, we ask that for each set of returns the organization specify if the performance is net of fees, if it is net of transaction costs, if it excludes cash equivalents, and if the composite is dollarweighted. Managers are asked to explain returns that are not in the requested format. Another important item to confirm is the existence of simulated data. Sometimes this is difficult to

51

verify because of confusion about which numbers are simulated, which are actual, which are based on $1 million portfolios, and which are based on significant assets. The Standards require that composites not be changed to reflect changes in personnel or accounts. Therefore, we ask organizations to specify if the returns represent the current portfolio manager's performance record while with the firm or if they represent the manager's past track record while with another firm. Similarly, we ask if the returns reflect the performance records of portfolio managers who are no longer with the firm. The new portfolio managers in a firm should not include their prior records, and managers who leave the firm should exclude their records. Similarly, returns for clients that fired the firm must be retained in the firm's composite. The nature of the returns is also important. Organizations must specify if the returns represent a composite, an individual account, a commingled fund, or a mutual fund.

Uses of the Information Dealing with the information collected through the questionnaires presents a large data-management problem. The amount of information provided by investment management firms can be overwhelming; each firm often submits more than one composite. Callan has 2,924 funds in our total data base for manager-search purposes, representing 860 firms, or about 4 composites per firm. Sixty-six of the composites are for only three firms-Chancellor, Loomis Sayles, and T. Rowe Price-and these composites exclude their mutual funds. To control the proliferation of records, Callan requests that each organization provide a single proxy per product. Specific information within the performance summary helps to determine the suitability of the composite. For example, managers are specifically asked whether the composite should be used in the manager-search process. We classify managers by style. Each manager is asked to identify which style of management best describes their process. A style is assigned to each product on the basis of philosophies and strategies, the information provided in the performance summary, and meetings with portfolio managers or marketing representatives. In defining those styles, we use various quantitative routines and a clustering analysis, and we also look at portfolio characteristics. We examine each manager's sales literature and then ask our consultants what they think the managers 52

do. If we think the manager is one thing, and the manager claims to be something else, that manager is not classified. Consequently, only about 53 percent of our data base is classified by style; nevertheless, we consider style classification to be very important. Callan utilizes style groups to organize the available candidates for each search. Our initial "cut" is not based on performance; it is based on investment styles. Mindless screening of quantitative information will keep generating the same managers-those with the best track record-so the first screen should be the client's job description. The client is interested in a style grouping of candidates-for equity, bond, or international managers-to fit their management structure. It is very useful to isolate that portion of the data base that reflects the style the client is looking for, unbiased by who is performing best at this period of time. Managers who do not fit in specific style categories are looked at in general groupsgrowth-oriented, yield-oriented, core-and they, too, are included in the initial screenings, so no one is eliminated. The next step is exercising our due diligence to validate the information. The general questionnaire is used as background, but we do not release numbers on any specific firm unless we are engaged in a search for a specific client. Then, those numbers are reconfirmed by direct contact with the managers. The questionnaire-generated data are fine for use as the initial screening point for a manager search, but not for the final phases. In a serious search, each of those numbers and each of the answers to our questions are validated by telephone. This is an important, practical step. If we send our clients a documented report showing a manager's numbers, with footnotes on how the manager deviated from the Standards, and the manager makes a final presentation with a different set of numbers, we look foolish. Sometimes we learn something new by making the calls. This approach relies on an honor system, of course, whereby managers fully disclose any practices that do not meet AIMR Performance Presentation Standards; we have to believe what the managers say. With most managers, merely continuing to ask the right questions provides the information needed to ascertain whether they are in compliance. Other ways can be used to discover whether managers have made full disclosure of their performance. We make great use of confidence-interval graphs in looking at returns of managers. Confidence-interval testing is a useful indicator of the percentage of time a given manager is likely to outperform a benchmark during any given period. This information can be used to compare and contrast

managers. Figure 1 shows the cumulative performance of four managers (A through 0, respectively) relative to a target baseline or goal. The target baseline can be anything; in this case, it happens to be a style-group composite of all managers that are supposedly similar. The baseline eliminates timeperiod bias in a manager's cumulative returns. This particular baseline begins in 1982; to examine what happened since 1986, this baseline could be moved up or down by use of a transparent ruler to review different inception dates. The confidence graphs illustrate a number of issues. In Figure 1, Manager A is shown to have achieved relatively good performance, but with significant volatility. Manager B had relatively good performance, but with significant volatility. Manager C experienced extremely poor relative performance relative to a peer group. Manager D's performance indicates a need for Callan to contact the firm about possible organizational changes or personnel turnover because of the recent dramatic decline in cumulative returns. The decline indicates significant negative performance in recent periods. As it turns out, Manager 0 went through an organizational change during which several key people left the firm, and about that time, relative performance fell apart. Investment management is one of the most fragile business enterprises in existence. It can work with the synergy of a selected group of people operating under the right environment for a good period of time, but changes can make relative performance decline. Measuring performance relative to some base reveals these problems so that something may be done about them. They are not always obvious in the absolute returns. Figure 2, which illustrates Manager E's experience, is an example of why we do not like simulated data. The first half of that investment performance is simulated and the other half is actual returns. Note the dramatic decline in relative returns with a real portfolio. One very special use of these graphs is to make that composite or target baseline the composite of a manager's product. In other words, we use the composites that managers provide us and measure the live performance of clients who are supposed to be receiving that same kind of approach or objective measure. We compare the cumulative variation of those clients with the composite. This would highlight dispersion of returns across accounts. One must be careful, however, not to compare accounts with different objectives or restrictions. Cumulative variation can differ from a firm's composite for many reasons. Cumulative variation is very useful in understanding the composite, however. For example,

is it the wrong composite? Did a client's constraint affect the portfolio? Does the variation reflect the quality of the disciplines of the individual investment managers?

Work to Be Done The AIMR Performance Presentation Standards are an important step, but they do not address all of the problem areas. There is work to be done in many areas-options, private placements, and short selling, for example. Other areas that need work include real estate, balanced accounts, cash management, and international. Real Estate The real estate industry is rapidly moving toward establishing some performance presentation standards, but it has a long way to go. Our performance measurement approach in the real estate area requires collecting data on each property our clients hold. We have identified several areas that should be addressed, including a reconciliation or audit program to make sure the data supplied are what we requested, that the data balance, and that the return is treated like an investment return and not a property return. Real estate managers report returns broken down by capital or appraisal appreciation and cash. A good percentage of that calculated cash yield, however, is reserved for tenant improvements and capital expenditures. From an investor's perspective, that is not a cash return. So, part of the calculation procedure we would like to see is to report just the cash returned to the investor. That makes sense from a real estate perspective, but not necessarily from the perspective of the Standards for domestic stock and bond management. Balanced Accounts The most controversial aspects of the AIMR Performance Presentation Standards are the guidelines for balanced accounts. The allocation of cash between components is often not in line with the Standards. Using the example of a two-asset portfolio of stocks and bonds, the Standards require that cash be separated into two "pots," one for the fixed-income portion and one for the equity portion. We discover violations of this when a manager breaks its balanced returns into an equity composite and a fixed-income composite. Sometimes, the fixed-income portion will contain all of the cash. In other instances, the cash is double-counted and appears in both sets of returns or is not counted at all. Composite "creation" methods that do not comply with the AIMR Standards are another area where we find violations of the Standards. For example, we 53

Figure 1. Cumulative Performance Relative to Target Equity Rising and Declining Periods Manager A

=

T Cumulative Manager Effect In +60::.:

%

:I

: MANAGER A

: - - - - MANAGER A

+50

ManagerB

:: ---- 10% go" Upper Confidtnte Low« CcaMtna:

,~

+40

I' I' V

,

.

,"

+30

,-J

+20

---'... +10

-10

\

\,

-20

.........

-30

........

o

-40 Rlsin.

I I 1982

Rlsin,

0ecIn1n,

I I I 1983

I I I 1984

1985

1986

RlslnS

1981

I

Ded

f--.L!===-'-=="--L_-l__.L-'i:l~~~L··_··_··_···~·_··'::··::···"'··L...J«;8 Rlslns

1988

198

OecJlninl

1981

Risin,

1982

Decli:dnl

1983

Rlslne

1984

ManagerC or

Cumulative Manager Effect in

+60

=«'

+50

MANAGER C - - - - MANAGER C - - - - 90% Upper Confidence -----._- 10% lower Confidence

or

%

m::r.»:': +60

:~~ ••••••••

10% Lower

+20 +20

~~.:.~:r ~·: . r:~. r :~. ~: . ~: .:~

+10

..

:::::::. ::::::::

:.~

Il tt:::: :t:: \. \ :f: ..: :. :!:::.:':;: <:-:: ::f

-II

-10

·30

: :l:. : :. .:.

I I I 1990

.~.~.~ '~ .~.~.

\

::

I

-,

I:::: •.

'~. '.:~ .:~ .: ~. ':

..

I~

. ..i..·;:;.

Conflden~ I

IIII, rt jt~~~/ . . ..

....

--,,,- ...

-,......... , ,,'-'

,

, .........

,, ,,

RO"

..........

-20

..........

III ::: .....-....

1:."""'0"""';';;<""',"'--:RJ="",,:-.-""0"',,,'•• ;';"',"--'---:'RJ7,,,,-,-'----':0"--...lRJ::-.:-,,-'---':09 1981

I I I 1982

K

'I' 1983

I I I 1984

Source: Callan Associates

54

::

:::::::. ::::::::

o'";d

I' I 1989

;F~N~::=::I

+30

:!::..:l.::: .. :..:.!

Rlslns

Cumulative Manager Effect in %

+40

:~:~.: :~.•

0

'I'"1988

"" 1986 1981

ManagerD

+40

')j .: : : : :. :j : : .:!..::

I I 1985

I I I 1985

'I' 1986

" I II I I 1981 1988

I 1989

1990

,

II 1981

II I 1982

II I 1983

I I I 1984

III 1985

II' 1986

11'111 I 1981 1988

II 1989

1990

Figure 2. Cumulative Performance Relative to Target Equity Rising and Declining Periods (Simulated) ManagerE

'" =

MANAGER E

%

I ... '

- - - - SIMULATED; MANAGER E

+50

- - - -

110% Upper Confldmte

"

""

==

Cumulative Manager Effect in

+60

\'"

:II ' ~~~~jlj~~~jj j~;;;~j

~i:J.1~:

" I

,l

••_-_•• - 10% lower Confidence

,

"

!~!j!~!1 :l:j!~! ,"

:1:1..:1.

.

\ ~~

\~~j~~

J

.... ~ . ~1j

1\-- -"" 1:1:1.::1

.

III

TOirlet

Buellne

-10

--11-----

-20

Illllllllilllllllll~

-30 -40

LIVE

.1 ml .:.

D"'=r""'f'rn"TRlr""r'rTT"TTTT-TTT-j'R1=r""T-'r rrTTi FR'n"-rD::;:"':::r""T-',R1n"":::;'--rr I I I I I I I I I I I I I I I I II I II 8

1981

1982

1983

1984

1985

the Standards if the firm does not have the necessary historical documentation to recompute the returns or if they have an unusual management process. Cash Management We perform a lot of cash-manager searches. No other area of investment management has more potential for abuse and misleading numbers. The precise guidelines make a big difference to those working in cash management on the steep part of the yield curve. The quality and maturity guidelines are important. The ability to go to two-year instruments as part of the portfolio, rather than a maximum of one-year or shorter assets, makes a big difference in the rate of return that is achievable in any market environment. In a recent cash-manager search, we identified six different methods of calculating the returns: mark-to-market, straight yields, the Bank Administration Institute (BAD method, internal rates of return, net asset value methodology for mutual and commingled funds, and amortized cost. For example, returns based on the mark-to-market concept, in which average balances are priced daily, might be calculated as follows:

1986

1987

1988

1989

Return for eriod = Accrued interesl+/-Unrealized gains or losses. P Average daily balances

1990

Source: Callan Associates

encountered a manager who presented questionable equity returns and compounded the problem by choosing an arbitrary equity / fixed-income ratio. The footnotes from the investment manager explain that: The Expanded Value equity only and equity plus cash results for 1983 to 1987 are the actual performance of the 10 largest holdings of five underlying equity managers. Results for 1988 and subsequent periods are Manager XYZ's portfolio performance based on the product strategy. The Expanded Value balanced performance prior to 1989 is 65 percent the firm's Expanded Value equity product and 35 percent the shortto intermediate-term fixed-income product. The balanced results for 1989 and subsequent periods are Manager XYZ's portfolio performance. This is an excellent example of the honor system and full disclosure. This information was supplied in the performance summary and discovered in our due-diligence process. It may also illustrate the problems money managers may have in complying with

A yield calculation in which values are based on book is as follows: M

on

thl

_ Accrued interest + Capital gains Book value

t

y re urn -

In this case, a manager was using bonds up to five years in maturity. What relevance is yield in this situation? Amortized cost, in which average daily investment is at book value, is another way of calculating returns: Annualized return

=

(365 x Amortized book +/- Realized gains or losses) ( Number of days in period ) Average daily investment

None of the above calculations take into account the cash flows into and out of the portfolio. Our concern in this area is twofold: (1) how are cash flows being accounted for, and (2) what is the validity of a "yield-type" calculation when portfolios can hold securities with maturities as long as five years? Securities that have maturities of less than one year are held at par, so there is no need to mark to market. For portfolios that only hold securities with maturities up to two years, one could argue that the amortized cost methodology produces returns that are fairly close to those arrived at by marking to market. But in the realm of cash equivalents, 10 to 20 55

basis points of uncertainty because of the performance calculation may be unacceptable with the narrow dispersion of returns. We have not come to any conclusions, but feel that this is an area that merits attention. International Balanced-account evaluations are difficult, but evaluating global accounts with country allocations is even more so. Callan's international department has adopted the same Standards that are applied to domestic managers. Information is collected in a similar fashion. We prefer composites that represent the performance of U.S.-based clients because of the problems of currency exchanges and comparability. We do not feel the notion of allocating cash to country portfolios applies as it does to a domestic balanced account. We are currently working on a recommendation to AIMR on this subject. In general, the performance problems are the same on an international basis as they are in the United States. The key to this process is the validation of information and open communication with investment firms regarding questions or concerns. Any noncompliance with AIMR Performance Presentation Standards is disclosed to clients.

