July 23, 2006

Performance anxiety
Fee-only group calls for performance disclosure

A group of fee-only advisors have banded together in an effort to push regulators to mandate performance reporting on client statements (sent by fund companies and brokers). The group has set up a website called Show Me The Return where they state their case and offer an online petition to be signed by willing parties. Previously, industry constituents got their knickers in a knot since they see personalized reporting on statements as a costly endeavour.

The details

Specifically, the group is calling for the performance reporting portions of the Fair Dealing Model concept paper to be implemented by the Ontario Securities Commission. A key goal of the mammoth concept paper was to more clearly define the advisor-client relationship since most sporting the 'financial advisor' title (or some similar moniker) are licensed to sell products not to give advice. The FDM also called for increased transparency, via better disclosure of an investment.s essential fundamental features; greater clarity with respect to potential risk exposure; disclosure of advisor remuneration; and clear performance reporting on client statements.

The Performance Reporting working group's direction document notes that AIMR (now known as CFA Institute) standards should be employed in the performance calculation. Presumably, however, that working group - and the group behind Show Me The Return - are only calling to incorporate the CFAI standards relating only to the formula to be used.

More than a mouth full

Based on the text of the FDM concept paper and the Performance Reporting working group's direction document, it seems that either the wording was not sufficiently clear; or that the individuals involved did not fully appreciate the scope and intent of the CFAI's Global Investment Performance Standards (GIPS).

I contend that GIPS are not compatible with the goal of detailing individual performance. Let me illustrate by quoting directly from the GIPS paper. The overview section summarizes key requirements as:

"The GIPS standards REQUIRE FIRMS to include all actual fee-paying, discretionary PORTFOLIOS in COMPOSITES defined according to similar strategy and/or investment objective and REQUIRE FIRMS to initially show GIPS-compliant history for a minimum of five (5) years or since inception of the FIRM or COMPOSITE if in existence less than 5 years. After presenting at least 5 years of compliant history, the FIRM MUST add annual performance each year going forward up to ten (10) years, at a minimum".

This is one paragraph from a 59-page document, which lays out GIPS requirements in painful detail. In case it's not clear from that short excerpt, let me point out why GIPS are not suitable for reporting performance for an individual's portfolio.

First, many clients of financial advisors don't pay fees directly. The firms sponsoring the products they buy charge fees, out of which commissions are paid to the financial advisor. So, only clients paying a fee directly to the advisor.s dealer would qualify.

Second, the vast majority of 'financial advisors' do not have discretionary authority over their clients' accounts. Many have trading authorizations, which allow advisors to execute trades without a client signature - but permission is still required on each trade.

Third, each firm (not advisor) would be required to group their clients into composites based on the similarity of their objectives or chosen investment strategy. But the basic Know Your Client form required by regulators does not contain enough information to properly group clients into composites.

Finally, do you notice anything here about the performance of any individual account? No, because GIPS were designed for discretionary investment counsellors and portfolio managers to aggregate performance in a standardized way - not for brokers and financial planners to show Joe Client how his account has grown over the past five years.

The purpose of GIPS is to create a global standard for individual and institutional clients. Here is an example of a GIPS-compliant performance report from Winnipeg-based Cardinal Capital Management, Inc. This type of report tells prospective investors how the aggregate of all of the firm.s Canadian Equity clients have performed over the period - not how any single client has done.

Clearly defined standards for reporting returns to investors should be championed but not GIPS.

Importance of performance reports

Having said all of this, I'm not opposed to providing investors with some disclosure of how their investments have performed. In fact, I'm all for it because it is a fundamental piece of information to which all investors are entitled. What I find puzzling is the industry's long list of objections to such requests. Most dealer back office software programs have algorithms built in to perform various performance calculations.

But some of these algorithms are faulty, so the onus should be on the software providers if they want their products to remain compliant (assuming reporting returns is eventually mandated). Sure, dealers and advisors may pay a little more for such software enhancements but competition can keep a lid on the extent of fee increases. That way, investors will get what they have long deserved.