The honor system for complying with the AIMR performance presentation standards is not working. Drafters of the standards had hoped investors would support the standards and, in doing so, would cause managers to comply. Unfortunately, investors generally have not supported the standards because they are unaware of the potential benefits. Nevertheless, the majority of investment managers claim to be in compliance; ashamedly, the majority of those who claim to be in compliance are not.
The end result is that the standards have compounded the problem of misrepresented performance rather than solved it. This is because the standards have no teeth.
The performance presentation standards, developed and issued by the Association for Investment Management & Research, became effective Jan. 1, 1993. The standards are intended to protect prospective investors from misrepresentations of investment performance track records at two levels. At Level 1, performance presenters are required to include all fee-paying, discretionary accounts in at least one composite at all times; this is the completeness standard, designed in part to deter managers from cherry-picking only their best accounts to present in marketing. At Level 2, Level 1 requirements must be met, plus performance calculations must meet accuracy criteria. Compliance is voluntary and may be documented - although the standards don't require it - by a third-party verifier.
Far too many investment managers view the standards as a measure of ethics rather than a prescription for a level playing field. Admitting non-compliance is tantamount to confessing to deceptive reporting practices, even though compliance is often unachievable because of purely mechanical reasons, such as loss of data. Consequently, an "ignorance is bliss" mentality has evolved where many of those who claim compliance readily promulgate procedures that are in conspicuous violation of the standards.
To further complicate matters, the value of third-party verification has become questionable. The standards only recommend verification; and for those managers who choose to have their compliance with the performance presentation standards verified, the standards allow for verifiers with reasonable qualifications. Yet, the industry has looked to certified public accountants to perform this function. Accordingly, the few verifications that have been performed have been done by accounting firms, primarily Big Six auditing firms.
The experience for Level 1 verification has been unsatisfactory for both the managers and the accountants. Managers have had to train highly paid accounting professionals about the nuances of professional money management; a common complaint is "we had to teach the accountants what a composite is." The accounting profession has come to realize that Level 1 is not an accountant's work, and is now declining to do Level 1 assignments.
As a result, the AIMR's verification subcommittee has endorsed a new verification procedure where the verifier can attest to the accuracy of an individual composite, which is Level 2 verification, while relying on the management institution's word it has complied at Level 1, which is the completeness standard. This is a bizarre outcome that might be attributed to belief in the statement made by one of the accountants on the verification subcommittee: "There will be no standards without the accountants." The reality is there will be no teeth to the standards with the accountants.
The industry has been self-policing accuracy for decades, and the system works very well. Sponsors employ consultants who re-crunch all of the manager's numbers, and custodians record accurate asset values and cash flows to reconcile against the managers. Accepting the new verification is missing the turn - be careful not to run through the barricade.
All of the game-playing has occurred in composite construction, leading to the indictment: "I have never seen a manager below the median." Examples of this game playing are including just the best-performing accounts in a composite or excluding the worst performing. The completeness standards set forth in Level 1 make this cherry-picking more transparent to the knowing consumer, and therefore Level 1 is the most important standard. To accept the honor system for Level 1, where the games are being played, while verifying Level 2, where the industry is already self-policing, is absolutely ludicrous. One can only hope that (1) investors eventually will care, and (2) quality non-accountant verifiers will appear to provide Level 1 services.
Lest any reader view these comments as the sour grapes of a former verifier, this commentator believes that investment managers typically are honest and that the concept of a level playing field is widely supported. The problem is that playing by the current rules - the AIMR performance presentation standards - can be extremely difficult, or even impossible, for many firms. The solutions to this problems are not easy, but we should not give up hopes. Let's not give up the aspiration.10
Ronald J. Surz is president of Performance Presentation Consulting Alliance Inc., Wheaton, Ill.