Conclusion For Callan Associates, the AIMR Performance Pre-

56

sentation Standards have been extremely useful. They set a foundation that helps us to protect clients from misleading and incorrect information. They have given us a benchmark against which to measure returns. We recognize, however, that not all managers are able to comply with the Standards at this time. Because of this, we stress the need for full disclosure via an honor system. Noncompliance is disclosed to clients by the appropriate footnoting of all information presented to them. All of our clients benefit from standardized performance presentation because they get answers to questions they normally might not have asked. Having standards of measurement should be a boon to our industry because sponsors can obtain a higher quality of factual information for decision making from consultants. The negative side for the consulting industry is that compliance is very expensive, time consuming, and complicated. Staff time must be devoted to going over the questionnaires and validating the information. When managers visit us, the first thing we do is validate the returns and composites on our data base to find out if they are correct. Dealing with 3,000 composites leaves much room for error, and that number is going to grow. Supporting investment decisions through a process of defined standards takes a lot of people and money, which must be underwritten with adequate consulting revenues.

A Fixed-Income Manager's Perspective John H. Watts Chairman Fischer Francis Trees & Watts, Inc.

Our firm is very much in favor of standards for performance reporting. We believe that sensible standards can greatly facilitate the evaluation of existing managers and the selection of prospective managers. The proposed AIMR Standards are an important step in this direction. In our view, however, these Standards need to be extended in some specific ways to be genuinely useful when applied to fixed -income portfolios.

Extension of the Standards Four additional standards or practices could make reported bond results more meaningful. The need for these additions stems from the unique nature of fixed-income assets and from current trends in managing large fixed-income portfolios. The four practices we suggest are as follows: 1. Measure results over market cycles. 2. State risk explicitly. 3. Compare results with clients' benchmarks. 4. Restrict composites to funds with similar benchmarks and guidelines. As a fixed-income specialist, our firm finds that institutional clients increasingly set very specific purposes for their bond portfolios. Portfolios are designed to offset certain liabilities, to diversify results from other assets, to keep a fund within specific risk tolerances, to hedge against deflation or inflation, or to produce results relative to a given currency. Because of these very different objectives, our clients specify a widely diverse set of benchmarks and guidelines. Although we apply the same investment process to these disparate assignments, the various benchmarks and guidelines do exactly what they are designed to do: produce results that differ as widely as do the benchmarks and guidelines that underlie them. In contrast, an equity, real estate, or convertible bond specialist usually has one or a few "products" that fall within accepted categories of quite similar

portfolios. Hence, standards for reporting their results can be simpler. The problem is that a fullspectrum, global fixed-income manager, such as our firm, even if concentrated only in high-grade securities, has dozens of distinctly different types of portfolios. Consequently, for such a firm to present results in a meaningful way is a formidable challenge. We believe the four additional steps I will discuss would help meet this challenge. Measure Results over Market Cycles Results are often analyzed, for either comparison or evaluation purposes, over an arbitrarily specified number of years. The period we see used most often is five years. Particularly for fixed-income portfolios, an arbitrarily chosen period can lead to an unintended, if not perverse, conclusion. For example, if a five-year reporting period happens to fall within a bull market, a manager that has a long-term bond bias will look strong, and vice versa. Imagine a firm that, when its outlook on rates is neutral, tends to favor a combination of cash and longer-term bonds with a bond market beta of about 1.3. This is by no means unusual behavior. Now imagine another, more cautious firm that, when neutral, retreats to cash and intermediates with a beta of 0.7. Again, not an unusual behavior pattern. Assume that both managers have a neutral view of the market 30 percent of the time-not atypical-and that their neutral positions are randomly distributed. Both are equally capable and over a market cycle will produce the same value-added-l percent annually in excess of a broad market benchmark. The performance results for these two firms will differ depending on which five-year period is used for the calculation. Table 1 shows the value added over an aggregate bond market benchmark for these two managers in three recent five-year periods. These equally capable managers, with equal results over a rate cycle, nevertheless appear to have very different records during these particular five-year periods, purely because the time periods chosen were not "rate cycles," that is, periods in which rates 57

Table 1. Value-Added over Bond Market Benchmark, by Equally Capable Managers, over Five-Year Periods (in Basis Points) December to December

Bullish-Bias Manager

Bearish-Bias Manager

1985-90 1980-85 1975-80

117 119 46

83 81 154

Source: Fischer Francis Trees & Watts, Inc.

begin and end at the same point. Spread trends can similarly influence apparent results unless they are analyzed in the light of the "spread cycle." For example, from the beginning of 1980 to the end of 1985, Government National Mortgage Association (Ginnie Mae) spreads over Treasuries narrowed from about 250 basis points to less than 100 basis points. Managers that heavily favored Ginnie Maes got well over a 1 percent per annum return lift from those holdings during that period. In the subsequent five years, however, those that stuck with heavy Ginnie Mae commitments had a negative annual return of about 35 basis points on that part of their portfolios because of increased Ginnie Mae spreads. A manager's tendency to overweight a particular sector calls for a look at the spread history during the measurement period. In general, return on fixed-income portfolios in any particular period, as well as the value-added from active management, are heavily influenced, if not dominated, by price change. Unless the period is a cycle with rates or spreads beginning and ending at the same level, results will be biased by price trends. Projecting that a price or spread trend will continue indefinitely is not reasonable. Therefore, using a time period other than a cycle to evaluate fixed-income results, or to project future results, is likely to lead to surprises. Doing a proper, portfolio-theory-based analysis of results-with alphas, betas, and sigmas-will unmask much of the effect of duration bias during a trend in rates, though not a spread trend. Until application of such measurements is more widespread, however, evaluating results over a market cycle and inspecting for effects of spread trends is the safer course. It may not be AIMR's business to specify periods for fixed-income measurement. If all the data are there, a sponsor should be able to puzzle out the effects of rate and spread trends. Nevertheless, at the minimum, AIMR Performance Presentation Standards should not imply that 5, 10, or any other 58

specific number of years is the appropriate measurement period. State Risk Explicitly For bond and money market portfolios, risk measures should be explicitly stated rather than just "encouraged," as the Standards put it. Risk is of central importance to fixed-income results. The purpose of fixed-income assets in many portfolios is to reduce or control risk. Risk correlates very closely with bond returns, positive or negative, in most periods. Fixed-income portfolios can operate over a broader spectrum of risk than is common in equity portfolios of similar investment style. For the latter, betas generally lie will within plus or minus 15 percent of the average. In contrast, we manage a number of fixed-income portfolios with benchmarks having a beta or duration 80 percent below or 60 percent above the aggregate bond market. The risk, as well as the return, of such varied portfolios differ widely and should be measured. Also, in fixed-income management, decision risk, or the return volatility introduced by active management, typically is a larger proportion of overall volatility and calls for examination. If risk is not measured, an evaluation of fixed-income results misses a central piece of evidence in answering the question, How likely are these results to be experienced in the future? How should risk be measured? The measures we find are effective include return volatility compared to that of the benchmark and perhaps to that of other relevant market indexes. Separating return volatility (as well as value-added) into bull and bear market periods yields further valuable insights. Plots of total return and return volatility for all accounts, compared to return and risk for their benchmarks over all periods, are the best way to understand the signature of a firm's management process. Report Results Compared with Clients' Benchmarks Twenty years ago, almost all fixed-income portfolios used as their benchmark the Salomon Corporate Bond Index, which was predominantly longterm utility bonds. Today's situation is dramatically different. The majority of our clients have developed tailored benchmarks appropriate for their specific objectives. Benchmarks are the essential vehicle by which a client specifies what a portfolio is expected, on average, to accomplish in order to fulfill its purpose. Because portfolio purposes differ, benchmarks differ. For example, our clients' benchmarks have bond market betas ranging from 0.2 to 1.6, and the components of their benchmarks differ widely. As a direct consequence, results vary widely as well, even

though our value-added, compared to benchmark, is quite comparable across divergent portfolios. A clear example of the need to specify the benchmark is evident in short-term securities. Among the "cash" portfolios we manage, a large percentage have as benchmarks either the threemonth, the six-month, or the one-year Treasury bill. Current industry practice is to lump all these very different portfolios together into a "cash composite." Figure 1 shows a risk/ return plot of U.s. Treasuries over a market cycle from January 1979 through December 1988. Returns on these benchmarks over a market cycle have varied by almost 1 percent per annum. As a consequence, portfolio returns with benchmarks of those maturities have varied similarly, in spite of the fact that the value-added is essentially the same across the portfolios. Figure 1. Return and Risk, Treasury Securities (Interest Rate Cycle: 1/79-12/88) 11.4.-------------------, 11.2 11.0 10.8

30 yr. 7 yr. 10 yr.

10.6

E ~ lOA

J1=.E 10.2 u

] g

o " £-<:$

6 mo.

10.0 9.8 9.6

904 9.2 9.0 8.8-t---r--,--,....---,....---r-----,----,----i 4 6 8 10 12 14 16 o 2 Risk (Standard Deviation of Return, Annual Percent)

Source: Fischer Francis Trees & Watts, Inc.

Our longer-term clients' benchmarks also vary widely. Some are 100 percent corporate bonds, mortgages, or Treasuries. Again, the absolute returns of these portfolios vary widely even when our valueadded over their benchmark is consistent. Obviously, such portfolios should not be stirred into a composite described as "long-intermediate" or "broad market." The way to represent most accurately what either a short-term or a long-term portfolio's return means is to specify the client's benchmark for each and to present benchmark returns alongside portfolio returns. Restrict Composites to Funds with Similar Benchmarks and Guidelines If one group of clients uses the six-month Treasury bill as their benchmark and if another uses the Lehman Aggregate Bond Index, why not com-

bine them into a composite? The answer is that many fixed-income portfolios with the same benchmark have guidelines that allow different techniques and markets, which in turn lead to differences in results as great as if the portfolios had very different benchmarks. For example, among our client portfolios that share a six-month Treasury bill benchmark, some use leverage, some permit nondollar assets, and some use futures and options. That group of portfolios is also subject to maximum limits on average maturities ranging from 12 months to five years. Some can go net short. Clearly, these should not all be in the same composite. Similar differences occur increasingly in longerterm bond portfolios. Sharing the Lehman Aggregate benchmark, for example, are portfolios we manage that mayor may not use leverage, options, or nondollar securities, hedged or unhedged. One subset of our clients has explicitly directed us to expand our "decision" risk taking, boosting the amount by which we otherwise would shift duration or shift allocation to maturities or issuers from that of the benchmark. In contrast, others limit the scope for decision risk with"collars," for example, holding duration to plus or minus one year from that of the index. Even more complicated are "active dedicated" portfolios, with guidelines that limit the risk of mismatching the duration and hence the cost of a specified set of liabilities. If our experience is typical, the trend is for increased tailoring of guidelines within groups of portfolios that have common benchmarks. Results on these portfolios should-and dodiffer by a percent or more in many five-year periods, although the investment process applied to each is parallel and our value-added is proportional to their allowable range of market exposure. For composites, then, the rule should be to group portfolios that not only have common benchmarks but also have comparable guidelines. Others should be presented separately, with their guidelines dearly specified.

Conclusion The four proposals I have outlined begin to take account of the special challenge in reporting and evaluating fixed-income returns. Of course, adopting these proposals will not solve all reporting problems for fixed-income managers, but it is our firm's belief that the four, taken together, can advance AIMR's effort. They help to account more realistically for the broad array of fixed-income portfolios that are being designed to clients' increas59

ingly complex needs. Establishing standards is an ongoing effort. Sufficient issues remain to occupy several more conferences. Other areas for improvement, particularly relating but not confined to fixed-income management, include the following. • Presentation of the currency impact on returns. Our belief and practice is that the currency impact of nondollar securities should be presented separately. AIMR can usefully get out in front on this important issue by addressing reporting of currency impact. • Survivorship. Just as the universe of a given

60

•

manager's returns is incomplete without the record for former clients, so the universe of investment managers is biased when the firms who no longer exist are dropped. Composites of managers' returns should include all firms that were active during the measurement period. Use of leverage. At least for fixed-income portfolios, more thought and arguably a different approach from that suggested in the draft standards needs to be applied to portfolios that use leverage. Standards are needed for those that can go short as well as long.

