I recently conducted a software certification of a software vendor’s composite system, where they use the term “Discretionary” as a characteristic of accounts. They correctly point out to their clients that this term is meant from the “GIPS” view; that is, a “discretionary account” is one that is representative of the strategy. A “non-discretionary account” is one that has imposed a restriction(s) or requirement(s) that causes the account to not be representative of the strategy.
The problem is that this term is SO OFTEN misunderstood. Recall that it ranked #1 on my list of “most confusing things about GIPS.” Can’t we do something to improve the situation?
Discretion: Not the first word doing double duty GIPS Discretion
Sadly, we too often use words in performance and risk that mean multiple things. Here are a couple other examples:
- Excess return: (a) portfolio return minus benchmark return, (b) portfolio return minus risk free return
- Alpha: (a) Jensen’s alpha (takes beta into consideration), (b) excess return (simply portfolio return minus benchmark return, aka “excess return”)
And so, yes, it’s not the only word that suffers from multiple uses, but …
GIPS Discretion is more critical
Given the word discretion’s prominence in the GIPS standards, confusion reigns supreme, which isn’t a good thing. It’s used many times in the Standards, for example:
SO OFTEN, when we conduct verifications, our clients think only in terms of legal discretion. But legally non-discretionary accounts aren’t even included in a firm’s assets!
How to solve the problem with GIPS discretion
Want a real simple solution to avoid the confusion? Do what I just did: append the word “GIPS ” to “discretion.” And when you mean the legal version, specify it: “legal discretion.” Make it clear in the Standards that there are two different meanings, and that for GIPS purposes, it means …
An alternative would be to come up with a different name.
We can solve this problem, but need to take it seriously.
Have a verifier, and think it’s time for a change, or interested in being verified for the first time?
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