STANDARDS OF PERFORMANCE MEASUREMENT AND USE FOR NAAIM MEMBERS

Approved on February 1, 1991
Revised May 2, 1992; June 7, 2000

Introduction

The techniques employed by investment advisers in general to measure investment performance and the use of the results have been varied, uneven, and, in some instances, outright irresponsible and dishonest. In order to ensure that NAAIM members represent the highest ethical and moral standards, a fair and understandable policy should be followed to arrive at a complete, accurate and fair presentation of investment performance. This report will formulate standards to provide the NAAIM membership with some guidelines and background information for compiling and using portfolio performance data to meet the above objectives.

The problems associated with measuring investment results are complex and make it extremely difficult to arrive at a satisfactory and still simple solution to them. This applies to all types of investment managers including mutual fund asset allocators and fund timers. These problems are well documented but are beyond the scope of this report. However, in formulating the recommended standards for this report, these problems were taken into consideration, and where necessary to provide an understanding of the rationale for the recommended standards or measurements provided herein, they are described.

While clients and client prospects are encouraged to make extensive qualitative judgments of investment managers, these NAAIM guidelines concentrate on the quantitative--on a complete, accurate and fair presentation of investment performance data. The standards recommended here include those quantitative, statistical performance measurements that apply to all types of portfolios and those that are unique to active management. Despite the imperfect character of purely numerical measurements, the NAAIM does endorse certain standards of measurements and use, and discourages the use of certain other measurements and their use. The recommendations are not intended to deal with every facet of performance measurement. Some areas are intentionally treated in a general way because being too specific on some subjects would result in having to establish more rules to deal with exceptions than seems practical. Therefore, this report is confined primarily to recommendations of minimum standards on how to calculate performance data and how best to use this information.

The overall philosophy underlying these standards is the need for full disclosure of investment performance data to clients and client prospects. Certain statistics and presentation data have been delineated as requirements; but the main theme is that investment managers may present any reasonable statistics provided that their derivation, and particularly any exclusions therefrom, are fully disclosed.

All members and their firms are required to adopt and abide by these recommendations, and in doing so, may make the statement regarding the presentation of investment performance figures that: "All performance representations herein were prepared by (Name of Preparer) in accordance with standards approved by the Society of Asset Allocators and Fund Timers, Inc., (NAAIM) - However, NAAIM has not reviewed these performance representations"

Any apparent violation of these Standards of Performance Presentation and Use shall be reported to NAAIM according to the procedures specified in Article III, Section 7 of the NAAIM Bylaws.

RECOMMENDED PERFORMANCE PRESENTATION STANDARDS

I. Basis for Performance Calculation

Before performance can be measured, it must be determined what is to be measured. That is, what is the basis for the performance. A. Substantiated Performance Basis: Substantiated performance is based on information obtained from actual trades made, substantiated by mutual fund or other trade confirmation statements. All investment results should be based on this method. Substantiated performance falls into two categories:

1. Actual Portfolio Returns: Performance based on actual portfolio returns.


2. Simulated Performance: Performance based on the application of actual "buy" and "sell" signals, substantiated by mutual fund or other trade confirmation statements, to a "benchmark" market index (proxy for the stock market) or to mutual funds of the same asset class but different from the funds actually traded.

B. Hypothetical Performance Basis: Hypothetical performance are those results based on backtesting of trading systems or trading indicators and applying the resultant "buy" or "sell" signals to mutual funds or market indexes. Because: (1) there is no guarantee that the investment manager would have actually used the signals generated by these methods in "real time", (2) these methods can be developed with hindsight and the results can be "smoothed" or "curve fitted" to the data and, (3) proprietary trading systems cannot be verified independently to substantiate the results, reporting results based on this method is subject to potential abuse. Therefore, the following disclosures, displayed prominently, must be made in each presentation of backtested performance results.

1. The limitations inherent in hypothetical, backtested results, particularly that the performance results do not represent the results of actual trading using client assets, but were achieved by means of the retroactive application of a backtested model that was designed with the benefit of hindsight;


2. That backtested performance information may not reflect the impact that any material market or economic factors might have had on the adviser's use of the model if the model had been used during the period to actually manage client assets;


3. That the conditions, objectives, or investment strategies of the timing model changed materially during the time period portrayed in the advertisement and, the effect that such change had on the results portrayed;


4. That any of the securities contained in, or the investment strategies followed with respect to, the hypothetical portfolio do not relate, or only partially relate, to the type of advisery services currently offered by the adviser (e.g., the performance results include some mutual funds that the adviser no longer offers for its clients); and


5. That the adviser's clients had investment results materially different from the results portrayed.

C. Portfolio Selection Basis: The primary purpose of the presentation of a performance record is to demonstrate to prospective clients the abilities of an investment manager. It is often very difficult to construct a sample of data which is an accurate representation of all of a timer`s work. This is true whether the data sample is constructed from one account or all accounts. Therefore, the basis for the selection of the portfolios and accounts used in constructing the performance results must be included in any performance presentation. In addition, the exclusion of any accounts that might distort the results for any particular program must also be delineated along with an explanation for the exclusion.

