The professor who influenced me most at Towson University was Richard E. Vatz, Ph.D., who teaches classes in Persuasion and Advanced Public Speaking. Vatz is a short, wiry guy with a bushy mustache and a wicked sense of humor. Thirty-five years ago, he began his Persuasion class by telling us a story about his best friend, Bob. He described how they grew up in a small town in Pennsylvania, were classmates from elementary school through high school, and after sharing several memorable adventures, were both drafted to go to Viet Nam. After boot camp they were deployed and served in the same unit, where after a year of fairly boring service, just outside of a small, Vietnamese village with a name I can’t remember, Bob stepped on a land mine and died in Vatz’s arms. By the time he finished the story, the entire class (including yours truly) was openly weeping. Vatz then proceeded, with a smug grin, to tell us that he made up the entire tale, and in one of the greatest teachable moments of my young life, asked us why we believed him. After getting over the shock of this deception, we spent the rest of the class discussing how details, numbers, dates, times, names, graphs, etc., all constituted evidence that was very persuasive. We examine this kind of evidence when we determine who and what we believe. Vatz taught me that the speaker who defines the terms of a debate, and who offers the best evidence, is sure to be the winner. It is a lesson I’ll never forget.
Fast forward to today. Consumers who are considering retaining Pinnacle Advisory Group, or any other firm, as their investment advisor, should analyze the numbers that constitute our investment track record. When consumers evaluate the performance numbers of an investment manager, they should look to see if the manager claims to be GIPS compliant. GIPS is the acronym for Global Investment Performance Standards, and virtually every publicly traded fund meets the GIPS requirements. Managers who claim GIPS compliance are saying that they’re reporting their performance in a way that allows consumers of investment advice to be confident that the track record they’re studying meets a standard of “fair representation and full disclosure” that is accepted by the investment community. Nowadays you can claim GIPS compliance without having an outside firm verify or audit your accounting. Nevertheless, many private firms like Pinnacle are going ahead and getting verified anyway. We are holding our breath and getting our GIPS audit this week.
All of which brings me to my main point, which is to identify the many ways that an investment track record can be distorted so that investors make decisions based on misleading evidence. The key to understanding how the deception usually works is to understand a sub-standard of GIPS reporting called Supplemental Information. Supplemental Information is defined as “any performance-related information included as part of a compliant performance presentation that supplements or enhances the required and/or recommended disclosure and presentation provisions of the GIPS requirements.” Supplemental returns are considered to be misleading if:
- Model, hypothetical, back-tested, or simulated results linked to actual performance results.
- Non-portable performance from a prior firm linked to current ongoing performance results.
This seems reasonable to me. The following are not considered misleading and are allowed as Supplemental Information:
- Carve out returns that exclude cash
- Non-portable returns
- Model, hypothetical, backtested, or simulated returns
- Representative account information, such as portfolio-level country weightings, portfolio-level sector weightings, and portfolio-level risk measures
- Composite or portfolio-level specific holdings
- Peer group comparisons
- Risk-adjusted performance
Consumers need to be especially aware of model, hypothetical, and back-tested or simulated returns where firms can literally conjure up an investment track record out of thin air, as long as the fine print calls it supplemental information. Of course, GIPS guidance doesn’t call it fine print, but requires “the standard of reporting to be clearly labeled and identified.”
Let’s review an example of how this is commonly abused.
Imagine that you want to manage money using a quantitative, momentum-based investment strategy that is all the rage with today’s investors. You have hired a fabulous quantitative analyst in the past year who has been tinkering with several investment models that would have delivered excellent returns over the past ten years based on back-testing the results. You are allowed to publish those completely fictional returns as supplemental information as long as you disclose to investors that the returns are fictional… or supplemental. You then put together a glossy, five-page marketing brochure which shows how you neatly sidestepped down markets over the past ten years and earned investors fabulous returns with little risk. The supplemental track record is in large, bold print with multicolored explanatory graphs. The disclaimer showing the actual six-month GIPS compliant track record and the statement that the large print multi-year track record is hypothetical and back-tested is found in very small print at the bottom of page five. You then hire a sales force that does a terrific job of simplifying the “complex,” “proprietary,” and “scientific” investment process behind the amazing returns, using language effective with investors yearning for mystical success in dangerous markets, and you raise a few billion dollars of assets under management before lunch. This is a terrific way to make a living… except for the fact that you never actually managed money using the fictional strategy!
Institutional investors avoid hypothetical back-tested returns like the plague. They know that investing in a strategy that is only successful in the rear-view mirror is completely different than investing with a money manager who earned their returns in “real-time.” It turns out that quantitative investment strategies are notorious for working until they don’t work anymore. The typical reason that quant strategies stop working in real-time is that other investors see what is working in the market and arbitrage away any excess returns by piling into the same strategy. In many instances the quant model is tinkered with and changed after short periods of underperformance. Or, the money manager simply “overrides” the model when it inevitably stops working in untested or unprecedented market conditions.
As a student of rhetoric and persuasion, I know that long columns of performance numbers, coupled with colorful charts and graphs can be very persuasive. I wonder if consumers of investment management who are desperately trying to make an informed investment decision are aware of just how misleading the numbers can be. And, I wonder when consumers will be educated enough to avoid comparing our actual, GIPS compliant track record of performance earned in real time and with the same analysts that we employ today, with fictional returns based on “too good to be true” back-tested nonsense.