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Adjustments To Prior Period Returns

One problem that is common among all money management firms is the need to address adjustments to prior
period returns. This article discusses some of the reasons for these problems; alternative ways people are dealing
with them, and a set of proposed standards for handling adjustments. It is our hope that these standards will
become universally accepted and agreed upon.

David Spaulding
is the founder and president of The Spaulding Group, Inc. He is the author of Measuring Investment Performance
(McGraw-Hill, 1997) and Investment Performance Attribution (McGraw-Hill, 2003); he is a contributing author
to Performance Measurement in Finance (Butterworth-Heinemann, 2002). Dave is a member of the AIMR-PPS
Implementation Committee and the Investment Performance Council. He has a B.A. in Mathematics (Temple
University), an M.S. in Systems Management (University of Southern California), and an M.B.A. in Finance (Uni-
versity of Baltimore).

Stefan Illmer, Ph.D.


is director and head of Performance Measurement and Portfolio Analytics at Credit Suisse Asset Management in
Zrich. He is responsible for Performance Measurement, Performance Reporting, Risk and Return Attribution
and for the compliance of Credit Suisse Asset Management (Switzerland) with the Global Investment Perfor-
mance Standards (GIPS). Furthermore, he is working on global projects on performance measurement and
portfolio analysis. On a global basis, he is the chairman of the European Investment Performance Committee
(EIPC), represents Europe within the Investment Performance Council (IPC) and is a member of the Interpreta-
tions Subcommittee as well as the Country Standards for GIPS. Together with PriceWaterhouse Coopers, he
founded the Swiss Performance Attribution Roundtable.

WHY WE HAVE TO MAKE ADJUSTMENTS


corporate action may have been missed completely
or simply not processed correctly.
Each month, money managers use their portfolio ac-
counting data as the basis for the rates of return they
C missed cash flows. Perhaps the client added or with-
publish and report. Prior to initiating the reporting cycle,
drew funds from the account; while the custodian
however, the portfolios typically go through a recon-
may have recorded these actions, the manager may
ciliation process with the accounts official books and
not have been aware of them and therefore didnt
records. These records are typically maintained by the
record them on the portfolio accounting system.
accounts custodian or clearing broker, who is respon-
sible to ensure complete integrity of the data.
C pricing problems. This is especially a problem for
securities that arent actively traded or for which
For a variety of reasons, there are often exceptions dis-
market prices arent available. We may have over-
covered between what the money manager believes the
ridden a price, only to learn later that our manually
portfolio looks like and what the custodian shows. There
applied price was incorrect. Pricing inconsistencies
can be a variety of reasons for this, including:
can lead to erroneous rates of return being reported.
This is especially problematic when the problems
C missed trades. Perhaps a trade was processed against
are related to capital flows.
the wrong account or wasnt correctly registered on
either system. C exchange rates. Differences in the sources for ex-
change can also cause differences. Sometimes huge
C mishandling of corporate actions. On occasion, a differences.

