In Discourse on the Method, René Descartes concisely set out the systematic rules that guided him in an effort to place his knowledge on solid footing. He would accept as true only that which presented itself to his mind so clearly and distinctly that he could have no occasion to doubt it; and he would proceed by dividing each difficulty into the smallest possible parts, progressively advancing from the simplest to the most complex, and reviewing each step to ensure he hadn’t omitted anything. But Descartes recognized that, while he was engaged in demolishing and rebuilding his conceptual house, he would need temporary lodging. Accordingly, he formulated a “provisional morality”—three or four maxims to live by while rehabilitation was in progress.[1]
At present the investment industry does not have generally accepted client reporting standards. Developing global standards, as Stefan Illmer and Dmitri Senik have urged,[2] will require organizational sponsorship and the active participation of many knowledgeable practitioners. Until the project is undertaken, however, and the industry reaches agreement on client reporting standards, a small set of provisional principles might be useful. Here are some common-sense ideas.
- The purpose of client reporting is to communicate portfolio and performance information.
In other words, the purpose is not, say, to retain and grow assets under management, nor to demonstrate the firm’s cleverness. In application, Provisional Principle 1 means that client reports should be formatted to convey portfolio and performance information effectively, and commentaries should be written in plain language. By writing Discourse on the Method in French, rather than Latin, Descartes sought to reach literate people outside the scholarly community. The simplicity and directness of his style are also exemplary. Incidentally, an earlier version of this first principle read, “The purpose of client reporting is to communicate portfolio and performance information enabling the client to evaluate the manager’s execution of the investment strategy in light of market conditions during the measurement period.” The revised version represents a considerable gain in economy for a small loss in content.
2. Portfolio performance should be presented fairly, accurately, and completely.
This wording, borrowed from the CFA Institute Standards of Professional Conduct, is somewhat less exigent than a similar provision in the Asset Manager Code of Professional Conduct, which states that managers must present performance information that is “fair, accurate, relevant, timely, and complete.” It doesn’t seem necessary to mention relevance and timeliness; the one is implicit in communicating effectively, and the other is a competitive requirement. In practice, fairness means using standard measurement periods such as the month, quarter, or year; presenting the performance of a valid benchmark for the same period(s); and ensuring that all charts are straightforward. Accuracy means calculating results correctly on the basis of the firm’s best estimate of asset values. Completeness means providing sufficient pertinent information for the client to evaluate investment results, possibly including market commentaries, portfolio and benchmark characteristics, ex post risk measures, and/or attribution analyses.
3. Clients should be informed of revised portfolio and performance information when material errors are discovered.
This is a tough one. Everybody knows that people who actually work occasionally make mistakes, but nobody likes admitting them. ‘Fessing up may be especially painful for people in operational roles who have few offsetting opportunities to gain more favorable attention. All the same, firms should formulate and consistently adhere to well-defined policies for evaluating materiality, correcting errors, and disseminating revised information. (The GIPS® Guidance Statement on Error Correction is a valuable resource.) For supervisors, the key is never to squander a good mistake, nor, for that matter, a near miss. Figure out how it happened and strengthen controls to safeguard against a recurrence.
4. Client reporting policies should be developed in consultation with internal stakeholders, documented, and kept up to date.
Descartes devised his methodology with a specific project in mind, but he clearly intended it to apply to any intellectual endeavor. Breaking things down, moving from the simpler elements to the more complex, and continually reviewing the work for completeness are generally good rules for thinking. Similarly, establishing a consultative process, documenting policies, and keeping them current are sound managerial practices in any organization and any function. The internal process of setting, memorializing, and refreshing policies is especially important in the present case because client reporting directly affects how the firm is perceived by those who have entrusted it with their wealth.
[1] Descartes introduced his provisional moral system with this housing metaphor in the third part of Discours de la method (1637). Oeuvres de Descartes, ed. Charles Adam and Paul Tannery (Paris: Vrin, 1996), vol. VI, 22.
[2]Stefan J. Illmer and Dmitri Senik, “Client Investment Reporting: The Need for a Global Standard,” Investment Performance Measurement Newsletter (CFA Institute), August 2009. Unfortunately, Illmer and Senik’s article is not available on the CFA Institute website.
Tags: client reporting, Firm management
I believe that the investment manager’s duty of loyalty should be the bedrock principle guiding all investment activities, including client reporting. We all use the term “Client reporting” when in reality this tends to be little more than “Investment Manager” reporting.
