by Russ Glisker, Ariadne Associates
The tradeoff between risk and return is one of the main drivers of investment management. Returns cannot be properly compared or interpreted without taking risk into consideration. The GIPS® standards first addressed this important relationship in 2011, by requiring 3-year annualized standard deviation of returns. While an important step, it barely scratched the surface in terms of providing enough information to support a sophisticated analysis of a strategy’s risk/return tradeoff.
GIPS was initially established to address significant issues in performance calculations for investment strategies and their use in marketing and client reporting. The lack of standards left open opportunities to cherry-pick data, not present performance after fees, select accounts for composites inconsistently, etc., undermining confidence in the industry’s performance reporting. Today, GIPS is widely used and highly influential in establishing performance best practices.
Its minimal risk reporting limits GIPS’s efficacy and utility. Requiring other risk measures would enable users of GIPS-compliant reports to make more informed comparisons across firms and strategies. In establishing the current requirement, the committee indicated that additional risk-related requirements would be incorporated into the standards in the future. So far, no further requirements have been added, although risk is mentioned in the 2014 Strategic Plan and several “Risk Guidance Statements” have been published. In fact, the GIPS Committee in the 2011 requirement encourages firms to provide information beyond what is mandated. It requires an additional 3-year ex post measure if the “3-year standard deviation is not relevant or appropriate”, so implicitly the standards acknowledge that the current requirement is not fully adequate. Further, the standard leaves to the firm the judgment of the relevance of standard deviation and applies the requirement for an alternative measure only if an alternative measure is “available and appropriate”. Is that a loophole within a loophole?
As a consultant in performance measurement, attribution and investment risk analysis, I appreciate the challenge faced by the GIPS Committee in specifying risk disclosures that are practical and relevant for the wide variety of GIPS-compliant firms. So what is to be done? A good starting point is to decide whether to use ex post (after the fact) or ex ante (forward looking) risk methodology, or both. I would suggest ex post for several reasons:
- It matches nicely with the GIPS-reported returns, which of course are calculated at the end of the measurement period.
- The data required for many ex post risk measures are the same as for return calculations.
- The measures are straightforward to calculate and explain, which is often not the case for ex ante measures
As to the question of specific risk measures to be calculated, a number of suggestions come to mind:
- Tracking error
- Downside deviation
- Information and/or Sharpe ratio(s)
- Biggest gain / largest loss
- Batting average
- Upside / downside capture
- Maximum drawdown
Including any or all of these measures would provide greater insight into the strategy than the current standard deviation requirement. Perhaps firms should be required to select some number of measures, perhaps three or four from the above, that the firm believes best illustrate the characteristics of the strategy and the firm’s management. GIPS should also include rules preventing frequent changes to the measures presented, unless there is a significant and legitimate basis.
As stated at the outset of this post, the tradeoff between return and risk is central to investment management. The motivation for GIPS was to ensure fair and consistent reporting of performance information, and as discussed, the standards now require inclusion of limited risk information. In fulfilling its mission, I believe it is now essential that GIPS expand the required presentation of risk information to provide a greater variety of relevant risk measures to enable consumers to interpret the GIPS performance figures in comparing investment products.
GIPS® is a registered trademark owned by CFA Institute.