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Once the reconciliation is complete, the money man- change our returns on our GIPS presentations?
ager confidently moves forward and produces rates of
return which will appear on client statements, in their The problem with changed returns is that the client nor-
GIPS and AIMR-PPS presentations, and in the firms mally notices them, especially if calendar year or fixed
marketing brochures. period returns are shown. Showing rolling period returns
(e.g., rolling year) can reduce this risk, but this kind of
Unfortunately, the story doesnt end here. On occasion, reporting is not in line with the GIPS or the AIMR-PPS.
we will learn of problems that occurred in a prior pe- In addition, most clients want to see returns reported by
riod, after the reconciliation has been done, which may calendar years.
cause us to reconsider the accuracy of previously re-
ported rates of return. What can cause these problems? Reasons Not To Make The Changes
Well, they are often similar to the problems we identify
during the reconciliation process: One reason firms often dont want to tell their clients of
changes is they feel this will suggest that the firm doesnt
C failed trades. Perhaps a trade that was booked wasnt have the correct controls in place to catch these prob-
able to settle, necessitating the trade being cancelled. lems before the reports are issued. They feel that these
adjustments will only raise concerns about their process-
C incorrectly processed trades. Trades may have been ing, and the new results will have little benefit to the
recorded and reconciled but later found to be in error. client. (This is the same reason why indexers do not want
to communicate recalculated index data to their clients.)
C problems with corporate actions. Often, all the de- While we can understand the basis for this position, we
tails necessary to properly process a corporate ac- dont feel its justified. Clients need to be aware that
tion may not be available for several weeks, possi- there will be occasions when prior period results will
bly months following the announcement. For ex- change. Our clients should be pleased that we are will-
ample, with a spin-off, there may be shares plus cash ing to go back and make the necessary adjustments to
issued, but the specifics may not be known for some ensure the highest quality of our reported data.
time. Once they are known, backdated adjustments
may be needed. The change will be captured in a subsequently reported
return. This often does happen. For example, perhaps
C pricing problems. Perhaps as a result of misapplied we missed a trade, thus our ending period market value
corporate actions or trade problems, we may also may be incorrect. However, the correction will be made
have pricing problems. in a subsequent period, and we expect the numbers to be
adjusted in the next period. While this may be true, it
On occasion, our custodian may have made an error that doesnt take away from the fact that a prior period had
they do not discover for some period. When they do, an erroneous return.
they adjust their records. Should we?
Another reason firms may not wish to make changes is
Another source of potential errors is benchmarks. On because they have little impact on the previously reported
occasion, a benchmark provider will go back and adjust numbers. Changes that may be considered minuscule
a previously reported index. Perhaps they had mispriced may not be felt worth addressing. We dont necessarily
a security or failed to process a corporate action; or, there disagree with this notion and have included it in our pro-
may have been some other cause for their error. If weve posed approach. We refer to this as materiality, which
used the benchmark data in our attribution analysis, we you will see below.
may want to go back and recalculate our numbers.1
HOW FIRMS HANDLE RETROACTIVE
Once the money manager becomes aware of these as-of
ADJUSTMENTS
adjustments, they must decide what to do from a report-
ing point of view. Do we recalculate our previously re-
ported returns and inform the client of changes? Do we We have discussed this topic at a few meetings of the

The Journal of Performance Measurement - 12 - Summer 2003


Performance Measurement Forum and have some in- or AIMR-PPS report, we may want to use a phrase like
sight into what the process may look like. In general, figures have not been verified yet and are therefore
this is what seems to occur. subject to change.

1) Ascertain the materiality of the correction. In order Another matter, which should be part of the firms poli-
to do this, we must calculate the return after the correc- cies, is when the books should be closed. And, if they
tion is made and compare it with the previously reported are closed, under what circumstances can they be re-
number(s). Firms will often establish (perhaps not for- opened?
mally) some cut-off, below which nothing will be done.
Criteria such as the change relative to the published re- Lets now address when errors are truly errors. Do
turn or how far back the change would have to be made people expect their reports to be estimates? In which
will be considered. case, adjustments are merely finalizing the previously
estimated reports? Under this approach, would it be
2) Freezing of time periods. Many firms will freeze necessary to announce a correction, since the recipient
a time period, after which no change will be applied.2 should understand that what they received was an esti-
While we can understand the reasoning behind this, de- mate?
pending on how recent the freezing may be applied, we
may be creating some problems. For example, if our A lot depends upon the level of sophistication of the
policy is to freeze any returns reported prior to the last recipient. Its difficult, if not impossible, to know how
quarter, were not allowing much of a window for ad- performance-savvy our clients are. The reality is that
justments. Freezing may be applied to the previous cal- the knowledge level probably varies considerably from
endar year with a lagging period of six months (after client-to-client. We may want to consider having a policy
verification).(If a material return error does not wash with each client, which outlines when we will notify them
out over time, then the firm has no choice but to recal- of changes. Education is important as (a) the returns, in
culate. Investment advisors cannot knowingly report many cases, are only approximations of the true, time
incorrect returns.) weighted rate of return and (b) because individuals who
are knowledgeable about the investment industry know
PROPOSED APPROACH that changes do occur.