A Multiasset Manager's Perspective Robert G. Wade, Jr. President and Chairman of the Board Chancellor Capital Management, Inc.

Chancellor Capital Management is a relatively large organization, with about $20 billion in assets under management. We have more than 500 separate accounts categorized in four major product groups: traditional equity, traditional fixed-income, investment technology, and venture capital. The size of the organization compounds the problems in complying with the AIMR Performance Presentation Standards. On the other hand, because we are a large organization, we have sophisticated data processing systems, so we are able to comply technically with the Standards. On a conceptual basis, we have some concerns about the Standards, which I will discuss in this presentation.

Allocation of Cash in Balanced Accounts The Standards require firms to divide cash between equity and fixed-income sectors of balanced accounts. There are several problems with this concept. The major problem is that it is not easy to determine where the cash belongs. I have participated in many strategy sessions in which much of the meeting was spent arguing about whose cash it was, fixed-income or equity. Compliance with the Standards is difficult if you cannot determine internally where the cash belongs. A second problem is that allocation of cash to the fixed-income or equity sectors of a balanced account does not make sense if the firm is practicing tactical asset allocation. In a balanced management environment, we pay a great deal of attention to asset allocation, and we treat cash as a separate asset class. At the present time, in showing the components of balanced performance, we would show fixed-income, equity, and cash. Within the fixed-income sector, of course, cash does playa significant role in duration, but we do have cash that belongs neither to the equity nor to the fixed-income group. It is an asset class of its own. This will cause a problem in trying to meet the requirement to break cash into equity and fixed-income portions. Finally, not many accounts are balanced ac-

counts anymore. The movement of the industry has been toward more-specialized managers. In this environment, the allocation of cash is not a critical decision.

Composites The Standards state that all client accounts should be included for whatever period such accounts were under management. Managers are encouraged to construct separate composites if valid reasons exist for doing so. These types of composites may be misleading, however. I am suspicious of composites, particularly for an organization as large as ours. The more accounts that are brought into a composite, the less it means. We have nine composites, because we have a great variety of products. We are a growthbiased manager in the equity area, so our major composite is growth equity. We also have value products (Value Fund, Real Estate Stock Fund) that are managed separately. The recommendation to show performance for 20 years, if practical, or since inception, may not provide valuable information, in my opinion. Our firm has a long history, and I am not sure how useful data going that far back will be. Results of 15 years ago may be particularly meaningful to the people who are presently managing the firm's assets, but the 5- and lO-year history is probably of much greater interest to most prospective clients.

Performance Net of Fees The AIMR Standards require the presentation of total returns before fees, so long as the manager's fee schedule is included. The Securities and Exchange Commission (SEC) requires the presentation of returns on a net-of-fees basis, except for one-on-one presentations. We have a problem with the SEC's requirement to present performance results net of fees. AIMR provides a basis for showing performance and describes how to do it, but the SEC only

61

states what it wants. AIMR's method is the more useful of the two because it shows actual performance, which any client or prospect can then adjust by applying the relevant fee schedules. We hope the SEC will modify its position. The one-on-one aspect of making presentations to a prospect or a client is straightforward, but at this point, the SEC views the performance numbers we send to consultants as advertising. 1 The consultants are asking how we arrive at these performance results net of fees, and we confess that at the moment we do not know the answer. Fee schedules can vary greatly. We now have a standard fee schedule, but prior to that, arrangements were entered into with some organizations that resulted in very favorable fees. We have spent a great deal of time in the past couple of years ensuring that every client has been brought up to the standard fee schedule. Nevertheless, in an account with assets well beyond $100 million, considerable variation in the fees can result. Some discounts from a standard fee schedule are legitimate. Also, the fee should bear some relationship to the total amount of activity the manager is going to undertake. Another aspect of the net-of-fees problem is how to account for performance fees. We are increasingly asked about performance fees, and the number of accounts that are on a performance-fee basis is increasing. We were among the first to tell the SEC that we think performance fees make a certain amount of sense for sophisticated clients, particularly public funds. The problem is how to incorporate potential

lSee Ms. Podesta's presentation (pp. 19-26) for a discussion of this issue.

62

performance fees into a set of performance figures net after fees.

Ensuring Compliance I believe performance numbers should be audited to ensure compliance. We should develop a central depository where performance figures in accordance with the Standards are put into a data base so they may be readily accessed, particularly by consultants. Managers spend a great deal of time responding to consultants' questionnaires. The information consultants require differs somewhat from one to the next, however, so a central depository of numbers could be a great labor-saving device for the industry as a whole. This central utility would also ensure compliance with the Standards. It would force all of the participants to enter their numbers in conformity with the Standards, and those who failed to do so would have to explain why. Managers, consultants, and possibly sponsors should be happy to help underwrite such an institution.

Conclusion The Performance Presentation Standards are long overdue. They may not need to be quite as complicated as we are making them, but having some Standards and ensuring compliance with them is essential to restore respect for the numbers this industry is generating.

A Bank Trust Department's Perspective Mary E. McFadden, CFA Vice President, Pension Consulting Division Mellon Bank N.A.

The process of developing a system to conform with the AIMR Performance Presentation Standards has specific ramifications from the perspective of the clients that we deal with-master trust clients. The funds for which we are responsible range in asset size from about $80 million to more than $12 billion. The funds use multiple managers and regularly evaluate their performance. Moreover, our clients always want our rate of return calculations to agree with those of the investment manager and the outside consultant; so, in practice, we must deal with three sets of return calculations. In this presentation, I will outline what we do, noting how our performance presentation practices compare with the AIMR Standards.

Return Calculations We use an approximate time-weighted rate of return calculation. We calculate monthly dollar-weighted rates of return, which we then link to estimate a time~weighted return for longer periods of time. The returns for periods longer than a year are annualized on a compound basis. All of the returns are computed on an accrual basis-eontributions and withdrawals are recorded on the day they occur, no matter what their size. Adjustments can be made when the cash flows are large (usually greater than 10 percent) and affect the rate of return calculation. The returns are before fees because some plan sponsors pay their fees out of the trust, while others pay them directly from corporate funds. Therefore, in our rate of return system, fees are treated as a cash withdrawal. We also are able to calculate performance net of fees. Occasionally, at the request of some clients, we calculate both net-of-fees and before-fees performance. For each account, we calculate the total return and the returns for each segment of the account. Our standard account segments are equities, fixed-income assets, convertible securities, and cash equiva-

lents. Optional segments include real estate, international equities, and international fixed-income. To be considered a fixed-income asset, a bond must have a maturity of at least one year. We can also combine segments and produce, for example, equity plus convertible returns or fixed-income plus convertible returns. We also can create any type of customized benchmark by using combinations of existing indexes or by creating a client's own benchmark starting at the security level. Balanced accounts are not really an issue for us, because very few of our clients have balanced accounts anymore. Most of them control their own asset allocation decisions. We do have some nontraditional balanced accounts in which a client will include, for example, an international equity fund, an international fixed-income fund, and perhaps a real estate fund. Consistent with the AIMR Standards, we calculate separate returns for each segment, as well as the total return on the account. Weare unable to apportion cash between segments, however, because all excess cash is invested in a short-term investment fund. If we have a traditional balanced account, we calculate returns for equity, fixed-income, and cash equivalents; we do not calculate an equity and cash return or a fixed-income and cash return as a standard practice. The decision about when the performance measurement calculation should start has always been a difficult issue. Ideally, we would like to start the calculation with the first full month after the money comes in, rather than pretending the money was there for part of a month when it was not. Plan sponsors usually fund their accounts early in the month, and they do not want to wait until the next month to get performance results. To provide performance for the first partial month, we preposition the account to get a beginning-of-month portfolio value. For example, if the money comes in between March 1 and March 6, we pretend the funds came in on February 28 so we can calculate the return for the whole month of March. Agreement between the 63

investment manager and client as to when performance measurement starts is very helpful.

Composites The way we calculate composites is different from the way most money managers would do it for performance presentation purposes. We dynamically create composites; the investment manager returns are not weighted. We start by grouping similar managers; for example, within the equity asset class, we would group active equity, passive equity, international equity, and all-equity managers. The asset class groupings would be combined to create an all-master-trust grouping. All managers are included, even those that have been replaced. If a manager switched asset classes-for example, from managing a balanced-account portfolio to an equity portfolio-that manager would remain in the balanced composite up to the time the switch was made, and then they would join the equity composite. We are a member of the Trust Universe Comparison Service (TUCS), which creat-es various universes of manager and composite accounts. TUCS relies on its members to submit quarterly rates of return calculated according to standards agreed upon by the member banks. This universe is the largest one of its kind. In 1990, it comprised more than 5,000 portfolios with an aggregate value of $550 billion managed by 900 different management organizations-about 700 investment counselors and 200 bank managers. Within TUCS, the composite universes usually have lower rates of return than those for the individual managers. This is because managers that have not done well are usually replaced, but their performance results remain in the composite accounts. The composite universes therefore avoid survivorship bias. The TUCS universe information is used to rank individual managers, groupings of managers, and the entire master trust against their peers. All accounts and composites have benchmarks. We have the capability to create any type of custom benchmark using combinations of existing indexes or by creating a client's own benchmark at the security level. As an example, for an international equity manager whose investment guidelines only allow for a 20 percent investment exposure in Japan, a custom benchmark using 80 percent of the Morgan Stanley EAFE ex-Japan Index and 20 percent of the Japan Index can be created. At the security level, a normal portfolio can be created.

64

Plan Sponsor's Reaction Mellon's Client Advisory Board is made up of plan sponsors of various sizes. This board met recently to review some of AIMR's Standards. The members were enthusiastic about the features of the Standards, which they felt should improve their manager selection process in the future. The board discussed the proposed performance calculation methodology-that is, the linking of monthly dollar-weighted returns to form estimates of time-weighted rates of return. Although this approach can cause distortions when there are large interperiod cash flows, most of the plan sponsors do not have frequent large flows of funds into and out of their accounts, and the flows tend to balance out. Some board members were concerned about the cost of doing true daily time-weighted returns; others were also concerned about the validity of universe comparisons unless cash flows are taken into account. The compromise they reached was to make adjustments for any cash flow larger than 10 percent of the portfolio. The board also expected a money manager to be able to explain performance results when they differed from those provided by a consultant.

Other Considerations Eventually, bank trust departments probably will calculate rates of return both on a daily timeweighted basis and on a dollar-weighted basis for master trust clients. Plan sponsors need to see both calculations to measure how well their overall assets are doing. They should also keep in mind that the cash flows do influence the growth of the fund. Even with the eventual movement to daily timeweighted rates of return, differences in what is calculated probably will persist. Much of this discrepancy is attributable to differences in pricing sources, especially on fixed-income investments. One problem is that some security-pricing sources do not provide daily pricing on such securities as municipal bonds, collateralized mortgage obligations, and mediumterm notes. Another problem is that pricing tapes have different cut-off times. Adding to the confusion is the proliferation of new and different securities that have to be priced. Some of our clients are involved in venture capital, private placements, and other nonconventional investments, which are difficult to price.

Conclusion In moving toward compliance with the AIMR Standards, we encountered three areas that had to be addressed: the use of true daily time-weighted rates of return, which would totally eliminate cash flow implications; the treatment of cash equivalents in balanced accounts; and the costs these changes would entail. The cost of storage and maintenance of daily pricing sources can make the computation of daily returns prohibitive. There would also be a cost to develop a system to calculate the returns and to handle the daily linking. To separate cash equivalents into an equity portion and a fixed-income portion would require the establishment of a

separate short-term investment account for equity securities and another one for fixed-income securities. The comparison issue is the major concern. Clearly, one institution, using the same pricing sources and method of calculation for all managers and adjusting for large cash flows, can make valid performance comparisons over time. How the balanced accounts are treated has ramifications for the rucs universes. Right now, the equity and fixed-income segments of a balanced account are treated separately. Returns are combined and compared with those of similar segments managed by comparable managers. No provision is made for looking at equity and cash together or fixed-income and cash together.

65

Performance Measurement Systems Sam H. Smith President Trust Systems, Inc.

My firm is in the business of developing computer systems for large bank trust departments. Last year, our user banks set a common goal of enhancing their performance measurement capabilities and improving their performance reporting. In this presentation, I will highlight some of the challenges and issues we encountered in completing that project. Our users established a very clear set of implementation goals. Most importantly, they wanted a system that would adhere to the AIMR Performance Presentation Standards because that would help them eliminate the confusion and inconsistency that they were encountering in performance calculations. They also wanted a convenient interface of performance data to other systems and a straightforward, easy-to-use process. This sounds simple, but building these Standards into a computer system was a complex task that required many changes in our existing system, affecting the method of allocating cash, the treatment of cash flows, the comparison of indexes, historical retention, the way composites are constructed, and the number of sectors.

