Around the Peak.

This article is part two of a three-part series on how to survive a GIPS verification. If you haven’t had a chance to read part one, we recommend going back and reading the first part of this series, which covers tips and tricks for setting up your verification for success. In this article, we cover recommendations for kicking off the verification and then provide some context around responding to the initial request made by the verifier. Understanding what the verifier is requesting and why they need it will help streamline the response and allow you to send only the information that is necessary.

Kicking off the Verification

Many firms are eager to quickly get through their verification. One way to help promote efficiency is to schedule a call with your verifier before they even send their initial request. The kick-off call will help ensure everyone is on the same page – especially if it is your first verification or if your firm and strategies have changed since the last verification was completed. For first-time verifications, this time should be used to communicate unique aspects of your firm, discuss the timeline, and introduce key members of your project team.

Most verifications are completed annually. A lot can change over the course of a year that may impact your compliance with the GIPS standards. The kickoff call will initiate these discussions at the onset so surprises don’t delay your ability to complete the verification. The following are some items to consider discussing during a kick off call:

• Any changes to the definition of your firm for GIPS purposes – such as acquisitions, mergers, portfolios moving to/from model-based platforms (e.g., UMA)
• Any new or closed composites or pooled funds
• Any material changes to your GIPS policies and procedures
• Any personnel changes at the firm – especially with individuals that are involved in the verification project
• Any upcoming deadlines that impact the timing of the verification

What to expect with the Initial Data Request

Once all parties are ready to begin the verification, your verifier will provide their initial data request, which lists all items the verifier needs to get the verification process started. After these items are received and reviewed, additional samples will be requested for the verifier to complete more detailed testing. These follow-up testing items are discussed in part three of this series. The most common items requested in this initial data request include:

• GIPS Policies & Procedures
• List of Composites and/or Pooled Funds
• Portfolio and Composite Performance
• Composite Membership Change List
• Assets Under Management (“AUM”) Report
• List of Non-Discretionary Portfolios
• GIPS Reports
• GIPS Report Distribution Log
• Marketing Materials
• CFA Notification Form
• Other miscellaneous items such as (where applicable):
  • Regulatory Correspondence
  • Changes to your Portfolio Accounting System
  • Error(s) Since the Last Verification
  • Incentive Fees Charged

The following sections discuss each of these commonly requested items in more detail.

Policies and Procedures

GIPS policies and procedures are one of the most important documents the verifier needs to get the verification started. The end goal of verification is the opinion letter that attests to “whether the firm's policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis.”

In other words, your firm’s GIPS policies and procedures document is used throughout the verification process to ensure that the policies and procedures are 1) adequate and 2) have been applied consistently across your firm. Your verifier will use your GIPS policies and procedures as the backbone for the entire project, and as a guide for how to test various aspects of your firm’s GIPS compliance.

The GIPS standards offer flexibility in many areas and, therefore, not all firms use the exact same calculation methodology, definition of discretion, timing for composite inclusion/exclusion, etc. Because of this, it is critical for the verifier to have a strong understanding of how these policies and procedures are applied at your firm.

If changes are made to composite policies, composite inclusion rules, or if a calculation methodology changed because of a conversion to a new portfolio accounting system, etc., it is essential that these changes are clearly recorded in the policies and procedures document before the verification begins. If the document is not kept up-to-date, the verifier will find inconsistencies between the policy documentation and the actual practices of your firm. This will stall the verification process.

List of Composites and/or Pooled Funds

If not already included in your GIPS policies and procedures, the verifier will request a current list of all active pooled funds and composites, including any composites that have terminated within the last five years.

This list commonly includes composite or pooled-fund-specific policies. This is an important piece of information to help the verifier understand what policies are applied to a given composite/pooled fund and ensure that they are selecting a meaningful sample.

Based on this list, a sample of composites/pooled funds will be selected for more detailed testing. This testing generally includes the recalculation of performance results presented in the corresponding GIPS Reports. The verifier will use the rules and methodologies outlined in the GIPS Report and composite definitions to gain confidence that the policies were consistently applied.

It is important that any new composites/pooled funds are added to this list and any that are terminated are labelled as such. Since this impacts the sample selection for the testing, the verifier needs to have a fully updated list to avoid having to modify samples and change testing procedures later in the process.

Portfolio and Composite Performance

Based on your firm’s list of composites and pooled funds, the verifier will select a sample to review in more detail. Often, verifiers focus on the main marketed composites, but they will also rotate through others to ensure all are being maintained as described in your GIPS policies and procedures.

For the selected composites, most verifiers will have you provide monthly portfolio-level market values and returns as well as monthly composite returns. With this information they will reconstruct the composites using the rules and calculation methodology described in your GIPS policies and procedures. As they do this, they will focus on the following:

1. Can they use the portfolio-level data to calculate the same composite returns you provided by following the calculation methodology outlined in your GIPS policies and procedures?
2. If a composite has a minimum asset level or significant cash flow policy, do they see portfolios in the composite breaking these rules?
3. How does the dispersion look on a monthly basis? Is it consistent month to month or are there months with large spikes? What outlier performers are driving this dispersion?

The information gleaned from this composite reconstruction and review drives the sample selection for the next phase of testing. Specifically, portfolios appearing to break established rules as well as a sample of performance outliers will be selected for further testing. These testing items are discussed in detail in part three of this three-part series.

Because the results of this initial screen drives the sample selected for further verification testing, it is important that the data is free of errors and has been constructed in a manner that is consistent with your documented policies. To gain comfort, a review of all portfolios should be conducted prior to providing the data to the verifier – either on your own or with the help of a GIPS consultant. These checks should confirm that:

1. Policies such as minimum asset levels and significant cash flows have been applied consistently and in line with how they are described in your GIPS policies and procedures.
2. Outlier performers within the composite are not caused by material, client-driven restrictions as defined in your firm’s definition of discretion.
3. Any portfolios added or removed from the composites during the period were done so in a manner consistent with the rules outlined in your GIPS policies and procedures.
4. There are no portfolios currently excluded from the composite that should have been included based on your firm’s GIPS policies and procedures.

If you do not have a way to test this internally, we strongly encourage you to reach out to Longs Peak for outlier testing. We can save you the headache of multiple rounds of testing with your verifier.

Composite Membership Change List

The Composite Membership Change List should include all portfolios entering or exiting your composites during the period under review. This is generally listed by composite and provides the portfolio name or number that entered or exited and the date of the change.

This list allows the verifier to select a sample of portfolios and test whether they are entering/exiting the correct composite at the correct time, based on your firm’s policies and procedures.

While the verifier is selecting only a sample of composites and/or pooled funds, they will likely want to gain an understanding for composite membership changes across the entire firm. Again, although the focus is primarily on portfolios within the selected sample described earlier, they may broaden their sample for this testing item. This is most common when there are material changes for composites not originally selected for testing or if the sample composites selected did not have enough changes to meet the sample size requirements set for your firm’s verification.

Beyond selecting samples, the verifier will also compare the composite membership changes on the list to the data provided to ensure they are in sync. They will do this comparison to ensure that any noted membership change is reflected in the performance data.

For example, if the Membership Change List documents that portfolio ABC exited the composite at the end of the month, but this change is not reflected in the raw performance data, the verifier will likely come back with questions.

Assets Under Management Report

Verifiers generally want to see an Assets Under Management Report that breaks the assets out by portfolio and clearly labels each portfolio as discretionary or non-discretionary and, if discretionary, what composite the portfolio is included in.

The verification is conducted at the firm level and this report will give the verifier a clear picture of the full scope of the GIPS firm. Specifically, it will help the verifier:

1. Gain comfort that the total firm assets reported in the GIPS Reports is accurate
2. Assess what percentage of the firm assets are discretionary versus non-discretionary
3. Confirm if there is any risk of double counting assets (usually caused by portfolios included in more than one composite or segregated portfolios investing in pooled funds managed by the firm)
4. Ensure none of the assets included appear to be advisory-only or model assets
5. Test that composite assets match the assets in the supporting information provided as well as what is reported in the firm’s GIPS Reports
6. Compare the total AUM to regulatory filings (such as your ADV) to ensure any material differences are understood and align with how the firm is defined for GIPS purposes

The verifier will likely test some of the assets in this report by selecting a sample of portfolios and requesting that independent support for the valuation be provided (e.g., custodial statements). Since a sample of these values will be tested for consistency with the GIPS Reports, it is important that this document is clean, accurate, and presented in a manner that is easy for the verifier to understand.

List of Non-Discretionary Portfolios

If the AUM Report has non-discretionary portfolios clearly labelled then this separate list may not be needed. Either way, it is best if each non-discretionary portfolio listed includes an explanation for why it is deemed non-discretionary for GIPS purposes. Including comments about why the portfolios are non-discretionary will help the verifier understand why each portfolio is excluded from the composites, and help ensure the testing goes smoothly.

