Tag Archive for: investment

A quant’s guide to detecting a future "Madoff"

Worried about getting taken in by an investment management Ponzi scheme?

With the SEC ratcheting up its fraud detection efforts, it’s less likely that you’ll get scammed, based on what I heard at the CFA Institute’s GIPS conference last week. But the conference also introduced me to a quantitative method for detecting fraud in “The Importance of Risk and Attribution in the Post-Madoff Era” by Dan diBartolomeo, president and founder of Northfield Information Services.

The solution boils down to identifying investment returns that aren’t economically feasible. The effective information coefficient is an important tool for that, said diBartolomeo. 

A personal commitment to preventing future Madoff-style fraud 
DiBartolomeo wants to make people more aware of–and attentive to–risk.  He’s so committed that every year he hires a pickpocket to attend his annual client conference and warns his clients that “Keith the thief” will be targeting their wallets, watches, and other possessions. Despite the warning, each year, diBartolomeo has to return a pile of stolen goods. Keith succeeds because he’s good at distracting people–and Bernie Madoff was good at this, too, said diBartolomeo.

Speaking of Madoff, diBartolomeo’s firm was involved in the efforts of Harry Markopolos to uncover the secret to Madoff’s steady investment returns. At the time, diBartolomeo only knew that he was analyzing the returns of Manager B. But within a few hours, analysis revealed that Manager B’s returns “were either fictitious or had arisen from a strategy other than what was being represented to investors, wherein returns were probably being enhanced by illegal means.” You can read more of the details of this analysis in a March 2009 FactSet podcast with diBartolomeo. 

How to uncover a fraud 
“Do these returns make sense?” That’s an essential question for those who perform due diligence on potential investments, according to diBartolomeo. Returns-based methods aren’t adequate for analyzing this question, he said. Instead, one needs “a risk-based measure of investment performance that can detect manager skill(or lack thereof) quickly.”

The information ratio is one place to start, but it has flaws. The information ratio has nothing to do with making money for investors,” said diBartolomeo. For example, the information ratio would look great for a manager with alpha of 1 basis point and a tracking error of zero, but the manager’s clients wouldn’t benefit much. He also pointed out that “the statistical significance of a ratio is hard to calculate.”

The effective information coefficient (EIC) could be the answer to this problem. For more details on the EIC, read “Measuring Investment Skill Using the Effective Information Coefficient,” which appeared in The Journal of Performance Measurement (Fall 2008). 

I wonder what Madoff’s EIC was. I don’t know if diBartolomeo got an opportunity to calculate it.

Oct. 31 update: diBartolomeo’s talk is now available as a podcast from the CFA Institute.

Top 5 tips for investment performance advertising

Knowing the rules for advertising your investment performance is your key to staying out of trouble with the regulators.

Here are some of the tips I gathered from “Performance Advertising 101: Regulatory Do’s and Don’ts” presented on Sept. 23 at the CFA Institute’s GIPS conference by Rajan Chari of Deloitte & Touche, who focused on GIPS issues, and Steven W. Stone of Morgan, Lewis Bockius, who focused on SEC issues. 

1. Don’t think that you’re not subject to advertising rules because you’re not buying a newspaper or magazine ad. Advertising is broadly defined. It’s “basically, any written communication addressed to more than one person (or used more than once) that offers investment advisory services with regard to securities,” according to the speakers’ slides. Advertising includes client materials. It may also refer to anything that you distribute in unchanged form to 10 or more people. 

2. Make the necessary disclosures about performance. Consult with experts who are knowledgeable about your disclosure requirements. 

3. Tread carefully in performance advertising areas of particular concern to the SEC. For example, projecting returns may be viewed as promissory. Back testing is easily manipulated. To avoid the appearance of cherry picking, top stock picks must be balanced with worst stock picks. 

4. Keep a log of the people to whom you send advertising materials. I’ll bet that many people aren’t doing this. But it’s essential for making things right if you discover that inappropriate materials have been distributed. 

5. Take your audience’s sophistication into account when you choose the materials you send them. The regulators give you more leeway in materials aimed at sophisticated investors.

Despite the fact that “Performance Advertising 101: Regulatory Do’s and Don’ts” was presented at the CFA Institute’s GIPS conference, GIPS didn’t get much attention compared to the SEC.  That’s because investment managers always have to pay attention to SEC rules, whereas “GIPS advertising rules are only applicable if you choose to claim [GIPS] compliance in an advertisement.” You can read the GIPS Advertising Guidelines, on pages 33-37 of the Global Investment Performance Standards.