Primary Challenges A number of basic problems had to be tackled initially in adapting the system to produce numbers that will meet all the AIMR Standards. A helpful exercise in analyzing these problems was relating the Standards to the uniqueness found in the trust industry. Handling the volume. The basic difference between bank trust departments and investment advisors in measuring performance is one of volume. Bank trust departments have thousands of accounts. To meet the Standards, they would have to value thousands of portfolios monthly, or to be more accurate, daily. Obviously, the problems associated with implementing the Standards are magnified for a superregional bank operating in several states and processing tens of thousands of accounts daily. How can such a bank do this efficiently at an affordable 66

cost? The failure to adequately address the volume problem is probably the most significant reason that many bank trust departments will not meet the Standards. Handling such large volumes is a major addition to a portfolio management system. Performance has to become a byproduct of the daily accounting portfolio. Also, the information must be provided online as opposed to in printed reports; otherwise, the volume is too great to process. Survivorship bias. In the trust management business, owners of poor-performing portfolios tend to change managers, leaving the good-performing portfolios in the pool of existing clients. If the records of the poor-performing portfolios are deleted when the accounts leave, survivorship bias results. This bias must be eliminated from composite calculations to adhere to the AIMR Standards. Most trust systems periodically purge closed trust accounts, thereby purging the historical data that would allow them to go back and calculate unbiased composites. The proper way to handle the problem is to give composites a life of their own by creating historical records for them independently. Then, individual account data can be purged, leaving the composite intact. Daily valuations. Although the Standards recommend monthly valuations, daily valuations are encouraged to facilitate the most accurate timeweighted rate of return calculation. Most large trust departments value all of their securities daily, but very few of them value all of their portfolios daily. They use daily values only for the portfolios that need to be valued on any particular day. To value tens of thousands of portfolios daily, when only a few require it, causes a severe conflict between efficient processing and accurate performance results. We came up with a compromise: value daily, but do it monthly. At the end of the month, we have daily values for every asset, and we know the position of every trust account on any particular day, so we can calculate the value for all accounts as of every day and then calculate returns based on that. This allows us to calculate daily time-weighted rates of return,

with exact timing of cash flows, without the burden of the high-volume process of valuing every portfolio every day. Comparable benchmarks. Another challenge was how to apply the Standards in the selection of benchmarks for composites. If you asked any 15 banks how they would assign numbers or codes to investment styles and which indexes would be good yardsticks for those investment styles, you would get 15 different answers. Although working with a large number of clients has its disadvantages, one great advantage is that it forces your system to be flexible. To accommodate this need for flexibility, we designed a method by which users create their own composites at the portfolio level. The roll-up problem. The purpose of a composite is to enable measurement of the manager's performance, not the individual portfolio's performance. In the trust industry, the question is, Who is the manager you are measuring? Is it the equity manager? The fixed-income manager? Is it the investment department? The trust division? The bank? The regional bank? The holding company? The answer to those questions is, Yes. All of those need to be measured from time to time. Our solution was to create composites of all those entities, plus composites for various account characteristics such as account type, account size, investment discretion, account objectives, and taxability. Someone mentioned needing 8 composites; for a large trust department, 80 composites might be a minimum number. Believable numbers. A performance system must be able to provide documentation that the calculations are correct. All investment managers have seen performance numbers that do not look right. The system must enable the manager to verify the accuracy of the numbers. If it cannot do that, it will not be used. Our system provides enough information so that investment managers questioning a number can sit down with the material from the system and reproduce the results to determine whether it is right or wrong. Purpose for measurement. A trust department measures performance for at least three reasons. One is internal performance measurement, to compare the performance of internal portfolio managers based on the objectives of the portfolios they are managing. A second reason is to report performance results to the customer. The third reason, of course, is to provide those results to prospective customers. All three of those entail a different set of requirements and reports. For example, measuring internal managers requires a series of reports that will permit portfolios and performance to be broken down by objectives to show why two managers that have the

same objectives are getting different performance results. A trust division has a diverse set of customers, ranging all the way from master trusts to guardianships. The requirement to measure performance on all portfolios means mixing all those portfolios and then separating them. Correcting the data. Obviously, a system must allow for corrections and changes. If the algorithm is correct, the only reason information could be incorrect would be because of the data. If the data are not changed, the information is forever going to be incorrect. Our system provides different levels of security, but if managers are approved to do certain things within the system, they can change the data. Of course, all changes are logged. Custom measurement. Providing custom measurement while meeting the Standards is fairly difficult. Because the clients of trust departments are so diverse, they have diverse reporting requirements. A uniform set of reports is simply not adequate for a large bank trust department. To enable a trust department to meet these different needs and yet measure performance in conformity with the Standards, we assigned the performance of each asset to two composites-one for the Standards, and one for the custom measurement. This allows a trust department not only to meet the Standards with their composites, but also to meet the unique requirements of any particular <:;ustomer or any particular set of composites that for whatever reason are outside the Standards. Exceeding the Standards. Early in the design of our enhancements, many of the investment managers at our banks said that the AIMR Standards are inadequate and should not be used as a basis for redesigning the system. I always answered that I am neither qualified nor prepared to defend the Standards themselves, but that I am prepared to defend their use. This argument has enabled us to withstand what may be the biggest issue we have faced in this systematic application of a Standards-meeting process: failure to adhere to the Standards because of an opinion that they are inadequate. To adopt such a position would bring us full circle, right back to confusion and inconsistency-the very state that the Standards were intended to eliminate.

Conclusion Trust departments face unique problems in implementing the AIMR Standards primarily because of the large number and diversity of the portfolios they manage; however, today's technology provides the speed and flexibility necessary to allow the largest of trust institutions to apply the Standards. 67

Portfolio Benchmark Design Stephen W. Pelensky Vice President and Director of Research BEA Associates

Benchmark portfolios have become an important part of the investment process at BEA. They have been used to communicate the manager's investment style and to demonstrate the value of the manager's active investment decisions. Benchmarks are used in performance reports distributed to our clients and consultants, as well as for internal performance analyses of BEA's portfolio managers. The interpretation of portfolio performance versus an appropriate benchmark is very important. Therefore, it is imperative that a benchmark be appropriately constructed in accordance with the objectives and guidelines of the client. Benchmarks are not always designed properly, and therefore do not accurately capture the value added by a manager to a portfolio's performance. In this session, I will discuss benchmark applications, benchmark design issues, the problems of misspecified benchmarks, capturing style rotation, and an example of a benchmark that captures our investment process.

be used to control the plan's aggregate risk leveL For example, a plan sponsor may have a growth manager, a value manager, and a small-capitalization manager. The combination of these three managers may result in unintentional or undesirable exposures to certain risk factors. These undesirable exposures can be controlled by offsetting exposures to the same risk factors through the use of a completion fund. A completion fund employed in conjunction with the plan's roster of investment managers will give the plan sponsor the risk-factor exposures that they desire. A properly designed benchmark allows performance measurement and evaluation to be conducted in a more accurate manner, with sources of value added by the manager properly attributed to their decisions regarding asset allocation, factor selection, and security selection.

Benchmark Design Issues Benchmark Applications A properly designed benchmark can be employed to provide risk profiles of the pension plan's investment managers, to control the plan's aggregate level of risk, and to provide a basis for the measurement and evaluation of a portfolio's performance. A plan sponsor can use a benchmark to assess the normal exposures of an investment manager's portfolio to several macroeconomic, market-related, and stock-specific risk factors. Macroeconomic factors, such as changes in inflation, interest rates, the dollar, and'real economic growth, affect a manager's performance. Returns of the equity market itself affect a manager's performance. Stock-specific factors, including fundamental attributes (such as leverage and earnings stability) and security attributes (such as trading liquidity and valuation ratios like price/ earnings and price/book), also affect a manager's performance. The combination ofall of the individual manager benchmarks into an aggregate plan benchmark can 68

A benchmark must be carefully constructed to serve these useful functions. Four primary design issues need to be considered in the construction of a proper benchmark portfolio: I, The benchmark construction process should capture and parallel the manager's investment process. It should reflect the techniques that the manager actually employs, both quantitative and qualitative. 2. The benchmark must properly represent the universe of securities from which the manager selects issues for inclusion in the client's portfolio. In most of our portfolios, we select securities with a market capitalization in excess of $100 million. 3. The benchmark must properly capture the manager's weighting scheme. Benchmarks with equally weighted security positions will lead to very different results than capitalization-weighted positions in the same securities. 4. The performance of the benchmark should

generally parallel the performance of the manager's portfolio. Specifically, a high correlation between portfolio returns (in excess of the market) and benchmark returns (in excess of the market) would indicate that most of the manger's performance relative to the market is explained by the benchmark's performance relative to the market. 3.

Misspecified Benchmarks The improper specification of a benchmark can lead a sponsor to incorrect analyses and conclusions about the style and performance of an investment manager. Misspecified benchmarks are those constructed in a manner that is not consistent with the manager's investment process. Benchmarks are improperly constructed for a variety of reasons, such as the following: 1. Screening criteria employed to determine whether a security is included in or excluded from the benchmark are often arbitrary in nature. That is, certain appropriate issues may have been eliminated by failing to exceed a threshold criterion, or certain inappropriate securities may be included in the benchmark due to inappropriate screening criteria. For example, a set of otherwise eligible growth stocks may be omitted from the benchmark because they failed a certain price-to-book ratio, even though they passed all of the other screening criteria such as earnings growth rate, return on equity, or payout ratio. 2. The exposure of the benchmark to various risk factors may not match the exposure of the

4.

5.

6.

portfolio. A benchmark's exposure to a risk factor can easily be set equal to the portfolIo's average exposure to that factor over time. This average may not, however, accurately capture the manger's investment process over time. It is incorrect to attempt to match exposures to a factor that is an unintentional fallout rather than a conscious target of the portfolio manager's investment process. As a benchmark is updated for changing portfolio holdings, its factor exposures can "chase" the portfolio's factor exposures (see Figure 1). This can create an apparent unstable benchmark factor exposure, although the true underlying process that is generating the portfolio's factor exposure is stable. The manager may engage in tactical or strategic factor "bets," in which the portfolio's factor exposures significantly differ from the benchmark's exposures. Going forward in time, it is important to know whether these changes are temporary (and should therefore be ignored by the benchmark) or permanent (and therefore may need to be incorporated in the benchmark). In an effort to capture a manager's investment process, a benchmark can be "overdefined." If that happens, all of the manager's active investment decisions will be "absorbed" into the benchmark's performance. It would not be possible to discern what value the manager added relative to such a benchmark. The sources of active return and risk in the portfolio can be incorrectly identified. A comparison of the portfolio's performance to that of a misspecified benchmark will lead to an

Figure 1. Factor Exposure: Portfolio Versus Benchmark 1.6--r---------------------------, 1.4 1.2 1.0 0.8

" 0.6 ~ 0.4 ~ 0.2

Ui o.o-P--...;;:-----/=---=--...-.::::...------:ir-..-...:-=::-----,..,-:-j;-o""::::..-------1

:s -0.2

g -0.4 u.. -0.6 -0.8

-1.0 -1.2 -1.4

-1.6 -l-,.......,--r-..,.....,;--r--r..,.,-,-...,-,,---.-...,.-,,-r-r-r-r--r-..,.....,rT-r..,.,-,-...,-rl Sept-90 Sept-88 Sept-86 Sept-84 Sept-82 - - Portfolio Exposure

Benchmark Exposure

Source: BEA Associates

69

incorrect evaluation of the sources of value added by the portfolio manager.

Style Rotation A benchmark should be able to detect whether a change in the investment manager's style is a real change or only an apparent one. If the benchmark accurately captures a manager's investment process, then it will alert the sponsor when that manager drifts away from his normal style. A misspecified benchmark, however, can generate false or misleading signals about a change that appears in the misspecified framework to be a change in style. For example, a "value" manager who may have avoided growth stocks for several years may now find them undervalued according to his investment process, and therefore raise his exposure to growth by investing in such issues. Using a misspecified benchmark that fails to capture the manager's process, this increase in exposure to growth stocks may appear to be a violation by the value manager who is "stepping out of his bounds" into growth stock territory. If the benchmark is properly constructed such that the manager seeks value in all types of stocks, including growth stocks, this increase in growth exposure will not be flagged, but rather it will be recognized as a fallout of the manager's process of seeking value wherever it may be found.

70

A Benchmark That Captures Our Investment Process A benchmark should be designed to accurately capture the manager's investment process. At BEA, our investment process for one client leads to active decisions at three primary levels: asset allocation, factor selection, and stock selection. We developed a broad benchmark that encompasses this broad span of active decisions and is consistent with the client's objectives and guidelines. Because one of the client's objectives is the preservation of capital, we have set the benchmark asset allocation to a 10 percent cash/90 percent equity mix. Due to the size of the account, the benchmark consists only of actively traded stocks with a market capitalization in excess of $100 million. Because of the concern about liquidity of small-capitalization equities, we specify a mix of S&P 500 stocks (75 percent) and smaller-capitalization issues (25 percent) in the benchmark. The equities are equally weighted in the benchmark portfolio. The benchmark portfolio is rebalanced semiannually, with an allowance for trading costs associated with rebalancing. The resulting benchmark has proven to be a reliable predictor of our performance, and provides an accurate measurement of the value added by the active asset allocation, factor selection, and stock selection decisions.