Verifiers will select a sample of these portfolios to ensure there is a valid reason for them to be non-discretionary and excluded from your composites. It is important that this list is accurate and up-to-date so the verifier can select appropriate samples and test portfolios without finding errors in classification.

GIPS Reports

GIPS Reports act as your firm’s external representation of your GIPS compliance. Since you are required to provide GIPS Reports to prospective clients, verifiers will test that the presented statistics can be supported and that all required disclosures are included. It is important to have a quality control process in place to check that all required statistics and disclosures are included prior to distributing the GIPS Reports to prospects or verifiers. This checklist can be used to aid in this review.

If not already provided as part of other testing requests, the verifier will likely require that you provide support for the statistics presented. This may include support for:

• Composite assets
• Number of portfolios
• Total firm assets
• Composite returns
• Benchmark returns
• Composite dispersion
• Composite external standard deviation
• Benchmark external standard deviation
• Percent bundled fee portfolios (if applicable)
• Percent non-fee-paying portfolios (if applicable)
• Any supplemental information presented (if applicable)

GIPS Report Distribution Log

The 2020 GIPS standards now require firms to demonstrate that they made every reasonable effort to provide GIPS Reports to their prospective clients. Additionally, verifiers are also required to test that the firms they verify have done this. Generally, this is achieved by documenting each distribution in a log that can be provided to the verifier. Some firms document this in their CRM while others log it in a spreadsheet (here's a sample). If doing this in a CRM, it is critical that a report can be exported to fulfill the request made by the verifier to confirm distribution. For more information on GIPS Report Distribution Logs, check out this article.

Marketing Materials

GIPS Reports are the only document that must be provided to prospective clients for GIPS purposes. However, your verifier is also likely to review your website and ask for a sample of other factsheets and pitchbooks – regardless of whether GIPS is mentioned in these materials. The purpose of this is to test that:

• Wherever GIPS is mentioned, all required disclosures accompany your claim of compliance
• The way you hold your firm out to the public is in sync with how your firm is defined for GIPS purposes
• Information presented is not false, misleading, or contradictory to what has been presented in your firm’s GIPS Reports

If no marketing materials are available outside of the GIPS Reports, that is perfectly fine. A simple confirmation of this scenario will suffice for the verification.

CFA Notification Form

All GIPS compliant firms are required to file a form with CFA Institute notifying them of their claim of compliance with the GIPS standards. This is completed once the firm is ready to claim compliance for the first time and then must be repeated prior to June 30^th each year.

Verifiers are required to confirm that this has been completed as part of their verification. This is generally tested by saving the confirmation email provided when completing the notification form and providing a copy of this confirmation to the verifier when requested. So, save those emails!

Miscellaneous GIPS Data Requests

Outside of the primary initial requests we have already discussed, the verifier may have some other miscellaneous items included in their initial data request. Most of these items help the verifier better understand your firm or ensure changes to policies and/or GIPS Reports are captured in the documents provided. The following are some common miscellaneous items we see verifiers request.

Regulatory Correspondence – The verifier may ask if your firm has had any recent regulatory correspondence other than standard filings. If you have had an examination resulting in a deficiency letter, they will want to review this letter as well as your response. The purpose of this is to help the verifier assess the risk of the engagement and to help them tailor their testing to risk areas already identified. This is especially important if any deficiencies resulted from your firm’s GIPS compliance or the calculation and presentation of investment performance.

Changes to the Portfolio Accounting System – If changes have been made to system settings since the last verification, especially if they impact calculation methodology, composite membership, etc., the verifier will want to know about it. This will help them ensure their testing is in sync with your actual current practices, documented policies, and disclosures in your GIPS Reports.

Errors Since the Last Verification – Unfortunately errors happen and verifiers want to know about them. They are not looking to penalize you for having errors, but rather need to confirm that the appropriate action was taken to rectify the error if/when it occurs. It is important that when errors arise, your firm consistently follows your firm’s error correction policy. It is also helpful to maintain an error log. Maintaining an error log will help your firm document changes to your GIPS Reports resulting from errors and actions taken to address them. Providing this log to the verifier will help demonstrate that your error correction policy was consistently applied.

Incentive Fees – Verifiers often ask if incentive or performance-based-fees were charged to any portfolios during the verification period. GIPS requires net-of-fee returns to be reduced by incentive fees. Thus, if your firm charges incentive fees and actual fees are used to calculate performance, your verifier will want to confirm that net-of-fee returns have been reduced by the incentive fee.

If model fees are used, your verifier will test to ensure that the model fee is high enough to result in net-of-fee returns that are equal to or lower than what the results would have been if actual investment management fees (including any incentive fees) had been used. If no incentive fees were charged, then simply notifying the verifier that this is not applicable for your firm is sufficient.

Verifier Independence – While this might not be a “request,” your firm is required to gain an understanding of your verifier’s policies and procedures to ensure they remain independent throughout the course of the verification project. If your verifier does not provide you with a copy of their independence statement at the start of the verification, you should be proactive and request it. Save this document to support that your firm meets this requirement and is aware of the steps your verifier takes to ensure they remain independent.

Prioritizing What You Provide

In a perfect world, every initial document requested by the verifier is available and ready to provide in your first data submission. However, that is rarely the case. If everything is not available right away, the question becomes – what do you prioritize to make sure the verification progresses forward? If you have to send the initial request in stages, we recommend focusing on requests that allow the verifier to select their portfolio-level samples.

Depending on the size of your firm and composites, the portfolio-level testing phase of the verification can have many follow up requests and typically is the most time-consuming part of the verification. Therefore, it is best to get that phase of the verification kicked off as soon as possible. The items that allow a verifier to select their portfolio-level testing samples include:

1. GIPS Policies and Procedures
2. Portfolio and Composite-Level data
3. Membership Change List
4. Non-Discretionary Portfolio List

The remainder of the initial request documents can be provided as they become available. They will be needed to complete the verification, but the above listed documents should be the first priority to allow the verifier to select their portfolio-level samples.

Conclusion

The documentation provided for the initial request helps set the stage for the next round of testing. The cleaner and more organized the initial data, the better off you will be for the rest of the verification. Providing clean data in this sense means that you are confident performance data and disclosures are error free and outliers have been reviewed and deemed appropriate. If the verifier is able to move through these initial documents efficiently, it will set you up for success for the remainder of the project.

For more information on verification testing, check out part three of this three-part series where we dive into portfolio-level testing. We’ll cover the types of documentation requested and help you understand what your verifier is looking for. If you have any questions about GIPS or investment performance, check out or website or reach out to matt@longspeakadvisory.com or sean@longspeakadvisory.com for more information.

This article is part one of a three-part series on how to survive a GIPS verification. In this series we will discuss how to structure a successful verification, the initial requests made during a verification, and follow-up sample testing. Part one focuses on the approach we have seen firms successfully implement to get through a verification.

Step 1: Find a committed project manager

Probably the single most important thing necessary to get through a verification is having someone on your team that is committed to seeing the project through to the end. Verified firms come in all shapes and sizes. Therefore, there is not a one-size-fits all approach to managing a GIPS verification that works for every firm. Individuals tasked with overseeing verification projects naturally have other responsibilities, so finding time to focus on the verification can be difficult. But finding the right individual to manage the project can make all the difference.

Step 2: Educate your employees & stakeholders on GIPS and the verification process

Regardless of the size of your firm—and since GIPS compliance is achieved at the firm level—you will likely need input from a variety of people to complete your verification. Small and mid-size firms may not need to create a specific GIPS project team, but should still prepare to obtain input from different departments as verifiers regularly request information that requires input from others.

Educating your team about the importance of your firm’s GIPS compliance/verification and explaining how they can or will contribute to this effort is crucial. Getting their buy-in can make or break your timeline, as disengaged individuals are slow to respond to requests for information. We recommend making sure you get everyone on board. If Longs Peak is helping manage your verification, we can put together a training and deliver it to your team.

Step 3: Build your GIPS verification team

For larger firms, it may make sense to create a GIPS project team to help divide and conquer. Again, GIPS is achieved at the firm level, and therefore it will typically require input from various departments, including: performance, operations, client services, and trading, to name a few. Ideally, you’ll want at least one individual that clearly understands how your organization operates, the various departments that may need to be involved and where to access the documentation required.

The most efficient verification teams get together to discuss verifier requests and develop a plan for how the information is gathered, who is responsible for each type of request and who is ultimately responsible for sending the information back to the verifier.

We find that teams who meet regularly and communicate frequently are most successful at sticking to the timeline.  Having a designated project manager to act as the primary contact for the verification can simplify communication and ensure the requested information is organized. Ideally, this individual understands the fundamentals of GIPS – but don’t worry, if they don’t, Longs Peak can act as your GIPS guru. And, unlike your verifier, we’re not restricted by independence requirements so we can get as involved as you need.

