Cherry Picking

On the Internet, Everyone's a Critic But They're Not Very Critical - WSJ.com:

"Other critical reviewers say they get flak for their brutal honesty. Mark Nuckols, an American teaching finance in Moscow whose Amazon book ratings average a three, says he's concerned by what he senses is a practice of 'pre-emptive deletion.' When he posted a 'mildly critical review' of a recent children's book by Tom Tomorrow, it never surfaced. When he tried to post a review of another Tom Tomorrow book, it didn't show up, either."

Businesses whose revenue depend upon moving merchandise without a physical presence (e-tailers) need positive reviews of the items and have a conflict of interest when negative reviews appear. As a result, negative reviews are ripe for removal s Mr. Nukols discovered.

The Global Investment Performance Standards are designed to prevent this type of cherry-picking. Essentially, GIPS boils down to no cherry-picking of results. If it did not, then every asset manager would be look good.

One of the 2010 changes disallows carve outs that do not have its own cash. Previously, a firm could create a product from exisitng ones and claim it was representative of how the newly created product was actually managed. The simplest form was breaking a balanced account into its equity and fixed income components and marketing three products - the actual balanced one, an equity one and a fixed income one.

While that does not seem misleading, one already has a situation where the potential investor can no longer sum the AUM totals of the three products to get an idea of how much money and investment firm manages. Nevermind the deeper concern that the equity and fixed income carveouts are dependent on the balanced account guidelines for asset allocation decisions.

The more likely a practice can mislead a potential investor the more likely it will violate GIPS. Carveouts can certainly be one of those asset management practices.

Losing Money Is Easier Than Making It Back

Small Investors Pile Into Funds Devoted to Riskier Investments - WSJ.com:

"Murray Schofield, a retired orthodontist in Arizona who sold most of his foreign investments in the second half of 2008, has been buying emerging-market funds, and funds dedicated to China and India, since March. He now has 23% of his portfolio in funds that invest in these stocks. “I have to recapture part of my losses,” says the 84-year-old. “Otherwise I’d be more conservative.” His portfolio is up 20.4% for this year, following a 44% loss in 2008, he says."

I have bolded the last sentence attributed to Mr. Schoefield because it demonstrates a natural flaw in people's thinking when it comes to percentage losses and gains towards recovering them. A common error is to see the 44% loss and the subsequent 20.4% gain and do a quick back of the envelope calcuation that he is down 23.6% now.

That is wrong. The back-of-the-envelope calculation is to take the 20.4% gain and multiply it by the 44% loss to see how much Mr. Schoefield has recovered - about 9%. That still leaves him down about 35% from start of 2008. (A performance measurement professional would say from 12/31/2007.)

To see how far he is actually down, assume $100 on 12/31/2007. A 44% loss in 2008 would leave him with $56. In the first half of 2009, he has gained 20.4%. $56 plus ($56*.204) equals $67.42. Or still down a cumulative 32.58%.

FWIW, Mr. Schoefield will need to see an additional 50+% return over the next six months to get his portfolio back to its 12/31/2007 value.

GIPS 2010 And Operational Definitions

Stan Liebowitz’ informative study, “New Evidence on the Foreclosure Crisis”, in Friday’s Wall Street Journal brought to mind one of the 2010 Global Investment Performance Standards (GIPS®) changes. The change is the requirement of firms claiming GIPS compliance to revalue its portfolios at every large cash flow.

Mr. Liebowtiz’ operational definition of sub-prime mortgage provides the basis of his study. He uses the technical one used by mortgage and lending professionals to show it isn’t sub-prime borrowers (FICO scores less than 620) that are the root of the foreclosure crisis, but those borrowers who have negative equity in their home.

He contrasts that with the operational definition politicians and ordinary people may be using for “sub-prime mortgage” – a loan to a person who cannot afford it. Whether this is an actual sub-prime loan or prime one or a liar loan or a 103% loan, these are mortgages taken out by borrowers, and granted by lenders, who would not have been expected to get one even 15 years ago.

Here is where the 2010 GIPS requirement to value portfolios at “large cash flows” runs into the issue of operational definitions. The CFA Institute is not providing a definition of what a “large cash flow” is. As a result, expect wide latitude in operational definitions of “large cash flow” amongst firms claiming GIPS compliance.

GIPS 2010 - Valuation at Every "Large" Cash Flow

This morning's Wall Street Journal article on PPIP and its unpopularity drives home an upcoming difficulty in the GIPS 2010 changes. GIPS compliant firms will be required to value all portfolios on the date of large cash flows.

The banks are refusing to sell its toxic assets under the PPIP for fear of disclosing its market value and changing the values being shown on their books. Without the market, values for these securities is left to more subjective measures. Yes, even a discounted cash flow model is subjective thanks to the assumption the security will exist until maturity with principal repayment.

How will the GIPS compliant firm determine price in the event one of their portfolios has a large cash flow and these kinds of toxic debt?