Creating Acceptable Composites G. Thomas Mortensen Partner and Chief Administrative and Financial Officer RCM Capital Management

Composites are needed for several compelling reasons. First, performance records and standards are essential for investment managers, who need to be able to compare their results directly with those of various market indexes and with those of their competitors. Further, the public has shown signs of frustration with the often uneven, irresponsible, and dishonest presentations of performance results by certain investment managers. Not only is such activity misleading and confusing to clients and potential clients, but it also raises significant questions about the integrity of members of the investment profession. Potential clients should be entitled to review and fully understand all facets of each firm's investment philosophy, style, management depth and experience, and performance results. Presenting individual results for every portfolio managed for each reporting period since the founding of any sizable firm, however, would require a quarterly document the size of the Internal Revenue Code. Such a document would be unreadable, indecipherable, expensive to mail, and too large to fit in a briefcase. Hence, the need for composites. Historically, many clients, potential clients, and placement consultants request only a manager's representative accounts, median return, and/or the mean return. However, this information alone does not provide sufficient information to evaluate a management firm's overall performance record. Such presentations neglect the impact of portfolio size and the inherent marketability problems of larger portfolios. In this presentation, I will review the key components of a performance measurement system that avoids these problems. The system designed by RCM Capital Management is used to illustrate my points. I will also discuss the criteria for inclusion in composites. Several terms will be used throughout this presentation which require some definition. An "account" is an account on the records of the client and / or trustee/custodian. An investment manager keeps accounting information at the account level to allow for accurate recording and reporting, and for proper reconciliation with the trustee/custodian.

However, for one "account" the investment manager may be given authority to invest in more than one major asset class or investment style. When this occurs, the account should be divided into one or more investment "portfolios." (For example, portfolios could be established for domestic equities, domestic fixed-income, international equities, shortterm cash management, etc.) Each portfolio is a subset of the account and can be combined with portfolios with similar investment objectives to create "composites." "Composites" can be developed for various asset classifications (e.g., equity, fixed-income, balanced), by client type (e.g., equity composite for tax-exempt clients) and by investment style (e.g., composite of intermediate municipal bond portfolios). Although probably not very prevalent yet in the industry, each portfolio can be further divided into "components" (e.g., equity, cash reserves, fixed-income). The ability to capture within each portfolio, discrete valuation, transaction, cash flow, and income data for a component can provide the investment manager with additional return information (e.g., reporting on equity only, fixed-income only, and cash equivalents for both the equity and the fixed-income portfolios). Figure 1 summarizes the interrelationships between accounts, portfolios, and components.

Data Base for a Performance Measurement System The database for any performance measurement system has three mandatory component subsystems. The first subsystem is the performance account reference system. As Exhibit A-I of the Appendix shows, this system contains the core and generally immutable information with respect to any account. This information includes the name, the date performance began for that account, the title of the account, the contact at an administrative level for performance calculation and presentation, the run dates for performance (for example, we run our performance and capture and retain data historically on a monthly 71

Figure 1. Structure of a Performance History Data Base

Source: RCM Capital Management

basis), and the fiscal year-end of the account so that special reports can be run to meet client reporting needs. The system should also show other options such as computation frequency. In our system, computation frequency can vary. This system provides the option to compute and report, although not necessarily capture, performance data at various intervals (daily, weekly, or monthly). We provide daily reports of our equity portfolios to keep our managers abreast of the performance of their portfolios. We only price fixed-income securities once a month, so there is no point in running those portfolios on a daily basis. We can also price portfolios and run them on demand for specific client meetings and dates. As Exhibit A-2 indicates, the performance account reference system should also provide information on which benchmarks each client desires to be compared with. In addition to standard indexes such as the S&P 500, our system provides for specialized indexes-for example, a combination of 50 percent S&P 500 and 50 percent Lehman Government/Corporate Bond Index. The specified indexes will be printed with the client results on all reports. The second subsystem is the performance history system. The data base should include principal, income, and total returns for each portfolio and each 72

component (see Exhibit A-3). The information includes cumulative market values, principal unit values, the income unit value, and the total unit value of the portfolio for that accounting period. These can be linked and delinked to calculate cumulative returns and, subsequently, annualized returns for the portfolio or for the account. The system should also capture some capital market statistics-for example, beta, standard deviation, and R2-and some portfolio relationship data, such as inception and termination date, both for the portfolio and for portfolio performance, which may be different dates. (The portfolio performance date is client directed and generally within 60 days of inception date of the portfolio; the portfolio performance termination date is when the portfolio is no longer managed in accordance with the stated investment guidelines-e.g., during liquidation of the portfolio, which can proceed the portfolio termination date.) The system has to store the data for collecting returns. The main data elements for calculating the returns are market values, cash flow additions and withdrawals, and earned income. An important part of any performance calculation is the treatment of cash flow activity. In our system, the breakdown of additions and withdrawals is relatively complex, but it allows the firm to analyze how it has grown. We collect data on the source of capital funding in the

organization and where the dollars have come from. Has the cash flow come from initial deposits, terminations, or periodic contributions or withdrawals from the sponsor to the plan? Has it come from the reinvestment of income? When talking about performance at the component level, such as equities, it is important to know the net value of transactions that have taken place during the accounting period. These are then summed and day-weighted for use in the return algorithm. The system should have the capability to show the income component of returns by sourcedividends and interest, amortization of premiums, and discounts on fixed-income securities. These can be further classified between taxable income and income that is tax-exempt for federal purposes, and by income earned in the period and accrued to date. Other items that must be captured include sources and methods of data update, the management fees for the period, the median market value of an issue in the portfolio, and the number of issues/members in the portfolio. In our system, the issues/members entry indicates how many portfolios are participating in a composite and the average and median market values of that composite. Our system also calculates turnover statistics in accordance with SEC standards for mutual funds. These are built into the performance measurement system to supply information requested by clients, potential clients, and placement consultants. The third subsystem is the performance account group system (see Exhibit°A-4). Composites can be created by using this flexible classification matrix (a computer system that lists each portfolio which should be included in a particular composite and its inclusion and exclusion dates) and a performance account reference database. Alternatively, composites can be developed by manually inputting the portfolios to be included in the composite along with their inclusion and exclusion dates. When designed in this manner, a firm has total flexibility in constructing composites in accordance with any reasonable measure of risk or client investment objective. The minicomputer-based system used by my firm was designed to meet the needs of a mid-sized investment management firm with significant trading volume and approximately 300 accounts. The critical design elements of this system can be applied in smaller organizations using microcomputerbased portfolio accounting systems or service bureaus, providing that these accounting systems can supply data at the discrete level necessary. They can also be applied in large organizations with mainframe applications by designing an interface to workstations or microcomputer environments that

allow cost-effective development of similar systems.

Sample Reports The type of reports one might provide multiportfolio clients is illustrated for the fictitious XYZ Company in Exhibits A-5 through A-II of the Appendix. Balanced accounts are the most complicated from a system-design point of view, so I will illustrate the key system-design features using balanced accounts. The AIMR Performance Presentation Standards state that balanced accounts spould be divided into distinct categories, each of which will have its own strategic and frictional cash reserves. This requirement applies to more than the traditional 60/ 40-type balanced account. In my opinion, it covers all accounts where the manager has the discretion to invest in more than one major asset class. For example, for an account where the manager has discretion to invest in cash equivalents, equity, and fixed-income securities, the account should be divided into three separate portfolios-an equity portfolio with its associated cash reserves, a fixed-income portfolio with its associated cash reserves, and a short-term cashmanagement portfolio that would be used strategically in balancing the overall account. Each portfolio is then considered a subset of the account and can be combined with other portfolios with similar objectives to create composites of the firm's performance in managing that specific major asset classification. The structure shown in Figure 1 defines relationships for both accounting and performance measurement purposes. This is a simple structure with equity and fixed-income portfolios, but it could also include any major asset class such as a cash-management portfolio, a futures portfolio, or an international equities portfolio. The fourth component listed is for the accruals-accounts payable and accounts receivable. This component may be surprising to nonaccountants, but in redesigning our performance system, we found that cash seemed to get mixed in with the concept of trade-date accounting, so the results reported on reserves invested pending the settlement of trades in the future were inaccurate. This component is a catch-all for payables and receivables, including securities purchased and sold. It has no return, but from a structural perspective, it is required to make everything balance. Account Performance Reports Exhibits A-5 through A-8 provide details about the client's investment account. Please note that the explanatory boxes do not hide any data critical to a general understanding of the reports. Exhibit A-5 shows the consolidated investment account summary. It is a summary of the total investment ac73

count for the XYZ Company pension plan, including assets in unsupervised portfolios (portfolios of assets in which the investment manager does not have investment discretion). Each of the clients' portfolios is combined by major asset class to provide the client with a distribution of cost, market value, and percentage of total account invested in each major asset class for the entire account. Exhibit A-6 shows an investment account summary by portfolio and major asset class for XYZ Company. This report shows the major asset class breakdown within each of the portfolios managed for the client. In this case, there is an equity portfolio and a fixed-income portfolio; each is split between investments and cash. For example, the equity portfolio contains cash and short-term investments and direct equity investments. The summary includes both the percentage of the client's portfolio in these classes and the percentages represented of the total account. From this type of report, the client can easily understand how the account has been divided and how its assets have been deployed. Exhibit A-7 is an investment portfolio summary. The format is standard-organized by asset class (in this case, equity investments) and industry segments. This summary provides percentages with respect to the total portfolio and the deployment of assets within the industry class-for example, the percentage represented by general finance in the equity investments. Exhibit A-8 shows the most detailed level of an investment portfolio asset report. It includes individual investments, unit costs, total cost, percentage of portfolio, market value, and so forth. This helps clients understand the asset deployment for their accounts. Dividing the accounts into portfolios in this manner captures the evaluation, transaction, income, cash flow, and fee data necessary to provide clients with a complete record of performance in each asset class, including frictional and strategic cash reserves. Total account performance may be calculated by summing the underlying data in the account level and calculating total account return, including the consolidated return for each asset class. This format provides flexibility in combining asset classes that are used in different portfolios. For example, a manager might decide to use three-year Treasuries in an equity portfolio as part of a defensive strategy. Treasury securities might also be used in a fixed-income portfolio. Those positions will be combined at the total account level (as in Exhibit A-5) and shown with their respective portfolios at the portfolio level (as in Exhibits A-6 through A-8). If you have asset allocation discretion, account rebalancing is done by 74

transferring cash or cash equivalents among the investment portfolios. This is a major tactical asset allocation and needs to be separate and distinct from management of the underlying portfolios. In our firm, part of our fixed-income group manages cash-reserve portfolios. The managers of the long-term fixed-income portfolios use cash reserves to help manage the duration of the portfolio. The fixed-income group also manages cash reserves of the equity portfolios; so, separate portfolios managed by separate individuals or groups of individuals are brought back together to represent the firm's entire efforts for that account. These data at the investment portfolio level can easily be used to establish, or interface with, a performance measurement system with composite-creation attributes. Composite Reports The AIMR Performance Presentation Standards are designed to allow significant flexibility in determining the criteria for inclusion of portfolios in composites, based upon an organization's particular management style. Each firm can determine the criteria for inclusion in a composite, but all portfolios that fall within the rules must be included in its composites. You must also be prepared to disclose performance history for each participating portfolio and its assets at any point in time. It is important, in my view, that every portfolio managed at any time by your firm be included in at least one composite. If you desire to exclude a portfolio, you are obligated, under the Standards, to provide reasons for such exclusion. The ultimate objective is to insure that any portfolio that qualifies under inclusion criteria, which you have established, is included in that composite. The AIMR Standards state that fixed-income and equity portions of balanced accounts should be included in their respective fixed-income and equity composites. Once a firm has gone through the tactical asset allocation decision and set up an equity portfolio with frictional and strategic cash reserves, is that portfolio in any way different from a standalone managed account with the same set of objectives? In my mind, no, and it should be included in the composite of equity performance. Exhibits A-9 through A-II illustrate ways to present cumulative performance reports for a balanced account for XYZ Company. For illustrative purposes, this balanced account can be considered a composite of an equity portfolio and a fixed-income portfolio. Exhibit A-9 provides the cumulative performance summary for the total assets under management at the account level. It provides results for all of the major asset classes used in the accountcash, equities, and fixed-income assets-summed,

even if they are represented in more than one portfolio. The report also shows principal, income, and total returns. This particular form lists cumulative results for various periods, and another version provides these numbers on an annualized basis. Exhibit A-IO shows the equity portfolio performance history of the balanced account, and Exhibit A-ll shows the fixed-income portfolio performance history of the balanced account. Prior to November 1988, our firm did not have the discrete data necessary to calculate separate returns for the cash and equity components, so these reports provide only total return levels going back to the inception of the organization. Verification, or auditing, by a third party is as important for performance composites as it is for income and expense statements or tax returns. Most people would not be confident in a firm's system of internal accounting controls without regular evaluation by an independent authority such as an account-

ant. The same thing holds true for composites. An audit of your composite returns will assure you, your clients, and your potential clients that the calculations are accurate and in accord with AIMR Standards, that all portfolios that meet the criteria for inclusion have been included, and that all feegenerating managed portfolios are included in at least one composite of investment performance. Audited reports of composite performance should include concise notes defining the rules for inclusion.