Step 4: Create a verification project timeline

In our experience, most firms want their verification completed as soon as possible. Setting up a project timeline with specific milestones and clear deadlines will make this goal a reality. Verifications include numerous rounds of data requests to test different aspects of your firm’s GIPS policies and procedures. What’s great is you don’t have to do it yourself – your verifier or GIPS consultant can help you build out a timeline that works for your firm and will include all the critical objectives necessary. Check out this sample timeline to give you an idea of what’s typical.

When building out your timeline, the most important consideration is setting expectations for all parties involved and making sure they are on board with the project plan. Goals and deadlines are difficult, if not impossible to meet without communication. The firms that struggle the most are typically those that fail to transparently communicate expectations and receive buy-in for the project timeline from the start. Therefore, we strongly encourage you to involve all relevant parties (including your team, verifier and any third-party consultants) in setting project deadlines so everyone is aware of critical dates and milestones that need to be achieved.

Timelines should include goal dates for your firm as well as the verifier to hold everyone accountable to the ultimate goal: completing the verification. Tracking progress on the timeline will provide clarity on where the project is getting delayed and if the overall timeline is in jeopardy. Key stakeholders can use the timeline to evaluate the percentage of completion and can give your team a good sense of how close the project is to finish line.

Step 5: Set up recurring calls/meetings to stay on track

As simple as they are, setting up recurring meetings are a great tool to help keep the verification on track. These recurring calls can be internal to discuss the current requests and create action plans on collecting and delivering the needed data, or they can include your verifier to discuss progress, ask questions, and ensure they can correctly interpret the documentation provided. These meetings should have clear agendas to help the team stay on track with the timeline. Here’s a sample agenda we’ve used with our clients.

If nothing else, the recurring calls help build accountability – no one likes admitting they didn’t achieve what they agreed to since the prior meeting. The tighter the deadline, the more frequent these meetings should happen. These discussions can also be used to evaluate if you need to adjust the timeline from initial expectations.

Step 6: Organize data submissions

As mentioned, verifications typically have multiple rounds of requests for various types of testing (here’s a typical verification request for your perusal). Usually, the most efficient way to get through them is to submit everything from each request at once. This helps you stay organized by making sure all documents needed in a given round are provided. However, this is not always achievable and it may not be appropriate, especially in a time crunch or if just a handful of testing items are holding up the rest.

While potentially less desirable, a piecemeal approach at least keeps the sharing of documents moving and although some documents may still be pending, at least the items provided can be reviewed – getting your firm that much closer to the completion of the verification project.

If you are not able to submit everything from the data requests at once, we recommend approaching the verification requests either by the specific type of testing or type of document being requested. Approaching the verification in blocks of smaller requests will allow you to stay organized, reduce overwhelm, and keep the verification progressing. You can ask your verifier to organize their request in this format or if you work with Longs Peak, we can help you organize it in this fashion and help you get through the request at your own pace.

After data from the initial request is submitted to the verifier (details on initial data requests are discussed in more detail in part two of this three-part series) the verifier will then begin sending sample testing requests (the details of which are covered in part three of this three-part series). If this seems overwhelming, it doesn’t have to be. We literally started Longs Peak to make it easier for firms like yours get through this process.

If anything is not clear from a specific verification request or you are unsure if the documentation pulled is sufficient, give the verifier a call and talk through these issues. Open and ongoing communication will keep your verification on track – and help you avoid wasting time on something not needed.

Step 7: Schedule an onsite verification or extended virtual screenshare

One way to expedite the verification project (or to reignite a stalled project) is to conduct the verification onsite. Most GIPS verification firms are willing to travel to their client’s office to do on-site-testing. This is an efficient way to move through a verification as you will have the verifier’s undivided attention to specifically work through testing items and answer questions – plus, they might have your undivided attention too!

Even if an onsite is not feasible, setting up an extended virtual meeting with screensharing capabilities can help move through data with the verifier and address questions as they arise. Screenshare meetings will allow your team and the verifier to review documents together and talk through any questions on the spot. Feedback can be shared during these meetings to ensure what was provided is sufficient to complete a given testing request.

Conclusion

Regardless of your firm’s size or approach to the verification, ongoing communication between all parties involved is critical to efficiently get through a verification. Setting up a project plan and executing on that plan will help you get through the verification as quickly as possible. Seek help from your verifier as questions arise and if you still are struggling, reach out to an independent consultant like Longs Peak to help you get the project to the finish line.

At the end of the day, GIPS compliance is achieved at the firm level and will likely require contribution from a variety of individuals from your business. Getting buy-in from everyone involved is critical to making sure all parties are on board with the plan and understand the end goal.

For more information on data requests and verification testing, check out part two and three of this three-part series. You can email matt@longspeakadvisory.com or sean@longpseakadvisory.com with questions or reach out to us on our website if you need help getting through your verification project.

Alpha and beta provide key insights into whether the active management of an investment strategy is truly adding value or merely adjusting the strategy’s exposure to risk. Understanding alpha and beta can help you assess whether a strategy is outperforming on a risk-adjusted basis.

What is Beta?

Beta measures the sensitivity of a strategy to market movements, which is the most common way to assess the systematic risk of a strategy compared to its benchmark. If the strategy returns move perfectly in sync with the benchmark return, then the strategy’s beta, as compared to that benchmark, is one (i.e., they are perfectly correlated). A beta greater than one means that the strategy is more sensitive (or volatile) than its benchmark while a beta less than one means it is less sensitive (less volatile) than its benchmark. A beta of zero means that the strategy is uncorrelated to the benchmark, while a negative beta means that it is negatively correlated with the benchmark. We will explain this more, but first let’s discuss how it works.

How to Calculate Beta

Beta is calculated as the covariance of the strategy and the market (benchmark) divided by the variance of the market (benchmark).

If every time the benchmark goes up 1%, the strategy goes up 1.2%, and every time the benchmark goes down 1%, the strategy goes down 1.2%, then the beta is 1.2. This means that the portfolio has increased its systematic risk (perhaps through adding leverage, but otherwise replicating the index). In this case, the portfolio manager has increased the strategy’s systematic risk and volatility as compared to the benchmark, but the manager has not “added alpha.” This strategy will outperform on the upside but will underperform on the downside.

Conversely, if every time the benchmark goes up 1%, the strategy goes up 0.8%, and every time the benchmark goes down 1%, the strategy goes down 0.8%, then the beta is 0.8. This means that the portfolio has decreased its systematic risk (perhaps through adding cash, but otherwise replicating the index). In this case, the portfolio manager has decreased the strategy’s systematic risk and volatility as compared to the benchmark and, as a result, the strategy is expected to underperform the benchmark on the upside and outperform on the downside.

Betas can also be negative; in which case the strategy is negatively correlated with the benchmark and would move in the opposite direction. For example, we would expect a strategy with a beta of -0.5 to go down 0.5% for every 1% increase in the benchmark. Betas can also be zero, indicating that the strategy’s movements are uncorrelated with the movements of the benchmark. Market neutral strategies generally strive to have a beta of zero to eliminate systematic risk from the management of the strategy. This is often achieved through a mix of long and short positions.

Beta vs. Standard Deviation

When analyzing performance, there are two types of risk: systematic and unsystematic risk.  Beta is a measure of systematic risk (i.e., market risk) and standard deviation is a measure of total risk. While beta is focused on correlation with the market or the strategy’s benchmark, standard deviation is focused on the variability of returns. This variability is a combination of systematic risk (market risk) and unsystematic risk (company-specific risk).

Both measures can be used in assessing risk-adjusted returns. Beta is used as the denominator in the Treynor Ratio, which measures how much excess return is generated per unit of systematic risk and is used to show the volatility the investment adds to a fully diversified portfolio. Standard deviation is used as the denominator in the Sharpe Ratio, which helps investors understand their returns as compared to the total risk of the portfolio. In contrast with Treynor, Sharpe is often used to compare fully diversified strategies against each other. For more information on systematic risk verses total risk, check out our article on Investment Performance & Risk Statistics.

What is Alpha?

Jensen’s alpha measures how much the strategy outperformed its expected return, with the expected return determined based on the Capital Asset Pricing Model (CAPM).

How to Calculate Alpha

To determine if the portfolio manager has “added alpha,” you can calculate Jensen’s alpha for the strategy. Using CAPM, the expected return is determined by the risk-free rate plus the beta-adjusted benchmark return. Specifically:

Jensen’s Alpha is then determined by subtracting the expected return from the actual return. Specifically:

If the portfolio manager is truly “adding alpha” (through stock selection, over/underweighting sectors, etc.) and not just increasing systematic risk in their active management, then the strategy’s Jensen’s alpha should be positive.

