Today marks the 99th anniversary of Ronald Reagan’s birth. And so it’s fitting to recall one of his signature lines: “trust, but verify” (the Russian version is in this entry’s title). Perhaps it’s a coincidence that Jason Zweig chose to address this topic in today’s WSJ: “Will we ever again trust Wall Street?“

Wall Street has always been an easy target for politicians, and we’re seeing this occurring with increased vigor of late. But with the shenanigans of folks like Bernie Madoff, one can’t really be too surprised by this attention. Clearly, the bad guys number in the minority, with most portfolio managers and investment firms exercising a high degree of ethics and proper action for their clients. But, as we know, it only take a few bad apples...

Perhaps this is also one of the reasons why the Global Investment Performance Standards (GIPS(R)) is seeing performance examinations rise to a level its original framers probably wouldn’t have envisioned. If one looks at the draft that was first published for GIPS, there is no reference to such a review: only firm-wide verification. By the time the first edition was published in 1999 examinations (equivalent to the AIMR-PPS(R) Level II verifications) had been added. But while firms were encouraged to indicate in their presentations that they had undergone a verification, no such recommendation appeared for examinations; if anything, the opposite. But the 2010 version (to go into effect in January 2011) has a special disclosure for firms to include if they’ve undergone an examination. Is this a good thing? I think not. This addition wasn’t part of the original exposure draft, so the public didn’t have the opportunity to offer an opinion.

My views on examinations have been expressed here before, as well as in our newsletter. Examinations, in my opinion, have little to do with GIPS, per se. They’re an audit of the numbers to ensure that the reported returns are accurate. Our research shows that most RFPs don’t inquire about examinations, although most do ask about verifications. No doubt many verifiers are pleased to see this increased attention because it may result in pressure for more firms to undergo costly examinations. But for what benefit? Most clients of asset managers receive, in addition to reports from the manager, custodial statements (and possibly statements from consultants, too). If their mangers are playing fast and loose with the numbers, surely the client can see this when they compare the reports. Why must a manager put their composites through these very costly exercises?

Some unethical (in our opinion) verifiers talk their clients into having ALL of their composites examined, even the ones they don’t market. While this brings thousands of dollars of added revenue to the verifier, it’s a waste for the most part for the manager.

We favor trust, but verify and strongly encourage managers who claim compliance with GIPS to be verified. As for trust, but examine? Nah.