Conclusion In conclusion, the development of a system such as I have outlined can enable organizations such as ours to provide accurate and comprehensive data that conform with the AIMR Performance Presentation Standards and that can significantly enhance our image in the eyes of our clients and potential clients.

75

Appendix. Development of a Performance Database Exhibit A-I Performance Account Reference Page lof2 Account Num/Short Name:

Performance Inception Date:

Title:

Curr Month Run Date: Last Month Run Date:

Address: Country

Phone

City/State/Zip:

Fiscal Year End:

Contact: Title:

Include Management Fees: Computation Level:

Computation Frequency:

Retention Frequency: Special Performance Run:

PAR File Maintenance Data Maintenance Date:

Maintenance Source:

Account Closing Data Close Date:

Money Manager:

Close Value:

JDL

Index Group:

Close Reason:

(index records only)

ExhibitA-2 Performance Account Reference Account Num/Short Name:

Page 20£2

Reporting Data: Thous/Mil Ind: Reporting Level:

Num Components Reported: Internal Reporting Ind:

Primary Report Indices Secondary Indices

Capital Market Statistics: Regression Index 1:

Compute Statistics? Percentage:

Index 2:

76

Index 3:

Percentage:

Index 4:

Percentage:

Index 5:

Percentage:

Index 6:

Percentage:

N

Exhibit A-3 Performance History Data Base: Period and Cumulative Return Data Account

Portfolio:

Title

Date: Data Type: Calc Freq: Conversion:

Component Title:

Market Value: Return Basis:

Principal Return:

rrUllOlp'i1l

Unit:

Income Return:

Income Unit

Total Return

Total Unit

Beta:

R2

Dollar Return: 1;~~~~gl!11

Std Deviation:

Portfolio Performance

Inception Termination Manager

Manager

Exhibit A-4 Performance Composite Group Data

77

ExhibitA-5 Consolidated Account Summary (December 31,1988) XYZ Company Pension Plan (Sample Report) Tolal Cosl

Estimated Annual Income

Tolal Market Value

Current Yield

=::::::===="'==== Cash and Short Term Investments

580.315

580.315

47.237

EquIty Investments

235,981

230.224

6.241

1.9%

FIxed Income Investments

114.527

115.979

10,443

8.6%

Totollnv9stment Account

930.823

926.518

8.1%

=====::=::==== 63,92\

100.0%

5.0%

Summary of Totallnvestment Account Including Assets In Unsupervised Portfolios

Exhibit A-6 Investment Account Summary (December 31, 1988) XYZ Company Pension Plan (Sample Report) Totol Market Volue

% 01 Totol Porllollo

% 01 Total Account

Estimated Annual Income

Cunen' YIeld

26,026

8.1%

6,241

1.9%

Equity Portfolio

319,733

319.733

58.1%

Equity Investments

235,981

230,224

41.9%

549.957

100.0%

32.267

3.1%

260.582

69.2%

21,211

8.1%

115,979

30.8%

10,443

8.6%

31,654

8.4%

============ 63,921

5.0%

Total Investment PO/tlo

Fixed Income Portlollo Cosh and Short T

-_ .................

Summary of Investment Account by Portfolio and MajOr Asset Classification

Fixed Income Inv

............... __ ..

---.- .. -........-.-

Totallnvesfment Portfollo

375,109

Total Investment Account

============ 930.823

376,5

====- -===== 926,518

Percent of Portfolio In Each Major Asset Classification, e.g., Fixed Income Investments

78

34.5%

Cosh and Short Term Investments

...................

100.0%

Percent of Totallnvestment Account In Each Major Asset Classification, e.g., Cash and Short Term Investments

ExhibitA-7 Investment Portfolio Summary (December 31,1988) Equity Portfolio XYZ Company Pension Plan (Sample Report) Total

Auef ClassifIcatIon

Asset Closs

,"of POlllollo

Estimated Annual Income

319.733

lOO.O%.

58.1%

26,026

8.1%

319,733

100.0%

58.1%

26.026

8.\%

66.750 125,511

29.0% 54.5%

12.1% 22.8%

1,128

1.7%

3.253

2.6%

192.261

Total Market Value

ost

'" of

Currenl YIeld

Cosh and Short Term Investments 319,733

Commingled Sholt Term funds

Summary of Equity Portfolio by Industry. Industry Group and Major Asset Classlflcatlon

Tofal Cash find Short Term

Equity Investments

Generol Finance Banking

.

83.5%

34.9%

4,38\

2.4%

40,298

16.5%

6.9%

1.860

4.5%

40.296

16.5%

6.9%

1,860

4.5%

41.9%

6,241

1.9%

100.0%

32.267

3.1%

195.683

Total Inferest Sensitive 011 and Related Services

Total Energy

235,981

Totol Equity Investments

........ ---------_.

"'''''''''':=====:: 555.714

To1allnvestment Portfolio

Percent of MajOr Asset Class In Each Industry and Industry Group

Percent of Equity Portfolio Invested In Each Industry. Industry Group and Major Asset Classification

Exhibit A-8 Investment Portfolio Assets (December 31,1988) Equity Portfolio XYZ Compan Pension Plan (Sample Report) Shales or Current Face

Asset Description

Cost Unfl

- lax Basis lotal

Market Price

% Total Portlollo

lotal Market Value

Estlmated Annual Income

Current Yield

Cash and Short Term Investments 319.733.16

Man

Total Commingled S Total Cosh and Short T

Detailed Listing of Equity Portfolio Assets

1.000

319.733

1.000

319,733

319,733

58.1%

26,026

8.1%

·319,733

58.1%

26,026

8.1%

26

8.1%

912 216

2.7% 0.7%

319,

319.733

Using Market Value

Equity Investments 1,200

Amerlcan Express Co Student tn Mktng Assn Non Vtg

'00

30.922 76.173

37,106 30.469

33.275

128.108

Total General Finance 3.850

Bonk New Englond Corp

67.575

Totol80nklng

128,108

Totol Interest Sensitive

;~

28.000 82.875

Cost of Assets Including Totals by Industry, Industry Group and Major Asset Classification

32,

V 63

__ .

15.109 25. I 89

6.1% 6.0%

66,750

12.1%

Using Current Face Value

195,683

45

33,600 33,150

73.750 77.375

1,128

1.7%

3,253

2.6%

3,253

2.6%

192,261

34.9%

4.381

2.4%

14,750 23.213

2.7% 4.2%

660 1.200

4.5% 5.2%

------_._._. __ ....

40.298

37.963

6.9%

1,860

4.5%

40,298

37.963

6.9%

1,860

4.5%

Totol Equity Investments

235,981

230,224

41.9%

6.241

1.9%

Totol Investment Portfolio

555.714

549.957

100.0%

32.267

3.1%

TolalO Total Ener

79

ExhibitA-9 Cumulative Performance Summary (December 31,1988) Investment Account - Managed XYZ Company Pension Plan (Sample Report)

~1·ReportInetudes Total I Assets Managed ~

Tofal Molltsl Value

Percent 01 Account

Cash and Shorf Term Investments Principal Reluln Income Return Tolal Return

580,315

62.6%

Equity Investments PrincIpal RetuIn Income Retuln Total Return

230.224

FIxed Income Investments PrlncIpol Rerum Income Return Total Return

115,979

DescriptIon

• - ••••• - •••• - •••• - - ••• Performance From: •• - •••• - - •••••• - ••••••••• - • 11/88 09/88 12/87 12/87 12/85 12/83 12/78 lncapflon Month QUCllsr VI To Ot 1 Yeo I 3 Vears 5 Years 10 Years 15.75 Yean

0.42% 0.42%

nla nla nla

% % %

nla nla nla

(1.06%) (0.33%)

nla nla nla

1.22% 0.41% 1.62%

OAl% 1.31% 1.72%

0.00%

PrincIpal Return Income Rejum Tolol Return

926,518

nla nla nla

nla nla nla

nla nla nla

nla nla nla

Returns for Eacll Major Asset Class

nla nla nla

nla nla nla

nla nla ola

nla nla nla

nla nla nla

nla nla nla

nla nla nla

nla nla nla

nla nla Ma

5.30% 5.65% 10.95%

20.80% 19.55% 40,35%

43.35% 47.27% 90.62%

131.65% 203.34% 334.99%

103.18% 300.41 % 403.59%

89.05% 62.70% 51.75%

149.08% 252.29% 401.37%

1.68% 182.34% 184.02%

(8.34%) 303.79% 295.45%

100.0%

Major Asset Classification

Benchmark Indices

nla nla nla

24.9%

0.73%

Total Investment Account· Managed

nla nla nla

5.30% 5.65% 10.95%

~

Standord & Poors 500 Index Prlnclpol Return Income Return Totol Return Shearson lehman Govl-Corp PrIncipal Return Income Return Totol Return

1.47% 0.31% 1.78%

2.15% 0.59% 2.74%

(0.43%)

(1.30%)

Comparable Index Returns

12.4 3.7 16.1

B.A.I. Approved Return Calculations

(1.55%) 9.14% 7.59%

(1.55%) 9.14% 7.59%

(2.77%) 30.02% 27.25%

8.84% 68.67% ]],51%

Exhibit A-IO Cumulative Performance Summary (December 31, 1988) Equity Portfolio XYZ Company Pension Plan (Sample Report) Total Percent 01 Morket Value Portfolio

Description

Percent 01 Account

11/88 Month

=c"' ...... ===...::="'''' ..::::",,,,..:::,,,=z::,,,,,,:: =",,,,z::=,,,,,,:: ",,,,,,,==::,,,,,, Cosh and Short Term Investments Principal Return Income Return Total Return

319.133

Equity Investm ents Principal RetUln Income Return Total Return

230.224

Total Equity Portfolio PrIncipal Return Income Return Total Return

549.957

Benchmark IndIces

a.

Standard Poors 500 I Principal Return Income Return Total Refufn

41.9%

100.0%

Percent of Portfolio In Eacll Major Asset Classification

Dow Jones Industrial Average Principal Return Income Retufn Totol Return

80

58.1%

34.5%

'"

Account Assets Allocated to EqUity Investments

-- .... _--- ... 165 ears

12/83 5 Years

12/78 10 Years

Inception 16.17 Years

"':::: :."'..::=='" =::=="''''::z: ::="'."':==

nla

nla nla nla

nla nla nla

nla nla nla

nla nla nla

nla nla nla

nla nla ola

nla nla nla

nla nla nla

ola nla nla

nla nla nla

1.13% 0.81% 1.94%

8.34% 3.90% 12.24%

8.34% 3.90% 12.24%

33.76% 13.49% 47,27%

62.27% 32.69% 94.96%

208.96% 166.48% 375.44%

182.45% 273.39% 455.84%

1.47% 0.31% 1.76%

2.15% 0.59% 2.74%

12.42% 7.% 16.1

12.42% 3.76% 16.18%

31.49% 13.61% 45.10%

66.44% 34.74% 103.16%

169.05% 162.70% 351.75%

149.06'r. 252.29% 401.37%

2.56% 0.33% 2.89%

2.64% 0.65% 3.29%

.47% .37% .84%

128.12% 265.48% 393.60%

0.00% 0.27% 0.27%

'''" nla ola

ola nla

2.44% 0.14% 2.58%

nla nla nla

2.09% 0.21% . 0%

'"

'"nla

24.9%

59.4%

Percent of Total Investment Account Represented by TillS Portfolio In a Major Asset Classification

Exhibit A-10 Cumulative Performance Summary (December 31,1988) Fixed-Income Portfolio XYZ Company Pension Plan (Sample Report) -------- ........... _== ==:: =="'::: ==

Descllptlon ==:: ====::= ===

=======

Tolal Percent 01 Market Value Po!tfolla ===== ==:: =:=== = ; : ========::

Cash and Shorf T81m Investments PrIncipal Return Income Return Total Return

260,582

Fixed Income Investments Principal Return Income Retutn Total Return

115.979

Total FIxed Income Portfolio PrincIpal Return Income Return Total Return

69.2%

30.8%

Percent 01 Account

100.0%

Inceptlon 63 12/18 10 Yeols 13.00 Year. ===: ===:::::="'= "."''''::::=''':=

0"

28.1%

0.00% 0.74% 0.74%

n/o n/o nto

n/o n/o n/o

n/o n/o n/o

n/o n/o n/o

n/o n/o n/o

n/o n/o n/o

n/o n/o n/o

(1.06%)

n/o n/o n/o

n/o nto n/o

n/o n/o n/o

n/o n/o n/o

n/o n/o n/o

n/o n/o n/o

n/o n/o n/o

12.5% 0.73% (0.33%)