A positive Jensen's Alpha means the manager is consistently beating the market. A negative Jensen's Alpha means the manager is consistently under-performing. Demonstrating positive alpha over a sustained period of time demonstrates to clients and prospects of the strategy that the active investment decisions made by the portfolio manager resulted in an increased return without increasing systematic risk.

It is important to note that Jensen's Alpha is part of a regression and usually is accompanied by t-statistics and p-values to test significance levels. In other words, looking at Alpha without testing for statistical significance should be used with caution. If Alpha is positive but not statistically significant, it may not actually mean the manager outperformed on a risk-adjusted basis.

Why it's Important to Understand Alpha and Beta

Alpha and beta are widely used statistics that help managers of active investment strategies demonstrate their skill. Comparing strategy returns to benchmark returns without accounting for risk will not provide the full picture. Adjusting for systematic risk will help isolate the return achieved from increasing exposure to the market versus the return that is achieved through investment decisions that increased return without increasing systematic risk exposure.

Adjusting for total risk, rather than only for systematic risk is also important when demonstrating skilled active management. As mentioned earlier, check out Longs Peak’s articles on Investment Performance & Risk Statistics as well as the Sharpe Ratio and the Sortino Ratio to learn more about this.

Recent investment performance calculation mistakes at Pennsylvania Public School Employees’ Retirement System (“PSERS”) have highlighted the importance of quality control reviews and raises questions about where risk exists, how these risks can be mitigated, and what role independent verifications should play in the quality control process.

What happened at PSERS?¹

An error in the return calculation for Pennsylvania’s $64 billion state public school employee retirement plan has had serious implications for its beneficiaries and those involved in the calculation mistake.

In 2010, the plan, which was already underfunded, entered into a risk-sharing agreement where employees hired after 2011 would pay more into the plan if the return (average time-weighted return) over a specific time period fell below the actuarial value of asset (AVA) return of 6.36%.

In December 2020, the board announced that the plan had achieved a return of 6.38%, a mere 2 basis points above the minimum threshold. But in March the board changed its tune, announcing that the calculation was incorrect and the 100,000 or so employees hired since 2011 (and their employers) should have actually paid more into the plan.

What’s worse is PSERS also announced that the FBI is investigating the organization, although details of the probe have not yet been released.

According to PSERS, a consultant, that had calculated the return, came forward and admitted to the calculation error. But the board also said that it is looking into potential cover up by its staff. From what we know, at least 3 independent consultants were involved in providing data used for the calculations, calculating the returns, and verifying the returns. So, with all these experts involved, how could this happen and what can your firm do to avoid a similar situation?

Key issues to address in an investment performance quality control process

Firms should develop sound quality control processes to help identify errors before results are published. Often these processes either do not exist or are insufficient to identify issues. Following a robust quality control process that considers the key risks involved and then finds ways to mitigate these risks greatly increases the accuracy of presented investment performance.

Although we do not yet know the cause of the errors found in the PSERS case, we can highlight a few primary reasons errors occur in investment performance reporting. Primarily, errors found in published performance results are caused by:

• Key Issue # 1 – Issues in the underlying data (e.g., incorrect or missing prices, unreconciled data, missing transactions, misclassified expenses, or failing to accrue fixed income)
• Key Issue #2 – Mistakes in calculations (e.g., manual calculations that fail to match the intended methodology)
• Key Issue #3 – Errors in reporting (e.g., publishing numbers that do not match the calculated results)

A robust quality control process should specifically address all three of these areas.

Considerations when designing a robust quality control process

Key Issue #1 – Issues in the underlying data

As they say, garbage in, garbage out. It is important to ask and address questions confirming the validity of data before it is used to calculate performance. Specifically, consider how the data used in the calculations is gathered, prepared, and reconciled before completing the calculations. Is there any formal signoff from the operations team confirming that the data is ready for use? Has a review of the data been conducted by an operations manager prior to this confirmation being made?

While deadlines to get performance published can be tight, taking the time to ensure that the underlying data is final and ready to use before performance is calculated can prevent headaches later on.

The following is a list of issues to look for when testing data validity:

• Outlier performance – Portfolios performing differently than their peers may indicate a data issue or that the portfolio is mislabeled (i.e., tagged to a different strategy than it is invested in).
• Differences between ending and beginning market values – Generally, we expect a portfolio’s market value at the end of one month and the beginning of the next month to be equal (unless using a system where external cashflows are recorded between months and differences like this are expected). Flagging differences can help identify data issues.
• Offsetting decrease/increase in market value – Market values that suddenly increase or decrease and then return to the original value may have an incorrect price or transaction that should be researched.
• Gaps in performance – A portfolio whose performance suddenly stops and then restarts may have missing data.
• 0% returns – The portfolio may have liquidated and may no longer be under the firm’s discretionary management.
• Very low market values – The portfolio may have closed and is only holding a small residual balance, which should be excluded from the firm’s discretionary management.
• Net-of-fee returns higher than gross-of-fee returns – Seeing net returns that are higher than gross returns could indicate a data issue unless there are fee reversals you are aware of (e.g., performance fee accruals where previously accrued fees are adjusted back down).
• Gross-of-fee returns and net of-fee returns are equal – If gross-of-fee and net-of-fee returns are always equal for a fee-paying portfolio, it is likely that the management fees are paid from an outside source (paid by check or out of a different portfolio). The returns labelled as net-of-fee in a case like this should be treated as gross-of-fee returns.

Key Issue #2 – Mistakes in calculations

Mistakes happen, but there are ways to reduce their frequency and impact. First, you’ll want to consider how manual your performance calculations are as well as the experience of the person completing the calculations.

Let’s face it, Excel is probably the most widely used tool in performance measurement, especially for smaller firms. While many firms likely find Excel to be a user-friendly tool for calculating performance statistics, it has its limitations. Studies have shown that up to 90% of spreadsheets contain errors and spreadsheets with lots of formulas are even more likely to contain mistakes. Whether it’s not properly dragging down a formula or referencing the wrong cell, fundamentally, the biggest problem is that users do not check their work or have carefully outlined procedures for confirming accuracy.

Although this may seem obvious, having a second set of eyes on a spreadsheet can save you from the embarrassing headache of having to explain errors in performance calculations. It is even better if this review is a multi-layered process. Having someone review details as well as someone to do a high-level “gut-check” to make sure the calculations and results make sense can reduce this risk. Depending on the size of your firm, this may be easier to accomplish with a third-party consultant, where you serve as a final layer of review.

Having this final “gut-check” can help prevent avoidable errors prior to publication. We find that this final “gut-check” is best performed by someone who knows the strategy intimately rather than a performance or compliance analyst, as these individuals may be too focused on the calculation details to take a step back and consider whether the returns make sense for the strategy and are in line with expectations.

If you use software to calculate performance, you can significantly reduce the risk of manual error, but due diligence should still be performed from time to time to manually prove out the accuracy of the calculations completed in the program. This does not need to be done every time but should be conducted when introducing a new software system and any time changes are made to the program.

Key Issue #3 – Errors in reporting

It may seem silly, but many performance reporting errors come from transposing strategy and benchmark returns in presentations or placing the return of one strategy in the factsheet of another. Therefore, it is important to consider how the final performance figures make it from the system or spreadsheet into the performance presentations. Are they typed? Copy and pasted? Or are the performance reports generated directly out of a system? It’s not enough to complete the calculations correctly, the final reports must also be accurate, so adding a step to review this is crucial.

A similar review process to the one described above can really make a difference, but ultimately, understanding the vulnerabilities of your performance reporting will help you design quality control procedures that address any exposure.

Calculations completed by external performance consultants

Whether performance is calculated internally or by a third-party performance consultant, the same key issues should be considered when designing the quality control process. Due diligence should be done on the performance consulting firm to evaluate the level of experience the firm has with calculating investment performance and what kind of quality control process they follow prior to providing results to your firm. This information will help you determine what reliance you can place on their procedures and what your firm should still check internally.

For example, outsourcing performance calculations to an individual or single-person firm likely necessitates a more in-depth review since this individual would not have the ability to have a second set of eyes on the results prior to providing them to your firm. However, even larger performance consulting firms with robust quality control processes may not have intimate knowledge of your strategies, meaning that, at a minimum, a final “gut-check” should be done by your firm prior to publication.

Reliance on independent performance verification firms to find errors

Many firms that hire performance verification firms rely on their verifier to be their quality control check; however, this may not be a good practice for a variety of reasons. If this is a common practice at your firm, you may want to check the scope of your engagement before relying too heavily on your verifier to find errors.