Written Policies and Procedures Definition of Materiality

We feel that firms must have written policies and pro- Our decision as to whether to apply a change or notify
cedures on handling prior period adjustments and that recipients of changes will be tied to the materiality of
these policies should be strictly adhered to. the correction. For example, if we reported a year-end
return of 23.16% but found that it should be 23.15%, is
Clearly, the presence of controls is of utmost importance, a one basis point change worthy of disseminating? Per-
as they will help minimize the need to make adjustments. haps not. So, what will the cutoff be?
For example, to avoid distributing returns until after the
reconciliation process has taken place. Unfortunately, Something to consider: report returns to ten basis points
the pressure to reveal numbers is often so great that we (one decimal place). This would mean that both 23.15%
issue returns prior to the reconciliation being completed. and 23.16% would be reported as 23.2%, meaning no
We recommend that any numbers published in such a notification would be needed. This may be easier said
manner carry notation such as preliminary numbers; than done, however, as many people expect to see re-
changes may occur as a result of reconciliation to alert turns shown to the basis point, as if this level of detail
the recipients that the numbers have not been finalized. really shows the true accuracy of the information.
Following the reconciliation, subsequent reports can
carry the notation of final. Of course, we realize that Table 1 shows an example of the factors that you might
final doesnt always mean final. Example: for a GIPS consider when defining your level of materiality. We

The Journal of Performance Measurement - 14 - Summer 2003


Table 1.
Materiality Table

Time Periods
Month Quarter Year
Portfolios Equities Restate 1 bp 2 bp 3 bp

Republish 3 bp 4 bp 5 bp

Fixed Restate 1 bp 2 bp 3 bp
Income
Republish 1 bp 2 bp 3 bp

Composites Equities Restate 2 bp 3 bp 4 bp

Republish 3 bp 4 bp 5 bp

Fixed Restate 2 bp 3 bp 4 bp
Income
Republish 2 bp 4 bp 6 bp

believe there may be one set of rules for portfolios and want to consider materiality based upon relative magni-
another for composites. Also, we might have rules based tude as well.
on security types. Other factors were considering are
the length of the reported time period (month, quarter, An absolute change of 10 basis points or more, for ex-
year). Finally, we have one set of rules for republishing ample, may trigger a correction.
and another for restating. We might recalculate our re-
turns based upon a certain degree of error, but wont From a relative standpoint (relative to the benchmark),
actually republish ( i.e., notify the recipient) the change a change which would cause the portfolio or composite
unless its of a higher degree of materiality. These rules to move in relationship to the benchmark (e.g., from
may be defined on product level because, depending on outperforming to underperforming), regardless of the
the underlying data (for example emerging markets), one absolute magnitude, might trigger a correction. Or, the
or two basis points may be nothing. change relative to the size of the return (one basis point
in comparison to a return of one percent counts a lot
Another issue is if we have accounts which are valued more than one basis point versus a 10% return.
only once a month and for which the account value is
only available three weeks after month end (e.g., for Freezing Time Periods
hedge funds). In these cases, other rules may be applied
because it makes no sense to send a letter for correction While we feel that its appropriate to freeze time peri-
every month to the client. ods, we should be prepared to open a previously
closed time period should the magnitude of the correc-
Our rule may be based upon the magnitude of the cor- tion warrant it. For example, if our policy is to close a
rection. Two possibilities: absolute and relative. While prior year once were at least six months into the new
our table shows the changes in absolute terms, we might year, what happens if we discover an error that would

Summer 2003 - 15 - The Journal of Performance Measurement


result in a change of 500 basis points (five percent)? Figure 1 shows a decision tree that you might employ
Wouldnt this warrant a reopening of the period (books)? for handling corrections. As you can see, the first step is
We believe it would. to determine whether or not a report has been sent to the
client; if it has, then a change would be needed (provid-
The policy should state when time periods are frozen ing the magnitude exceeded our threshold).
and what would be done if a very large change had to be
applied. Note: Ideally, the client contract has a section on per-
formance measurement and a disclaimer or understood
The Process policy with respect to corrections.

Some firms will go through the following process when Figure 2 provides a similar approach but with respect to
an error is identified: changes in composite returns. In this case, we do not
only need to address notification of the prospect, but
Step 1. Recalculate the returns. also clients, verifiers, and others.

