The imperfections of AIMR's performance measurement standards still plague us today, five years after the standards were first thrust onto the investment scene.
The project's creators had a laudable goal: to establish a level playing field for all investment advisers. They sought full disclosure, fair representation and direct comparability.
Have the performance measurement standards, established by the Association for Investment Management and Research, accomplished the task? Are all managers treated equally with respect to AIMR requirements? Do managers who represent themselves as meeting AIMR standards truly do so? Does the consulting community care whether managers meet AIMR requirements?
In a perfect world, the answers to these questions should be yes. Unfortunately, we do not live in a perfect world and imperfections of the standards are troubling.
That's not to say we haven't come a long way from the debates on whether we should be using dollar-weighted or time-weighted returns. To AIMR's credit, good has come from establishing its performance standards. Namely, we now have consistent performance calculations with asset-weighted and like-goal composites.
This is a standard?
It is not what AIMR has accomplished with which I take issue; it is what AIMR has not done. When AIMR names its performance measurement rules a standard, it connotes more than what it has earned. The word standard implies authority and completeness. As long as there are rules that are somewhat arbitrary, as long as there isn't sufficient policing, and as long as only a portion of the professionals embrace its governance, AIMR fails to achieve comparability and credibility.
The AIMR standards should be much more than just an audit of performance calculations. If comparability and credibility are the goals we desire to achieve, then we have to reach beyond the current set of standards and garner the support of all those participating in the process. The authors of these standards had worthy aspirations and expended a significant amount of time and energy in the effort.
With almost five years of operating experience under its belt, the AIMR performance standards need to be taken to the next level to better understand investment results. At a minimum, AIMR needs to point out how the standards are being misused and work harder to rectify the deficiencies. We need risk-adjusted returns when evaluating performance of composites. To establish true standards of performance measurement, we need to garner the support of the investment community, consultants, plan sponsors and software vendors alike.
Are AIMR standards enforced?
On the topic of credibility, I believe we have come a long way; but it is still disturbing to note that AIMR performance standards are not given the serious attention by some that they deserve.
We could believe we are operating on a level playing field: If we required certain AIMR compliance levels for managers to be included in searches; if we asked more in-depth questions on questionnaires with regard to AIMR compliance (beyond are you in compliance? Please check yes or no.); if the consulting community treated AIMR performance standards in a serious fashion; if there were some policing body to ensure managers actually were complying with the standards.
Ask many of the accountants who perform AIMR audits and they will tell you:
Many managers do not comply with the standards even though they say they do;
Many consultants do not look beyond the checked box on their questionnaires as to whether managers are in compliance;
There are sufficient gray areas under AIMR standards to create differences in interpretation, which lead to inconsistent comparisons.
Furthermore, what does it mean to be AIMR compliant? Some managers calculate their returns based on AIMR standards, some managers have gone through a Level 1 audit and others have gone through a Level 2 audit.
Calculation of returns vs. Level 1 or Level 2 audits results in significant differences. Yet when asked the question, all are AIMR compliant.
What issues are there with respect to comparability as it relates to performance measurement? Comparability is more than assuring that your composite contains similar accounts with similar objectives. Composite construction is important; but AIMR only scratches the surface on this issue.
For example, let's take the small manager who has successfully invested his client's assets, has historically been a balanced manager and now wants to expand his practice. He needs to display equity and fixed-income results separately to get into equity-only and fixed-income only searches. Sounds simple? Well it's not. How does this manager account for cash? Cash is not allowed to be an asset category by itself. His only choice, according to AIMR, is to allocate cash to equities and/or fixed-income in some proportional amount.
Quickly, we can review several of the manager's options. Assume he runs balanced accounts with a 60/40 strategic target allocation between equities and bonds. Last quarter he had a 40/40/20 mix of equities/bonds/cash. What is the appropriate allocation for cash? Three possibilities immediately come to mind (there are many others):
He can attribute all the cash to equities because that is what's needed to get equities back to 60%;
He can stipulate that equities and bonds represent equal portions of the portfolio today and allocate half of the cash to each;
He can allocate the cash according to the target allocation with 60% of the cash, or 12% of the total, to equities; and 40%, or 8% of the total, to bonds.
Which is correct? All three options could be used, with the potential of different results. Furthermore, after you choose your method you can change to another as long as you are consistent and restate your history.
The key point to make is that comparing three managers with the same asset category results and same asset commitment levels can lead to different results. This seems to inherently disadvantage smaller managers desiring to move from balanced management to asset-specific management. Furthermore, portfolio measurement accounting systems available today do not support any cash allocation methodology.
Finally, whatever allocation method is used, it is totally arbitrary and might not reflect your true allocation decision. In many situations, a balanced manager may consider cash as a separate and strategic asset category. Balanced portfolios are run differently and have different objectives from fixed- or equity-only portfolios. That same manager might run equity-only portfolios and fixed-income-only portfolios in a fully invested style with only fractional cash.
While the standards call for reporting dispersion of composite returns as a measure of risk, the standards do not call for reporting returns adjusted for risk. Therefore, evaluating the performance of two AIMR-compliant managers does not guarantee comparability.
For example, two fixed-income managers compete in an active duration manager search and display their results to a prospect. One manager is guided by the policies of his clients that allow him to invest in investment-grade debt or higher and restrict duration decisions to +/- 30% of the duration of the Lehman Aggregate index. The other active duration manager presents results from portfolio composites with no restrictions with respect to quality or duration.
Are these results comparable? You might argue the client or consultant should have done a better job in screening results to ensure consistent comparisons; yet these inequities happen too often. Should AIMR require risk-adjusted returns? If comparability is a goal for these standards, then you can't ignore how results were achieved. Accurate reporting means more than correct return calculations.
After five years, it is not too early to improve the AIMR standards.