Just look at the focus of the information the manager provides:
a) How did the portfolio (AKA “I the Manager”) do against a passive benchmark? If I don’t show value, the client may take money away from “ME” and give it to another manager.
b) How did the portfolio (again “ME”) do against a peer group? I’m in competition with other managers, and I have to show that I’m doing well. (Again, it’s really all about ME.)
c) I might show “risk” statistics, but I use arcane mathematical concepts that have little meaning or relevance to clients. But, they’re easy to churn out and seem impressive.
d) I only show my little piece of the puzzle. I don’t really care about who takes care of putting the entire portfolio together. So, bring in the “Consultants…”
e) As the Consultant, I show the average return of the various managers. I deliberately exclude the effect of external cash flows on performance, since this would not represent the skill of the individual managers. (Wow, these guys seem to be “in cahoots” with each other to help themselves look good!) If anyone questions why we do this, we’ll just invoke the GIPS standards, holding them up as the “gold standard” of the industry.
Now, the one thing that is conspicuous by its absence is any client reporting that is FOCUSED ON THE CLIENT. There are two critical yet missing parts:
#1: Real portfolio performance – a number that reconciles the beginning value, any cash flows added or withdrawn and the ending value of the client’s portfolio.
#2: Reporting that explains whether the investment managers, consultants etc. are succeeding in helping the client meet his financial goals. This may be expressed as a return number, but it’s more likely expressed as “having an adequate amount of money when it is needed to meet the client’s needs and desires – that is… his goals.”
For example, for an individual, this might mean showing that they have been able to withdraw the money they needed to live on, that they’ve had adequate liquidity and did not need to sell depreciated assets that needed time to recover their value, and that they’ve preserved enough portfolio value for future needs. For a charitable foundation, it might mean showing that their actual grant making has met or even exceeded their planned amounts, and that they have adequate capital to continue their charitable work. Notice that these performance goals were MONEY not RETURNS. For a pension fund, it’s an improving funding ratio that is adequate to pay the beneficiaries. This isn’t hard to “get one’s arms around.” It’s more about a willing heart than a lot of technical knowledge.
If the lofty goal of client reporting is to have any real benefit to clients, then it must start by focusing on meeting the clients’ true informational needs, and must be oriented toward the clients’ financial goals. Until the industry adopts this attitude, all this talk about “standards” is little more than noise to “tickle the ears” of performance staff. Let’s get to work!
While I am perfectly fine with Dimitri and Stefan pursuing this project, since they (especially Stefan) are quite passionate about the idea, I question the WHY behind them; that is WHY do we need these standards? And, might it first be appropriate to ASK the industry if they are desired, before marching down the long path, or are these standards that are coming regardless of what the industry thinks?
The standards, as they currently stand, anticipate the need for “verification,” as is done with the GIPS(R) standards; meaning what? Meaning more money for our firm (The Spaulding Group) and other verifiers, but also more costs for our clients. Yes, we will be happy to verify a firm’s compliance with the reporting standards, but I’d prefer there to be no standards at all.
Many firms pride themselves on what they craft, and feel that they set themselves apart from their competitors. What problem are these standards addressing? The GIPS standards (or perhaps more correctly, the predecessor AIMR-PPS standards) were crafted to address a problem; what problem exists today in client reporting? These standards will provide “best practice.” But as I have often addressed in my blog (http://www.investmentperformanceguy.blogspot.com/), what do. But what does this term actually mean? It isn’t defined in GIPS, though one can conclude that it’s “what the GIPS Executive Committee thinks best practice is,” meaning that if we change who’s sitting in the seats, we likely will get different answers; and the same apparently will hold true in this new standard.
Given the CFA Institute’s muscle in the industry, if these standards are actually formulated, they will become a defacto standard, just as GIPS is. But is this fair? Is this appropriate? To add more expense to asset managers?
At our annual PMAR conference and our Performance Measurement Forum we have had discussions on this topic, and while there are always a few who favor them, the vast majority appear not to. Guidance? That seems more welcome. But “standards”? It doesn’t appear to be what is wanted.
Thanks to Stephen Campisi and David Spaulding for their comments on this piece, or, rather, on the general topic of client reporting standards. Let me first find points of agreement with each of them.
