To take the hype out of past performance statistics of many investment managers, the Association of Investment Management and Research has developed standards for historical performance reporting. A second aspect of this performance reporting is a suggested independent review by CPAs. The attestation standards provide the vehicle.

Millions of personal, pension, and endowment dollars are placed weekly with professional investment managers based on advertised historical performance records that have never been subjected to independent scrutiny. Investment advisors have been granted a trust from prospective clients and their consultants virtually unheard of in matters involving such sizeable assets.

What's the Problem?

Investment managers live and die based on past performance. While the relative importance of a manager's record varies among prospective clients, it's usually first or second on the list of manager selection criteria. In the intensely competitive investment management business, the pressure to show a "good record" is enormous.

Despite client and consultant fixation on past performance, investment managers are allowed to present their historical track record on the honor system with a total absence of independent verification. The combination of performance pressures and "trust me" reporting has predictable results. There are rampant abuses in advertised performance records among investment managers. Mary Podesta, former Associate Director of the SEC's Office of Legal and Disclosure, observed in 1991, "The industry, clients, and regulators have known for some time that if all money managers can put their performance in the top quartile, something is wrong with the performance reporting system."

Selectivity Bias. Volumes could be written on the bending and breaking of rules that accompany investment managers' track records. The most widespread abuse is "selectivity bias." Here, the investment performance record is manipulated by the manager's inclusion of only selected accounts in the data. An example is survivorship bias, where historical performance is reported only for those accounts still with the firm. In this ploy, when an account cancels, its performance history is removed from the advisor's record. The remaining record thus reflects only the "survivors" who have likely experienced better performance from the advisor than the departed, dissatisfied accounts. The advisor's advertised record is truly reflective of the remaining accounts, but not reflective of the entire spectrum of the advisor's results.

Some advisors are more blatant in their reporting selectivity. They hand pick a single outstanding account or a handful of their best performing accounts during a given year as their official record. The selected account or group is often altered to include only the best performing among the advisor's client base in a given year. Banks' advisory arms and trust departments often practice another form of selective reporting. They have several different pools of managed assets in the form of commingled trust funds, separately managed trusts, commingled institutional funds, and separately managed institutional funds. The commingled funds may be further subdivided by differing objectives. Of the various pools, whichever sports the best record at the moment becomes the bank's official record for new prospects. If one suffers extended poor performance, the pool is "terminated," and client assets are moved into a new pool or one of the existing pools with better historical results. Thus, the poor performance of the terminated pools is laid to rest, never to be seen in public again.

Calculation Methodology. Another area of abuse is performance calculation methodology. Some managers report "average annual" performance over a specified number of years instead of the proper compound annual performance. Simple average calculations result in gross overstatement of performance over multi-year periods. Other differing calculation methodologies such as dollar-weighted versus time-weighted returns exist but tend to be less pronounced in their effect on reported data.

Hypothetical Data. Advisors also distort their advertised performance by reporting data that isn't derived from their actual client accounts. This abuse falls into two categories: back testing of decision rules and buy-list performance. The distortions related to such reporting can be very large when compared against actual client account results.

What's the Solution?

Two steps were proposed to eliminate these deceptions and bring credibility to the industry. The first was establishing standards of performance calculations, account eligibility, and required disclosures. The second was a form of verification of the reported data by an independent third party such as an independent accountant.

Enter the AIMR

The industry's self-governing body is the Association for Investment Management and Research (AIMR). For several years, MR studied the issues surrounding performance reporting, and in January 1989, a committee of its practitioners issued revised comprehensive guidelines for historical performance reporting. These guidelines effectively address the methodology standards issue. In fact, the AIMR guidelines probably require too much reported data. Few managers have fully adopted the AIMR guidelines to date due to their complexity. Moreover, AIMR has fallen short of solving the performance record problem by failing to include independent verification among its requirements. The AIMR standards include the suggestion of an independent review as optional.

The Benefits of an Independent Review Standard

There is every reason to believe independent review of historical performance reporting will become an accepted practice. If the standards are not revised to include such a requirement, the marketplace will do so. There are too many constituencies that would benefit from such a review for it not to happen.

Prospective investment clients would no longer need to worry about the validity of advertised data from competing managers during the selection process. Pension committees and other investors would be freed from analyzing the maze of footnoted oddities among performance records that cloud comparability of one manager to another.

Consultants should lead the drive toward standardized independent verification. Many consulting organizations, particularly brokerage firm consultants, simply accept at face value whatever managers tell them about prior performance. Since their manager selection services are so reliant on past performance records, shouldn't consultants demand accurate, verifiable data? SEI Corporation's Funds Evaluation Services Division is one of the few consultants using only "live" data that they calculate from actual monitored accounts in their performance calculations. SEI's data on investment advisors is therefore unbiased, uniform, and accurate for the monitored accounts. However, SEI's data on advisors is subject to manipulation through selectivity bias, since SEI's data may represent only a few client accounts while excluding the advisor's accounts not subject to the monitoring service. Adopting a comprehensive review standard is the only method of obtaining the true record.