376.561

Performance Flom: . _ •• _ •••••••••• - - .•••••••. - - - --

11/88

Monfh

40.6% (0.89%)

0,20%

0.20%

0.43%

2.16% 1.27%

8.47% 8.67%

8.47% 8.67%

1.06% 28.36% 29.42%

16.54% 68.06% 84.60%

207.83% 217.19%

6.42% 285.21% 291.63%

(0.43%) 0.77% 0.34%

(\.30%) 2.25% 0.95%

(1.55%) 9.14% 7.59%

(1.55%) 9.14% 7.59%

(2.77%) 30.02% 27.25%

8.84% 68.67% 77.51%

1.68% 182.34% 184.02%

(2.55%) 244.64% 242.09%

(0.31%) 0.74%

9.36%

Benchmark Indices $heorson lehman Govt-Corp PrIncipal Return Income Return Toto! Return

Source: RCM Capital Management

81

Question and Answer Session Question: Do you think the Standards will hold as

they are or be substantially modified in response to criticism (for example, that results should be on an equal-weighted as opposed to capitalizationweighted basis)? Bowman: I would guess the Standards would hold in substance, although with some modification. Standards are needed, without question. From my experience in viewing a lot of manager submissions, many sins are committed in putting forward performance figures. As a fund sponsor, we never see a bad manager's records until we hire him. It is in everyone's best interest to put their best foot forward, but it may prevent a comparable evaluation at the very beginning, so I would hope the Standards are applied substantially as they exist now. Boone: I don't think the Standards will change sub-

stantially. Most firms will have to make changes to comply with these Standards. We are making a number of operational changes to comply with the Standards, but I think our practices will be better because of the changes. Some aspects of the Standards are more open to discussion than others. It is these aspects that will receive more attention in the coming year, not issues such as whether the composite should be equal-weighted or value-weighted. For example, the question of composites is open and might be addressed in more detail. Another issue is the requirement to include cash with equities. Nothing prevents a manager from disclosing equity-only if he thinks that is a better measure of his stock-selection ability. An inappropriate cash level, however, can wipe out the benefits of good stock selection, and the client has the right to know. If the client wants to pay a manager to maintain liquidity and defines what it is, that is fine. To the degree that the manager is substituting bonds or cash for equity and his objective is equity, then he should be measured on an equity-plus-cash basis.

that they relate to firmwide activities, not peoplespecific activities. They have almost no applicability to the performance measurement of individuals, yet people count in this business. Have we depersonalized performance measurement too much? Bowman: Some investment gurus do very well, and

the press loves to write stories about them and put their pictures in the Wall Street Journal. From our perspective, very rarely would we give serious consideration to a firm that is entirely dependent upon one or two individuals' performances. Too often, they leave the firm, get hit by trucks, or various other things. We want to see a consistent firm philosophy so that the strategies are applied across all of the accounts. If the star system is emphasized too much, sometimes the details do not get properly addressed. We consider the firm history and the firm record very important. Wade: I cannot imagine altering the firm's history

because of the addition or subtraction of a star. By and large, the sponsors in this industry today are trying to hire an organization that has some very talented people within it who can make a contribution toward the total and be stars in their own right. To adjust the numbers because of an individual would not make sense. Boone: This has been one area that some firms have abused, and the Standards are directly aimed at stopping that. If the firm has a record and then changes because it is not working, and they bring in new investment people who have an impact, then that change in events should be disclosed, but the record of the firm cannot be erased. There are other things that could be disclosed. You have to use a little common sense. I think some old records have just disappeared, and some mutual funds have merged. You never see the poor-performing mutual fund as the survivor of a merger, even if it happened to be the larger fund.

Wade: I would expect and hope that the substance

of the recommendation will go forward. Obviously, I have some suggestions for modification, but we would support the Standards wholeheartedly if they go forward without any modification. This industry needs these Standards. Question: One overriding aspect of the Standards is 82

Question: How accurate do you think your cost estimates are? Boone: The estimates are probably wildly inaccurate. The time estimates will be affected by the accessibility of data. In particular, it will be difficult to find old records for accounts that are not part of

our present composites and to account for assets for which we have no statistics. In some instances, it is not worth the effort to recreate the past. We have to determine where to draw the line. The cost estimates are also loose because I did not separate professional time and time of some of the assistants. Wade: I have no idea what the cost is, partly because we are midstream in revamping our recordkeeping system to incorporate a variety of things required under these Standards. Question: Do you use the AIMR Performance Presentation Standards only for manager searches, which seem to receive a fair amount of emphasis, or for other activities as well? Bowman: One should make a distinction between an ongoing evaluation of performance that is being presented by investment managers as a group and specific investigations of performance related to a manager search. We do not look at our managers only when conducting a search. Obviously, we are trying to be alert to those firms that are successful and that we would hope would be candidates when we do want to hire a new manager. Often those firms visit us, but sometimes they do not, and to that extent, we like to have figures. If we see a manager that is doing well and keeps on doing well, obviously we are going to be interested and include that manager in our next search. From that standpoint, a consistently expressed standard is very helpful. To perform a comparative evaluation of managers, you really have to get into how those composites are constructed. Looking at the actual results of individual accounts that most nearly resemble your situation is probably more relevant, because this will most nearly replicate the way in which that manager will be working for you. The picture may be distorted by including composites of accounts that may not be relevant. Question: Is communication between manager and sponsor via consultants considered one-on-one by the SEC? Boone: I understand that the SEC would allow a pass-through of the one-on-one exemption, as long as the manager informs the consultant that the presentation or pass-through of those numbers would also only be allowed on a one-on-one basis. In general, a consultant would work on a one-on-one basis with some specific client, so submitting a manager's numbers to a client would not be advertising, as long as the manager instructed him only to

use them in a one-on-one situation. 1 Question: The AIMR Standards suggest that firms should form only one composite of its accounts. In reality, because oflegitimate differences in the nature of accounts, firms are recommending 16 to 18 composites. Are we making life too complicated by thinking up all of these separate categories? Wade: People tend to get preoccupied with these numbers as though they are the be-all and end-all, but they are really only a starting point. They are a means of looking at what a given manager has done over time. They are not an extensive review of the manager's performance in the present and going forward, particularly for the individual accounts. Boone: I am supportive of the composites. If managers are going to account for all of the assets under management, composites are the best way to go. People can get carried away with categories that could be lumped together, but if the assets included and excluded from the composite are disclosed, then we will have come a long way. In the past, a lot of performance numbers that did not include all accounts probably did not have a high level of integrity. In other cases, there is a good reason for presenting only a subset, but the subset should be presented in addition to the company composite. For example, I will probably make a separate composite for our South African-free accounts because they behave differently. If I find I am in competition for an account that has South Africa restrictions, then I can bring those to the fore, but I will also present a composite of the rest of the accounts. Bowman: The composites are only the first step, however. After you have looked at the composites, you have to do a far more extensive analysis that is specific to your situation, and that probably has some implications for the way managers organize their data. To meet the requirements of clients, managers are going to have to keep that individual account record information as well as the composite information so that they will be able to assemble the more specific figures when they are asked to do so. Question: The AIMR Standards will result in numerous composites per firm. What is your preference for the inclusion, the exclusion, or the summarization of data in requests for proposals (RFPs)? 1See Ms.

Podesta's Question and Answer Session, pp. 23-26.

83

Bowman: I want to see all the composites that are relevant to the search, and I do not care how many that is. Obviously, for an equity search, there is not much point in looking at fixed-income composites. On the other hand, there might be something to gain by looking at the convertible composites if that was a style being run by that manager. The more information we get the more helpful it is. As long as the composites are clearly identified as to what they actually represent, they are relevant. Question: Please address the usefulness of composites in the fixed-income area where the accounts are much less homogeneous. Bowman: The whole field of fixed-income needs a lot of work. It needs to be thought out. The various standards or styles that are being used to manage accounts are different. Client requirements often create substantial differences in the way the accounts are managed. Because of the lack of uniformity, the issue of what constitutes a relevant benchmark must be addressed. I am not convinced that many of the fixed-income indexes are really relevant benchmarks. I hope the industry will address fixedincome performance and come up with some good answers in the next few years. Question: In reporting to a current client, how do you account for the overnight short-term investments done by a master trustee? Boone: We split the total of cash and cash equivalents into "equity cash" and "fixed-income cash." We changed the accounting program so that dividends flow to equity cash and interest flows to fixedincome cash. External cash flows are split based on the equity/ fixed-income asset allocation. Question: Does your balanced-fund composite include all of your balanced accounts, even if they have different asset allocations? Boone: No, it does not make sense to mix accounts with different objectives. We are still struggling with how to show the results of changing the asset mix in balanced accounts. We may show a composite with accounts with similar asset allocations and disclose information about accounts with extreme allocations which are excluded. Question: In your last search, did you check to see whether managers complied with the AIMR Standards, or did you take their word for it?

84

Bowman: We went on faith in this search. We asked that the performance be presented in accordance with the AIMR Standards, and if it appeared that it was-that the disclosure was adequate and the numbers were consistent-we assumed that it was. In some instances we did have to go back for additional information. This is one of the first searches that I know of where we actually asked that the AIMR Standards be applied. In the future we will look more closely. Some of the managers that did respond had audited performance Standards. We assumed, of course, that these records were in compliance. Question: The AIMR Standards require as long a performance history as is practical, preferably 20 years if possible. Would you penalize a firm for not supplying a 20-year, or since-inception, record? Bowman: We give a much greater weight to recent performance than we do to past performance, believing that performance loses relevance the further back you go. The conditions under which it is produced change, and the needs of the clients change. Despite that, I think it is important for potential managers to provide the longest history possible, preferably spanning several cycles, or at least an economic cycle that includes both up and down markets. Question: Once you hire a manager, do you require them to submit their composite performance or just the performance on the portfolios they manage for you? Bowman: We only require them to submit the performance on the portfolios they manage for us. We calculate our own performance on those portfolios and we compare the two figures. If a manager encounters a serious problem and underperforms on one of our portfolios, we may ask to see his composites, but that is only done to try to get at what the problem is. Question: What are the advantages to having performance audited? Boone: We do not feel that our numbers need to be audited. We feel very good about their integrity. Other firms may feel that they will gain a competitive advantage in terms of marketing by having their performance audited. Large clients may begin to require audited numbers. On the other hand, if implementation of the AIMR Standards is widespread, as I certainly expect that it will be, then perhaps auditing will not be necessary.

Question: Do you think these Standards will be adopted by managers of their own free will, or do you think they will have to be required by a regulatory body? Bowman: The evaluation of RFPs is a subjective process to a large degree. Performance numbers, by themselves, are only part of the picture; they do provide information on the relative performance of a set of managers. Other information-for example, the matter in which those numbers are presented, the completeness of the report, the number of composites, whether they are audited or not-also contributes to the overall impression that the manager makes in the subjective part of the evaluation process. To the extent that compliance is attempted and full disclosure is provided, a manager is going to make a better impression than the one who just submits numbers where there is not full disclosure and where it is apparent that the proper care has not been taken. This should put pressure on managers to comply.

Question: In the Callan data base, do you identify whether a manager is in compliance with the AIMR Standards? Dennis: Yes, it is footnoted. If a manager is in violation of the Standards, the importance of the violation depends on the area of noncompliance. I do not view equal-weighting rather than dollar-weighting to be a serious violation. Question: What are the most common reasons managers give for not complying with the AIMR Standards? Peyton: The reasons are usually related to specific situations. The majority of managers that work with our clients are larger organizations that have their acts together as far as reasonable composite numbers go. I don't know, however, if their composites currently include every account for which they receive a fee. The most common reasons relate to cost, time, and the availability of data. Question: Please comment on the AIMR Standards' requirement to dollar-weight versus equal-weight accounts in a composite. Dennis: The Standards were set as a balance between ethical ideas and practical considerations. It

is easier to equal-weight composites, which is the practical consideration side. The ethical standard side deals with correcting potential abuses such as the allocation of hot new issues to the smallest account. Suppose, for example, that a manager gets an allocation of 1,000 shares of XYZ stock as a new issue. This stock is oversubscribed, so it is likely to increase to $20 from the issue price of$12 during the first day. If he is equal-weighting his composite, this manager has an incentive to put all 1,000 shares in his smallest account so that it can have the biggest impact on performance. That small portfolio is then equally weighted with larger portfolios to bring up the average of the composite. Question: Often, past performance is inversely correlated with future performance. Should we pick the poor performers? Peyton: The negative correlation between past and future performance occurs because almost everyone who has a disciplined style has a cycle. The major problem in the industry is time-period bias. Sponsors look at the return performance for the period just preceding the search and make intuitive selections based on that. Performance is not the only criterion, however. Sponsors should be looking for good organizations; they are beginning to see that what intuitively feels good may not really be smart timing decisions. Nevertheless, it is still hard to get a sponsor to hire a good manager who has performed poorly in anticipation of better performance in the future. Question: What do you think of the idea of a central performance repository system? Peyton: I would be concerned about who would have access to that data base. For instance, we often get calls from plan sponsors who want only the top five performers from our data base. That is how a centralized data base would be used if everybody had access to it. We do not provide manager numbers to our clients except on a specific assignment for which the job description and criteria have been defined. Also, users of outside software or services have no control over the quality and do not know where the glitches are. If this central repository makes mistakes, we will not know about them. Question: What method do you use to calculate returns? Dennis: We calculate daily time-weighted rates of return. This is the preferred calculation according to the AIMR Standards. Because we calculate daily 85

