GIPS 2010 Calls for Standard Deviation

By Jonathan A. Boersma, CFA
CFA Institute

In these uncertain economic times and treacherous market environments, investors are searching for information about the likely performance of various investment strategies. The first question that must be answered is what counts as good performance. Is it the performance that helps a charitable organization meet its grant-making goals, the returns that help to grow the assets of an organization after inflation and expenses, or the results that ensure a pension plan is adequately funded or that enable individuals to save for their retirement? Does good performance mean that a portfolio beat its benchmark, or does it mean that you lost less than everyone else investing in the same style or strategy?

Investors are searching for answers to these questions every day. One objective of the Global Investment Performance Standards (GIPS) is to provide investors with sufficient performance-related information to make sound investment decisions. Historically, however, the GIPS standards have never required a measure of the risk of a strategy. In the development of the GIPS 2010 Exposure Draft, it has been proposed that including standard deviation as a risk measure in GIPS-compliant presentations would help investors form better answers to questions such as those posed earlier.

The GIPS 2010 Exposure Draft defines standard deviation as a statistical measure of how widely returns are distributed around the average return. Standard deviation is widely accepted as a common measure of portfolio risk. Because investors enter the capital markets for many different reasons, the success of a portfolio cannot be judged solely in terms of return. Just as importantly, the variability of performance must play an essential role in evaluating portfolio outcomes. More specifically, investors must be concerned about a portfolio’s risk–reward characteristics. Given two portfolios with similar expected returns, rational investors prefer the less risky one. Conversely, an investor who is willing to accept greater portfolio risk should expect to be compensated for the increased variability by earning higher returns over time.

An investor experiencing short-term market fluctuations may realize that significant negative returns can be exceedingly difficult to rebound from quickly. For example, a global equity portfolio that is worth $100 on 31 December 2007 and loses 40 percent in the following year will be worth $60 on 31 December 2008. The portfolio will have to achieve a return of 67 percent in 2009  to regain its original asset value of $100. At no time in recent history have the broader equity markets illustrated the dangers and rewards of variability as they have in recent months. Providing prospective clients the ability to readily ascertain a composite’s ex post (historical) standard deviation as a part of the larger compliant presentation will provide valuable information about how an investment strategy has performed. Would it matter that the global equity portfolio just described lost 40 percent in 2008 and then gained 67 percent in 2009, resulting in a two-year annualized return of zero? It would matter greatly if the investor needed to withdraw funds from the portfolio at the end of 2008.

To combat this variation of individual portfolio returns, sophisticated investors may invest in an all-encompassing multistrategy portfolio or combine several portfolios with varying levels of risk to achieve diversification on their own. Whether the overall investment program is designed using single asset class strategies or consists of one portfolio with multiple strategies, the goal for many long-term investors is low risk (standard deviation) and high returns. Standard deviation gives a general sense of how wide the historical swings in performance have been in the strategy presented.

Including standard deviation in the 2010 version of the GIPS standards recognizes a basic tenet of portfolio management and offers prospective clients additional performance information to assist in making good investment decisions. The following two provisions address standard deviation in the GIPS 2010 Exposure Draft, which is currently open for public comment:

4.A.29 FIRMS MUST disclose the 3 year annualized EX-POST STANDARD DEVIATION (using a minimum of monthly periods) for the COMPOSITE and for the BENCHMARK as of the most recent annual period presented. The PERIODICITY of the COMPOSITE MUST be identical to the PERIODICITY of the BENCHMARK when calculating EX-POST STANDARD DEVIATION.

5.B.7 FIRMS SHOULD present the 3 year annualized EX-POST STANDARD DEVIATION (using a minimum of monthly periods) and the corresponding 3 year annualized TOTAL RETURN for each annual period presented for the COMPOSITE and for the BENCHMARK. The PERIODICITY of the COMPOSITE MUST be identical to the PERIODICITY of the BENCHMARK when calculating EX-POST STANDARD DEVIATION.

Although admittedly not the perfect measure for every strategy, standard deviation is well understood and allows for some degree of comparison between strategies. Whether an investor is an endowment, a foundation, a corporation, a high-net-worth individual, or an average person, the variability of investment returns is an integral part of institutional and personal financial planning. Even though the expected outcomes are not always realized and will almost certainly differ from historical results, making investment decisions with thorough and accurate information may improve the likelihood of favorable results.