Verification is common for firms that claim compliance with the Global Investment Performance Standards (GIPS®). But even firms that claim compliance with the GIPS standards and receive a firm-wide verification are required to disclose that, “…Verification does not provide assurance on the accuracy of any specific performance report.”

This is because verifiers are primarily focused on the existence and implementation of policies and procedures. While their review may help identify errors that exist in the sample selected for testing, it specifically does not certify the accuracy of presented results. While the verification process is valuable and often does turn up errors that need to be corrected, regardless of the scope of your engagement, a robust internal quality control process is likely still warranted.

Firms that are not GIPS compliant may engage verification firms for various types of attestation or review engagements like strategy exams or other non-GIPS performance reviews. In these situations, the scope of the engagement may be customized to meet the needs (and budget) of the firm seeking verification. A clear understanding of exactly what is in-scope and specifically what the verifier is opining on when issuing their report is key.

Situations where the engagement entails a detailed attestation tracing input data back to independent sources, confirming that calculations are carried out consistently, and verifying that published results match the calculations, allow for heavy reliance on the verifier as part of your quality control process.

Alternatively, when the scope merely consists of a high-level review confirming the appropriateness of the calculation methodology, a much more robust internal quality control process should be applied.

Knowing the scope of the engagement your firm has established with the verification firm is an important element in determining how much reliance can put on their review and findings, which can then be incorporated into the design of your own internal quality control procedures.

Key take-aways

Mistakes happen in investment performance reporting, but a robust quality control process can greatly mitigate this risk. Understanding the risks that exist, designing processes to test these risk areas, and understanding the role and engagement scope of all consultants involved are essential items in designing a quality control procedure that work for your firm – and hopefully one that will help you avoid situations like what happened with PSERS.

If you are not sure where to begin, we have tools and services available to help. Longs Peak uses proprietary software to calculate and analyze performance. Our software helps flag possible data issues and outlier performers and also produces performance reports directly from our performance system.

In addition, our performance consultants are available to work with your team to help identify potential vulnerabilities in your performance reporting process and can help you develop better quality control procedures, where needed.

Questions?

If you would like to learn more about our quality control process or any of the services we offer (like data and outlier testing) to help improve the accuracy and reliability of investment performance, contact us or email Sean Gilligan directly at sean@longspeakadvisory.com.

¹ For more information on PSERS, please see this article from the Philadelphia Inquirer.

In July 2020, the Financial Industry Regulation Authority (FINRA), a government-authorized not-for-profit organization that oversees US broker-dealers, published Regulatory Notice 20-21, which addresses retail communications concerning private placement offerings. Specifically, Regulatory Notice 20-21, which addresses FINRA Rule 2210 and the use of IRR in retail communications for completed investment programs, now requires IRR to be calculated according to the methodology outlined in the GIPS® Standards.

What is GIPS?

The Global Investment Performance Standards (GIPS®) are a set of voluntary standards utilized by investment managers and asset owners throughout the world to provide full disclosure and fair representation of their investment performance.

The fundamental aim of GIPS compliance is transparency and consistency. Firms that comply with the GIPS standards improve transparency in the industry and standardize reporting, allowing prospects evaluating managers with similar strategies to make the comparison easier and more meaningful.

What does FINRA Rule 2210 have to do with the GIPS standards?

Within the Regulatory Notice, FINRA states that, “FINRA interprets Rule 2210 to permit the inclusion of IRR if it is calculated in a manner consistent with the Global Investment Performance Standards (GIPS) adopted by the CFA Institute and includes additional GIPS-required metrics such as paid-in capital, committed capital and distributions paid to investors.” Ultimately, this means that firms that present IRRs in private placements must now calculate and present performance information in accordance with the methodology outlined in the GIPS standards.

This understandably has led to some confusion for non-GIPS compliant firms that include IRR performance in private placement offerings.

In the CFA Institute’s March 2021 GIPS Standards Newsletter, some common questions were addressed regarding FINRA Regulatory Notice 20-21 and its reference to the GIPS standards. Please keep in mind that CFA Institute’s interpretation of the Regulatory Notice has not been adopted or endorsed by FINRA. The key takeaways from the questions and answers listed in the newsletter are listed below.

Key Takeaways From CFA Institute about FINRA Regulatory Notice 20-21:

A firm is not required to claim compliance with the GIPS Standards in order to comply with FINRA Regulatory Notice 20-21.

An exception is being made to allow firms and their agents to make a specific statement regarding the GIPS Standards only in retail communications concerning private placements offerings that are prepared in accordance with FINRA Regulatory Notice 20-21.

For firms that do not claim compliance with the GIPS standards:

[Insert firm name] has calculated the since-inception internal rate of return (SI-IRR) and fund metrics using a methodology that is consistent with the calculation requirements of the Global Investment Performance Standards (GIPS®). [Insert firm name] does not claim compliance with the GIPS standards. GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote [insert firm name], nor does it warrant the accuracy or quality of the content contained herein.

For firms that claim compliance with the GIPS standards:

[Insert firm name] has calculated the since-inception internal rate of return (SI-IRR) and fund metrics using a methodology that is consistent with the calculation requirements of the Global Investment Performance Standards (GIPS®). [Insert firm name] claims compliance with the GIPS standards. GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote [insert firm name], nor does it warrant the accuracy or quality of the content contained herein.

Any IRR, as well as the additional metrics required under the GIPS standards, must meet the input data and calculation requirements of the GIPS standards.

Additional metrics must be included when presenting IRR performance in compliance with the GIPS standards. The following metrics are required under the GIPS Standards:

• Since-inception paid-in capital (PIC) – The amount of committed capital that has been drawn down
• Since-inception distributions
• Cumulative committed capital – The capital pledged to the investment vehicle
• Total value to since-inception paid-in capital (TVPI or investment multiple) - TVPI provides information about the value of the composite relative to its cost basis
• Since-inception distributions to since-inception paid-in capital (DPI or realization multiple)
• Since-inception paid-in capital to cumulative committed capital (PIC multiple)
• Residual value to since-inception paid-in capital (RVPI or unrealized multiple)

How to calculate IRR consistent with the GIPS Standards

To meet the requirements of the GIPS standards, money-weighted returns must be presented as an annualized since-inception figure that uses daily external cash flows (at least quarterly is acceptable for external cash flows prior to 1 January 2020). Additionally, stock distributions must be treated as external cash flows and must be valued at the time of distribution. For pooled funds, returns must be net of total pooled fund expenses.

While IRR is the most common money-weighted return, Modified Dietz is also an acceptable method. Not to be confused with linked Modified Dietz returns that many firms use as a time-weighted return (calculated monthly and then geometrically linked to calculate annual returns), this Modified Dietz return is calculated once covering the entire performance period.

Most firms use IRR, or more specifically, the XIRR function in Excel, which allows for daily cash flows.

One important consideration is ensuring that the return is properly annualized. If using XIRR and the period is greater than 1-year then the result of the calculation using this function in Excel is already properly annualized. If using Modified Dietz, the result is a cumulative return that will need to be annualized for periods greater than 1-year. This figure can be annualized as follows:

((1+Cumulative Modified Dietz Return)^{365/Total Days})-1

Conversely, if the XIRR is calculated for a period shorter than 1-year, it must be de-annualized. This can be done as follows:

((1+XIRR)^{Total Days/365})-1

For more information on additional considerations when presenting IRRs, i.e. money-weighted returns, in accordance with the GIPS standards, please reference the “2020 GIPS Report Utilizing Money-Weighted Returns” section of our article on presenting performance under the 2020 GIPS standards.

Questions?

If your firm is interested in claiming compliance with the GIPS standards, or would like assistance in calculating and presenting performance in accordance with GIPS, we would be happy to help.

Feel free to contact us or email Sean Gilligan directly at sean@longspeakadvisory.com with any questions.

GIPS compliant firms must make every reasonable effort to provide a GIPS Report to all prospects (excluding broad distribution pooled fund investors), regardless of whether the prospect knows about GIPS, cares about GIPS or asks for a GIPS Report.

The requirement to distribute GIPS Reports (formerly called Compliant Presentations) is not new; however, under the 2020 Edition of the GIPS standards, this rule expanded to require those claiming GIPS compliance to demonstrate that their GIPS Reports are distributed to prospects. In other words, a log of the distributions must be maintained.

Verifiers are also now required to test that this distribution is happening, so it is essential that some sort of log can be provided to your verifier to successfully get through the verification process.

If you are not prepared for this new requirement, we suggest you keep reading!

Why is Distribution of GIPS Reports a Requirement?

The fundamental aim of GIPS compliance is transparency and consistency in the way firms present investment performance to prospects. Firms providing GIPS Reports to all qualified prospects (and asset owners providing GIPS Reports to their oversight boards) improves transparency in the industry and standardizes reporting. Standardized reporting allows prospects evaluating managers with similar strategies to make the comparison easier and more meaningful.