Happy advertising!

Sept. 27 addition from Rajan Chari
Thanks to the generosity of Rajan Chari, here are two links to give you more information on advertising standards.

SEC’s update to CFA Institute’s GIPS conference

One of the SEC latest initiatives resonates with the experience of Lucile Corkery, Associate Regional Director for Examinations, Boston Regional Office, U.S. Securities and Exchange Commission. That’s enhancing the licensing, education, and oversight of back office personnel. Corkery and her colleague, Melissa Clough, senior staff accountant, discussed a list of SEC initiatives on the first day of the CFA Institute’s GIPS (Global Investment Performance Standards) two-day conference in Boston on September 22. Both speakers gave the standard SEC disclaimer that their statements were strictly their personal opinions. 

Lesson from the back office 
Prior to joining the SEC, Corkery worked in an industry back office where she knew an aggressive registered rep who made her suspicious.

One day the rep came in with his cousin the lawyer and conservatorship papers for aunt, who had to be alive for the this purpose. Just one week later, the rep came in a death certificate for the aunt dated prior to his coming in with the conservatorship papers.

When Corkery challenged the rep, he said “I’ll give you whatever you want. What does it take?”

It’s no wonder that Corkery believes the licensing, education, and oversight initiative for back office personnel is “long overdue.” 

SEC initiatives 
Other SEC initiatives discussed by Corkery and Clough included:

  • Investor Advisory Committee
  • Proposed amendments to custody rules, including annual surprise exam and added controls when custody is provided by a related person
  • Revamping handling of complaints and tips
  • Advocating for a whistle blowing program
  • Conducting risk-based examinations of financial services firms
  • Establishing a new division of Risk Strategy and Financial Innovation, announced on Sept. 16
  • Enhancing examiners’ knowledge of fraud detection techniques and recruiting staff with specialized skills
  • Seeking resources to hire more examiners
  • Integrating broker-dealer and investment advisor examinations  

Job opening in Boston–posting closes this ThursdayThere’s an opening in the SEC’s Boston office for a senior specialized examiner, according to Corkery.

Act fast, if you’re interested. The posting closes on Thursday, Sept. 24. I think that means that Thursday is the last day you can apply. 

Posts from last year’s GIPS conference:


Guest post: Attaining and Sustaining High Productivity in Investment Management Marketing

Investment management firms need optimal internal collaboration to achieve the best possible communications, marketing, and client service as they cope with anxious clients, tight budgets, and lean staffing. Tips for how to achieve this goal are the focus of this guest post by Jacqueline L. Charnley and Christine M. Rostvold, founders of Charnley & Rostvold, a marketing communications firm.

“Productivity is never an accident.  It is always the result of a commitment to
excellence, intelligent planning and focused effort.”
~  Paul J. Meyer

Now more than ever, investment firms need to become well-oiled machines, leveraging every possible resource to produce the highest quality communications and service.  Timely and relevant content, whether for reporting or sales, needs to be developed, produced and distributed…all too frequently with too few resources.  What are best practices to attaining and equally as important, sustaining high productivity in marketing and communications?  How can counterproductive politics be minimized, good decisions be made and stressful deadlines be met in the face of rapidly fluctuating workloads?

Know Your Objectives and Plan to Achieve Them
First, management must document key objectives and agree on a plan to achieve them.  Communicate both the goals and the plan to everyone on the team and to senior management.  Document priorities (by product, by client, by consultant) and adhere to those priorities.  Stay focused by making it okay for anyone to question whether an activity is a fire drill or is on plan.  At the same time, recognize when deviating from the plan is a good idea.

Train People for Success
One firm is known for promoting people to roles where the individual’s past experience is not relevant to the new role.  Then when the individual fails, the firm simply moves to another candidate.  Instead, know the required skill sets for the new role in advance.  Know what can be trained and what cannot be.  Measure the individual against criteria required to do well in the role, and train and support that person to be successful.

Document Your Procedures
In a recent survey, members of  the Professional Association for Investment Communications Resources (PAICR)) shared that only 57% had written procedures for their firms and only 56% for their marketing departments.  You need procedures that are current and easy to follow.  In addition to being written, procedures need to be updated regularly.  Empower employees and trainees to question existing procedures, and to rewrite them to reflect their most current (and useful) form.