returns, we do not need to worry about the size of cash flows. Question: Do you calculate performance gross or net of fees? Dennis: We do it both ways. Gross performance is the standard because it does not advantage larger accounts versus smaller accounts, which is the reason AIMR set that standard. Question: Do you keep track of account performance with or without consultant fees? Peyton: I wish consultant fees were significant enough to be measured. Callan's gross consulting fees as a percentage of client revenues are less than one-tenth of a basis point. Question: Please comment on the issue of equalweighted and capitalization-weighted composites in performance measurement. Peyton: Which to use depends on the client, how big the manager is, and how big the portfolio is going to be. You may want to look at a composite that includes only clients that have a portfolio of $100 million or more. Use whatever makes sense. A capitalization-weighted composite is going to demonstrate the performance of larger portfolios; an equal-weighted composite, the smaller portfolios. Question: What percentage of managers use audited performance numbers? Peyton: I don't know. We don't pay particular attention to that. CPAs may formulate some good auditing principles and procedures, but right now I trust the basic data because they are easily verifiable against live results from the custodial statements. Audited numbers can have a marketing impact, however. Bowman: In the one search I referred to, only 6 percent of the 40 respondent managers submitted audited returns. Question: Should the balanced-account composite be a mix of equity and fixed-income portfolios or an actual composite of all balanced accounts, regardless of the asset mixes? Dennis: Clearly the latter. Question: How does Callan compare fixed-income 86

performance among managers? Dennis: Fixed-income managers are compared to their style groups. Our style groups are configured mostly along the dimension of maturity. The style groups range from short-term cash managementtype accounts, to intermediate-term bond accounts, to various active-management strategies and to nonmaturity-type accounts such as high-yield bond accounts. We feel that the styles capture the variety of different fixed-income management strategies. Question: Does Callan recalculate performance or rely on the numbers submitted by managers? Dennis: We rely on the honor system in our manager performance data base. We do not recalculate returns, but we do perform a few checks on the numbers. For example, if a firm added a large new account, we check to see that the composite increased by the amount of the new account. We also use regression analysis to compare the last 20 quarters of a manager's reported data with the last 20 quarters of the benchmark data. We know what the benchmark did in the 21st quarter; therefore, we have a pretty good idea what the funds should do in the 21st quarter. If it is outside a range of tolerance, bells and whistles go off. Question: Referring to your discussion regarding yield on book, because yield has historically accounted for the plurality of gain, not capital, why is Callan so negative on this return method? Dennis: The yield method favors a buy-and-hold manager over a period of rising interest rates. If we accepted that as given, we would be telling our clients we think interest rates are going to be continually rising, or at least that would be the inference I would make. To expand on that, this is a cash management account representing the residual cash of 13 managers who are independently raising or selling cash. The portfolio is worth $1 billion today but it might be worth only $100 million tomorrow. If the manager is forced to liquidate two-year securities to meet that cash call, he is going to realize a loss. That capital loss must be portrayed in the performance calculation.

Question: Shouldn't a fixed-income portfolio beta incorporate more than duration? How about a separate risk coefficient for maturity or sector dif-

ferences from the benchmark? Watts: Duration is a useful concept, but it is an ex ante estimate of risk that has some limitations. We believe ex post observations are more useful. We also believe risk should be disaggregated. It is useful to show the actual volatility of returns divided into periods of rising bond prices and periods of falling prices. It is also interesting to measure value-added during both bull and bear markets. Question: Will implementation of the AIMR Standards require a lot of work for your firm? Watts: No. In fact, we present our returns in a format required by AIMR. In addition, we use what we call a "triangle," which shows each account's return and volatility in each period, as well as the return and volatility of the client's benchmark. Question: One of the speakers suggested that conventional bond indexes may be less than useful. What are the alternatives?

what extent is getting good pricing for infrequently traded securities a problem? Watts: Pricing is a big problem for our firm. And, because we focus on highly marketable securities, pricing of frequently traded issues is not an issue at all. We used to insist on pricing with actual bids. Now, because of clients' preferences, we use pricing tapes. Tape pricing does introduce errors, but the effect on returns washes out over time. So, using tape prices instead of dealers' bids has proven better than we anticipated.

Question: How do you report fixed-income returns when you have a blend of taxable and tax-exempt securities? Can you report just one number for both?

Watts: At the outset of a new assignment, we often utilize parts of the conventional indexes as a benchmark to approximate how the client wants the portfolio, on average, to operate. Usually it is possible to select an appropriate index or combination of the several elements of published fixed-income return indexes. After several years, however, most clients decide that they prefer customized benchmarks, often comprising specific securities, rather than using a published index.

Smith: There are two levels to consider: the portfolio level and the composite level. A portfolio has various sectors, and portfolio performance can be reported separately by sector, including the taxable and tax-exempt sectors. The composite is a little more complicated. We came up with the technique that permits including the performance of a particular portfolio in two composites. For example, a taxable fixed-income portfolio would be included in both the fixed-income composite and the taxable fixed-income composite, and the tax-exempt portfolio would be included in the fixed-income composite and the tax-exempt fixed-income composite.

Question: How many different fixed-income composites does your firm have?

Question: How do you make adjustments for cash flows greater than 10 percent?

Watts: Of our 60 clients and 90 portfolios, we have about 40 distinctly different combinations of benchmarks and guidelines. This suggests that we have 40 different composites, but many of them would comprise only one or two accounts. At present, we compile returns on five groups of portfolios. The first are those with a six-month benchmark duration. Two others are portfolios with similar guidelines that use either the "aggregate" or the "government / corpora te" indexes as benchmarks. A fourth group are those with intermediate indexes. The fifth composite includes those with "short-intermediate" benchmarks. All of the accounts in composites have similar guidelines.

McFadden: We look at the date the cash flow occurred and try to revalue the portfolio the day before and the day of the cash flow. Our system can flag cash flows in excess of 10 percent. After the month is complete, we can adjust the return for the actual timing of the cash flow to produce a time-weighted rate of return. Ideally, advance notification of major cash flows is needed to capture the appropriate portfolio values.

Question: Other than Treasury and agency securities, which pricing method do you rely on, and to

Question: Why can investment management firms get pricing so much faster than bank trust departments? Smith: Investment managers may not get prices any quicker; they simply may get the results out quicker. Most bank trust departments get fairly quick prices, 87

but with the volume they have to deal with, their results might be a bit slower. McFadden: I agree. We use the major pricing services, but given the number of securities and accounts involved, it takes time to complete all of the reports. Question: How does your new system handle cash in balanced accounts? Smith: Our system provides some flexibility in allocating cash in balanced accounts. Generally, cash can be allocated over the other assets or sectors of the portfolio in three ways. The old way is to allocate it based on how the account is invested: If the allocation is 50 percent fixed-income and 50 percent equity, the cash would be assigned 50/50 to those two sectors. Another way is to allocate the cash according to allocation targets. A target might be 60 percent equity and 40 percent fixed-income, and even though the actual proportions may differ from this target, the cash is allocated 60/40. The third way is to allow the portfolio manager to specify how to allocate the cash. For example, the target may be 60/40, but the sale of some equities temporarily creates extra cash. Obviously, that is equity cash and should not be allocated to another asset class. Generally, cash is allocated using a combination of the latter two techniques.

McFadden: Most money managers are able to calculate daily time-weighted rates of return. The trusts are put in a position of trying to match that. Normally, the returns we calculate are okay. Large cash flows are the reason people want to see performance calculations based on the daily time-weighted rate of return. This is the most appropriate measure of performance of a money manager. Question: Do you think daily valuations distort or confuse the intent of the Standards in any way? The Standards recommend that they be done at least monthly. McFadden: They do have to be done at least monthly, but the time has come to reconcile everybody's returns because they differ so much. Investment managers, for the most part, calculate returns on a daily basis. Question: If measuring every account is not feasible for trust divisions, do we simply disregard the all-account composite standard? Smith: Measuring performance for every account requires a highly automated solution, but we have the technology, speed, and internal memory to do it for every account because the methodology is generally the same for all of them. The difficulty lies in handling the volume.

Question: How does your system value free receipts, deliveries, and assets transferred to another account at original cost so as not to skew the performance results? Smith: It values them at their value as of the day of receipt or day of delivery, not at cost, which would be meaningless to the performance measurement. Question: If equities are long-term assets, isn't the industry getting myopic about daily valuations for the purpose of calculating investment performance? Smith: No, I don't think so. I worked on a performance measurement system in the early 1970s that used fairly easy methods of valuing things dailymidmonth assumptions on cash flow and other methods that would not be acceptable today. Going back over time, performance is generally about the same, regardless of how specific the valuation. In the short run, there will be distortions from time to time. The short run is what bothers people enough to lean toward daily valuations, not so much the performance calculation in the long run.

88

Question: What was the reason for including in the system design the capturing of capital market statistics such as beta, standard deviation, and R2? Was it on a monthly basis, quarterly basis, or trailing 12 months? Mortensen: We have not started using capital market statistics in the presentation of composite information. The system was designed to meet anticipated future needs. Currently, those statistics are being captured on a monthly basis. Question: How often do you use specialized benchmarks? Mortensen: Probably not more than 5 or 10 percent of all accounts have either requested, or we have felt that it is appropriate to supply, calculated benchmark indexes. We use specialized benchmarks on a number of our balanced accounts.

Question: Why did the fixed-income fund have an equity component?

view of what the overall record of your organization has been.

Mortensen: That almost never happens, but we allow for the possibility to be able to make things add up. In some rare cases, an equity asset would be contributed to a fixed-income portfolio, held for a brief period of time, and liquidated. You have to have a place to put the asset to make things add.

Question: How do you deal with nondiscretionary portfolios, or portfolios for which there are significant restrictions?

Question: The line between fixed -income and equity is getting fuzzier, and the way in which we divided them 10 years ago is not the way we would today. My hunch is that 10 years from now we will not do it that way. Mortensen: I agree. A junk bond, for example, might be better classified as an equity these days. Question: But if you classified it as fixed-income three years ago, would you change the classification today? Mortensen: Yes, it might move around. When a junk bond security resembles in risk, pricing, and other relevant characteristics an equity security, it might be appropriate to classify it as an equity security. Question: Are the reports that you have described based on your own data base and portfolio accounting systems? Mortensen: Yes and no. The basic portfolio accounting system we acquired three years ago from Belvedere Financial Services had rudimentary performance calculation capabilities. Obviously, we have spent considerable time, effort, and money in bringing that system to the level necessary to meet the needs of our clients and to comply with the AIMR Standards. Question: Is there a magic number of composites beyond which you decide you are refining too much? Mortensen: No, there is no magic number. The answer depends on the firm and what is reasonable given the mix of accounts it services. A manager might have a composite with only one account in it if that account is unique relative to the other accounts. More importantly, every portfolio should be in at least one composite. Obviously, if there is too much aggregation, at some point you will not be able to see the forest for the trees. Of course, looking at the forest may keep you from seeing what the trees look like, too, but it gives a consultant or a client a

Mortensen: The system is designed to have multiple portfolios and multiple composites. Nondiscretionary portfolios could comprise one of the composites. Obviously, interpretation of those results would have to be done carefully. Similarly, if you have a client that instructs you to set an amount of cash aside for a period of time, you can withdraw the cash from the actively managed portfolios and place it in an nondiscretionary/unsupervised portfolio until the client withdraws it or directs you to manage it in accordance with the investment guidelines of your actively managed portfolio. Question: Do you think AIMR should mandate compliance with these Standards? Mortensen: Yes. Question: What role do you think the SEC should have in these Standards? Mortensen: I believe our industry needs a strong self-regulatory body. I do not believe that governmental agencies, such as the SEC, should be actively involved in managing the development of standards or in the implementation or enforcement of those standards. Question: How much money has your firm spent to enhance its performance measuring system? Mortensen: Our firm has spent more than $125,000 during the past two years. The costs have primarily been for capitalized software development, which works out to about $20,000 a year for an organization of our size. A smaller firm could develop a similar system for a lot less money, if it has sufficient underlying accounting data available. Service bureaus should be providing such accounting data for their clients. Question: What was involved when your firm hired an auditor? How much did the audit cost? Mortensen: We hired an auditor to perform an examination of our performance statistics since the inception of the firm in 1970. The auditor took a statistical sample of activity throughout the period

89

from 1970, reviewing confirmations of security transactions, asset and bank statements of various accounts, and other relevant information. Fortunately, we had kept and were able to retrieve accounting data going back to 1970. The cost of the original implementation was partially reduced because of a three-year commitment with the auditors. Current-

90

ly, our ongoing audit costs for 300-plus accounts, more than 500 portfolios, and about eight composites runs about $25,000 a year. Although these costs may appear high, they are more than offset by the advantage gained in competing for new client relationships in an increasingly difficult investment environment.