Notes on a Postcard - Thoughts on Investment Performance Measurement
The data explosion which has occurred over the last ten years has directed and intensified a trend in the asset management world. Data now represents the heart of the Asset Management business and its efficient management provides tangible benefits which enhance a firm’s competitive advantage. Within the various nexus of data operating in an asset manager, the performance department has changed quite radically over the last decade. Seen as an operational function it has steadily moved from back to middle and now occupies a front/middle office function, augmenting the investment management process, providing analysis to fund managers, risk and quant teams, remuneration committees and client reporting to name a few of its internal and external customers. With its increased profile comes a requirement for data; the result is a flood which old processes, methods and systems were not designed to accommodate.
This data deluge has resulted over the last decade in a large number of entrants into the performance/attribution/risk software vendor space, which has almost displaced the old world “build it internally” mentality. The trend has been to buy in systems or outsource to service providers to satisfy the new data requirements and capture efficiencies.
However, there is a caveat to that “rule”; smaller asset managers may by-pass the cost of external solutions for the limited benefits those solutions may provide. It would be in these cases that spreadsheets and/or desktop databases, said to be the most widely used performance and attribution solution platforms in the world, would provide a flexible and well proven method of delivering the necessary functionality and process required for calculating performance, organising data and generating reporting and output.
Costs and Benefits
There are obvious downsides associated with this approach: there are limits to the scalability of data through-put, maintenance of time series data, security, controls and the audit of current and historical data, (although there are some systems on the market which can provide worksheet and cell specific security and audit, which actively monitor changes and updates to information.) The largest cost to the small scale approach, especially of a firm which is growing, is that associated with on-going development whenever new functionality is required to meet internal and customer demands. Keeping up with the market and your competitors is the key to maintaining your competitive advantage.
During the last few years performance and attribution systems have consolidated on developments in data management and organisation, which were put in place to deal with the shift to more frequent periodicity in data capture and calculation (the move from quarterly and monthly to daily and intraday). Global Investment Performance Standards (GIPS(R)) has spurred this move by entrenching the long term trend. With the explosion of readily available data comes opportunity and this has generated new developments in functionality pointing to how the solution platforms will shape up in the years to come. Below is an exercise in crystal ball gazing on where the market may be heading in the medium term:
Flexible Fixed Income Attribution
Many off the shelf performance and attribution products provide at least one fixed income attribution method. The common factor amongst many products is that the models are to a large extent “black boxed”. FI attribution shares many aspects of the function and result with equity attribution. Both approaches examine relative performance and attribute alpha to particular investment decisions. For equity, the breakdown is an accepted concept: selection, allocation, interaction, forward currency effect and surprise. For Fixed Income, the decision decomposition is not defined as concretely. This is due to the nature of FI analytics where there are many more dimensions to the investment decision. For example the FI decision can be broken down into 12 broad effects which can be decomposed further and/or recombined to produce aggregated effects. These include:
- Price Effect Return
- Asset Allocation Return
- Trading Return
- Liquidity Security Specific Return
- Currency Effects
- Yield Return
- Credit Return
- Yield Curve Return
- Residual Effect
An approach which allows defining, combining and dis- aggregating effects within a system would provide Asset Managers with the flexibility in creating models which best reflect the house investment view; and move away from the “black box” approach.
The market is familiar with many of the methods of Risk Adjusted Performance measures which form part of the complex interplay between Risk and Performance. The market’s exposure to risk attribution is in its infancy and takes the relationship between risk and performance one further step. It is an area of the industry which is destined to become more prominent. Risk Attribution aims to align attribution sourced from optimally derived investment decisions which generates alpha with attributed risk decisions designed to effect relative risk resulting in risk and attribution moving in the same direction at a granular level (on a Tracking Error (TE) basis and setting portfolio TE constraints). Risk attribution can prove useful in providing valuable inputs into the Asset Management process. Reconciling Relative and Total Risk to attributed decisions can generate some issues with the current relative based methodologies, which can invalidate the established risk- performance attribution relationship in certain scenarios. Therefore risk attribution should be used cautiously
Liability Driven Investment
Although Defined Benefit schemes are a smaller part of the asset management product offering, liabilities for existing schemes will remain for decades to come. Performance and Risk tools should match the measurement requirements generated by the investment strategies employed. The basic strategies employed to fulfill the investment style required to match a pension fund’s current and future liabilities to assets gained over time, ensures that some non – standard investment types will be part of the investment portfolio. Funds may invest in combinations of inflation rate, interest rate, mortality rate and alpha plus instruments to build the appropriate overlays or core investments to match current and future actuarial funding targets. Risk and Performance Liability Driven Investment strategies generate challenges relating to the following issues, but note that incorporating these factors into existing risk and performance processes will be complex, requiring specialist resources and creating an intellectually intense and challenging task:
- Sourcing of appropriate discounting factors which are regulated and recommended by legislation
- Calculating the correct exposure values
- Understanding and calculating ex-ante risk given the forward looking nature of LDI strategies
- Interacting and co-operating with actuarial services to ensure forecasting is accurately incorporated into the decision process
- Correct hedging ratios are used with regard to the use of derivative instruments
- Stochastic forecasting
- Liability benchmark calculations
Workflow within performance and attribution platforms has been a neglected area of functionality. Being able to track and manage data through the different stages of the performance process to meet internal and external SLAs and performance/client reporting deadlines is an increasingly important part of the performance manager’s duties. Workflow tools can provide unique and valuable insight into the efficiency of existing procedures and identify bottlenecks which arise on an ad hoc or a more systematic basis. Many client reporting platforms integrate complex and sophisticated workflow monitoring tools to manage through-put and output. Performance, which shares many similar data sets, would inevitably identify many of the same operational efficiencies that have been captured by client reporting processes.
Having explored some functional aspects of performance trends, the other side of the coin is that of Form, which was touched upon at the beginning of this note; how does the process manifest itself in the organization, what is the optimal method of delivery? Build or Buy is a question that has vexed many organisations and has been in the main answered, the next is whether to in-source or outsource?
Asset managers share similar general performance requirements; however delivery of the functionality can be wrapped in different layers of complexity and scalability needs. As noted before growth dulls the efficiency of smaller scale solutions which subsequently constrains the solution’s flexibility to react. Where internal capacity or a lack of desire to engage on a large scale implementation means the build or buy question is not addressed, outsourcing has been seen by many as the alternative track. Outsourced products are increasing in functionality, coverage and sophistication; additionally hosted solutions are also becoming more prevalent, providing an intermediate stepping stone to a full outsourcing solution. Thus a spectrum of outsourced and part outsourced solutions is now becoming available to augment internal solutions or replace them:
Full service performance, risk, investment accounting, custody, pricing, etc - solutions with an asset servicing arm of the usual large multinational players; hosted performance solutions from vendors and asset servicing providers; part solutions with performance calculated by external providers where the processed data is integrated into internal client data warehouses.
The Performance and Attribution department has grown to encapsulate a larger footprint within asset management organisations, where the lines are blurring between performance, risk, and client reporting so all the components in the value chain are being looked at together instead of separately. The deluge of data has wrought changes on the organisation of asset managers. Function and Form will change to adapt to new demands. Function will move to combine risk and performance into a closer relationship to provide a fuller and more holistic view of decision making. Form will continue to move towards providing a greater variety of solutions from software vendors and asset servicing providers. Moreover, risk and client reporting vendors are moving into the adjacent performance functional space, supplying the industry with additional options. Joined up thinking, allied with joined up solutions and process equal value for clients and added value for asset managers.