Requiring the distribution of GIPS Reports helps get this information into the hands of prospects that may not know to ask for it but could benefit from reviewing the information prior to making their investment decision.

Who Needs to Receive a GIPS Report?

GIPS compliant firms must provide a GIPS Report to all qualified prospects. The terms “prospective client” (for segregated account prospects) and “prospective investor” (for pooled fund prospects) are defined in each firm’s GIPS policies and procedures document to ensure it is clear who must receive a GIPS Report. While firms may modify the definition to fit their sales process and business model, most firms craft this definition around two criteria:

1. The prospect has expressed interest in a particular composite/pooled fund.
2. The prospect is qualified to invest in this composite/pooled fund (i.e., they meet any applicable minimum asset levels and your firm would be willing to take them on as a client).

A prospect is required to receive a GIPS Report for the composite or pooled fund they are interested in once meeting the definition outlined in the firm’s GIPS policies and procedures. If a prospect remains a prospect for more than 12 months, the GIPS Report must be provided again since it will contain another year of annual statistics.

Current clients do not need to receive a GIPS Report for the composite or pooled fund they are invested in; however, if they become a prospect of one of your other composites or pooled funds, they must be provided with the respective GIPS Reports.

It is important to note that databases populated with composite or pooled fund performance are considered prospects and, therefore, must receive a GIPS Report. If there is no opportunity to upload the GIPS Report, then it must be sent to your contact at the database. Similarly, when responding to a request for proposal (“RFP”) that provides information for a composite or pooled fund, your response must include the GIPS Report for the strategy discussed in the RFP.

Any outside parties that market your strategies on your behalf must also be treated as prospects and receive GIPS Reports. This includes third-party financial advisors, wrap sponsors, or anyone else that sells your strategies to their clients.

GIPS Report distribution requirements are a bit different for asset owners since they do not have prospects. GIPS compliant asset owners are required to provide GIPS Reports to their oversight board at least annually.

How to Provide a GIPS Report

GIPS Reports must be delivered directly to the prospect. This can be in hardcopy or electronic form, but cannot require the prospect to navigate to find it. In other words, you can email it as an attachment or using a link that directly opens up to the GIPS Report, but you cannot simply disclose that the GIPS Reports are available on your website, requiring the prospect to retrieve it themselves.

Firms most commonly include the GIPS Report as an appendix to the pitchbook provided to prospects as a standard part of the sales process.

To be clear, you are not required to provide all of your GIPS Reports to every prospect, rather, you are only required to provide the GIPS Report for the composite or pooled fund the prospect is interested in and qualified for.

How to Create a GIPS Report Distribution Log

Maintaining a log of all GIPS Report distributions is the best way to ensure you can demonstrate that GIPS Reports are provided to all prospects. Typically, this log includes:

• Date the GIPS Report was sent
• Recipient of the GIPS Report
• Firm representative that sent the GIPS Report
• Contact information of the recipient
• Composite/limited distribution pooled fund included in the GIPS Report
• Version of the GIPS Report or file name if multiple versions are maintained
• How the GIPS Report was distributed
• Future deadlines for distribution (making sure the team sends an updated version of the GIPS Report 12 months later if the prospect is still defined as a prospect at that point in time)

There is no right or wrong way to track and monitor distribution efforts, as verifiers will accept any format that clearly demonstrates that the required distribution is taking place. It is common to leverage existing CRM systems, use excel spreadsheets or word documents to create these logs. We recommend leveraging any existing systems for tracking distribution and if none exist, use a spreadsheet (here’s a template to get you started). If you are using your CRM, make sure to tag the documentation so a report of the distributions can be exported and provided to your verifier when requested.

Remember, this is a requirement for all GIPS compliant firms and asset owners, regardless of whether they are verified or not. If you have any questions on this requirement or any other aspects of the GIPS standards, please do not hesitate to contact us.

The SEC has adopted a modernized marketing rule for investment advisers. This new advertising rule is designed to replace the outdated patchwork of guidance made through No-Action Letters and Enforcement Actions over the last several decades with principles-based provisions that are relevant to current industry practices. Advisers have 18 months from the effective date of this new rule to comply. Changes can be adopted early, but firms that adopt early must fully comply with all changes and cannot pick and choose between the old and new requirements.

The new marketing rule defines what is considered an advertisement, provides general prohibitions that are never allowed in any advertisement, sets a framework for how testimonials, endorsements, and third-party rankings may be used, and outlines what is specifically prohibited when presenting performance.

One of the key changes for presenting performance is that the new rule prohibits firms from presenting “performance results from fewer than all portfolios with substantially similar investment policies, objectives, and strategies as those being offered in the advertisement, with limited exceptions.” Despite advisers requests to continue its use, the SEC no longer allows the presentation of a single representative account.

There are two exceptions to this rule. Advisers can:

1. list the individual results of all portfolios that follow the same mandate rather than aggregating into a composite (not exactly ideal for a marketing presentation), or
2. provide performance based on an aggregation of a sample of the portfolios following the same strategy; however, the firm must support that these results are lower than if the full population had been used.

Based on these exceptions, it appears a representative account(s) may be presented, but only if the adviser can prove the performance is more conservative than that of the full composite. The only way to support this is by constructing a composite and testing if this is true. But once the composite is constructed, there is no longer a good reason to present the representative account instead. Ultimately, composites appear to be required to comply with the SEC’s new advertising rule.

While composites have historically been associated with GIPS compliance, there is no requirement for a firm to be GIPS compliant to utilize composites. With the requirements set forth in this new marketing rule, composites are likely to become much more prevalent, even with firms electing not to claim compliance with the GIPS standards.

Firms that are constructing composites for the first time may benefit from reviewing Longs Peak’s article on How to Construct Composites. Maintaining composites will essentially be required for any SEC registered firm looking to market investment performance in the future and this article helps explain how to set those composites up.

Creating and maintaining composites can have added benefits beyond just providing strategy results to present in marketing materials. Aggregating portfolios with similar investment mandates and analyzing the results can also help firms confirm that strategies are implemented consistently. Our article on Investment Performance Outlier Testing can provide some additional insight into these benefits available to firms maintaining composites.

Constructing and maintaining composites can be time consuming and difficult to manage without errors. Longs Peak specializes in setting up policies and procedures for composite construction as well as following those policies and procedures to implement and maintain composites for our clients. Reach out to us today to discuss how we can help your firm create and maintain composites.

There are two types of returns investment managers use to report the performance of their strategies: Time-Weighted Returns (“TWR”) and Money-Weighted Returns (“MWR”). The most common MWR is the Internal Rate of Return (“IRR”). Here we take a look at both TWR and MWR to help you understand when each method should be used and why.

The key difference between the two methods is that:

• Time-Weighted Returns REMOVE the effect of the timing and amount of external cash flows.
• Money-Weighted Returns INCLUDE the effect of the timing and amount of external cash flows.

Because of this, money-weighted returns represent the actual return received by the investor, while time-weighted returns represent the return achieved by the investment manager after removing the effect of external cash flows.

But when is it appropriate to use one over the other? Because MWRs reflect the investor’s actual returns, it may seem like the best method to use in all situations. However, if the purpose of reviewing the performance is to evaluate the portfolio manager’s discretionary management, we do not want decisions made by the investor to affect the results. The most appropriate methodology to use to evaluate the portfolio manager depends on who controls the external cash flows (contributions and withdrawals) from the portfolio.

Investor-Driven Cash Flows

When the timing and amount of external cash flows are controlled by the investor, investor-driven decisions impact the return. To present returns that allow investors to evaluate a manager’s discretionary management, TWR should be utilized to remove the effect of these investor-driven decisions. Because the effects of cash flows are removed, a TWR doesn’t penalize or benefit a portfolio manager’s performance for contributions or withdrawals that the manager did not control.

Investment Manager-Driven Cash Flows

When the investment manager does have control over the timing and amount of external cash flows (e.g., private equity funds where the investment manager has control over capital calls and distributions), their effects should be included in the evaluation of the manager’s performance. An MWR, which includes the effect of timing and amount of external cash flows, would therefore appropriately penalize or benefit a portfolio manager for contribution and withdrawal decisions that were part of their discretionary management.

External Cash Flow Impact on Returns

Without external cash flows, TWR and MWR are equal. When external cash flows (and volatility) are present, the results will differ.