1. Actual Portfolio Performance Selection Basis: Selection of portfolios for reporting actual portfolio returns might be based on:
a. the total of all accounts managed by the timer, including closed accounts.
b. the total accounts within a particular asset class program such as equities, bonds, strategic (equities and bonds) etc
c. the total accounts within a particular fund group or using a particular mutual fund as the aggressive vehicle.
d. a model portfolio account which is representative of the firm`s work.
Characteristics of a model portfolio that may make it representative of a firm`s work include an account that is the longest, continuous account managed by the timer, or one that represents the exact results of all accounts totally or within a specific asset class.
On the other hand, if a model portfolio account was selected because it has one of the best rates of returns of all accounts managed, then that must be disclosed and it must be stated that it is representative of itself and no other accounts managed by the timer.
Whatever portfolio selection criteria is used, it must be disclosed.
2. Simulated Performance Selection Basis: Selection of the portfolios for reporting simulated performance results must be based on the same criteria as applies to model portfolios for computing actual portfolio returns. That is, the actual account(s) used to generate the simulated performance results should be representative of the firm`s work. If the selection was based on the account that yielded the best rate of return, than the same disclosures and statements as applies to actual return portfolios must be made. Likewise, whatever portfolio selection criteria is used, it must be disclosed.

II. Performance Calculation and Standards of Measurement
A. Total Return: Investment results must be computed on a total return basis. This includes income and capital gains and losses both realized and unrealized. Investment income should be included on a full accrual basis from period to period and not on a cash accounting basis unless the income for the period is less than 1%of the portfolio value. If the income for the period is less than 1% of the portfolio value, it may be accounted for on a cash basis or estimated by prorating the indicated annual rate of return at the beginning of the period on a daily basis.

B. Advisery Fees and Expenses: Investment results must reflect the deduction of advisery fees, sales charges (load fees) incurred while under management of the firm, brokerage or other commissions, and any other expenses that a client would have paid or actually paid except custodial charges. At a minimum, deductions for average advisery fees may be used for general presentations, but when making presentations to prospective clients, the advisery fee rate applicable to the size of the account of the prospective client should be used.

C. Rates of Return: Investment results must be computed as "time-weighted" rates of return for use in making performance comparisons with market indices and results of other portfolios. For multiple account performance calculations, a method approximating the exact time weighted rate of return is acceptable. Acceptable methods are listed below. For model portfolios consisting of one account, a precision dated time weighted rate of return should be used.

Investment results should measure the performance of the portfolio manager, not the portfolio. The impact of the size and timing of cash flows into or out of a portfolio can substantially influence the growth in market value of the portfolio. A portfolio manager has no control over either the timing or the size of cash flows.

Accordingly, in judging the competence of a portfolio manager, a method which eliminates the effects of external cash flows must be used. The time weighted rate of return provides such a measure and thus measures the performance of the portfolio manager not the portfolio. The time weighted rate of return performance calculation is the mandatory methodology, since it represents the only practical method for comparing manager results over time.

The time weighted rate of return is also suitable for comparisons with market indices, which are by default time weighted since there are no cash flows.

It is difficult for many organizations to provide an exact time weighted rate of return measurement because of the necessity to revalue the entire portfolio whenever cash contributions or withdrawals are made. Therefore, an approximate time weighted rate of return formula is satisfactory in most cases. The following principles and procedures must be observed:

1. Portfolios must be valued at least quarterly. Monthly valuation is the preferred frequency where practical.
2. A time-weighted return formula which minimizes the effect of contributions and withdrawals must be utilized. Daily accounting for contributions and withdrawals (precision time dated) is the preferred method. The following formulas are the minimum acceptable for calculating the time weighted rate of returns. Any formula which provides a greater accuracy is also acceptable. a. Bank Administration Institute (B.A.I.) method b. Dietz method
3. When a contribution or withdrawal is significant (e.g. over 10%) in relation to the latest calculation of market value, a portfolio should be revalued on the date of the contribution or withdrawal in order to reduce possible distortion.
4. Rates of return for each sub-period (monthly or quarterly) should be linked together geometrically.

D. Asset Classes: Performance results for any one asset class (e.g., equities) applicable to actual portfolio returns should include cash equivalents and any other securities (e.g., bonds) held by the manager in place of that asset. For example, if some monies are normally held in money market funds for some clients so that fees may be deducted without disturbing the assets in the equity portion of a portfolio when a fully invested equity position is called for, those assets should be included in the performance results. Because the manager may not make the decision to have the monies set aside for such purpose, any reduction or increase of performance due to such practice should not be charged to the manager. The manager may explain that the effect of such holdings may reduce the performance and may separately and in addition report the performance of accounts which do not hold such cash equivalents but which have fees paid from outside the account as long as the effects of the fees are included in the performance.

