Throughout our discussions with industry professionals a pervasive concept often emerges: a confusion between financial and performance accounting. In particular, when managers are asked whether they ensure the accuracy of their performance system’s outputs by annually reconciling their system, they often respond « no » citing that their administrator calculates net asset value (NAV). Notably, this answer does not line up with the question. In essence, though financial accounting outputs represent data inputs for performance measurement, accounting figures are not sought by investors: NAVs are never placed in company presentations because little insight can be drawn from them. The key takeaway from this article is that the accuracy of performance system outputs cannot be assumed and must be reconciled ideally over 1-year intervals. Furthermore, financial accounting means little to investors and managers need to look inward and ask whether they are doing all they can to ensure that their message is getting across accurately.
Exclusive Reliance on Administrators Exposes Managers to Reputation Risk
Relying exclusively on administrators for performance outputs represents the industry’s lowest common denominator. Administrators can produce errors as no entity is perfect. Often misunderstood by industry participants is that the onus is on the manager to ensure that all data and information is accurately captured and maintained in order to support all reported items included in compliant performance presentations. Not performing an annual systems reconciliation is akin to saying that a vehicle is running well so therefore there is no need to look under the hood. As well, human beings need annual medical checkups. Assuming all is fine because the individual appears healthy falls short. To truly assess a person’s health blood work is needed among other things.
Financial Accounting Feeds Into Performance Systems
Typically, accounting systems have automated feeds that come from trading systems (for transactions) and external data services (for market prices). Once fed with this information, accounting systems become the primary source of data inputs for performance measurement systems. A key difference between financial and performance accounting is that the latter makes no distinction between realized and unrealized capital gains and losses, which in turn influences the treatment of book value and before-tax performance measurement. With respect to performance best practices, on or after January 1, 2005 GIPS requires that trade-date accounting be utilized as opposed to settlement-date accounting. This is notable as discrepancies can occur for instance near the end of a performance period when comparing a portfolio that uses settlement-date accounting, and a benchmark that uses trade-date accounting. To be clear, GIPS requires the use of trade-date accounting for both the portfolio and the benchmark to avoid discrepancies emmanating from lag effects.
Financial accounting may treat management fees differently from the way that they are treated in investment performance accounting. Performance systems accrue management fees such that net of fee returns are equated to the gross of fee returns less management fees and carries interest (i.e. manager portion of portfolio profit).
According to GIPS, on or after January 1, 2011 a portfolio must be valued under the guise of Fair Market Value. Liquid Level 1 Assets are quite straight forward. Level 2 and 3 Assets are less so. Fair Market Value is determined as what can be exchanged for in arm’s length transactions between willing and knowledgeable parties. Level 2 Assets can be based on firm best estimates. Level 3 Assets can be based on valuations from a qualified third party. Note that it would be a red flag for such an entity to be changed too often.
According to GIPS as of January 1, 2010 all assets must be valued each calendar month-end or on the last business day of each month. Valuation is required to occur on the dates of large external cash flows because they can have a significant distortion on dollar-weighted rate-of-return (ROR) calculations. Valuation should not be performed more frequently then defined so as to prohibit the temptation to cherry pick.
We are calling on managers to understand that NAVs produced by reputable entities such as financial accounting auditing firms says nothing about they quality of their performance outputs. Investors are conditioned to peer at investment performance reporting in core marketing decks as part of their initial manager review. As such, every effort should be made to ensure its accuracy.
CIPM Expert Book 2, ‘Overview of the Global Investment Performance Standards’, by Philip Lawton, PhD, CFA, CIPM, © 2016 CFA Institute. All rights reserved.
CIPM Expert Book 2, ‘GIPS Standards’, © 2016 CFA Institute. All rights reserved.