The following are examples of how the MWR and TWR will differ under different market scenarios:

1. If a contribution is made and then the portfolio has subsequent performance that:
   • SHIFTS POSITIVELY – MWR > TWR (investor added money just before the upswing)
   • SHIFTS NEGATIVELY – TWR > MWR (investor added money just before the decline)
   • REMAINS STEADY – TWR = MWR (investor added money during a period without volatility)
2. If a distribution is made and then the portfolio has subsequent performance that:
   • SHIFTS POSITIVELY – TWR > MWR (investor withdrew money just before the upswing)
   • SHIFTS NEGATIVELY – MWR > TWR (investor withdrew money just before the decline)
   • REMAINS STEADY – MWR = TWR (investor withdrew money during a period without volatility)

To help visualize how this works, below are three examples. For the sake of simplicity, we assume the portfolio perfectly replicates the index. The line on the graphs demonstrates the index return stream for the performance period while the filled in area represents the amount of capital invested during each segment of the period. Since TWR removes the effect of the external cash flows, the TWR will approximately equal the index return while the MWR will be impacted by the amount of capital invested for each segment of the performance period.

Example 1: A portfolio with a beginning value of $100k has a steady return of 10% without any volatility for the full period (scenarios with and without external cash flows):

The TWR and MWR is equal for all of these scenarios because there is no volatility. With a steady return stream, there is no market timing that would make external cash flows cause a difference between the TWR and MWR.

Example 2: A portfolio with a beginning value of $100k has a 10% increase, but subsequently declines to end the period at the same level at which it began.

The TWR is 0% for all scenarios because the strategy lost all of its initial gains to end up back at the starting point.

The MWR is negative when adding money at the high point because in this scenario the capital base is smaller while the strategy is performing positively and larger when the strategy is performing negatively.

The MWR is positive when removing money at the high point because in this scenario the capital base is larger while the strategy is performing positively and smaller when the strategy is performing negatively.

Example 3: A portfolio with a beginning value of $100k has a 10% decrease, but subsequently increases to end the period at the same level at which it began.

The TWR is 0% for all scenarios because the strategy gained back all of its initial losses to end up back at the starting point.

The MWR is positive when adding money at the low point because in this scenario the capital base is smaller while the strategy is performing negatively and larger when the strategy is performing positively.

The MWR is negative when removing money at the high point because in this scenario the capital base is larger while the strategy is performing negatively and smaller when the strategy is performing positively.

Criteria to Determine When MWR is Appropriate

Ultimately, investment managers should be evaluated based on TWR unless specific criteria are met, in which case MWR is more appropriate. The criteria[1] for using MWR includes:

The investment manager has control over the timing and amount of external cash flows and the investment vehicle has at least one of the following characteristics:

• Closed-end
• Fixed life
• Fixed commitment
• Illiquid investments as a significant part of the investment strategy

MWR vs TWR for GIPS

The use of money-weighted returns in GIPS Reports instead of time-weighted returns has broadened under the 2020 edition of the Global Investment Performance Standards (“GIPS”). All firms can show MWRs in addition to TWRs if they wish to do so; however, if a firm wishes to replace its TWR with MWR, the criteria listed in the prior section must be met. For more information on these requirements, please see Question 10 of Longs Peak’s GIPS Compliance FAQs.

For more information on how to present performance information in compliance with the GIPS standards, see our recent article on updating GIPS reports to comply with the 2020 edition of the GIPS standards.

If you have questions about calculating investment performance or GIPS compliance, please contact us or email Sean Gilligan at sean@longspeakadvisory.com.

[1] Global Investment Performance Standards (GIPS®) – For Firms, Fundamentals of GIPS Compliance, Provision 1.A.35, pages 5-6.

Our team has assisted hundreds of firms and asset owners with their GIPS compliance. Over the years, there are some questions that we see quite frequently. This article lists each of these GIPS FAQs and provides some clarification to help navigate the GIPS standards.

Question 1: What are the requirements for distributing GIPS Reports?

The GIPS standards require that all qualified prospective clients and prospective investors (as defined in your GIPS Policies and Procedures) receive relevant GIPS Composite Reports or GIPS Pooled Fund Reports (“GIPS Reports”) once they initially meet this definition. If the prospect still meets this definition 12 months after they initially received the GIPS Report, they are required to receive an updated version of that Report at that time.

Prospective clients include individuals and institutions that are considering opening a segregated account that will be managed in line with any composite strategies. Prospective investors include individuals and institutions that are interested in investing in pooled funds. Additionally, if composite strategies or pooled funds are offered through intermediaries, these intermediaries also must be treated as prospects and must receive the GIPS Reports each year. This includes third party advisors, wrap sponsors, and institutional databases that are used to present strategy information. Responses to Requests for Proposal (“RFPs”) must also include a GIPS Report for any strategies or pooled funds discussed in the RFP.

To clarify, regarding pooled funds, providing the GIPS Report is only required if the fund is a “Limited Distribution Pooled Fund”; “Broad Distribution Pooled Funds” (most mutual funds in the US) are exempt from this requirement. For more information on distinguishing between broad and limited distribution pooled funds, please see question 9 below or check out How to Update Your GIPS Reports for the 2020 GIPS Standards.

Please keep in mind that the requirement to distribute GIPS Reports is relevant to any composite or limited distribution pooled fund a prospect may be interested in, even if they are considered “non-marketed” strategies. In other words, you must always distribute a GIPS Report to a prospect for the strategies they are interested in, even if the composite is not marketed, and even if the prospect doesn’t ask about GIPS or request the report.

Also, the 2020 GIPS standards now require proof that this distribution requirement was met. To do so, distribution now needs to be tracked. There is no required format, but most often this is either done in a CRM system or in Excel. The format must be such that it can be provided upon request to verifiers and/or regulators who wish to see evidence of compliance with this requirement. These internal logs should document who received the GIPS Report, when they received the GIPS Report, which GIPS Report they received, and the form of delivery.

Question 2: To comply with the GIPS standards, are we required to market all composite results and how can performance be presented outside of GIPS Reports?

GIPS Reports are the only required marketing document that must be created and maintained for composites and limited distribution pooled funds to comply with the GIPS standards. Outside of the distribution requirements to prospects (see Question 1), you are not required to present the performance of any composite. Most firms just have a few composites they actively market while the other composites exist primarily to meet the requirement of having every discretionary, fee-paying portfolio in at least one composite. What you choose to present outside of your GIPS Reports is outside the scope of GIPS and can include anything meaningful to your organization and strategies as long as it does not violate any local regulatory requirements, does not conflict with the information presented in the GIPS Report, and is not considered false or misleading.

When advertising, mentioning GIPS is optional. If mentioning GIPS, then either a GIPS Report must be included or the GIPS Advertising Guidelines can be followed instead. The GIPS Advertising Guidelines offer an abbreviated way to mention GIPS compliance without including a full GIPS Report. A checklist of the required advertising disclosures can be downloaded here: 2020 GIPS Advertising Disclosure Checklist.

Since the advertising provisions are optional, mentioning GIPS or the claim of compliance is not required in any documents outside of the GIPS Reports if not desired. Anyone claiming compliance with GIPS may maintain their current procedures for internal client reporting and other marketing documents, as long as there is consistency with GIPS in their strategies and how they hold themselves out to the public.

Question 3: What is the scope of a GIPS verification and are we required to be verified?

GIPS verification provides assurance on whether GIPS policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. Compliance with all applicable requirements of the GIPS standards, even those beyond what is specified in the verification procedures, is required to claim compliance. Therefore, verification does not guarantee the accuracy of any specific performance presentation or set of statistics, but rather opines on the existence of a framework put in place to consistently apply the requirements of the GIPS standards.

During a verification, the selected verifier will use the GIPS policies and procedures to test various aspects of the established framework for GIPS compliance. Undergoing a verification is not a requirement to be able to claim compliance with GIPS, but it is a recommendation set forth by CFA Institute.

Question 4: When should composites utilize minimum asset levels and significant cash flow policies?

The GIPS Standards allow for the creation of composite-specific rules, such as minimum asset levels and significant cash flow policies. The purpose of both policies is to help ensure the composite results are a meaningful representation of the portfolio manager’s discretionary management.

Minimum asset levels ensure that small portfolios that may not be diversified the same as larger portfolios are excluded from composites; significant cash flow policies temporarily remove portfolios from composites for periods where the client is making contributions or withdrawals that are large enough to disrupt the management of the portfolio. Both policies require pre-determined thresholds to be documented in the GIPS policies and procedures document.

For example, if $100,000 is the minimum size needed to fully implement the composite’s strategy, a minimum asset level could be set at $100,000, which would then trigger the exclusion of all portfolios with assets less than $100,000. If a significant cash flow policy has a threshold of 20%, this means that any period where a portfolio experiences a contribution or withdrawal of 20% or more of the portfolio’s fair value, the portfolio is temporarily excluded from the composite for that performance period. Detailed rules must be documented to specify exactly how long the portfolio remains excluded and should be based on the typical amount of time needed to bring the portfolio back in line with the composite’s strategy.