F. Leveraged Performance: The effects of the use of leverage on any performance results must be calculated and disclosed.

G. Formation and Presentation of Performance: All managers should construct and present accurate composites of investment performance. Rules for such composites include:

1. Total Time Period Shown: Managers should compile and present such results for as long a period of time as accurate accounting can be accomplished. The minimum objective should be a length of time encompassing at least one market cycle containing rising market and declining market periods in order to permit an assessment of investment performance during both types of markets. For the purposes herein, a rising or declining market period is defined as a period during which the S&P 500 Composite index total return has risen or fallen by 20% or more.
2. ime Interval Returns: Investment results should indicate the total rate of return on an annual basis for individual years and on a compound annualized basis for all cumulative periods covered in the presentation, unless specific requests are for different periods. The use of average annual rate of return computed by averaging the annual returns for each year or by computing the total return for the cumulative time interval and dividing by the number of years in the cumulative time period is considered misleading and is strictly prohibited.
3. Risk Adjusted Returns: The adequacy of the rate of return should be measured in perspective of the amount of risk incurred, since higher returns are expected to accrue to higher risk investments. Otherwise, no one would be willing to bear risk.
Presentation of risk measures such as Alpha (Superiority Rating), Beta (Volatility/market related risk), Standard Deviation (Total Portfolio Risk/Portfolio Variability), Relative Standard Deviation (versus market proxy), Correlation (R-Squared) and the Sharpe Index for model portfolio or composite results is strongly recommended. Since one of the stated goals of market timers and asset allocators is to reduce risk without sacrificing returns, the use of such risk measures in presenting performance results is even more meaningful in presenting an accurate picture of the manager`s ability to achieve those objectives. Ideally, a composite measure of the risk adjusted rate of return reflecting both risk and return should be presented as a minimum. This measure should measure the manager`s success (or lack of success) in selecting securities (e.g., mutual funds) and/or timing the market. The Alpha coefficient (Alpha) is the recommended measure for determining the risk adjusted rate of return. It measures the extra reward -the difference between the portfolio`s actual performance and the portfolio`s expected performance based on the relative risk of the portfolio with respect to the market. Alpha will be positive if the manager is successful and negative if the manager is unsuccessful.
4. Composite Performance Measures: In presenting investment performance results, it is appropriate to use summary statistical techniques such as averages, medians, etc., as long as they are representative of a broad sample of similar portfolios. A firm should be prepared to substantiate statistical and graphical representations by being ready to describe the details of the underlying calculations.
5. Inclusions and Exclusions: Complete information on inclusions and exclusions of data from account performance calculations should be presented. For composite performance presentations, all client accounts should be included for whatever period such accounts were under management unless the portfolio manager did not have effective discretion in managing the account or the inclusion of the account would impose an inordinate computational burden in calculating the composite performance. The number of accounts used in composite presentations should be delineated. Arbitrary inclusion or exclusion of data for portions of periods under management is prohibited. Clients` accounts no longer under management should be included in composite(s). So-called "survivor" performance results are to be avoided.
6. Tax-Exempt Portfolios: The purpose of showing investment results to prospective clients is to illustrate what has been achieved under varying conditions. Due to the differences in the impact on investment results of various tax brackets, it is difficult to compare the results of different taxable portfolios. In order to demonstrate the investment process, the common base of tax-exempt portfolios can be used with both tax-exempt and taxable prospective clients.
7. Comparison with Market Indices: Managers should explain in advance any indexes used for performance comparisons. These indexes should parallel the risk or investment styles the prospective client account is expected to track. Investment results should be shown in a way to facilitate comparisons with market indexes. All index comparisons must be made on a total return basis for periods in excess of one quarter.
Comparisons with specific measures (e.g., real returns adjusted for inflation, riskless returns from T-Bills, etc.) may be used so long as NAAIM standards on other factors, as presented herein, are followed.
8. Verification of Performance Results: Audited performance figures are encouraged. At the very least, managers presenting performance data should make a positive written statement that full disclosure of assets included and excluded has been made and that calculations conform to NAAIM standards. Any deviations from these NAAIM standards should be specifically stated.
9. Regulatory Compliance: All presentations and advertising of performance results must comply with the Investment Advisers Act of 1940 and applicable state statutes, rules and court cases. Outlined below are guidelines of what is deemed permissible and not permissible within the context of this report in distributing performance results.

Permissible: Investment performance data may generally be shown which are:
(1) clear disclosures of all relevant facts,
(2) accurate,
(3) for objectively justifiable time periods,
(4) for generally recognized categories of mutual fund market timing and asset allocation programs (e.g., total or model portfolios of equity programs, bond programs, strategic programs)
Not Permissible: Investment performance data may not be shown which are:
(1) unclear, untrue or otherwise false or misleading and/or,
(2) in the case of advertisements as defined under the Investment Advisers Act of 1940, in violation of the rules relating to advertisements.