Guidelines Help Evaluate Money Managers

Laid off by your employer of 20 years, you’re handed a $250,000 lump sum check for your pension benefits. Your first thought is to invest in mutual funds--but then you think, why not have a pro create and oversee a personal portfolio for you?

When you sit down with veteran money manager Sam Megabucks, you ask about his track record. “Well, look right here,” Sam says, producing a glossy fact sheet. “I delivered a 25% average annual return for my clients over the last 12 years!”

Without much further thought, you might be tempted to give that check to Sam. After all, how could he lie about his performance?

The truth is, the calculation of portfolio “returns” has for years been more art than science among many investment pros. Unencumbered by any sort of national reporting standards, some private money managers have concocted performance numbers which, if not outright lies, stretched the truth considerably.

Starting this year, however, the individual investor gets much-needed help in evaluating the performance pitches of the nation’s tens of thousands of money managers: Two professional investor associations have adopted tough standards by which money managers are to calculate and report their performance to clients and potential clients.

The two groups--the Assn. for Investment Management and Research and the Investment Management Consultants Assn.--have issued separate standards, but on major points they are virtually identical. The overriding goal is to assure apples-to-apples comparisons of investment returns by private money managers, so that investors can accurately judge managers’ expertise and success.

Though the standards aren’t legal requirements, client pressure on managers to conform with the rules is expected to be intense. Likewise, managers who adopt the standards can use that as a marketing tool against unwilling peers, to nudge them toward compliance.

“I think the industry is in dire need of this,” says Steven Check, whose Check Capital Management in Costa Mesa manages $65 million for clients.

The standards developed by the AIMR have received the widest publicity in the investment community because the AIMR’s 23,000 money-manager members work for some of the most respected firms in the business. Indeed, the list of major management firms endorsing the AIMR standards includes such heavy hitters as the California Public Employees Retirement System (CalPERS), Los Angeles-based Capital Guardian Trust and Chase Manhattan Bank.

The AIMR rules, some of which are mandatory (starting this year) and some of which are simply recommendations, are aimed at private money managers who oversee individual accounts, usually starting at $100,000 in value. Mutual funds aren’t a target of the standards because the funds already meet or exceed them, thanks to tough Securities and Exchange Commission regulations.

Katrina Sherrerd, senior vice president at the AIMR and a key architect of the new rules, says the effort got underway in 1986 when industry leaders began to focus on the innumerable ways that a money manager’s “performance” could be calculated.

“The question was, how do you compete in this business when nothing’s comparable” in quoted results, Sherrerd said.

For example, if a money manager performed well over the last three years, but had terrible performance in the five years prior, the manager’s natural inclination would be to stress with potential clients the recent results and downplay or ignore prior results.

Other abuses have been far more serious, Sherrerd and other experts note. Perhaps the most objectionable is some managers’ blending of “simulated” results with real results: A manager who has been in business only five years might present 20-year performance numbers, which represent mostly how the manager’s stock-picking discipline might have worked if the firm had been in business the entire period.

Still, such outright misrepresentations of results have been the exception rather than the rule, most experts say. The far bigger problem has simply been the lack of consistency in money managers’ calculations of their “average” returns--the numbers they use to show a potential client what current clients have earned.

Thus, much of what’s in the AIMR and IMCA standards focuses on the proper way to figure an “average investment return,” or “composite,” for similar accounts under a manager’s discretion. Some of the specific guidelines appear in the accompanying box.

While compliance with these standards might appear to be relatively simple, in fact the rules have been extraordinarily controversial.

For example, the AIMR has already granted bank trust departments an extra year to comply, after bankers cried that they face a nightmare of accounting problems in trying to include all of their many client portfolios in one composite index.

The bank trust departments typically “have thousands of accounts, often small and inactive, and often not totally discretionary,” Sherrerd says in explaining the AIMR’s forbearance for that group.

A debate also has raged over the AIMR’s recommendation that a manager’s overall performance figures should be weighted by size of accounts, thus giving more emphasis to larger accounts. Some money pros believe that’s unfair--that all accounts should have equal weighting. (The AIMR actually recommends that managers show performance calculated both ways, but not equal-weighting alone.)

What’s more, some pros worry about the emphasis placed on average performance numbers. In evaluating a money manager, “you shouldn’t just be looking at performance” over a particular period, argues Charles Brandes of Brandes Investment Management in San Diego. “That’s the easy way, but the wrong way.” How a manager achieved certain results, and the level of risk taken in the process, is equally important, he notes.

AIMR officials caution that their group doesn’t have the force of law behind it. “We can’t make members swear that they’re in compliance,” says Lee N. Price, a money manager at RCM Capital in San Francisco and co-chair of the AIMR implementation committee.

Also, Sherrerd admits that the group doesn’t have the ability to monitor compliance or actively police managers for abuses.

Still, the standards at least give many individual investors something they didn’t have before: a set of guidelines by which to judge the accuracy of a money manager’s advertised returns. If your manager isn’t complying with the AIMR, the natural question is: Why not?

How to Judge Accuracy Of Money Pros’ Results Here are some of the guidelines for money manager investment performance calculation and reporting, as developed by the Assn. for Investment Management and Research in Charlottesville, Va. Does the manager show portfolio results for all years? Potential clients are entitled to full disclosure, which means performance results for every year the manager was in business, the AIMR says. Showing results only since a certain date would allow a manager to skew results for periods of particularly good performance. What’s included in the “average portfolio return”? The AIMR requires that all fee-paying, discretionary accounts be included in at least one “composite” portfolio return that a manager uses to show performance. When you’re quoted historical results, ask if the number includes every account the manager has. If not, why not? Does the manager account for cash reserves in stock portfolios? The AIMR requires that performance figures reflect not just the stocks in the portfolio, but the effect of cash reserves as well. High cash positions lower a portfolio’s overall return in bull markets. Is the “average portfolio return” size-weighted? The performance of bigger accounts should have greater weighting in a manager’s quoted “average return” than the performance of smaller accounts, the AIMR says. Otherwise, the unusual success of a minor account could skew dismal performance results. Does the manager drop from its historical numbers accounts that have left? That’s wrong, the AIMR says. If the manager is showing 10-year performance, it should include in that figure all accounts managed in that period--including those that may have left because they were unhappy with their results. Does the manager show the range of performance among individual accounts? It’s one thing for a manager to show an “average return.” But the AIMR says clients are also entitled to look at so-called dispersion: the range between the worst-performing account and the best-performing. A wide range of results could call into question the manager’s consistency. Source: Assn. for Investment Management and Research