The investment advisory industry probably has the most to gain. As in any profession, money managers as a group include individuals with varying degrees of ethics and integrity. For honest managers, a review standard will level the playing field in competitions for new clients. It will end the frustration of losing out to less qualified managers on the basis of falsified performance data. Most importantly, the public's perception of the investment advisory industry's ethics will improve.

Getting the Job Done

The latest version of AIMR's performance presentation standards is contained in a publication issued in 1993. While they do not require independent verification, they recognize two types of verification that could be performed. They are--

Level I. Verification that the investment manager's composites (portfolios or asset classes representing a similar strategy or objective) include all appropriate portfolios and time periods according to the standards.

Level II. Verification that the actual calculations are performed according to the manager's stated methodology and the methodology conforms to the standards.

AICPA Notice to Practitioners

In 1993, the AICPA published a Notice to Practitioners (NTP), Engagements to Report on Performance Presentation Standards of the Association for Investment Management and Research. This publication is presented as a sidebar. The NTP specifically notes that Statement on Standards for Attestation Engagements No. 1 applies to these engagements. It provides examples of reports to be issued on either a Level I- or Level II-type engagement.

The AIMR standards attempt to provide guidance in this area but are deficient. Appendix G to the standards contains an example of performance calculation verification statements, but there is none for a presentation of composites of portfolios or asset classes. The examples of reports to be issued contained in the AIMR standards are inappropriate, and practitioners should follow the guidance for reporting in the NTP.

The Scope of Work

The NTP states that a practitioner engaged in this type of engagement should use judgement in determining the adequacy of evidence to be obtained to express an opinion. The verification procedures suggested in the AIMR standards may not be sufficient to render an opinion.

As required under the attestation standards, before beginning such an engagement, a practitioner should have or develop expertise in the area of AIMR Performance Presentation Standards. The practitioner should also possess knowledge of investment vehicles, determination of market values, timing and method of recognition of earnings from investments, and timing and recognition of investment manager fees.

As with any engagement, the first, most important, step is to obtain a clear definition of the scope and responsibility the practitioner is assuming. This can be accomplished by preparing a formal engagement letter that includes the following key items:

a. A description of the nature, timing and limitations of the services to be performed;

b. A summary of departures from the AIMR Performance Presentation Standards the investment manager has adopted in the performance composite information;

c. A written example of the attestation report expected to be issued on the engagement; and

d. Estimated time and fees.

Since no two attest engagements are alike, the engagement letter takes on increased importance in defining the specific level and nature of work to be performed in a verification engagement on performance composites. A properly written engagement letter will help avoid misunderstandings between the CPA and the investment manager client requiring the scope of work and report to be issued.

In addition to a properly structured engagement letter, the following areas should be addressed at the beginning of an attest engagement to help ensure efficient completion of the engagement:

a. Obtain a written statement from the investment manager that identifies specific procedures and methodology used for calculating performance composite results. This document should also include a summary of specific departures from AIMR Performance Presentation Standards.

b. Identify any unusual investment accounts or transactions in the investment manager's portfolio that may have a significant impact on the performance composite results. Consider these investment accounts or transactions for disclosure in the footnotes to the performance composite results.

c. Review the investment manager's formulas and internal procedures for calculation of performance composites. Emphasis should be placed on consistent application of methodology and assumptions used in calculating performance composites from year to year. Any changes in methodology must be adequately disclosed in the report with related impact on performance composite results.

These of course are only a few of the procedures that would be included as part of the evidence gathering in such an engagement. The attestation standards should be reviewed in planning the engagement to see that the scope of the work will comply with such standards.

A Service Opportunity

Investment professionals and their clients have begun to realize it's time for the investment management industry to join public companies, mutual funds and the multitude of other groups who submit their results to the scrutiny of independent verification. As the demand for verified results grows, attest engagements will represent a significant practice opportunity for CPAs in the next several years. Establishing your firm as an expert in performing attest engagements of performance composites for investment managers can lead to a very profitable market niche for your practice.

NOTICE TO PRACTITIONERS AICPA AUDITING STANDARDS DIVISION

Engagements to Report on Performance Presentation Standards of the Association for Investment Management and Research

The Association for Investment Management and Research (AIMR) has issued a report containing performance presentation standards (PPS) for investment managers and advisors to use in presenting their performance to the public. The primary objective of PPS is to create consistency and comparability in performance reporting. (A copy of the report may be obtained from the Association for Investment Management and Research, 5 Boar's Head Lane, Charlottesville, VA 22903.)