I wholeheartedly agree with Campisi’s statement that the manager’s duty of loyalty to the client should be the “bedrock principle guiding all investment activities, including client reporting.” This may seem so obvious that it goes without saying, but, as I have discussed here and elsewhere, the uniform fiduciary standard proposed by the SEC—a standard whose components are the duties of loyalty and care—has met with considerable resistance among broker-dealers. Campisi is entirely justified in alluding to this ethically fundamental obligation in the context of client reporting.
I’m also inclined to agree with Campisi that firms conflate portfolio results and promotional messages; that’s why, in my gloss on Provisional Principle 1, I said that the purpose of client reporting is neither to preserve and increase assets under management nor to put the manager’s intelligence on display. Effective communication is client-centered.
That said, I have reservations about Campisi’s position on the proper content of client reports. I don’t intend to host a debate about the relative merits of time-weighted and money-weighted returns, but I will observe that many of my contemporaries cannot retire because they did not save enough. Advisors are responsible for investing clients’ assets suitably; they are not answerable for their clients’ spending habits.
I strongly agree with Spaulding’s statement that “best practice” is an amorphous notion posing as a term of art in the fields of standard-setting and management consulting. Tom Messmore rightly called me to task for bandying this phrase about several years ago. He said, “Unless one can write down ten unique stipulations of BP in any given industry-subsector-specific case that the top five competitors uniformly strive to achieve but seldom accomplish, BP is arguably insufficiently specified.” I now try to avoid the phrase in my writing and consulting.
It is not my opinion that standards necessarily entail verification. Two examples come to mind. ISO 31000, “Risk Management—Principles and Guidelines,” about which I’ve written at length in this blog, is a benchmark but not a standard for certification. Similarly, the Asset Manager Code of Professional Conduct mentioned in the present blog entry is not subject to verification. This is explicitly stated on the CFA Institute website, where it also says, “CFA Institute supports many self-regulation models and voluntary sets of professional conduct standards relevant to the investment industry, of which the Asset Manager Code of Professional Conduct is one.” For the record, I am not convinced that verifying firms’ adherence to client reporting standards would be appropriate. It appears, in any case, that the industry will have plenty of time to decide the question.
Finally, I don’t think a show of hands at a Spaulding Group conference is compelling evidence, but I do not have empirical data in support of my position, either. One would have to conduct a survey of clients, not managers, to determine whether report users perceive value in setting standards to guide firms in communicating investment results. As a part-time blogger, I am not prepared to undertake a proper survey. My part is, of necessity, limited to raising the issue of excellence in client reporting and offering a few provisional principles.
Philip, as to the “show of hands,” I do not disagree; however, it’s indicative of at least some degree of opposition; and when this follows both a presentation and discussion on the topic, and is from a group of legitimate industry performance measurement professionals, their sentiments should not be taken for granted. And my point is that when the CFA Institute gets around to posting their ideas, will there be a question “do you support these standards?,” or will it be presumed that of course people do. And if the majority respond “no,” will they be dropped or converted to guidance, or moved forward regardless?
And as to verification, this wasn’t my idea: it’s part of the plan,apparently.
Thanks for this, Dave, and for the piece you posted on your blog, Investment Performance Guy, this morning. I don’t have any idea what CFA Institute has in mind. I know verification isn’t your suggestion — quite the contrary — and I doubt verification would stand up to cost-benefit analysis.
I am surprised at Philip’s observation on the so-called “debate” on time weighted vs money weighted returns. That’s not the focus of my comments. I did say that money makes a better performance measure than returns do, at least when it comes to evaluating success in fulfilling on the client’s goals, which are money goals and not return goals. The performance industry is not going to take a single step forward until it gets off their soap box about return calculations and starts addressing the real questions that clients have regarding whether they have the money to fulfill their financial responsibilities. Enough with the return calculations! Start answering the real questions, like: “What was the return on my portfolio?” and not just “What was the average return of the managers in the portfolio?” The first question is client-centered while the second in manager centered. How about: “What is the risk my portfolio will fail” instead of “what was the statistical volatility of return relative to the mean return?” See the difference? Let’s start answering the clients’ relevant questions; we are not doing this now. Let’s remember whom we work for.
Oops… I spelled my name wrong. Quell surprise.
Oops… I spelled “quelle” wrong. I may be spelling it wrong still. One would think two years of high school French 40 years ago would have served me in better stead. C’est domage!
Dommage, too. But not bad! Thanks again for adding to this conversation. I think we’re not too far apart.