Commit the Time to Communicate, to Train, to Debrief
Time is one of the biggest obstacles to regular communications, training and debriefing.  Other priorities will always come first until you recognize and commit to the importance of communicating your plan and procedures, to train people to succeed and to debrief after major projects as to what worked, what didn’t work.  Debriefing leads a team into greater and greater productivity and away from politics and failure to produce.

Evaluate Systems and External Resources
New systems and technologies to enhance productivity are constantly being brought to market.  One of the biggest time and resource drains is updating and proofing data.  There are systems that can connect and update client files, presentation books, database responses and RFPs instantly and provide tracking.  Software and service systems can help with project management and communications.  Commit resource and time to stay on top of what is available.

“You can catch more flies with honey than with vinegar”
Keep your culture positive and supportive.  Constantly ask what can be done differently to help clarify and streamline a direction or process.  Avoid blame games when something does go wrong.  Instead, find the solution that will make it go right the next time.  Evolve from your own experiences.  Critique in private, praise in public.  Celebrate victories and accomplishments.  Celebrate being a productive team.

Is the efficient market hypothesis dead?

The efficient market hypothesis is taking a lot of heat. It’s getting slammed in opinion pieces such as George Soros’ “The three steps to financial reform” and articles such as Joe Nocera’s “Poking Holes in a Theory on Markets.”

What do YOU think? Did the efficient market hypothesis contribute to the current financial crisis? Answer the poll in this blog’s right-hand column.

What’s a good elevator pitch for this blog?

Whether you’re marketing your company, job hunting, or just networking, everybody needs an elevator pitch that succinctly conveys how they add value.

Even a blog needs an elevator pitch, says Darren Rowse of ProBlogger in “Write an Elevator Pitch for Your Blog.

Here’s my elevator pitch for this blog:
The Investment Writing blog helps investment and wealth management professionals to communicate more effectively with their clients and prospects. The blog provides helpful communications tips and timely articles about industry topics.

How did I do with my elevator pitch? Do you have suggestions on how to improve it?

Also, if you’re a blogger, please share your blog’s elevator pitch along with a link to your blog..


Fidelity expert: "CMBS Challenges & Opportunity: Are CMBS Securities Mispriced?"

By some measures, commercial mortage-backed securities (CMBS) are in good shape, according to Mark Snyderman, portfolio manager and CMBS group leader, Fidelity Investments, who presented on “CMBS Challenges & Opportunity: Are CMBS Securities Mispriced?” to the Boston Security Analysts Society on May 5. Still, he answered “No” to the big question posed by his title.

Good news: New construction and cash flow growth
Commercial property is not overbuilt, said Snyderman. In fact, in recent years, new construction has lagged the 2% growth rate needed to keep up with population growth and replacement of obsolete buildings. So, commercial property rents and occupancy should fare relatively well.

Commercial property growth has fallen from its peak. But even in 2009, Snyderman expects it will be flat or perhaps down by single digits. So, cash flow isn’t much of a problem.

Problem: Lack of debt financing to squeeze mortgage borrowers
CMBS delinquency rates could rise to roughly 20 times their current level, which is below 2%, said Snyderman. Commercial real estate is suffering as debt financing becomes less available for highly leveraged properties purchased at historically high valuations. The disappearance of cheap debt financing and concerns about cash flow growth suggest that CMBS delinquencies will increase dramatically.

Pessimism will create opportunities
Investors must approach CMBS cautiously, said Snyderman. They can’t rely on ratings because the ratings agencies haven’t adequately reformed themselves. Instead, investors must do old-fashioned, bottom-up credit analysis on a property-by-property basis. It’s also helpful to consider the “vintage” of a CMBS deal, even though there are deal-by-deal differences. 

Right now, we’re in a wave of market optimism, said Snyderman. But, he predicted, a wave of pessimism will bring attractive opportunities in CMBS.

Financial services: An industry at odds with its clients

Toward transparency and sustainability: Building a new financial order,” a newly released study by the IBM Institute for Business Value raises some provocative questions about the relationship between financial services firms and their clients. 

Two big questions
1. Do financial services firms really put their clients’ best interests first?
2.  Do financial services firms understand what their clients want?

Clients’ best interests lose to financial services providers’ 
“…providers offer products that serve their own best interests, rather than those of their clients,” according to more than 60% of the institutional and retail investors and intermediaries surveyed by IBM.  