Since these policies are composite-specific, each composite can have different thresholds. You may also elect to set up these policies for some, but not all composites. The most important factor in determining if these policies should be implemented for a composite is whether asset amounts are important to implementation of the strategy and if big external cash flows materially disrupt the investment process. If the strategy is very liquid then these policies may not be necessary. Also, if the composite is large in terms of number of portfolios, a little dispersion caused by small portfolios or portfolios experiencing significant cash flows may have only a very minor impact on the composite results. If the impact is small, the burden of administering the policy may not be worth the effort.

Another important consideration is whether adding these policies to a composite could create performance breaks in the future. If a composite is very small in terms of number of portfolios, these policies should not be utilized unless they are essential to create meaningful composite results. If utilizing these policies creates a scenario where all the composite’s portfolios are excluded for the same period, there will be a break in the performance track record that cannot be linked.

Question 5: When are we required to file the GIPS Compliance Notification form?

GIPS compliant firms and asset owners are required to notify CFA Institute of their claim of compliance once they initially become compliant and once a year thereafter (before June 30^th of each calendar year). We recommend setting reminders on your internal compliance calendar to make sure this requirement is not missed. Firms and asset owners are allowed to complete this form each year between January 1^st and June 30^th with information based on December 31^st of the prior year. Once the annual form is filed, save the email confirmation from CFA Institute. Firms and asset owners that are verified are required to provide this confirmation to their verifier to support that this requirement was met.

Question 6: How do we determine the discretionary status of a portfolio for GIPS purposes?

Not all portfolios with discretionary contracts are considered discretionary for GIPS purposes. Portfolios with material, client-mandated restrictions may be deemed non-discretionary if they are not a meaningful representation of the portfolio manager’s discretionary management. Documentation of the definition of discretion must be maintained in your GIPS policies and procedures to ensure clear criteria can be consistently applied when determining the discretionary status of each portfolio.

The most common criteria documented that trigger portfolios to be deemed non-discretionary for GIPS include:

• Investment restrictions that affect over X% of portfolio assets
• Portfolio manager must obtain client approval prior to trade execution
• Tax sensitivity that restricts trading or requires the harvesting of gains/losses
• Client directed use of margin
• Liquidity needs and/or recurring contributions or distributions
• Restrictions on credit ratings or duration

Please note that this is not an all-inclusive list, nor is it a list of required criteria. We recommend documenting examples that are meaningful to your organization and the types of strategies managed.

Utilizing percentage thresholds can help ensure the criteria is applied consistently. For example, if you manage clients with legacy positions (and these positions cannot be segregated from the strategy for performance purposes) you can set a percentage threshold to indicate when the size of the position is large enough to require exclusion from the composite. Specifically, this means that if the threshold is set at 10%, portfolios with restricted positions totaling less than 10% will be included in the composite while portfolios with restricted positions totaling 10% or more will be excluded from the composite. Using a threshold rather than excluding all portfolios with restrictions in any amount helps reduce the number of non-discretionary portfolios and allows as many portfolios to be included in composites as possible. Again, applying a clear threshold helps ensure there is consistency in the determination of discretionary status.

Question 7: Before we change our portfolio accounting system, what GIPS questions should we consider?

Because the cost of portfolio accounting systems can be significant, it is common to re-evaluate options and occasionally switch systems when feasible to do so. When considering a new system, it is critical that you confirm that the new system’s calculation methodology meets the minimum requirements set forth in the GIPS standards. If considering a newer system that is not well known, it is best practice to confirm that the system has current users that are GIPS compliant and that these users have had their GIPS compliance verified by a reputable GIPS verification firm. Confirming this can provide added comfort that the calculation methodology has been tested.

Once you know that the system meets the requirements of the GIPS standards as well as other general accounting and reporting needs, it is important to plan the logistics of the conversion. Part of this includes ensuring that the historical performance track record is maintained and can be adequately supported to meet the books and records requirements of the GIPS standards.

Standards related to books and records require the ability to support everything reported in your GIPS Reports. Portfolio-level holdings, transactions, prices, etc. should be maintained to be able to reproduce or prove out any statistics requested by a verifier or regulator. If historical results are hardcoded in the new system without portfolio-level details, it is important to ensure that transactions, holdings, prices, etc. are still retrievable in the prior system or from the custodian.

If historical transaction details will be added to the new system, it is important to consider if the historical portfolio and composite results will be hardcoded from the old system or recalculated in the new system. This is because the new system may have a different calculation methodology than the old system (e.g., daily valuation instead of only revaluing for large cash flows) and the historical results may change when recalculated in the new system. The GIPS standards do not allow for a retroactive change to calculation methodology so this new method should only be applied prospectively.

Additionally, we strongly recommend having an overlapping period where both systems run concurrently. Especially when historical periods are recalculated in the new system, it often takes time to get this historical data reconciled to match the old system.

The final consideration includes updating GIPS policies and procedures documents to reflect changes. Documentation of the portfolio accounting change should be made with details describing any changes to methodology. The date of the conversion must be clearly documented with a clear description of what the methodology was before that date and what it will be going forward.

Question 8: What is required when a making a benchmark change?

The GIPS Standards allow changes to the benchmarks used in the GIPS Reports if a different benchmark is considered a more meaningful comparison to the strategy. When a benchmark change is made, benchmark(s) can either be changed prospectively or retroactively.

Prospective benchmark changes are typically made when the composite or pooled fund strategy has shifted and a different benchmark will be a more meaningful comparison for the strategy going forward, while the old benchmark is still the best benchmark for the older periods. Retroactive benchmark changes are typically made when a new benchmark is determined to be a more meaningful comparison for the entire history of the strategy.

Both prospective and retroactive benchmark changes require disclosure in the GIPS Report that had the change. Prospective changes must be disclosed for as long as the original benchmark remains part of the presented information, while the disclosure of a retroactive change may be removed after a one-year period. For example disclosure language see: 2020 GIPS Report Disclosure Checklist.

Question 9: How do we determine if our pooled funds are considered limited or broad distribution and what is different about applying the GIPS standards in each case?

New to the 2020 edition of the GIPS Standards is requirements specifically addressing the presentation of performance to prospective investors in pooled funds. Pooled funds now must be classified as either broad or limited distribution. The best approach to determine this classification is to look at the way these funds are discussed with prospective investors.

If the sales communications are done exclusively in a private, one-on-one setting, the fund is likely a limited distribution pooled fund (e.g., a pooled vehicle set up as a limited partnership). If the fund is offered to prospective investors publicly (e.g., a mutual fund), the fund is likely a broad distribution pooled fund. The determination on whether your pooled fund is a broad or limited distribution fund must be done at the total fund, not share class, level.

Anyone claiming GIPS compliance is required to maintain a list of both types of funds and must include descriptions for the limited distribution funds (descriptions are not required for broad distribution pooled funds). GIPS Reports must be provided to all prospective investors of limited distribution pooled funds, but this is not required for prospective investors in broad distribution pooled funds.

The GIPS Report can be specific to the limited distribution pooled fund itself or it can be for the composite in which the pooled fund is included. Whether providing a GIPS Pooled Fund Report or a GIPS Composite Report, the detailed fees of the fund including the fund’s total expense ratio must be included. For more information on this requirement check out How to Update Your GIPS Reports for the 2020 GIPS Standards.

Regardless of the type of pooled fund, if it meets the definition of an existing composite (i.e., a composite created for segregated accounts), the fund must be included in the composite. If no composite exists matching the strategy of the fund, there is no longer a requirement to include the fund in a composite (i.e., beginning in 2020 creating composites for pooled funds is no longer required if the strategy is only offered to prospective pooled fund investors).

Question 10: When do the GIPS standards allow the calculation of money-weighted returns instead of time-weighted returns?

The use of money-weighted returns (“MWR”) in GIPS Reports instead of time-weighted returns (“TWR”) has broadened under the 2020 edition of the GIPS standards. MWRs may be shown in addition to TWRs if desired; however, if replacing TWR with MWR, certain criteria must be met. Specifically, the manager must control the timing and amount of the external cash flows for the strategy and must also meet at least one of the following criteria:

• The investment vehicle must be closed-end
• The investment vehicle must have a fixed-life
• The investment vehicle must have fixed commitments, or
• A significant portion of the assets in the strategy must be illiquid investments

If a strategy meets these requirements, then the option to present only MWR in the GIPS Report is available, but not required (TWR can still be used if preferred). When switching the returns from TWR to MWR (or vice versa) in the GIPS Report, the change must be disclosed. Switching methodologies should be avoided unless absolutely necessary as one method should be selected as the most meaningful representation of the strategy’s performance. Examples of disclosure language are available here: 2020 GIPS Report Disclosure Checklist.

Questions?

If you have questions contact us or email Matt Deatherage at matt@longspeakadvisory.com.