The PPS address two types of presentations--1) a presentation of composites of portfolios or asset classes and 2) a presentation of performance calculations for portfolios or asset classes. The AIMR encourages presenters to engage an independent party to attest that one or both presentations are in conformity with PPS. Many CPAs have been requested to attest to such presentations. This Notice to Practitioners provides guidance about performing and reporting on such engagements.

The AICPA's Statement on Standards for Attestation Engagements No. 1, (SSAE No. 1, AT 100) applies to these engagements. SSAE No. 1 provides specific performance and reporting guidance that practitioners should follow when attesting to either type of presentation. In applying SSAE No. 1 to PPS engagements, practitioners should consider the matters discussed in the following paragraphs.

SSAE No. 1 requires a written assertion by the party responsible for the composite or performance calculations. This requirement is satisfied when the investment manager or advisor presents either a statement of composites or a statement of specific performance results (or both). AlthOugh an investment manager or advisor may also present a written report asserting that they believe the statement(s) conform with AIMR PPS, such a report is not mandatory because this assertion is implicit in the statement(s) themselves.

When performing an examination of either or both presentations, the practitioner should use his or her judgment in determining when sufficient evidence has been obtained to express an opinion. Although the AIMR report containing the PPS provides some suggested "verification" procedures, practitioners should recognize that such procedures are illustrative and may not be sufficient to express an opinion. Practitioners engaged to perform these examinations are responsible for determining the appropriate scope of work for an examination-level engagement.

When performing an examination of a presentation of performance calculations (referred to as Level II in the AIMR report), practitioners should recognize that the PPS for presentation of performance calculations also require conformity with the PPS for a presentation of composites (referred to as Level I in the AIMR report). Thus, an examination of a presentation of performance calculations requires the practitioner to examine both the composites and performance calculations and determine whether they conform with the PPS.

When reporting on an examination of either or both presentations, the practitioner's report should identify the appropriate PPS (composite standards, performance calculation standards, or both) as the criteria against which the opinion is expressed. That is, the practitioner's opinion should state whether the presentation conforms with the AIMR Performance Presentation Standards for composites, performance calculations, or both. In addition, the investment manager's or advisor's presentation of composites, performance calculations, or both should include a note containing a description of the criteria. Such a description should be based on that set forth on pages 36 and 37 of the AIMR report (December 1991). (See Illustrative Report No. 1 in the Appendix.)

If a practitioner is engaged to examine and report only on a statement of composites but a statement of performance calculations is also included in the presentation, the practitioner's report should indicate that the practitioner was not engaged to examine the statement of performance calculations and disclaim an opinion on such a statement. Reporting in this manner makes clear to report readers that the practitioner is not expressing an opinion on the performance calculation presentation. (See Illustrative Report No. 2 in the Appendix.)

APPENDIX

ILLUSTRATIVE PRACTITIONER ATTESTATION REPORT

Report Illustration No. 1

Report on Presentation of Composites and Performance Calculations (Unqualified Opinion)

We have examined the accompanying |identify the presentation of assertions--for example, Statement of Composites and Statement of Performance Calculations of XYZ Capital Management for the year ended December 31, 19X1. These statements are the responsibility of the company's management. Our examination was made in accordance with standards established by the American Institute of Certified Public Accountants and, accordingly, included such procedures as we considered necessary in the circumstances.

In our opinion, the |identify the presentation of assertions--for example, Statement of Composites and Statement of Performance Calculations of XYZ Capital Management for the year ended December 31, 19X1 referred to above presents |identify the assertions--for example, the composites and performance calculations of XYZ Capital Management in conformity with the Performance Presentation Standards of the Association for Investment Management and Research set forth in Note X.

Report Illustration No. 2

Report When Responsible Party Presents Both a Statement of Composites and a Statement of Performance Calculations But Practitioner Engaged to Examine Only the Statement of Composites

We have examined the accompanying |identify the presentation of assertions--for example, Statement of Composites of XYZ Capital Management for the year ended December 31, 19X1. This statement is the responsibility of the company's management. Our examination was made in accordance with standards established by the American Institute of Certified Public Accountants and, accordingly, included such procedures as we considered necessary in the circumstances.

In our opinion, the |identify the presentation of assertions--for example, Statement of Composites of XYZ Capital Management for the year ended December 31, 19X1 referred to above presents |identify the assertion--for example, the composites of XYZ Capital Management in conformity with the Performance Presentation Standards of the Association for Investment management and Research set forth in Note X.

We were not engaged to examine, and did not examine, the |identify the presentation of assertions not examined--for example, Statement of Performance Calculations of XYZ Capital Management and we do not express an opinion on this statement.

Michael E. Jones, CFA, is co-founder and managing director of Clover Capital Management, Inc. Gerald J. Archibald, CPA, is a partner of Bonadio, Insero & Co.