Almost half of the American industry executives surveyed–and about 40% of executives worldwide–agreed that providers’ best interests get top priority. You can view graphs of the survey results on p. 10.

What do clients want? Financial services firms don’t get it. 
Financial services firms think they know what clients want. Clients’ top priorities are “best-in-class offerings” and “one-stop-shop,” according to their survey results. They reckon that most clients would pay a 5%-15% premium for these characteristics.

But neither of these items cracks the top two in client survey results. In fact, in the IBM survey, clients rate “Unbiased quality advice/client service excellence” and “convenience” as their top priorities. Best-in-class offerings rank third and one-stop shopping comes in eighth. I do wonder if some survey participants may confuse “convenience” and “one-stop shop.” I’m also curious about the make-up of the clients whom IBM surveyed.

You can view the providers’ and clients’ top 10 answers at the top of page 10. 

The survey results also lead IBM to suggest that financial services providers must segment their products accordng to how clients behave. “The ability to serve specific client clusters represents a major–and largely ignored–opportunity for the industry to make money,” says the report.

“We have lost sight of the client in our own striving for outsized returns. We must get back to basics and focus to a far greater extent on our clients.”–Global Head of Prime Brokerage, large U.S. bank

Related post: Research study: How financial services firms will make money in the future

Research study: How financial services firms will make money in the future

The financial services industry can’t continue to make money the way it used to. So the IBM Institute for Business Value tackled the challenge of answering the following questions:
*  Which forces are disrupting the industry? 
*  What will clients be willing to pay for?
*  How will the basis for competition change? 
*  And what steps should financial services firms take to prosper over the next three years?

Recommendations for a “new financial order”

You can read the researchers’ answers in “Toward transparency and sustainability: Building a new financial order.” As I see it, their answers boil down to a need for financial services firms to

1. Work with regulators to develop a system that hits the right balance between protecting investors and fostering financial creativity

2. Deliver on their promises to clients, including their promise “to focus on the interests of their clients”

3. Become more specialized, with a division between “beta transactors” and “alpha seekers”

On #1, the need for the right regulation, the executives surveyed by IBM anticipate “greater transparency and higher capital requirements,”IBM’s analysis suggests seven elements for an appropriate solution (see p. 7).

As for #2 “… firms will need to become more cost-effective, manage risk more competently and move closer to their clients,” says the report (p. 9). 

The specialization called for in #3 may result from unbundling. Although the industry executives surveyed by IBM favor the universal banking model,”the vast majority (89 percent) anticipate that overcapacity will ultimately result in some sort of unbundling” (p. 12).

Provocative ideas

“Most providers do not even realize what their clients actually want,” says the report. So they’ll struggle to meet their clients’ needs.

Managing risk will require cutting costs because “the amount of risk [financial institutions] can underwrite relative to the capital they employ will be much lower…. Slashing headcount and closing business lines–the levers traditionally employed when the industry wants to save money–will not be enough” (p. 9). Companies must slash 20% beyond the savings they realize from divestitures and eliminating redundancies, according to IBM’s analysis. It sounds as if firms have a lot more cutting to do.

Focus on benefits, not features, in your marketing

Focusing on the benefits your clients will receive from your financial services is much more effective than touting your firm’s features. In other words, focus on you, the client–not us, the firm.

I found a great example of this when I looked for gyms near me.

Gym 1 said, “Gym 1 is a premiere fitness, athletics, and rehabilitation facility that features the highest caliber trainers, equipment…”

Sounds impressive, doesn’t it? But does it get you excited about joining a gym?

Now read the beginning of Gym 2’s ad. 
     We’ve helped our members: 
     -fit into their clothes 
     -make their exes jealous
     -look amazing at their wedding

Sure, some people would opt for Gym 1 over Gym 2. But clearly Gym 2 makes more of an emotional connection with the reader.

You can find similar contrasts in wealth management.

For example, one firm says, “Our company has been in business for 60 years.” Prospective clients may read that statement and ask “So what? Why should I care?”

They might re-word that as “Your money will be managed by a firm that has weathered up-markets and down-markets for 60 years.”

A reader of this blog post suggested a nice alternative: “If you’re like most of our clients, you’ve spent a long time building your success. We’ve been assisting people like you make informed decisions to protect that success for more than 40 years.”

Note: I updated and fixed the spacing on this post in Jan. 2017.

Image courtesy of Stuart Miles at FreeDigitalPhotos.net.