Step 2. Compare degree of correction to the materiality Ideally, clients should be able to identify their rules for
table. If the magnitude warrants action, provide to a re- materiality (i.e., at what level they want to be aware of
sponsible party (individual or committee) for review. changes to prior periods). Alternatively, they would de-
This may also go through the firms legal or compli- fault to standard firm policy.
ance department for review.
PERFORMANCE-BASED FEES
Step 3. Decide on what action to take. Document the
original number, the corrected figure, and the action It is important that the firms policy be sensitive to situ-
taken. ations involving performance-based fees. There is a be-

Figure 1.
Decision Tree for Portfolio Changes

Portfolio
Change
Happens

Yes No

Reported yet?

Change Material?

Yes No
Change
Change Portfolio
Portfolio Data; Don't
and Report Report

Time Period
Composite
Issues
Issues
(rule)

Apply to
Go Back Current
Period

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Figure 2.
Decision Tree for Composite Changes

Impact
Composite?
Material?
Based on
Absolute and
No Yes Relative Rules

No Action Change
Report Different
materiality rules;
avoid nuisance
Notify? factor; more
subjective

Consultants? Prospects?
Clients?
Verifier?
All, whether Client service
decision person's
made or not? responsbility

lief that if an adjustment is made, it will be caught up in municated may vary, depending on the size or sophisti-
a subsequent period. If this is true, perhaps an adjust- cation of the client. However, if the portfolio is subject
ment is not needed. But this needs to be assessed. to prior period adjustments, its important that the client
be aware of this and what may cause an adjustment.
Another issue occurs if the custodian provides the re-
turn which is used for the fee and the error occurs there. This educational exercise is not only important for cli-
A review should be performed to determine the magni- ents but also for consultants.
tude of the error and how the change should be handled.
A similar issue is adjusting the return of an attribution
What if the problem is with the index provider? If the software to the official return calculation.
provider makes an adjustment, then a review is in order.
If the provider didnt make an adjustment, then the firm All users of returns should realize that the correctness
may elect to recalculate the indexs return as they be- of a return figure is dependent upon the quality of lots
lieve it should be and, if appropriate, report and take the of input data for which the money manager doesnt con-
appropriate action to ensure the correct fee is assessed. trol and is not responsible for.
However, this option is clearly not available to all firms,
in addition, the firm would have to explain why he did PROPOSED STANDARDS
this. So, caution needs to be exercised if this action is
taken. Perhaps a better step is to simply make it known Now, to the standards we discussed early on.
that the index is in error.
In a recent issue of this publication we find proposed
EDUCATING THE CLIENT standards for attribution (Spaulding 2002/2003). This
paper was fairly extensive.
As noted earlier, its important for clients to be aware
that errors do, on occasion, take place. How this is com- Regarding handling corrections, we propose some fairly

Summer 2003 - 17 - The Journal of Performance Measurement


basic standards, which we feel the industry should fol- REFERENCES
low. As youll see, they are rather brief:
Spaulding, David, A Case for Attribution Standards,
1.) Develop and maintain a written policy: All firms (who The Journal of Performance Measurement, Winter 2002-
are subject to as-of adjustments, (and who isnt?)) should 2003, pp. 1321.
develop and maintain written policies and procedures that
outline what steps they take in the event of changes to ENDNOTES
prior period returns. Any as-of changes (whether or not
action is taken) should be documented (the change, the 1
Why do index providers not care about informing money
reason for the change, the action(s) taken). managers about changes to index data? We dont have the
answers. They generally seem unwilling to inform clients about
This is in line with GIPS, which now mandates the de- data changes. Historical data changes are a nightmare for ev-
velopment of policies and procedures. This is just one ery return attribution department, because it is not so easy to
of those policies which a firm should have. identify the changes by yourself.

2
2.) Make available upon request: Written policies must Some firms refer to this as closing their books. But
closed books can be opened again under certain circum-
be made available to clients and prospects, upon re-
stances (analogous to unfreezing time periods).
quest.

We do not propose that there be one universal set of


standards and that everyone adopt them. However, we
realize that changes occur and that its important that
investment firms outline how they handle them. This is
also in line with the spirit of GIPS: consistency, disclo-
sure and fair representation.

Everyone is subject to the problem of having changes


occur. The question is what do we do about it? Weve
attempted to outline the reasons, issues, and some sug-
gestions on how to deal with these problems.

The Journal of Performance Measurement - 18 - Summer 2003