One year after the introduction of standardized performance reporting requirements, investment industry professionals are confused over how performance verification is to be conducted and how much verification is needed to claim compliance.
The Association for Investment Management and Research's standards were effective Jan. 1, 1993. They were designed to provide a common, accepted set of ethical principles to create consistency and comparability in money managers' performance reports to clients and prospective clients.
While verification is not mandatory, the AIMR encouraged money managers to retain an outside independent "third party" to attest the firm is in compliance. But the actual evaluation process has become subject to widespread misunderstanding as money managers scramble to obtain verification documents to include in marketing efforts and to use in responding to plan sponsors' requests for proposals.
The American Institute of Certified Public Accountants stepped in recently and issued guidance to accountants on how to interpret the AIMR standards. But, that guidance itself has created some misunderstanding because it applies only to accountants and not to consultants, banks or others allowed to conduct verification audits.
According to the AIMR, money managers may claim compliance without being audited. The misunderstanding centers on the degree of verification necessary before a money manager can receive a letter from the "third party" claiming compliance.
"The big issue on verification is firm-wide vs. product compliance," said Susan D. Martin, AIMR consultant. "A manager cannot claim that a product is in compliance; the firm must be in compliance. After a manager has completed a Level I (firm-wide) verification, the manager could then have a Level II verification completed on specific composites."
The Level I verification is to ensure each portfolio is in a composite; that returns are size- and time-weighted, rather than equal weighted; returns are used; and that appropriate disclosures have been made.
The Level II evaluation more closely resembles a traditional audit, said Ms. Martin, and examines verification of performance calculations, asset pricing, capital gains and losses, trade verification, cash flow evaluation and other accounting issues.
The problem is some firms are claiming a Level II audit without completing a Level I evaluation, and some auditing organizations are issuing Level II letters without conducting a Level I review.
According to the AIMR and accounting specialists, a Level II audit cannot be performed without first conducting the Level I evaluation.
In addition, some accounting and consulting sources discount findings in recent surveys that indicate between 60% and 75% of money managers believe they are in compliance with the AIMR standards.
Money managers in full compliance with the standards are far less than the surveys indicate, they claim.
"There is a lot of confusion regarding performance verification," said Ron Surz, president of Performance Presentation Consulting Alliance Inc., a Wheaton, Ill., firm that specializes in assisting money managers in conforming with the standards.
"There have been searches by some large public plans which want audited AIMR performance verification .|.|. and a lot of the letters are wrong as to verification," said Mr. Surz.
"In reality, everyone is saying they are complying, but if you ask them (managers) if they are using equal-weighted portfolios (in composite portfolio reporting), and many are, they are not in compliance automatically. .|.|. Everyone abides by their own interpretation of the standards unless there is independent verification."
As the requirement for audited conformance to the standards gains momentum, it has created a phenomenon among money managers to "get a letter, any letter" to show conformance, said Mr. Surz.
"Consequently, managers have had verification letters written by non-professionals who have not followed the standards. Plan sponsors should be outraged that these bogus validations are being passed off on them," said Mr. Surz.
While accountants appear to be capturing much of the verification business, other service providers such as banks, consultants and even brokerage houses are performing audits.
One money manager agreed on the need for professional ethics standards as specified by the AIMR, but said the system is open to abuse.
"The problem is that verification letters may be issued by any third party, so what is to stop me from calling up my friends at XYZ consulting firm and asking for a verification letter?" he asked. "Let's face it, in this industry people cut corners, and the conditions which created the need for AIMR professional ethics standards in the first place are still there."
Mr. Surz said for most managers, a Level II audit may not be necessary because the Level I verification "is where the AIMR standards are."
He said the Level II audit of the accuracy of calculations, simply "reconfirms what the industry has been doing for the past 20 years."
The uncertainty surrounding the AIMR verification process is to be expected because the process is "virgin territory," said Helmut Mlakar, an accountant with Checkers, Simon & Rosner, Chicago.
He agreed there is "general uncertainty as to where the eventual standards, as promulgated by AIMR, will come down in terms of what the opinion letters will say and specifically the level of work required to satisfy the documentation requirements for issuing an opinion. It's an ongoing debate."
He said he expects the matter to be settled or to become clearer within a year.
Mr. Mlakar said recent surveys indicating most money managers believe they are in compliance with the standards already are probably exaggerated, and the only way to determine compliance is through third-party verification.
"It's like going into a room and asking a man if he believes he is better looking than the next guy; they are probably going to say they are better looking," he said.
David Spaulding is president of Spaulding Group Inc., a Somersett, N.J., management consulting firm that provides technical and consulting services to the money management industry. He said there is a "lot of confusion" among verifiers and money managers as to exactly what is required in verifying compliance with the AIMR standards.
The Spaulding Group recently released a survey of 550 money managers showing almost 75% believe they are in compliance with the standards and an additional 20% indicated they plan to comply, but only 53% have had, or plan to have, their performance verified.
While the actual number of money managers in compliance may be less than 75%, Mr. Spaulding said the discrepancy does not stem from deliberate deception by money managers who may simply be misinterpreting the standards.
Mr. Spaulding said the AIMR should establish guidelines for third-party verifiers. He said some accounting firms conducting AIMR audits "apparently don't understand the standards either, and see this as an opportunity to generate revenues. A lot of them just don't understand what they are doing."